U.S. Treasury on Tax Reform

A new study from the U.S. Treasury examines how tax reform could promote capital accumulation and economic growth. An excerpt:

The President’s Advisory Panel on Federal Tax Reform (the Tax Panel) released its report on reform of the federal income tax on November 1, 2005. The Tax Panel unanimously recommended two reform options: the Simplified Income Tax (SIT) and the Growth and Investment Tax (GIT). Both reform options are a hybrid of an income and consumption based tax. The Tax Panel also extensively examined a Progressive Consumption Tax (PCT). The Treasury Department’s Office of Tax Analysis (OTA) provided estimates to the Tax Panel on the likely growth effects for each of these plans....

All of these models predict that fundamental tax reform could lead to substantial increases in the national capital stock and national income. For example, the models suggest that the GIT recommended by the Tax Panel could lead to long-run increases in the capital stock ranging from 5.6 to 20.4 percent and long-run increases of national income ranging from 1.4 to 4.8 percent. The simulated growth effects of the SIT plan were considerably smaller, with long-run increases in the capital stock ranging from 0.9 to 2.3 percent and national income increases ranging from 0.2 to 0.9 percent. The growth effects of the PCT were the largest of the three plans, with long-run increases in the capital stock ranging from 8.0 to 27.9 percent, and long-run increases in national income ranging from 1.9 to 6.0 percent.

Poverty and Single Mothers

The June NBER Digest is out, covering these topics:

• Megan’s Law Hits Local Property Prices
• Canada’s Universal Childcare Hurt Children and Families
• The Safety and Efficacy of the FDA
• Why Poverty Persists

Here is an excerpt from the last piece:

The period after 1980 saw large changes in family structure -- notably a doubling of the percent of families headed by a single woman. Because poverty rates among female-headed families are typically 3 or 4 times the level in the overall population, such changes in the distribution of family types can have potentially large effects on poverty. The authors find that these changes in family structure can account for a 3.7 percentage point increase in poverty rates, more than the entire rise in the poverty rate, from 10.7 percent to 12.8 percent since 1980.

Zimbabwe Update

Let's catch up on the hyperinflation in Zimbabwe. Today, the BBC reports:

Zimbabwe is introducing a bank note worth 100,000 Zimbabwe dollars, to help consumers as inflation exceeds 1,000%.

The note will be worth about $1 at the official exchange rate, but only $0.30 on the informal market. The 50,000 Zimbabwe dollar bill, introduced only four months ago, is not enough to buy a loaf of bread.

I like the phrase "to help consumers."

Samwick on Internships

Economist Andrew Samwick, Dartmouth professor and a former colleague of mine at the CEA, writes on his blog:

One of my regrets after my year at CEA was that I did not go work there as an intern or research assistant 15 years earlier while I was in college. It would have made me a better economist.

I agree with the implicit advice that Andrew is offering. I recommend that every student planning a career as a professional economist try to spend a summer, or even a year, working at a place like the CEA, CBO, or the Fed.

Hassett on John Snow

Economist Kevin Hassett grades the outgoing Treasury Secretary:

When history hands down its marks for Bush administration officials, Snow will be one of the few to have deserved an A.

A Must Read

From today's Wall Street Journal:

Mr. Paulson's Challenge
By N. Gregory Mankiw

When Hank Paulson replaces John Snow as Treasury secretary, he will be taking stewardship of an economy that is enjoying low unemployment and brisk growth. But while Mr. Snow helped steer the economy through a recessionary storm, he leaves for Mr. Paulson a more daunting task -- getting the long-term fiscal numbers to add up.

To understand the challenge that Mr. Paulson faces, let's start with a fact about which every serious policy analyst agrees: The government budget is on an unsustainable path. Americans are living longer and having fewer children. Together with advances in medical technology that are driving up health-care costs, this demographic shift means that a budget crunch is coming when the baby-boom generation retires. The promises made to my generation for Social Security, Medicare and Medicaid are just not affordable, given the projected path of tax revenue.

Policy analysts diverge, however, on what to do about it. Those on the political left want to raise taxes to fund all those promises. Some want to go even further by expanding entitlements, such as providing taxpayer-financed national health insurance for all Americans. That is a feasible choice, as many European nations demonstrate, but it is not advisable. As we economics professors never tire of explaining, market economies allocate resources efficiently (with a few exceptions, which I will return to in a moment). Taxes distort incentives and debase market outcomes. In technical terms, they cause "deadweight losses." In less formal terms, taxes shrink the size of the economic pie, leaving most people with a smaller serving of prosperity.

Some supply-siders like to claim that the distortionary effect of taxes is so large that increasing tax rates reduces tax revenue. Like most economists, I don't find that conclusion credible for most tax hikes, and I doubt Mr. Paulson does either. Yet the supply-siders are right about one thing: Because higher tax rates reduce the size of the tax base, raising taxes generates less revenue than the "static" revenue estimates assumed in Washington would suggest.

One of Mr. Paulson's first briefings from the Treasury staff should be about what high taxes have done to the economies of Europe. According to research by Nobel laureate Edward Prescott and by economists Steven Davis and Magnus Henrekson, the high tax rates in Europe have reduced work effort and distorted the industrial mix. The Davis-Henrekson study reports that a tax increase of 12.8 percentage points (a change of one standard deviation) reduces work for an average adult by 122 hours per year. It also reduces the employment-population ratio by 4.9 percentage points and increases underground economy by 3.8% of GDP. As Mr. Paulson works to resolve the fiscal imbalance, he should keep the European experience firmly in mind.

President Bush confirmed his commitment to low taxes when he announced Mr. Paulson's nomination: "One of Hank's most important responsibilities," he said, "will be to build on this success by working with Congress to maintain a pro-growth, low-tax environment." Avoiding tax hikes, however, does not mean avoiding hard choices. The only alternative to large tax hikes is large spending cuts. Politically, this option may be even harder, but it should be the focus of public debate and Mr. Paulson's attention.

Many economists, including myself, would recommend that the nation consider a gradual but substantial increase in the age at which people become eligible for taxpayer-financed benefits for the elderly, including both Social Security and Medicare. We face three options: raising taxes on those who are still working; reducing benefits for the very old; or reducing benefits for the relatively young old. I would rule out the first option on grounds of economic efficiency, the second on the grounds of social compassion, leaving the third as the best of a bad lot. If we raise the age of eligibility for retirement benefits, people could still retire early, but they would do so on their own nickel, rather than the taxpayer's.

The fiscal problem we now face arises largely because the age of eligibility bears little relation to demographic reality. When Franklin Roosevelt established Social Security, he set a fixed age of retirement; when Lyndon Johnson established Medicare, he followed suit. Imagine if, instead, Roosevelt and Johnson had set up an entitlement system in which the youngest 90% of the population agreed to support the oldest 10% -- and those percentages were fixed over time. Such a system would have been better able to withstand the changes in demography that have occurred over time.

There is still time to correct their mistake, taking an approach adopted in a small way in Ronald Reagan's 1983 Social Security reform. Congress could pass a law increasing the age of eligibility by, say, two months every year. That increase would continue until the Trustees for Social Security and Medicare (a group that includes the Treasury secretary) declared the programs in long-term fiscal balance. Those already retired or near retirement would not be affected, but those of us now middle-aged would have to work longer or save to finance our own early retirement. The beneficiaries of such a reform would be our children, who would not have to inherit European-style tax rates.

Although the fiscal gap could be completely closed with reduced spending, a realistic political compromise will likely include higher revenues as well. Even here, however, rather than consider a reversal of the Bush tax cuts, the new Treasury secretary should look for more efficient revenue sources.

Economists have long noted that while most taxes distort incentives and shrink the size of the economic pie, others improve incentives and enlarge it. A higher tax on gasoline, for example, is better than CAFE standards as a policy to improve the fuel efficiency of the American car fleet. It would also encourage people to drive less by, for instance, living closer to where they work. A tax on carbon is the best way to deal with global warming. These are called Pigovian taxes, after the British economist Arthur Pigou, an early advocate of using taxes to correct market imperfections.

Similarly, economists have increasingly viewed "sin taxes" as a good way to raise revenue. While Pigovian taxes aim to protect innocent bystanders from the actions of others, sin taxes aim to protect people from themselves. To the extent that people have problems with self-control, sin taxes can be welfare-enhancing. Economists Jonathan Gruber and Sendhil Mullainathan report evidence that smokers are happier when cigarette taxes are higher. Of course, non-smokers won't object to shifting the tax burden to others. Maybe we should consider higher taxes on smoking, drinking, gambling and other activities about which people lack self-control.

Finally, even if the income tax is to be used to increase revenue, we should broaden the base rather than raise rates. Last November, the President's Advisory Panel on Federal Tax Reform offered several good suggestions when it handed its report to John Snow. Mr. Paulson should continue talking about tax reform and insist that these ideas get more attention from Congress than they have gotten so far. For example, the panel proposed eliminating the deductibility of state and local taxes. This makes sense. Under current law, if one town enacts high local taxes to finance a municipal pool while a neighboring town does not, the first town gets a federal subsidy at the expense of the second. That outcome is neither efficient nor equitable.

The President's Advisory Panel also proposed scaling back the mortgage-interest deduction. The federal tax system now tilts the playing field toward residential capital at the expense of corporate capital, which in turn reduces productivity and real wages. Even if one believes that policy should promote homeownership over renting (a debatable claim), there is no reason to encourage people to buy ever larger homes. Let's lower the cap on subsidized mortgages well below its present $1 million level.

There are many options for dealing with the long-term fiscal imbalance while keeping tax rates low. The main reason the problem is not yet resolved is that the American people have not put enough pressure on their elected representatives to take the issue seriously. The sooner they do, the better. If Hank Paulson wants to leave the nation's finances in better shape than he found them, his main job will be to focus attention on the problem.

Feldstein on Taxation

From the most recent working paper by my Harvard colleague Martin Feldstein:

An across the board increase in personal tax rates involves a deadweight loss of 76 cents per dollar of revenue and only collects about two-thirds of the revenue implied by a “static” calculation.

Krugman as Economist and Pundit

Here is a good story about the varied career of Paul Krugman.

New Treasury Secretary

President Bush just announced that Goldman Sachs CEO Hank Paulson will replace John Snow as the Secretary of Treasury.

Remember all that squawking in the media and blogosphere about how no serious person would want the job? In case you forgot, here is Daniel Gross writing in Slate:

John Snow will have a replacement, and he may very well come from the corporate world. But if it's an A-list Wall Street CEO, I'll buy a copy of Dow 36,000 and eat the first chapter.

Next time you hear similar squawking from these astute pundits, be sure to give it the attention it deserves.

Mr Gross: Bon appetit!

Dilbert on Outsourcing

Sometimes the most incisive economic analysis is found in the comics.

The IS-LM Model

A reader emails me the following question:

Dear professor Mankiw:

I like your blog a lot. I daily go to it in order to read good economics. Keep up the excellent work!

May I ask you why economists authors of textbooks on intermediate macroeconomics like you keep using the IS-LM model even though we already know that the Central Bank does not set the monetary supply. Instead, it does set the interest rate. Shouldn´t you do like Wendy Carlin and David Soskice in their recent and fantastic book "Macroeconomics: Imperfections, Institutions and Policies" where they replace the LM curve by a monetary rule (for example, a Taylor rule). Wouldn´t that be more representative of what occurs in reality rather than supposing that the institution gets the control of the quantity of money?

Thanks for your attention in advance.

Best,
[name withheld]

To answer this question, let me start with an excerpt from Chapter 11 of my intermediate macro text. This passage shows how I handle these issues when teaching this course:

What Is the Fed's Policy Instrument--The Money Supply or the Interest Rate?

Our analysis of monetary policy has been based on the assumption that the Fed influences the economy by controlling the money supply. By contrast, when the media report on changes in Fed policy, they often just say that the Fed has raised or lowered interest rates. Which is right? Even though these two views may seem different, both are correct, and it is important to understand why.

In recent years, the Fed has used the federal funds rate--the interest rate that banks charge one another for overnight loans--as its short-term policy instrument. When the Federal Open Market Committee meets every six weeks to set monetary policy, it votes on a target for this interest rate that will apply until the next meeting. After the meeting is over, the Fed's bond traders in New York are told to conduct the open-market operations necessary to hit that target. These open-market operations change the money supply and shift the LM curve so that the equilibrium interest rate (determined by the intersection of the IS and LM curves) equals the target interest rate that the Federal Open Market Committee has chosen.

As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates. Keep in mind, however, that behind these changes in interest rates are the necessary changes in the money supply. A newspaper might report, for instance, that "the Fed has lowered interest rates." To be more precise, we can translate this statement as meaning "the Federal Open Market Committee has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift the LM curve, and reduce the equilibrium interest rate to hit a new lower target."

Why has the Fed chosen to use an interest rate, rather than the money supply, as its short-term policy instrument? One possible answer is that shocks to the LM curve are more prevalent than shocks to the IS curve. When the Fed targets interest rates, it automatically offsets LM shocks by adjusting the money supply, although this policy exacerbates IS shocks. If LM shocks are the more prevalent type, then a policy of targeting the interest rate leads to greater economic stability than a policy of targeting the money supply. (Problem 7 at the end of this chapter asks you to analyze this issue more fully.)

Another possible reason for using the interest rate as the short-term policy instrument is that interest rates are easier to measure than the money supply. As we saw in Chapter 4, the Fed has several different measures of money--M1, M2, and so on--which sometimes move in different directions. Rather than deciding which measure is best, the Fed avoids the question by using the federal funds rate as its policy instrument.

----[end of excerpt]

My email correspondent wonders whether it would be better just to jettison the traditional IS-LM model in favor of an alternative framework that ignores the money supply altogether and simply takes an interest-rate rule as given. This approach has been advocated by my old friend David Romer. (Economics trivia fact: I was the best man at David Romer's wedding, and he at mine.) You can find David's approach here (figures here). David calls his alternative presentation the IS-MP model, because it combines an IS curve with a monetary policy reaction function.

The first thing to understand about the choice between IS-LM and IS-MP is that it is not about determining which is the better model of short-run fluctuations. There is no truly substantive debate here. These two models are alternative presentations of the same set of ideas. The key issue in deciding which approach to prefer is not theoretical or empirical but pedagogical.

The IS-LM approach has a long history behind it. That is one reason to stick with it, but it is not dispositive. If I were convinced that the IS-MP model was a clear and substantial step forward, I would switch. So far, however, I am not convinced that the new approach is easier to teach or more intuitive for students.

The key difference between the two approaches is what you hold constant when considering various hypothetical policy experiments. The IS-LM model takes the money supply as the exogenous variable, while the IS-MP model takes the monetary policy reaction function as exogenous. In practice, both the money supply and the monetary policy reaction function can and do change in response to events. Exogeneity here is meant to be more of a thought experiment than it is a claim about the world. The two approaches focus the student's attention on different sets of thought experiments.

I like the IS-LM model because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background. The IS-MP model also has some quirky features: In this model, for instance, an increase in government purchases causes a permanent increase in the inflation rate. No one really believes that result as an empirical prediction, for the simple reason that the monetary policy reaction function would change if the natural interest rate (that is, the real interest rate consistent with full employment) changed. This observation highlights that neither model's exogeneity assumption should be taken too seriously.

In the end, I remain open-minded, but at this point I prefer the IS-LM model when teaching (at the intermediate level) about the short-run effects of monetary and fiscal policy. If one were to teach IS-MP to undergrads, I would prefer to do it as an supplement, rather than a substitute, for IS-LM.

Related link: Here (and here in published form) is Paul Krugman's cogent defense of teaching the IS-LM model. The article was written quite a while ago, before IS-MP hit the scene, so I don't know what he would say about this alternative framework. But the Krugman piece is interesting, if only vaguely on point, so I wanted to give it some free advertising.

Job-Market News for PhD Students

Over at Slate, Joel Waldfogel summarizes a new NBER working paper by Paul Oyer. An excerpt:

Imagine two newly minted Ph.D.s who have produced equally important dissertations. Both are on the edge between a good job and a bad one. One finishes her degree in a year when there is strong demand for new faculty. As a result, she gets a good job at a Top 50 university. The other finishes in an off year, when a recession keeps most public universities from hiring. Although equally promising as a scholar and teacher, she starts her career at a more obscure school. Five or 10 years hence, what do the careers of these two young professors look like?...

If the quality of initial placements persistently affects career success, then the academics who start in boom years should remain in better positions five or 10 years out—even though the bust-year graduates were equally talented and qualified when they left the starting gate. And sure enough, five years into their respective careers, members of the boom cohorts are more likely to hold good jobs at Top 50 institutions than similar candidates entering the job market in bust years. In general, about a quarter of elite Ph.D.s end up at first-tier institutions. Starting one's career in a boom year raises the probability of ending up at a Top 50 department by between 40 and 60 percent.

The evidence here is related to a previous post about the long-run effects of short-run business cycles.

Thought for Today

The AP's Thought for Today, reported in the NY Times, comes from an economist:

''Only the man who finds everything wrong and expects it to get worse is thought to have a clear brain.''

John Kenneth Galbraith

It reminded me of another quotation from a famous economist, which I read in the NY Times back on January 6, 2004:

"If this kind of fecklessness goes on, investors will eventually conclude that America has turned into a third world country, and start to treat it like one. And the results for the U.S. economy won't be pretty."

Paul Krugman

What is the Government Debt?

A student emails me a question about government debt:

Professor Mankiw,

I am a student majoring in Economics at Drexel University and I really enjoy reading your blog. I think you are doing a great job with the blog as you did at the CEA and as a Harvard Professor! It is a great honor to write to you.

My question is, can you please explain in detail (or point to a good source) whether Intergovernmental Holdings, one of the two parts of the National Debt (the other being Public Debt), has an effect on the economy? Because I cannot entirely understand from my readings why it states the Intergovernmental Holdings as being only an Accounting function, yet Social Security and other such programs are a large part of the future government debt?

Thank you very much!
[name withheld]

The distinction you raise is important. If you look at, say, the back of the Economic Report of the President, you will learn that the "gross debt" is about $9 trillion and the "debt held by the public" is about $5 trillion. Most economists view the second number as more meaningful. The gross debt includes debt that the government owes to itself, such as the debt in the Social Security Trust Fund.

Here is one way to think about it. Imagine you wrote yourself an IOU and put it in your pocket. You could then say your debts have gone up (you now have to pay off that IOU), but so have your assets (that IOU is an asset to its holder--you). Writing yourself the IOU has not really changed anything. Similarly, if the govenment decided to deposit more bonds in the Social Security Trust Fund, its gross debt would go up, but its overall financial position would be neither better nor worse.

If you want to read more on the topic, let me point you toward economist Robert Eisner. Eisner makes a good case that both measures of government indebtedness are far from perfect as indicators of the government's financial condition.

Dollarization

A student from Colgate University emails me a question:

I recently went to El Salvador, and I noticed that the currency is the U.S. Dollar. So, I was wondering if the U.S. Federal Reserve policies affect inflation in El Salvador? And, also how does the Central Bank of El Salvador control the money supply? Do they have a covenant with the Fed?

Your question is answered in this excerpt from my intermediate macro textbook:

Speculative Attacks, Currency Boards, and Dollarization

Imagine that you are a central banker of a small country. You and your fellow policymakers decide to fix your currency--let's call it the peso--against the U.S. dollar. From now on, one peso will sell for one dollar.

As we discussed earlier, you now have to stand ready to buy and sell pesos for a dollar each. The money supply will adjust automatically to make the equilibrium exchange rate equal your target. There is, however, one potential problem with this plan: you might run out of dollars. If people come to the central bank to sell large quantities of pesos, the central bank's dollar reserves might dwindle to zero. In this case, the central bank has no choice but to abandon the fixed exchange rate and let the peso depreciate.

This fact raises the possibility of a speculative attack--a change in investors' perceptions that makes the fixed exchange rate untenable. Suppose that, for no good reason, a rumor spreads that the central bank is going to abandon the exchange-rate peg. People would respond by rushing to the central bank to convert pesos into dollars before the pesos lose value. This rush would drain the central bank's reserves and could force the central bank to abandon the peg. In this case, the rumor would prove self-fulfilling.

To avoid this possibility, some economists argue that a fixed exchange rate should be supported by a currency board, such as that used by Argentina in the 1990s. A currency board is an arrangement by which the central bank holds enough foreign currency to back each unit of the domestic currency. In our example, the central bank would hold one U.S. dollar (or one dollar invested in a U.S. government bond) for every peso. No matter how many pesos turned up at the central bank to be exchanged, the central bank would never run out of dollars.

Once a central bank has adopted a currency board, it might consider the natural next step: it can abandon the peso altogether and let its country use the U.S. dollar. Such a plan is called dollarization. It happens on its own in high-inflation economies, where foreign currencies offer a more reliable store of value than the domestic currency. But it can also occur as a matter of public policy, as in Panama. If a country really wants its currency to be irrevocably fixed to the dollar, the most reliable method is to make its currency the dollar. The only loss from dollarization is the seigniorage revenue that a government gives up by relinquishing its control over the printing press. The U.S. government then gets the revenue that is generated by growth in the money supply.

---

The CIA reports that El Salvador dollarized in 2001. Now, when the Fed set monetary policy for the U.S. economy, it also set monetary policy for the economy of El Salvador.

If you want to read more on the topic, here in an article I wrote about dollarization for Fortune magazine, here is an article from the Federal Reserve Bank of Atlanta, and here is an article from the IMF.

The best summary of the issues is found in this limerick from Bob McTeer, former President of the Dallas Fed:

There once was a hyperactive central banker
Whose boat needed a stronger anchor.
The ocean was big,
The boat was small,
So he tied his anchor to a tanker.

Am I eating a free lunch?

For the past several months, I have been using the Blogger service to create this blog. Blogger is a subsidiary of Google, which offers the service for free to the public. Google makes money from its search engine by selling ads, but my blog does not have ads unless I authorize them. I keep waiting for Blogger to offer to sell me some add-on services, but that hasn't happened yet.

What's in it for Google and its shareholders to give me all this free service? I am puzzled. I hope one of the commentators can enlighten me.

I'm with Joe

Economist Joe Stiglitz has a new op-ed discussing the IMF, global financial imbalances, exchange rates, and U.S. agricultural policy. An excerpt:

US farm subsidies translate into lower global agricultural prices, and thus lower prices for Chinese farmers. By extending its largesse to rich corporate farms, the US may not have intended to harm the world’s poor, but that is the predictable result.

This poses a dilemma for Chinese policymakers. Subsidizing their own farmers would divert money from education, health, and urgently needed development projects. Or China can try to maintain an exchange rate that is slightly lower than it would be otherwise. If the IMF is to be evenhanded, should it criticize America’s farm policies or China’s exchange-rate policies?

Although I disagree with Joe on a wide range of issues, I agree with him about this one. From the standpoint of either world or U.S. social welfare, U.S. agricultural policy is a bigger problem than Chinese exchange-rate policy.

Carolyn Shaw Bell

The economics profession lost one of its great mentors. From today's NY Times:

Carolyn Shaw Bell, an economist at Wellesley College who took her fight for equal opportunities for women in economics from the college into the national arena, died May 13 at her home in Arlington, Va. She was 85...

Dr. Bell started her work at Wellesley in 1950. By 1995, an article in The New York Times pointed to the "Wellesley effect," a disproportionately large number of graduates of Wellesley, a women's college, in executive suites and corporate boardrooms. It said the college's alumnae had long been overrepresented at Harvard Business School and said part of the reason was the dynamic teaching of Dr. Bell.

Dr. Bell carried her equality campaign to the American Economic Association, where she was a founder of the group's Committee on the Status of Women in the Economics Profession. In 1998, the committee established the Carolyn Shaw Bell Award for the person who has most advanced women in the profession.

To read more about Bell, see the Winter 2005 and Fall 1993 editions of the CSWEP newsletter.

The Mechanics of a Fixed Exchange Rate

A student emails me a question about China's exchange-market intervention:

Could you outline step-by-step how, say, $3000 spent by me on a Lenovo computer (Chinese) eventually becomes $3000 worth of debt (US Treasury bonds) owed by the United States to the Chinese government?

To keep things simple, let's suppose that China is fixing its exchange rate. (That was exactly true until recently, and is still approximately true, although China now allows some flexibility.) Here is how the situation unfolds:

1. You (an American) buy a Chinese export. To do that, you (or your retailer) has to pay the Chinese company in yuan, the Chinese currency. To get these yuan, you turn to the foreign-exchange market, supplying dollars and demanding yuan.

2. Your transaction puts upward pressure on the value of the yuan relative to the dollar.

3. The Chinese central bank, seeing the pressure on the exchange rate, intervenes in the foreign-exchange market. To keep the yuan from appreciating relative to the dollar, it supplies yuan and demands dollars.

4, The Chinese central bank has now acquired some U.S. dollars. Rather than holding these newly acquired assets in non-interest-bearing cash, it prefers interest-bearing securities. So it uses these dollars to buy U.S. Treasury bills.

In the end, your decision to buy a Chinese export has induced China to hold more U.S. government debt.

Step 3 is precisely what China critics object to. Click here and here for a discussion of the controversy.

The Message from M2

The quantity theory of money is alive and well at Econbrowser. Jim Hamilton's bottom line:

the Fed was a little too aggressively expansionary a few years ago. That may have been responsible for a slight increase we're seeing now in current inflation. However, the more restrictive measures adopted by the Fed over the last three years should help keep future inflation at acceptable levels.

Videos for Econ Students

Truck and Barter has put together a nice compendium of videos available on the internet that are useful for teachers and students of basic economics.

Update: To see the videos that accompany my principles text, click here and then scroll down until you see the button for the video clips.

I recommend index funds

Some investment advice from the Spring 2006 issue of the Charles Schwab magazine On Investing:

If you can anticipate positive earnings surprises for your stocks, it will help you outperform the market.

The statement is both vacuous and dangerous at the same time--an amazing feat. Although it says little more than "buy stocks that about to go up," it encourages people to try to outguess the market and churn their portfolios, generating fees for Charles Schwab. Schwab owes its customers better advice than this.

Helen Thomas on Etiquette

Now I understand why journalist Helen Thomas did not write the Miss Manners column. Here is part of her interview in today's NY Times:

How would you define the difference between a probing question and a rude one?

I don't think there are any rude questions. I don't even like reporters to say thank you.

But you're the one who officially said, "Thank you, Mr. President," at the close of every press conference until 2003, when the practice was abruptly discontinued.

"Thank you" is fine at the end of a press conference. But I don't think you thank the president every time he answers a question. That's his job.

In which case, I won't thank you for granting this interview, lest you judge me too deferential.

Oh, no. Listen. I love it when people thank me.

The Self-Interest of Economists

An anonymous commentator on a previous post asks a good question about economists' motives:

About self-interest, I have always been wondering about this question: if economists are right that we should generally assume self-interest for rational actors, why should we believe in anything that economists say? Obviously, they say those things out of self-interest rather than respect for truth.

So what motivates me? Self-interest or respect for the truth?

The answer, I believe, is both.

Suppose I filled my blog and books with nakedly self-interested statements: "The world would be a happier and more prosperous place if everyone sent Greg Mankiw $20." First of all, no one would believe me. Second, people would stop reading my blog and buying my books. Making self-interested statements like this is not in my self-interest.

What is in my self-interest? Providing arguments and evidence about the truth. People read this blog and buy my books because they find the discussion of economic issues cogent or at least thought-provoking. My self-interest and relentless pursuit of the truth are not conflicting goals; they are two sides of the same coin.

Or maybe it's just in my interest to have you believe that.

The Benefits of Later Retirement

In a previous post, I proposed raising the age of eligibility for government-provided retiree benefits. A recent NBER Working Paper suggests that raising the retirement age may have benefits beyond those for the government's finances. Here is the abstract:

While numerous studies have examined how health affects retirement behavior, few have analyzed the impact of retirement on subsequent health outcomes. This study estimates the effects of retirement on health status as measured by indicators of physical and functional limitations, illness conditions, and depression. The empirics are based on six longitudinal waves of the Health and Retirement Study, spanning 1992 through 2003. To account for biases due to unobserved selection and endogeneity, panel data methodologies are used. These are augmented by counterfactual and specification checks to gauge the robustness and plausibility of the estimates. Results indicate that complete retirement leads to a 23-29 percent increase in difficulties associated with mobility and daily activities, an eight percent increase in illness conditions, and an 11 percent decline in mental health. With an aging population choosing to retire at earlier ages, both Social Security and Medicare face considerable shortfalls. Eliminating the embedded incentives in Social Security and many private pension plans, which discourage work beyond some point, and enacting policies that prolong the retirement age may be desirable, ceteris paribus. Retiring at a later age may lessen or postpone poor health outcomes for older adults, raise well-being, and reduce the utilization of health care services, particularly acute care.

My Ten Principles of Time Management

An econ grad student writes to ask about time management:

One of the most interesting topics discussed in Benjamin Franklin's Autobiography was his schedule. It was helpful to see how he organized his day, which I imagine a proper allocation of time was necessary for his diverse and fecund life. In an earlier post, you answered why economists, including you, take the time to educate the public. My question is a combination of both: how do you spend your time?....I am curious how you schedule your time and, like Benjamin Franklin, if you have a fixed schedule or if what you do is guided by what you feel like doing.

Time management is a topic I have occassionally struggled with, as I like being involved with a diverse range of activities, and figuring out the right balance is not always easy. Here are ten things I have learned about myself. (Note: I don't pretend these observations apply to others; they are functions of my own tastes, quirks, and personality.)

1. When I am involved in a big writing project, such as one of my textbooks, I try to keep to a very regular schedule. I aim to start every day, seven days a week, writing about 600 words. It is the first thing I do (after getting my kids off to school). After that, I feel I have "earned" my freedom for the rest of the day. If you do this for a few years, you have a good-sized book on your hands.

2. I like to attend seminars and take classes. It feels like goofing off at the time, but it often ends up productive. Interesting ideas pop up in unexpected places. During the academic year, the seminar and class schedule is the skeleton of my day.

3. Travel is usually an inefficient use of time. I hate sitting on planes and waiting in airports. As a result, I turn down over 90 percent of invitations I get to attend conferences, give talks, etc. Being in Cambridge, at Harvard and near the NBER, makes this choice a luxury that is feasible at low cost. It is harder to replicate in other places. There are so many seminars and conferences here that I don't feel the need to travel.

4. I don't allocate any of my time to consulting. I did some consulting once, very briefly for Microsoft during the antitrust case. I was interested in the policy issues, and Microsoft approached me after I had written a column critical of the government's case. But I learned that consulting was not to my taste. I prefer the freedom of more academic work.

5. I avoid university committees. They are vast wastes of time. I won't bother saying anything more about them, because that would be a waste of time, too. (If some Harvard dean is reading this, thinking "Yes, we need a new committee to investigate how to make university committees more efficient," please don't ask me to be on it.)

6. I have never accepted offers to edit academic journals. Bob Solow made the same decision during his career. He once explained that decision to me as follows: "For every ten papers you handle, you create nine enemies and one ingrate."

7. Time allocated to talking with students is always well spent. Whenever my ec 10 students invite me to dinner, I accept the invitation if I possibly can. If I keep doing this, I am confident that Saint Peter will smile down upon me when my time comes.

8. I usually spend my research time working on whatever moves me. One of the great features of an academic career is the freedom to think and write about those topics that most interest you. As a young academic, one has to consider, to some degree, what will impress colleagues on promotion and hiring committees. (But even youngsters shouldn't overdo it: I recommend that students focus more on their own passions than on those of others.) But certainly, after publishing dozens of academic articles and collecting a few thousand citations in the Social Science Citation Index, I now think less about impressing others and spend more of my time doing what I want. It is one of the upsides of getting older, perhaps God's way to compensate for the graying hair and expanding waistline.

9. Lately, I have been spending some of my time writing this blog, which started as a by-product of teaching ec 10, the principles class at Harvard. I am still trying to figure out if this is a good use of my time or not. On the one hand, this feels like providing a public good. (Perhaps at a low cost: some of the time I spend on it has come from watching reruns of Law and Order.) On the other hand, at times writing this blog feels like being hooked on crack.

10. My wife would tell you that my life works only because I am a workaholic. But I don't think of myself as a workaholic, and I don't feel like I am working hard. I just really enjoy what I do.

Miron on Subsidizing Economics

My friend and colleague Jeff Miron argues against government subsidies to economics research:

Economists broadly, and even many libertarian-leaning economists, support government funding for economics research. Is that position defensible?

My answer is no. Economic research is a good thing, and knowledge is a public good that might be underfunded by the marketplace. But economists cannot argue convincingly against other bad government policies unless we hold ourselves to the highest possible standard.

I made a similar argument to a New Yorker reporter ten years ago. He quoted me in an article called The Decline of Economics (12/2/96):

"Is economics making enough progress to justify the millions of dollars a year that the taxpayer spends to subsidize economic research? I think economists are probably overfunded, given the rate at which we make progress.... Economists are like dairy farmers. We think we deserve every penny we get."

When the New Yorker piece came out, I was contacted by Dan Newlon, the economics program director at the National Science Foundation, who hands out the government largesse. Dan inquired whether I had been quoted correctly. I said I had. He then advised me that we economists should not be "airing our dirty laundry in public."

The key issue here concerns externalities. Economists who favor subsidies to research point out (correctly) that there are positive externalities to knowledge creation, so there will be too little in the absence of any government intervention. On the other hand, subsidies require tax revenue. Because taxes are distortionary, it is not enough that the externalities be positive: they must be large enough to justify the deadweight loss from extra taxation.

Dairy farmers can assert they deserve subsidies because farms are scenic and convey positive externalities to on-lookers. Economists are skeptical about such self-serving claims and want to see a serious cost-benefit analysis. But we economists are far too willing to cut ourselves some slack when it comes to our own subsidies. Miron is an admirable exception.

Do I deserve to be an American?

Representative James Sensenbrenner (via Voxbaby) says:

It is offensive to me to think we have legislators who are considering selling US citizenship for $2,000.

Many economists would agree: $2,000 is well below the equilibrium price.

The congressman goes on:

US citizenship is not for sale. It is a privilege bestowed upon those who appreciate its value, and who contribute to our nation by living in a manner that reflects the principles and ideology of being an American.

I wonder how many Americans would qualify for the privilege under this criterion. Those of us lucky enough be born in the United States often take U.S. citizenship for granted. By contrast, immigrants uprooting their lives, leaving behind friends and family, to find new hope in a foreign land often have a deep appreciation of the value of being an American.

That is how my grandparents felt about it when they immigrated from Ukraine. I bet the same is true of many Mexican immigrants today.

The Case for Higher Tolls

In today's NY Times, Mitch Daniels, the governor of Indiana, reports on the economics of toll collection:

As a private citizen, I had always been intrigued to stop at a concrete booth and fish out a dime and a nickel to pay the 15-cent toll at Gary. As governor, I asked, "What does it cost us to collect a toll?" This being government, no one knew, but after a few days of calculation, the answer came: "About 34 cents, we think."

Tolls are a good mechanism to deal with congestion externalities and to raise funds to finance public goods. But they don't make sense if they are too small.

How will the fiscal gap be closed?

At a dinner a few days ago, some students and I were discussing how the long-term fiscal imbalance in the United States would be resolved. I opined, as I have on this blog before, that the place I would start is by considering a gradual but significant increase in the age of eligibility for government retiree benefits, including both Social Security and Medicare. I noted, however, that this solution is not very popular in polls, and no major political figure has advocated it in recent years. (Commentators: Please correct me if I am overlooking someone.)

A student then asked my prediction about whether we would see the correction on the spending side or on the tax side. That is, of course, a positive question rather than a normative one. I said, some of both, but my answer was more in the nature of a shrug than an analysis.

This morning, however, I recalled an old paper of Henning Bohn, which probably gives the best analysis of the topic. Here is a summary of the paper, which was published in the Journal of Monetary Economics:

The paper provides a historical perspective on the issue of whether budget deficits are typically eliminated by increased taxes or by reduced spending. By examining U.S. budget data from 1792–1988, I conclude that about 50–65% of all deficits due to tax cuts and about 65–70% of all deficits due to higher government spending have been eliminated by subsequent spending cuts, while the remainder was eliminated by subsequent tax increases.

That seems like a reasonable forecast: about 2/3 of the adjustment on the spending side, 1/3 on the tax side.

John Snow and Me

Over the past few days, reporters have been calling my house to ask me about John Snow. I have missed all the calls (I have had an ec 10 exam to deal with, after all) and have not returned any of them (I am a bit tired of talking to reporters). But in case any of those reporters are reading this blog, here is what I would say in response to the two questions you want to ask:

1. "Professor Mankiw, what can you tell us about rumors of John Snow's resignation as Secretary of Treasury?"

Nothing. I never comment on such speculation. Why would I?

2. "Professor Mankiw, how did you get along with John Snow when you worked in the Bush administration?"

I had never met John before I interviewed for the CEA job. During my two years in Washington, I got to know him quite well, and we developed a good relationship, both personal and professional.

On policy matters, we usually saw eye-to-eye. In fact, in internal policy discussions, John was probably the other economic "principal" whose policy views correlated most strongly with mine.

That is not a surprise if one knows John's personal history. John is often described as a former railroad executive, which is true. But earlier in his career, John earned a PhD in economics (from UVa) and was on the economics faculty at the University of Maryland. His economics background was very clear from the first time I met him. John thinks like an economist, so it is natural that Treasury under his leadership worked well with the CEA.

I am ready to compete!

Matthew Yglesias challenges econ profs to put their money where their mouth is on the immigration issue:

I'll believe that this is all about altruism when I see an open letter from economists demanding that we scrap the complicated H1B visa system and instead allow unrestricted immigration of foreign college professors.

Brad DeLong responds:

I'll pick up the gauntlet: I hereby call on all governments to allow free mobility of university professors. All universities and other institutions of higher education should be allowed to hire whoever they want to reside, teach, and do research at their universities, without let or hindrance by any government whatsoever.

I agree with Brad. Bring 'em on!

Update: Jeff Miron also agrees. We have a good start to that open letter.

Phelps on the Taylor Rule

Ned Phelps has an op-ed in the yesterday's Financial Times arguing against the Federal Reserve adopting a Taylor rule for monetary policy (which I discussed in one of my last ec 10 lectures). An excerpt:

The rule advocated now, however, would set the short rate of interest. In the standard textbook rule, created by John Taylor, the Stanford University economist, in the 1980s, the real short rate (the money interest rate less the inflation rate) is set higher the greater is inflation, and lower the greater is unemployment. If perchance the inflation rate is at its "target" and unemployment is at the "natural unemployment rate", the real interest rate is to be set equal to the "natural interest rate" -- the real rate businesses could afford to pay if unemployment were at the natural unemployment rate. Mr Taylor took the natural rates to be constants.

Commitment to an interest rate rule would be dangerous because the product and labour markets could not rescue the economy from the consequences of an error in the rule. The natural interest rate is complicated to estimate. Should the natural interest rate be below the level the rule took it to be, no fall in prices and wages could restore unemployment to its natural rate: their fall would pull down the money supply with them, leaving no net restorative effect.

I think Ned exaggerates the danger here, for two reasons.

1. If the Fed overestimates the natural interest rate (essentially the constant in the Taylor rule), it will tighten monetary policy too much. The economy would respond with a lower rate of inflation, which in turn would induce the Fed to lower interest rates. In the end, overestimating the natural interest rate would mean a steady-state inflation rate below target. This is hardly a catastrophe. No one really knows if the optimal inflation rate is 0, 1, or 2 percent, so there is no big problem if we get a steady-state inflation rate a bit below the stated target. (A digression: Perhaps the optimal inflation rate is 3.14159265, which is why we always write inflation as π.)

2. Ned seems to be knocking down a strawman. I don't recall hearing anyone recommend a Taylor rule as a hard and fast rule to which the Federal Reserve would commit itself. The Taylor rule is more like a rule of thumb or a guideline for monetary policymakers, like the Pirate's code in "Pirates of the Caribbean: The Curse of the Black Pearl" (which, by the way, is a perfect movie if you have kids about 8 to 12 years old). As far as I know, no practical economist or central banker has proposed following a Taylor rule religiously.

Update: Brad DeLong helpfully find the quotation from the movie, where the villain Barbosa says:

First, your return to shore was not part of our negotiations nor our agreement, so I must do nothin'. And secondly, you must be a pirate for the Pirate's Code to apply, and you're not. And thirdly, the Code is more what you'd call "guidelines" than actual rules. Welcome aboard the Black Pearl, Miss Turner.

Ec 10: You're Done!

To my ec 10 students: As I post this, you are taking your final exam. By the time you read this, you will be done. Congratulations! I hope you enjoyed your first year studying economics as much as I have being your instructor. I wish you all a great summer. Please stop by in the fall and say hello.

With your exams now safely behind you, this might be a good time to reflect on a piece of wisdom from Dave Barry:

Basically, you learn two kinds of things in college:

• Things you will need to know in later life (two hours). These include how to make collect telephone calls and get beer stains out of your pajamas.

• Things you will not need to know in later life (1,998 hours). These are the things you learn in classes whose names end in -ology, - - -osophy, -istry, -ics, and so on. The idea is, you memorize these things, then write them down in little exam books, then forget them. If you fail to forget them, you become a professor and have to stay in college for the rest of your life.

What makes a good professor?

Earlier this week, the Wall Street Journal reviewed a new book by Harry Lewis, a former dean at Harvard, called "Excellence Without a Soul." I haven't read the book yet, but I plan to. I like Harry, and he always struck me a thoughtful dean whose heart was in the right place. (I say that as a person who often has a more jaded view of university administrators.)

This particular passage in the WSJ review caught my eye:

Most professors are "narrowly educated experts" with little experience outside academia. They are "poorly equipped to help college students sort out" their lives.

Of course, that is true. And it is true for a simple reason: We select professors based on narrow expertise.

Whenever we hire econ professors at Harvard, for instance, the first question we ask about job candidates concerns their research. We scrutinize their vitas to see how many papers they have published in the AER, QJE, and other scholarly journals. These publications typically reflect narrow expertise.

We also discuss other things, such as teaching ability. But about 90 percent of the weight in hiring goes to research, only about 10 percent to teaching. Not once have I heard anyone ask, "How well equipped is this candidate to help college students sort out their lives?" If I ever posed such a question in a faculty meeting, my colleagues would think I was joking.

This phenomenon is not unique to Harvard. Here is some generic advice from economist Dan Hamermesh (University of Texas at Austin) to young scholars:

Unless you are at a liberal arts college that stresses teaching, don't over-prepare your classes. The marginal product of additional preparation time diminishes rapidly; and most schools do not take teaching into account unless you fall below some standard. The loss function here is asymmetric.

That is probably correct advice for a junior faculty member aiming for tenure. But aspiring to be merely adequate does not strike me as socially optimal.

I am open to the idea that we should take a broader view in promotion and hiring than we do. I would increase the weight given to teaching relative to research. I would give some weight to life experiences outside of academia, such as working in policy jobs, writing op-eds, writing books for nonspecialists, and so on. But my perspective is a minority view in my department and, I believe, in research universities more generally.

Baker defends Bernanke and Bush

In today's Times of London, columnist Gerard Baker defends Ben Bernanke and George Bush. An excerpt:

The Bush Administration, of course, is everybody’s favourite villain. It is believed to be piling up huge amounts of debt, threatening US financial stability.

But this, too, is hyperbole. The US Government’s deficit, while slightly high, is not massively out of line with international norms. Nor is the US public debt. Now I’ll grant you, that debt level, approaching $9 trillion, does sound like quite a lot. To paraphrase another economist, nine trillion here, nine trillion there and pretty soon you’re talking serious money. But the total value of US GDP is more than $12 trillion per year. Its debt-to-GDP ratio then is about 70 per cent, still low by comparison with, say, your average European country.

Baker is right that the current level of U.S. government debt is not a major problem. The major fiscal-policy problem is the projected path, as I highlighted in the previous post.

The Entitlement Monster

An article in today's issue of USA Today tries to make real the looming problem of promised but unfunded retiree benefits. Here is how the story starts:

Retiree benefits grow into 'monster'

Taxpayers owe more than a half-million dollars per household for financial promises made by government, mostly to cover the cost of retirement benefits for baby boomers, a USA TODAY analysis shows.

Federal, state and local governments have added nearly $10 trillion to taxpayer liabilities in the past two years, bringing the total of government's unfunded obligations to an unprecedented $57.8 trillion. That is the equivalent of a $510,678 credit card debt for every American household. Payments on this delinquent tax bill must start soon if financial promises to the elderly are to be kept.

The cost of retirement programs will start to soar when baby boomers — 79 million born between 1946 and 1964 — begin collecting Social Security in 2008 and Medicare in 2011.

"This is a monster financial problem that both parties are going to have to solve," says Rep. Jim Cooper, D-Tenn., a member of the House Budget Committee. "Most Americans and Congress members don't realize the terrific burden we are putting on future generations."

I can't vouch for the accuracy of these numbers, but I am pleased to see the story. The more often the mainstream media remind voters of the upcoming budget crunch, the better.

Tabarrok on Immigration

Economist Alexander Tabarrok discusses why the immigration debate leads to some strange bedfellows.

Goolsbee on the Business Cycle

Today's NY Times has a fascinating article by University of Chicago economist Austan Goolsbee. It discusses new research on how the state of the economy when a person leaves school affects his subsequent career. An excerpt:

Consider the evidence uncovered by Paul Oyer, a Stanford Business School economist, in his recent paper, "The Making of an Investment Banker: Macroeconomic Shocks, Career Choice and Lifetime Income" (National Bureau of Economic Research Working Paper 12059, February 2006). Dr. Oyer tracked the careers of Stanford Business School graduates in the classes of 1960 to 1997.

He found that the performance of the stock market in the two years the students were in business school played a major role in whether they took an investment banking job upon graduating and, because such jobs pay extremely well, upon the average salary of the class. That is no surprise. The startling thing about the data was his finding that the relative income differences among classes remained, even as much as 20 years later.

The Stanford class of 1988, for example, entered the job market just after the market crash of 1987. Banks were not hiring, and so average wages for that class were lower than for the class of 1987 or for later classes that came out after the market recovered. Even a decade or more later, the class of 1988 was still earning significantly less. They missed the plum jobs right out of the gate and never recovered.

And as economists have looked at the economy of the last two decades, they have found that Dr. Oyer's findings hold for more than just high-end M.B.A. students on Wall Street. They are also true for college students. A recent study, by the economists Philip Oreopoulos, Till Von Wachter and Andrew Heisz, "The Short- and Long-Term Career Effects of Graduating in a Recession" (National Bureau of Economic Research Working Paper 12159, April 2006), finds that the setback in earnings for college students who graduate in a recession stays with them for the next 10 years.

As I read this article, I wondered: How can we reconcile these facts with standard macroeconomic theory? Standard theory describes the business cycle as temporary deviations of output and employment around their natural levels. A few years after a macro shock, everything is supposed to be back to normal. By contrast, Goolsbee describes a world where macroeconomic shocks have very persistent effects on a person's opportunities.

Maybe these findings are related to the time-series literature that suggests there is a large persistent ("unit root") component in GDP. And maybe these findings can alter our view about the social cost of the business cycle.

It seems that there are some good research papers to be written reconciling the micro facts that Goolsbee describes with macro theory.

Barney Frank cites Mises and Hayek

I have never been prouder of my Congressman, Barney Frank.

Fannie Mae

The financial giant Fannie Mae is very much in the news lately. The front page of today's Wall Street Journal had this story:

Fannie Mae Ex-Officials May Face Legal Action Over Accounting

This is not the kind of headline any financial institution wants to see.

The issues surrounding Fannie Mae, however, go well beyond possible charges of accounting fraud. Even if the firm and all its officials had done everything legally, there is an ongoing policy problem. Fannie Mae and its brother institution Freddie Mac enjoy implicit taxpayer subsidies because investors believe that, if these "government sponsored enterprises" ever got into financial trouble, Congress would bail them out. This perception gives the GSEs an advantage over truly private firms when raising funds in financial markets.

GSE reform was one of the issues I worked on while I was at the CEA. Here is an op-ed I wrote for the FT in 2004, and here is a longer speech I gave on the topic. The issues have not changed radically since then.

I have spoken with economists from the Clinton administration about the issues surrounding the GSEs. There is no disagreement between their view of the situation and what we Bush economists thought. The issue here is not Republican versus Democrat. It is good policy versus a powerful special interest. So far, the powerful special interest has won the day, blocking in Congress any attempt at meaningful reform. But with headlines like the one above weakening the special interest, there is still hope for good policy.

Advice for Grad Students

Because there appeared to be much interest in the advice I offered undergrads in a previous post, let me provide the same service for graduate students in economics.

But rather than doing the work myself, I will outsource the task to some of my colleagues in the profession:

• Don Davis gives some guidance about finding research topics.
• John Cochrane tells grad students how to write a paper.
• Michael Kremer provides a checklist to make sure your paper is as good as it can be.
• David Romer gives you the rules to follow to finish your PhD.
• David Laibson offers some advice about how the navigate the job market for new PhD economists.
• John Cawley covers the same ground as Laibson but in more detail.
• Kwan Choi office advice about how to publish in top journals.
• Dan Hamermesh offers advice on, well, just about everything.
• Assar Lindbeck tells you how, after getting that first academic post, to win the Nobel prize.

Updates: Matthew Pearson explains how to survive the first year of grad school. Hal Varian explains how to build an economic model in your spare time. Jonathan Shewchuk offers tips on giving an academic talk.

A Few Fun Readings

Ec 10 students: If you are looking for ways to procrastinate instead of studying for the exam, here are three recent articles I enjoyed.

• Jeff Jacoby on Immigration
• Philip Tetlock on Pundits
• Robert Samuelson on Birthrates

The Economy Through a Political Lens

In today's NY Times, David Leonhardt discusses the intersection of economics and politics. He starts as follows:

This Glass Is Half Full, Probably More

HERE is a political Rorschach test for this midterm election year. What's your reaction to the following:

These are the best of times in many ways. Americans are wealthier than previous generations, they are healthier and they enjoy a higher standard of living. The good old days simply weren't as good as the present day.

If that makes you a little squeamish, the odds are good that you generally vote Democratic. You see a lot of real problems — widening inequality, a big federal budget deficit, melting icecaps — and you have a hard time believing that the country has never been richer.

But the fact that by most broad measures — wages, average life span, crime, education levels, home ownership and racial and gender equality, to name a few — life in this country has clearly improved over the last generation.

And most Americans think about their lives in these terms. In polls, even low-income people generally say they are better off than their parents were, probably because most are.

Yet many Democratic politicians just don't seem comfortable talking about the ways that overall living standards have risen, focusing instead on the recent stagnation in wages for rank-and-file workers. "We do talk negative about the economy," Rep. Rahm Emanuel, an Illinois Democrat, told me yesterday, adding that it comes in part with being the opposition party.

Which math courses?

In response to my previous post offering advice to aspiring economists, a student emails me:

Since the time allocation is limited, I can take only some math courses and the problem is that I am not sure which courses are most important for a successful economist and which course I should take first. Can you possibly suggest for me a list of math courses that a typical economics student should take step by step?

Here is one plan of action:

Calculus
Linear Algebra
Multivariable Calculus
Real Analysis
Probability Theory
Mathematical Statistics
Game Theory
Differential Equations

There is, of course, some flexibility about the order of courses. Check the prerequisites at your school to figure out the right sequencing.

Let me also recommend a book if you need a crash course for catch up or review: Mathematics for Economists by Carl P. Simon and Lawrence Blume.

The President's Desk

Over at the Volokh Conspiracy, I ran across a compelling analysis of Slate’s Bushism of the Day. I cannot help but offer a few comments (which won’t make any sense until you click over to Volokh). I know this is off-topic for this blog, so please accept my apologies in advance.

1. I have always marveled at the Bushism feature in Slate. Slate’s motive is to say “Look at how inarticulate George Bush is.” But even before I had ever met George Bush and become one of his economic advisers, I had the opposite reaction to these items. I always interpreted them as “Look how sophomoric and condescending we editors at Slate are.” I suppose that sophomoric and condescending are in the eye of the beholder. People who seem sophomoric and condescending to me often see themselves as very clever.

2. During my time in the White House, I heard George Bush tell the story of the desk several times. It is one of his staples. There is, I think, a simple explanation: When people come into the Oval Office and meet the President of the United States for the first time, they are terrified. I know I was. So the President tries to put them at ease with small talk. Hence, the story of the desk and John-John Kennedy’s crawling under it. The subtext: “Yes, this is an awesome place, and I am as awed by it as you are, but the occupants here are real people with real kids doing real things, just like you and me.”

3. The last time I heard the President tell the story of the desk was when I visited the Oval Office with my wife and three kids for an “exit interview.” I was returning to Harvard after my two years of leave. The visit was a mere formality, but a nice one for me and my family. The President, as usual, tried to make his guests feel comfortable. He asked my kids about their school. We chatted about our new dog. And then the President told the story of the desk. Although I had heard it before, it was new to my wife and kids. Immediately, my six-year-old son Peter decided to reenact the event. Like John-John, he got on the floor and started crawling under the desk, trying to peak out the front. The President informed us that the front panel no longer opened, so a full reenactment was not possible. My wife was mortified that Peter made himself so comfortable so quickly. The President appeared amused.

Advice for Aspiring Economists

A student from abroad emails the following question:

Do you have some hints for me, how to become a good economist?

Here is some advice for, say, an undergraduate considering a career as an economist.

1. Take as many math and statistics courses as you can stomach.

2. Choose your economics courses from professors who are passionate about the field and care about teaching. Ignore the particular topics covered when choosing courses. All parts of economics can be made interesting, or deadly dull, depending on the instructor.

3. Use your summers to experience economics from different perspectives. Spend one working as a research assistant for a professor, one working in a policy job in government, and one working in the private sector.

4. Read economics for fun in your spare time. To get you started, here is a list of recommended readings.

5. Follow economics news. The best weekly is The Economist. The best daily is the Wall Street Journal.

6. If you are at a research university, attend the economic research seminars at your school about once a week. You may not understand the discussions at first, because they may seem too technical, but you will pick up more than you know, and eventually you’ll be giving the seminar yourself.

You may find some other useful tidbits in this paper of mine.

Updates: Here is some advice from Susan Athey about applying to grad school in economics.  And here are the criteria a top economics PhD program uses in determining admissions.

The Inflation Tax

One of my ec 10 students wonders whether it is possible to defend inflation:

Why is it such a bad thing for governments to rely more on the "inflation tax"? As long as it is applied within the context of an inflation-targeting Fed, all the negatives of inflation can be contained. That is, as long as the Fed sets a target inflation rate (say, 15%) and then uses open market techniques to bring inflation into line by taking into consideration the new money, there'll be no unexpected inflation, and therefore no inflation cost.

There are many advantages to the inflation tax, including: 1) Painless, free "collection." 2) Progressivity (those with the most accumulated assets pay the most.)

It is a provocative proposal. I don't know any economist who would endorse it, however. To explain why, let me make four points:

1. The inflation tax is not painless. There are various inefficiencies that inflation causes, even if it is steady and predictable. Those include the "shoeleather" costs of reduced real money balances, increased menu costs, spurious relative-price variability, and distortions in taxes due to the failure to have fully indexed tax laws. These are discussed in more detail in the textbook.

2. The inflation tax is probably less progressive than one might at first think. It is not a tax on all assets but only on non-interest-bearing assets, such as cash. The rich are able to keep their most of their wealth in forms that can avoid the inflation tax. (One exception is the rich in the underground economy; the inflation tax may hit criminals particularly hard.)

3. The inflation tax would raise only a modest amount of revenue. Here is a rough calculation. The monetary base is now about $800 billion. So an inflation rate of 15 percent would raise a maximum of $120 billion per year, or about 1 percent of GDP. That is an upper bound on the amount of tax revenue because, as inflation rose, the quantity of money demanded would fall, reducing the size of the tax base. (This is a standard "Laffer curve" argument, applied to the inflation tax.)

4. For reasons that are not fully understood, high inflation tends to be volatile inflation. A stable and predictable 15 percent inflation seems possible as a matter of economic theory, but it is rarely if ever observed. If we take this empirical regularity as a constraint, then choosing high inflation entails choosing volatile inflation, which increases uncertainty.

These are the reasons that most economists would be averse to a proposal of steady 15 percent inflation. But has some economist done a detailed and convincing cost-benefit calculation, weighing all the pluses and minuses, to figure out the optimal inflation rate? Not to my knowledge.

To read more about the inflation tax and the optimal rate of inflation, click here, here, and here.

Three Votes for a Carbon Tax

In today's NY Times, columnist John Tierney discusses the new Al Gore film, "An Inconvenient Truth." An excerpt:

Gore doesn't mind frightening his audience with improbable future catastrophes, but he avoids any call to action that would cause immediate discomfort, either to filmgoers or to voters in the 2008 primaries.

He doesn't propose the quickest and most efficient way to reduce greenhouse emissions: a carbon tax on gasoline and other fossil fuels. The movie gives him a forum for talking sensibly about a topic that's taboo on Capitol Hill, but he instead sticks to long-range proposals that sound more palatable, like redesigning cities to encourage mass transit or building more efficient cars and appliances.

Gore shows the obligatory pictures of windmills and other alternative sources of energy. But he ignores nuclear power plants, which don't spew carbon dioxide and currently produce far more electricity than all ecologically fashionable sources combined.

A few environmentalists, like Patrick Moore, a founder of Greenpeace, have recognized that their movement is making a mistake in continuing to demonize nuclear power. Balanced against the risks of global warming, nukes suddenly look good -- or at least deserve to be considered rationally. Gore had a rare chance to reshape the debate, because a documentary about global warming attracts just the sort of person who marches in anti-nuke demonstrations.

Gore could have dared, once he enticed the faithful into the theater, to challenge them with an inconvenient truth or two. But that would have been a different movie.

Tierney is right: To the extent that carbon-based global warming is a problem (an issue on which I do not have the expertise to opine), the best solution is a carbon tax.

An economist who has studied the topic of global warming extensively is Bill Nordhaus. Bill was a CEA member during the Carter administration and is now a member of the Yale economics faculty. In a March 2006 article, he wrote

As policy makers search for more effective and efficient ways to slow the trends, they should consider the fact that harmonized environmental taxes on carbon are powerful tools for coordinating policies and slowing climate change.

The two issues that Tierney raises--the carbon tax and nuclear energy--are closely related. One effect of a carbon tax is that it would automatically promote nuclear energy. Right now, production of electricity via nuclear power is not particularly cost-efficient compared to alternatives such as coal. But a carbon tax would make coal-produced electricity more expensive, encouraging utilities to take another look at nuclear power.

So here are three votes for a carbon tax: Tierney, Nordhaus, and Mankiw. The first is a journalist who leans libertarian, the second is an economist who worked in a Democratic administration, and the third is an economist who worked in a Republican administration. What do we all have in common? None of us is planning to run for elected office.

FTC on Price Gouging

This news story from today's Washington Post will not surprise many economists:

The Federal Trade Commission said yesterday that it found no evidence that the oil industry manipulated gasoline prices in the wake of hurricanes Katrina and Rita and that 15 instances that fit a definition of price gouging set by Congress last year could be explained by market conditions.

Nor will they will be surprised by the response from some of our nation's politicians:

Members of Congress promised tough questions for FTC officials due to testify at a Senate hearing today....

"Our evidence and common sense suggest a vastly different picture of unconscionable profiteering by Big Oil," said Connecticut's attorney general, Richard Blumenthal. Blumenthal has reached price-gouging settlements with eight gasoline retail stations this year. "The FTC has barely found the tip of the iceberg," he said.

Click here for a previous post on the topic.

President Gore

Al Gore on SNL.

Budget Deficit Shrinks!

Want to reduce the U.S. budget deficit by $175? It is easy. Just correct it for inflation.

Several commentators on a previous post expressed shock and dismay that the $600 billion figure that Senator Lieberman and President Bush have cited for the worsening in Social Security's finances is not corrected for inflation. That is, part of the increase in the present value of the shortfall is explained by a higher overall price level in the economy, suggesting it does not reflect a real increase in the problem. A fair point.

The exact same point can be made about the budget deficit as normally reported. Here is an excerpt from the best-selling intermediate macro textbook that explains how to make the inflation correction.

Measurement Problem 1: Inflation

The least controversial of the measurement issues is the correction for inflation. Almost all economists agree that the government's indebtedness should be measured in real terms, not in nominal terms. The measured deficit should equal the change in the government's real debt, not the change in its nominal debt.

The budget deficit as commonly measured, however, does not correct for inflation. To see how large an error this induces, consider the following example. Suppose that the real government debt is not changing; in other words, in real terms, the budget is balanced. In this case, the nominal debt must be rising at the rate of inflation. That is,

ΔD/D = π,

where π is the inflation rate and D is the stock of government debt. This implies

ΔD = πD.

The government would look at the change in the nominal debt ΔD and would report a budget deficit of πD. Hence, most economists believe that the reported budget deficit is overstated by the amount πD.

We can make the same argument in another way. The deficit is government expenditure minus government revenue. Part of expenditure is the interest paid on the government debt. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate i and the real interest rate r is the inflation rate π, the budget deficit is overstated by πD.

This correction for inflation can be large, especially when inflation is high, and it can often change our evaluation of fiscal policy. For example, in 1979, the federal government reported a budget deficit of $28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the public (excluding the Federal Reserve) was $495 billion. The deficit was therefore overstated by

πD = 0.086 x $495 billion = $43 billion.

Corrected for inflation, the reported budget deficit of $28 billion turns into a budget surplus of $15 billion! In other words, even though nominal government debt was rising, real government debt was falling.

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How much does this correction matter now? CPI inflation over the past year has been 3.5 percent. Government debt held by the public is about $5 trillion. This means the U.S. budget deficit is overstated by about $175 billion dollars.