What would Alan do?

There has been a lot of talk lately about whether the Fed will continue raising interest rates or pause for a while. I don't know the answer, but here is one way to think about it.

About five years ago, I wrote a paper on monetary policy in the 1990s. I estimated the following simple formula for setting the federal funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment).

Here "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate. The parameters in this formula were chosen to offer the best fit for data from the 1990s.

Right now, core inflation is 2.4 percent, and unemployment is 4.6 percent. This formula says the federal funds rate should be set at 5.42 percent--just 17 basis point above the current target of 5.25 percent.

So we now seem to be very close to the rate that Alan Greenspan would have set under these conditions.

Set your TiVo!

I am scheduled to be a guest on Kudlow & Company today. CNBC at 5 pm EST.

Update: I believe the show will be repeated Monday and/or Tuesday, when Larry is on vacation.

Mishkin to the Fed

President Bush nominated Frederic Mishkin to the Federal Reserve today--another great appointment. It always warms my heart to see a textbook author make good.

On Energy Independence

A reader emails me a question about "energy independence."

Professor Mankiw,

Because I graduated from Harvard in '05, I took Ec 10 from Marty (although I did have the pleasure of using your excellent textbook). I've been a dedicated reader of your blog ever since I discovered it this spring. Anyway, on to the question.

I'm working in DC right now, and everywhere you turn there is a politician advocating for "energy independence." What's more, both parties seem to have adopted the mantra, and I have not yet heard a serious voice denouncing the call to "end our addiction on foreign oil."

Am I crazy to think that "energy independence" makes absolutely zero sense and is instead a political canard to appease protectionists on the left and isolationists on the right?

I'm pretty sure that Marty gave a spirited lecture about the virtues of free trade and decried examples to the contrary like China's push for food "self-sufficiency."

How is "energy independence" any different?

[name withheld]

The reader is correct that "energy independence" is a bipartisan mantra. George Bush in his 2003 State of the Union address said, "Our third goal is to promote energy independence for our country." John Kerry in a 2004 campaign ad said, "It's time to make energy independence a national priority."

Does this make any sense? Consider this passage:

"One of my policy goals will be to shut down LNG facilities and to stop building new ones. These facilities make it easier for American to buy cheap natural gas from abroad. Americans may enjoy the lower prices, but these facilities keep us dependent on foreign suppliers. It is better to produce all our energy domestically, even if it means consuming less and paying higher prices."

Would either Bush or Kerry insert such a passage into a speech? Of course not.

If we could wave a magic wand and costlessly reduce the need for imported energy, that would be great. Calls for energy independence are usually followed by magic-wand-like claims about what conservation, technology, etc. are likely to produce. But politicians rarely suggest that Americans make significant economic sacrifice for purposes of energy independence. The rhetoric is usually hollow.

This is, in my view, fortunate. Hollow rhetoric is less worrisome than substantive, misguided rhetoric. Another word for "independence" is "autarky." While gasoline taxes can be justified as a policy to deal with externalities, "energy autarky" is not in itself a desirable goal.

Update: Econbrowser estimates what the price of oil would be under energy independence.

Define "Hack"

Mark Thoma calls our attention to an old column from Paul Krugman that contains these words of wisdom:

How can you tell the hacks from the serious analysts?... if a person, or especially an organization, always sings the same tune, watch out. Real experts, you see, tend to have views that are not entirely one-sided.

I couldn't agree more.

Define "Rich"

From Hal Varian's column in yesterday's NY Times:

After a detailed examination of the financial circumstances of people close to retirement, two economists, Stephen F. Venti of Dartmouth and David A. Wise of Harvard, concluded that the primary reason for differences in retirement assets was differences in propensities to save. It is not unusual to see low-income households with high savings rates holding more financial assets at retirement than high-income households who saved a smaller fraction of their income.

People often use the term "rich" as if the word had an unambiguous meaning. Venti and Wise show that high-income people and wealthy people are frequently different people.

On Arthur Burns

The conventional wisdom is that Arthur Burns was a failure as a central banker. The mysterious knzn, however, questions whether this assessment is right:

for the 12 months ending in February 1970, when Burns began his chairmanship, the CPI inflation rate was 6.3%. For the 12 months ending January 1978, when Burns ended his chairmanship, the rate was 6.7%. On balance, that hardly looks to me like letting inflation get out of hand.....it looks like Johnson’s influence on Martin deserves as much blame for the subsequent high inflation rates as does Nixon’s influence on Burns.

An intriguing suggestion, but I don't think we can revive Burns's reputation quite so easily.

While Burns was dealt a particularly difficult hand to play (OPEC shocks, productivity slowdown), inflation was not nearly as well contained as these numbers suggest. Recall that the Fed influences the inflation rate with a lag. Let's suppose that lag is one year, which I believe is roughly consistent with econometric studies. The story then looks very different. By this reckoning, Burns inherited an inflation rate of 5.0 percent (during his first year in office) and left his successor an inflation rate of 9.3 percent (during the year after Burns left office). Not a happy legacy for a central banker.

Wages and Work Hours

Here is an intriguing fact from a new NBER study:

In 1983, the most poorly paid 20 percent of workers were more likely to put in long work hours than the top paid 20 percent. By 2002, the best-paid 20 percent were twice as likely to work long hours as the bottom 20 percent.

That is, wages and hours worked went from being negatively correlated to being positively correlated. This may be an important piece of the puzzle of rising income inequality.

Credos of the Left and Right

From Barbara Ehrenreich:

Yeah, I'm talking "class war" as a solution to poverty and rising inequality. But remember, the working class didn't start this war.

From Jeff Taylor:

Nothing is more dangerous than a lunatic with government letterhead.

Wessel on the Fiscal Challenge

In today's Wall Street Journal, David Wessel hits the nail on the head (as he often does):

the political reality is that a Republican president can hope to restrain spending on Social Security, Medicare and Medicaid only if he can bring some Democrats along. And the only way to bring Democrats along is to put taxes on the table -- maybe not increasing tax rates, but raising revenues by simplifying the tax code, closing loopholes, targeting corporate subsidies, broadening the tax base or whatever brings in more money.

Let's take aim at the state-and-local tax deduction, the mortgage-interest deduction, and the exclusion of employer-provided health insurance. (And have I mentioned gasoline taxes lately?) But let's keep tax rates low.

Another Reason to Envy Brad Pitt

My principles text includes a case study on the fact that more attractive people are paid more. (See the chapter on Earnings and Discrimination.) A new study on the beauty premium tells us more about the phenomenon:

Using a rich set of data from the College of Economics at the University of XX, we examine the effects of students’ physical appearance on examination results. We find evidence that beauty has a significant impact on academic performance, a result which is consistent with and comparable to the impact found in the labor market literature.

In addition, since we can compare student performances in oral and written exams, where in the latter the evaluation is blind, i.e., not influenced by physical appearance, we can in fact understand better the source of the “beauty premium”, that is disentangle productivity from discrimination effects. We find that the effect of beauty on academic performance cannot be ascribed to pure professor discrimination. One could then argue that to the extent that wages rise with educational attainments, our findings corroborate the hypothesis that the payoffs to beauty reflect differences in productivity.

Thanks to New Economist for the pointer.

Is the Gas Tax Regressive?

Today's Washington Post reports:

When it comes to greenhouse gases, U.S. drivers are getting more of the blame.

Americans represent 5 percent of the world's population but contribute 45 percent of the world's emission of carbon dioxide, the main pollutant that causes global warming, according to a report by the nonprofit group Environmental Defense.

Americans own 30 percent of the world's vehicles, drive farther each year than the international average and burn more fuel per mile, the report says.

Unfortunately, the article does not discuss the natural solution: higher taxes on gasoline or carbon.

When I have advocated higher gasoline taxes previously on this blog, some commenters have argued against my position with the claim that the tax is regressive. That argument is nonstarter, for two reasons.

First, even if gasoline taxes were regressive, one could alter other taxes at the same time one increased the gasoline tax to leave the overall progressivity of the tax system the same. This is one example of the principle that we should, to the extent possible, separate the issues of efficiency and equality. We should set the gasoline tax at the efficient level to deal with externalities and then use more general taxes and transfers to achieve whatever distribution goals we have.

Second, gasoline taxes are not nearly as regressive as many people assume. Here is economist Jim Poterba:

Claims of the regressivity of gasoline taxes typically rely on annual surveys of consumer income and expenditures which show that gasoline expenditures are a larger fraction of income for very low income households than for middle or high-income households. This paper argues that annual expenditure provides a more reliable indicator of household well-being than annual income. It uses data from the Consumer Expenditure Survey to reassess the claim that gasoline taxes are regressive by computing the share of total expenditures which high-spending and low-spending households devote to retail gasoline purchases. This alternative approach shows that low-expenditure households devote a smaller share of their budget to gasoline than do their counterparts in the middle of the expenditure distribution. Although households in the top five percent of the total spending distribution spend less on gasoline than those who are less well off, the share of expenditure devoted to gasoline is much more stable across the population than the ratio of gasoline outlays to current income. The gasoline tax thus appears far less regressive than conventional analyses suggest.

The issue of distribution should not deter anyone from joining the Pigou Club.

Behavioral Economics

A reader asks about hot topics in economics:

What have been the most important theoretical papers/breakthroughs in the last 10-15 years? New growth theory is now getting quite old and while there are plenty of hot topics empirically, theory seems to have died down since the 1980s. Am I missing some important developments?

The reader is correct that the new growth theory ran into diminishing returns--as everything eventually does.

Without doubt, the next hot research topic after new growth theory, at least here in Cambridge, has been behavioral economics, which integrates economics and psychology. You can find a good introduction to this research in Harvard Magazine. To many economists, the rise of behavioral economics is old news, but readers unfamilar with the topic will enjoy the article. Even more recently, those working in this area have taken the next step of integrating brain science to create a new subfield called neuroeconomics. (Note to incoming Harvard students: David Laibson will be giving an ec 10 lecture on these topics in the fall.)

Research on behavioral economics has promise for providing new perspective on public policy. Here is a new case study from the sixth edition of my intermediate macro textbook:

Case Study
How to Get People to Save More

Many economists believe that it would be desirable for Americans to increase the fraction of their income that they save. There are several reasons for this conclusion. From a microeconomic perspective, greater saving would mean that people would be better prepared for retirement; this goal is especially important because Social Security, the public program that provides retirement income, is projected to run into financial difficulties in the years ahead as the population ages. From a macroeconomic perspective, greater saving would increase the supply of loanable funds available to finance investment; the Solow growth model shows that increased capital accumulation leads to higher income. From an open-economy perspective, greater saving would mean that less domestic investment would be financed by capital flows from abroad; a smaller capital inflow pushes the trade balance from deficit toward surplus. Finally, the fact that many Americans say that they are not saving enough may be sufficient reason to think that increased saving should be a national goal.

The difficult issue is how to get Americans to save more. The burgeoning field of behavioral economics offers some answers.

One approach is to make saving the path of least resistance. For example, consider 401(k) plans, the tax-advantaged retirement savings accounts available to many workers through their employers. In most firms, participation in the plan is an option that workers can choose by filling out a simple form. In some firms, however, workers are automatically enrolled in the plan but can opt out by filling out a simple form. Studies have shown that workers are far more likely to participate in the second case than in the first. If workers were rational maximizers, as is so often assumed in economic theory, they would choose the optimal amount of retirement saving, regardless of whether they had to choose to enroll or were enrolled automatically. In fact, workers' behavior appears to exhibit substantial inertia. Policymakers who want to increase saving can take advantage of this inertia by making automatic enrollment in these savings plans more common.

A second approach to increase saving is to give people the opportunity to control their desires for instant gratification. One intriguing possibility is the “Save More Tomorrow” program proposed by economist Richard Thaler. The essence of this program is that people commit in advance to putting a portion of their future salary increases into a retirement savings account. When a worker signs up, he or she makes no sacrifice of lower consumption today but, instead, commits to reducing consumption growth in the future. When this plan was implemented in several firms, it had a large impact. A high proportion (78 percent) of those offered the plan joined. In addition, of those enrolled, the vast majority (80 percent) stayed with the program through at least the fourth annual pay raise. The average saving rates for those in the program increased from 3.5 percent to 13.6 percent over the course of 40 months.

How successful would more widespread applications of these ideas be in increasing the U.S. national saving rate? It is impossible to say for sure. But given the importance of saving to both personal and national economic prosperity, many economists believe these proposals are worth a try.

Lazear on the Trade Deficit

CEA Chair Eddie Lazear testified at the Joint Economic Committee today. An interesting excerpt:

I would like to point out the historic record suggests that countries can be in a current-account deficit or a surplus situation for very long periods of time. New Zealand and Australia have had deficits for decades. Australia in particular has been running a current account deficit that has created a level of foreign indebtedness equal to about 72 percent of their GDP, whereas our foreign indebtedness was only about 21 percent of GDP in 2004 (most recent available published data). Yet, the Australian economy has been very strong and growing at robust rates over the past decades. Australia’s real GDP has grown at an average rate of 3.5 percent over the last decade.

Research on the Line-Item Veto

The Washington Post this afternoon reports:

President Bush called on Congress today to give him a line-item veto as a means to enforce fiscal discipline in spending bills.

What do economists who have studied the issue think about it? Here is something from the Journal of Public Economics in 1988:

The paper examines the claim that gubernatorial line item veto power reduces state spending. Analysis of a rich set of state budget data indicates that long run budgets are not altered by an item veto....These results suggest that state budgets have not been importantly altered as a result of the existence of the line item veto and shed doubt on the use of the line item veto to reduce federal government spending.

Source: "The line item veto and public sector budgets: Evidence from the states," by Douglas Holtz-Eakin, Journal of Public Economics, Volume 36, Issue 3 , August 1988, pages 269-292.

From the same journal in 2003:

Forty-three of the fifty states of the United States have granted item veto authority to their governors as part of state constitutions. In this paper, I test explanations of why and when a legislature would cede institutional power. Using data from 1865 to 1994, I show that these measures are most likely proposed by fiscal conservatives who fear the loss of power in the future; in order to protect their interests for those periods when they will be in the minority, they implement institutions such as the item veto which will limit future, liberal legislatures.

Source: "Budget institutions and political insulation: why states adopt the item veto," by Rui J. P. de Figueiredo, Jr., Journal of Public Economics, Volume 87, Issue 12 , December 2003, pages 2677-2701.

The bottom line: The line-item veto is a tactic of conservatives running scared in a vain attempt to control the growth of government.

But I wonder: Does the endogeneity of the line-item veto cast doubt on studies that suggest its futility? If the line-item veto is put in when conservatives expect to lose power to liberals, that would seem to bias estimates of its effect toward zero.

Send Ted a Secret Decoder Ring

Ted Gayer, an environmental economist at Georgetown and formerly one of my staff at the CEA, reminds me of another way to join the Pigou Club: Advocating an auction of pollution rights under cap-and-trade environmental regulations. If pollution rights are auctioned rather than handed out as freebies to firms, the system is equivalent to Pigovian taxes. (You can read Ted's article on the issue starting on page 5 of this pdf document.)

He is right. Welcome to the Club, Ted.

Leadership Change at Harvard

Consider this description of a great, visionary leader:

[He] is a voracious reader of science and history who questions subordinates relentlessly about their projects, she says. "If he respects you, he'll argue with you. If not, he ignores you," she says. "If he says, 'That's stupid,' it means he cares" about a project, she adds.

When I read that passage in yesterday's Wall Street Journal, I thought, "Yes, that captures the Larry Summers I know perfectly."

It wasn't written about Larry, however. It was written about Bill Gates. Apparently, the personality attributes that work well for an entrepreneur and CEO don't work nearly as well for a university president.

Larry has only a few days left as President of Harvard. The friends and fans of Larry, a group in which I include myself, are looking forward to finding out what his next act will be. How about President of the Bill and Melinda Gates Foundation? Bill and Larry would get along swimmingly.

Debating Wal-Mart

Jason Furman and Barbara Ehrenreich debate the impact of Wal-Mart.

Consumption vs Income Taxation

In a previous post, I expressed a preference for consumption taxation over income taxation. In a comment, Daniel Demetri (an ec 10 student this past year) asks an important question about incentives:

I'm confused as to why a consumption tax does not affect incentives while an income tax does.... People don't care about saving money--they care about spending it.

With income tax: 1 hr work --> $16 pre-tax --> $8 post-tax --> $8 of chocolate cake, video games, and Red Sox tickets.

With consumption tax: 1 hr work --> $16 pre-tax --> $8 of chocolate cake, video games, and Red Sox tickets + $8 of tax.

The amount worked and the amount spent are the same, so what's the real difference?

Daniel is exactly right, as far as he goes. If we are looking at the decision to work today in order to consume today, consumption and income taxes have similar effects. Both discourage work effort.

Consider, however, another margin of adjustment: Work today in order to save and consume in the future. Let's continue with Daniel's example of a 50 percent tax rate. Suppose that the interest rate is 7 percent, so $1 saved today becomes $2 in 10 years.

With income tax: 1 hr work --> $16 pre-tax --> $8 post-tax --> $16 of savings in 10 years --->$4 more in income taxes on the interest--> $12 of chocolate cake, video games, and Red Sox tickets.

With consumption tax: 1 hr work --> $16 pre-tax --> $32 of savings in 10 years --> $16 of chocolate cake, video games, and Red Sox tickets + $16 of tax.

So under a consumption tax, there is a greater incentive to work and save today in order to consume in the future.

Let's be even more wonky about this and do a bit of math. Let W be the real wage, r be the interest rate, and t be the tax rate. Suppose I work today in order to save and consume in T years. Under an income tax, the amount of consumption I get for one hour of work is:

(1-t)W*[1+(1-t)r]^T

Under a consumption tax, the amount of consumption I get is:

(1-t)W*[1+r]^T

Now compare these after-tax relative prices to the before-tax relative price, which is

W*[1+r]^T

You can see that the consumption tax creates a constant wedge: the after-tax relative price is 1-t times the before-tax relative price, regardless of T. However, an income tax creates a growing wedge. The larger is T, the greater is the gap between the before-tax and after-tax relative price. In other words, a consumption tax taxes current and future consumption at the same rate, whereas an income tax in effect taxes future consumption at a higher rate than current consumption.

The bottom line: Both consumption taxes and income taxes discourage work, but income taxes discourage saving as well.

Classic Milton Friedman

A great video of Milton Friedman, several decades ago. Thanks to Arnold Kling for the pointer.

Friedman discuss the minimum wage at 2:40.

Always Glad to Be Helpful

The Republic of Heaven blog endorses my book:

Gregory Mankiw's Macroeconomics textbook provides just the right amount of added height to the step stool for a child who wants to plant her feet on something while attempting to poop on the big potty.

Application Rejected

In today's Washington Post, Sebastian Mallaby worries that Americans have fewer close friends than they used to. Then he proposes a solution:

But there's one antidote to loneliness that is at least intriguing. In an experiment in Austin, Princeton's Daniel Kahneman found that commuting -- generally alone, and generally by car -- is rated the least enjoyable daily activity, but commuting by car pool is reasonably pleasant. Measures that promote car pooling could make Americans less isolated and healthier.

So here's my slogan for 2008: Gas taxes make you happy.

Mallaby might think this makes him a member of the Pigou Club. Sorry: the argument here is too squishy to qualify.

There is no externality here that I can see. My friend Jeff Miron and I live in the same Boston suburb, and we could commute to Harvard together if we wanted. While I would enjoy Jeff's company (and perhaps with enough carpooling I could talk him out of some of his loonier libertarian ideas), I also enjoy the autonomy I get from not having to coordinate with someone else. There are pros and cons to carpooling, and Jeff and I don't need the government to prod us to make the efficient decision. The Coase theorem should work just fine here. Mallaby's policy is the sort of social engineering that offends even namby-pamby libertarians like me.

I am, however, a forgiving sort. I will happily reconsider Mallaby's application for membership after a future column. Consider this a revise-and-resubmit.

Philanthropy vs Free Trade

Compare the numbers from two articles in today's NY Times:

Warren E. Buffett, the chairman of Berkshire Hathaway Inc. and one of the world's wealthiest men, plans to donate the bulk of his $44 billion fortune to the Bill & Melinda Gates Foundation and four other philanthropies starting in July.

According to the study [by the International Food Policy Research Institute], a deal similar to what is now on the table — modest cuts in real tariffs, limited cuts in domestic support payments, full elimination of export subsidies and 97 percent duty- and quota-free access for exports from the poorest countries — would create global gains of $54 billion per year.

In other words, success in the Doha round of international trade talks would give the world more every year than what Buffett can give once after a lifetime of being the world's most successful investor.

On Inequality

A student asks a broad question:

I was wondering if you could offer your views on income inequality.

Let me offer a few observations as broad as the question:

1. There is little doubt that U.S. income inequality has been increasing for the past three decades. (The trend in world inequality is very different.) Most economists who study the topic attribute the trend primarily to changes in technology that reward skilled workers relative to unskilled workers. Education and other skills are more valuable now than they were in the past.

2. Reasonable people can disagree about how much the government should redistribute income. Part of the disagreement is economic: for example, how large are the elasticities that determine tax distortions? Part of the disagreement is philosophical: for example, is taking money from high-wage individuals to give it to low-wage individuals a way to ameliorate the injustices inherent in a market economy or a form of government-sanctioned theft? Economists can help with the economic part of the disagreement, but we have no comparative advantage to help with the philosophical part.

3. However much redistribution we choose, the best way to accomplish it is by a progressive system of taxes and transfers. Economists sometimes call this a negative income tax, because low-income individuals pay a "negative" tax. The current progressive income tax together with the Earned Income Tax Credit is close to being an example (although the EITC has a variety of conditions that a pure negative income tax would not have). Wikipedia reports the following about the history of the EITC: "Enacted in 1975, the then very small EITC was expanded in 1986, 1990, 1993, and 2001 with each major tax bill, regardless of whether the tax bill in general raised taxes (1990), lowered taxes (2001), or eliminated other deductions and credits (1986). Today, the EITC is one of the largest anti-poverty tools in the United States, and enjoys broad bipartisan support."

4. Ideally, I would use consumption, rather than income, as the tax base for purposes of raising revenue and redistribution. The benefit of consumption taxes over income taxes is that they do not distort the intertemporal allocation of consumption. A variety of economists have proposed ways to implement a progressive consumption tax. For example, the Hall and Rabushka flat tax is progressive in average tax rates; the Bradford X-tax is similar but even more progressive.

5. Having achieved the desired degree of redistribution with a system of taxes and transfers, policymakers should focus on economic efficiency when setting most other policies. That is, policy regarding international trade, rent control, minimum wages, health care, housing and so on should, in my view, aim to make the economic pie as large as possible. Although these other policies affect the size of different slices, they are inefficient and poorly targeted instruments for purposes of redistribution. To the extent that we choose to redistribute income, we should use the best tools we have for that purpose (see points 3 and 4).

Steve Levitt is no macroeconomist

According to today's NY Times, Steve Levitt once said,

economics is a science with excellent tools for gaining answers but a serious shortage of interesting questions.

Steve must have skipped his classes in macroeconomics. We macroeconomists have a serious surplus of interesting questions but inadequate tools for gaining answers.

Salinger on Price Gouging

In today's Wall Street Journal, Michael Salinger (chief economist at the FTC, on leave from BU) has a nice piece on price gouging in the market for gasoline. It is based on a recent FTC report.

The bottom line is no surprise:

Just before Memorial Day, the FTC submitted its report to Congress. While the investigation found some instances of price gouging as defined by Congress, the staff concluded that virtually all the cases meeting the statutory definition were the result of competitive market forces, not market manipulation. More generally, the FTC staff concluded that the market worked much as one would expect a competitive market to respond to a shortage.

Mike also discusses the possibility of new federal laws to regulate price gouging. He views legislation as perhaps inevitable but certainly ill-advised. He suggests that we econ profs assign our students the following exam question:

Oil industry critics argue that lower inventory holdings have left the industry more susceptible to supply disruptions. How would 'price gouging' legislation affect the incentive to hold additional inventories to sell during shortages?

He offers this interesting tidbit:

the FTC investigation uncovered examples of gas stations that shut down rather than risk a suit under a state price-gouging statute.

Finally, he leaves us with this observation:

Professional economists are, of course, accustomed to giving unheeded advice.

Really? I never noticed.

Al Gore in the Pigou Club

Al Gore on the Charlie Rose Show this week reaffirmed his membership in the Pigou Club. Starting at 42:45, he endorses a revenue-neutral shift toward carbon taxes.

The Pigou Club is an elite group of economists and pundits with the good sense to have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes. The current membership includes:

• Greg Mankiw (Fortune 5/24/99, WSJ 1/3/06, 5/31/06)
• Bill Nordhaus (Foreign Policy in Focus 3/27/06)
• Martin Feldstein (WSJ 6/4/92)
• Gary Becker (Businessweek 5/27/02)
• Robert Frank (NY Times 2/16/06, 6/8/06)
• Andrew Samwick (his blog)
• Paul Krugman (Slate 4/18/97)
• Greg Easterbrook (NY Times 5/25/04)
• John Tierney (NY Times 10/4/05, 5/23/06)
• Jonathan Rauch (National Journal 2/9/02)
• Thomas Friedman (NY Times 9/21/05, 2/8/06, 6/16/06)
• Joe Klein (Time 5/7/06)
• Andrew Sullivan (Time 4/12/04)
• Jane Galt (her blog)
• Christopher Farrell (Businessweek 8/19/05)
• William Baldwin (Forbes 6/19/06)
• Clive Crook (National Journal 6/2/06)

We are always looking for more members.

Crook on Health Care Reform

The ever-thoughtful Clive Crook opines on the recent health care initiative in Massachusetts and what it takes to reform health care more broadly. An excerpt:

How to do national health reform worthy of the name? First, and most important, create a level playing field tax-wise for individuals and firms, so that nobody has a financial incentive to prefer employer-provided insurance to the individually purchased kind. You could do this by extending Connector-style tax relief to all taxpayers, or by abolishing it for employers. Abolition would be better. It would raise a lot of revenue (which will be needed in my plan) and would jolt people into changing their insurance arrangements.

Second, the free-rider problem makes the case for an individual mandate compelling, in my view. Massachusetts is right about that. And the mandate, in turn, makes health subsidies for the poor, which would be desirable in any case, unavoidable. Massachusetts is right about that, too. But to avoid the enormous problems of enforcing and administering the mandate (all in return for less-than-universal coverage in any case), turn this logic around and give everybody a voucher sufficient to buy stripped-down, Connector-style coverage.

These two ideas--scrapping the subsidy for employer-provided insurance and instituting an individual mandate--make sense to me. The individual mandate turns the traditional liberal idea on its head: Health insurance is not a right but a responsibility.

I see the appeal of the voucher idea, but I would like to see the numbers before I sign on. I am apprehensive about expanding entitlements, as we haven't figured out yet how to pay for those we have already promised.

Hillary vs Bastiat

One of the high points of the Clinton administration was Al Gore standing up for free trade against Ross Perot during the debate over NAFTA. Will Hillary Clinton continue this triangulation strategy of being a free-trade Democrat? I don't know, but check out this clue. (After reading this, you can read my views on the anti-dumping laws.)

Krugman on the Minimum Wage

An old article by Paul Krugman is relevant for the current policy debate. An excerpt:

So what are the effects of increasing minimum wages? Any Econ 101 student can tell you the answer: The higher wage reduces the quantity of labor demanded, and hence leads to unemployment. This theoretical prediction has, however, been hard to confirm with actual data. Indeed, much-cited studies by two well-regarded labor economists, David Card and Alan Krueger, find that where there have been more or less controlled experiments, for example when New Jersey raised minimum wages but Pennsylvania did not, the effects of the increase on employment have been negligible or even positive. Exactly what to make of this result is a source of great dispute. Card and Krueger offered some complex theoretical rationales, but most of their colleagues are unconvinced; the centrist view is probably that minimum wages "do," in fact, reduce employment, but that the effects are small and swamped by other forces. What is remarkable, however, is how this rather iffy result has been seized upon by some liberals as a rationale for making large minimum wage increases a core component of the liberal agenda.

Thanks to Mark Thoma for the pointer.

Niskanen on Monetary Policy

Bill Niskanen's piece in today's Wall Street Journal concludes as follows:

Mr. Bernanke and other members of the FOMC should stop speculating about future changes in the Fed funds rate. They could provide a lot of useful information to the financial markets, however, if they were more explicit about the conditions that affect their decisions on the Fed funds rate.

The distinction between speculation and useful information is less clear to me than it is to Bill. As soon as any Fed official starts providing the useful information that Bill wants, Fed watchers ask themselves what this useful information means for the next Fed decision. I am not sure how one would ever operationalize Bill's advice.

Careers in Law and Economics

A student emails me a question about being a lawyer:

Hi Professor Mankiw,

Ever since you came to Boston University and told us about your experiences at the CEA, I've been reading your blog incessantly and I love it. You give out a lot of academic advice and I appreciate it, it is really helping me with some decisions. Anyways, I am getting a masters in economics right now and was thinking about law school but I don't want to leave the field of economics. You mentioned that you can pursue an economic career with a law degree. I was wondering what type of law deals directly with economics? Does it teach you quantitative methods (When I think law, I usually think a lot of writing)? And what type of job besides being a lawyer could someone with a JD but an interest in economics (or masters) go into? I'm specifically interested in the public or international sector (non-private).Thank you and I just want to mention that your blog is much more intellectually stimulating then what I get from traditional sources of information.

[name withheld]

There are at least two areas of public policy in which economics and law are inextricably connected: tax and antitrust. If you go to the tax policy arm of the Treasury Department or to the antitrust division of the Justice Department, you will find lawyers and economists interacting every day. The same is true in several other places in government, such as the Federal Trade Commission and the staffs of Congressional committees that make tax policy. Other policy areas where economists and lawyers interact, but maybe to a lesser extent, include trade law and environmental regulation.

The economists who work in such places often appreciate lawyers with some economics training. (The reverse may also be true, but it is rarer to find economists like me who took a tour of duty in a law school). If you were to go to law school with a master's in economics, you would end up with a great mix of human capital for a policy job of that sort.

There are also international versions of these jobs. I know a tax lawyer who worked at the IMF, helping countries around the world reform their tax systems. That might be a type of job you would enjoy.

Finally, I should call to your attention a more general "law and economics" movement that tries to infuse economics more broadly into the study and development of law. One of the more famous figures here is Judge Richard Posner, whose book Economic Analysis of Law is a classic.

Toward a World Language

I enjoyed the piece by Austan Goolsbee in today's NY Times about the incentives and difficulties of immigrants' learning English. It made me recall my paternal grandmother, who never was very good in English, even though she spent most of her life in the United States. Partly as a result, my father learned Ukrainian before English, even though he was born and raised in Bayonne, New Jersey.

To those anti-immigrant readers who might take this story as a warning about things to come: Don't worry. The Mankiw family is fully assimilated now, thank you very much. Sadly, however, I inherited this grandmother's language-learning ability (rather than that of my maternal grandmother, who mastered several languages seemingly without much effort). The only language I ever managed to become proficient at besides English was Fortran.

Austan points out, no doubt correctly, that there are tremendous incentives for people to learn the prevailing language (making it pointless and a bit mean-spirited to make learning English a legal requirement). In our increasingly globalized world, I wonder how fast the trend toward a common world language will be. I also wonder which language it will be. Although a list of the most spoken languages puts Chinese at about twice English, I would bet on English. If people are weighted by their income, English would probably be the number-one language by a large margin. (If anyone has seen that calculation, please let me know.) As incentives go to learn other languages, the number of dollars will likely exert a more powerful influence than the number of people.

Here's my prediction: In 500 years, English will be the world language. You can hold me to it.

Self-Control and Academic Success

The Australian reports:

A child's capacity for self-discipline was about twice as important as his or her IQ when it came to predicting academic success.

I can believe that. But I wonder: To what extent is the capacity for self-control something we learn and to what extent is it something in our genes?

Sperling on the Minimum Wage

Gene Sperling, former economic adviser to Bill Clinton, tries to get President Bush to endorse a minimum-wage increase. Gene dismisses worries about adverse effects on employment. He writes:

No one has yet rebutted convincingly David Card and Alan Krueger's study that compared fast-food jobs on the border of New Jersey and Pennsylvania, and found no decrease in lower-wage jobs after New Jersey raised its state minimum wage.

The key word here is "convincingly." Gene is, apparently, not convinced by the Neumark-Wascher study that reevaluated the Card-Krueger work:

estimates of the employment effect of the New Jersey minimum wage increase from the payroll data lead to the opposite conclusion from that reached by CK.

Nor is he convinced by another Neumark-Wascher study that found

"no compelling evidence" that minimum wages help in the fight against poverty. A higher minimum wage...generates tradeoffs with respect to the incomes of poor and low-income families. Some families gain and others lose.

Nor is he convinced by the Neumark-Nizalova study that found adverse long-run effects of the minimum wage:

The evidence indicates that even as individuals reach their late 20's, they work less and earn less the longer they were exposed to a higher minimum wage, especially as a teenager.

Nor is he convinced by the Abowd-Kramarz-Margolis study that reported

movements in both French and American real minimum wages are associated with mild employment effects in general and very strong effects on workers employed at the minimum wage.

To me, Gene looks like a doctor prescribing a drug relying on a single controversial study that finds no adverse side effects, while ignoring the many reports of debilitating results.

Textbook Economics

A student asks an intriguing question about what happens when professors sell the free examination copies of textbooks they get from publishers:

Dear Professor Mankiw,

I am an undergraduate student currently taking a course on Principles of Microeconomics. The required textbook for the course is the fourth edition of your Principles of Microeconomics, which I have immensely enjoyed reading.

However, a NOT FOR SALE note on the back cover of the instructors edition of the book caught my eyes when I happened to see it on my professor's desk. The note reads:

This textbook has been provided free for an instructor to consider for classroom use. Selling free examination copies contributes to higher prices of textbooks for students.

This seems to contradict the analysis of changes in equilibrium that is introduced in your textbook and was discussed in our class. According to what I have learned about analyzing changes in equilibrium, I believe that selling free examination copies shifts the supply curve to the right, thus reduces (rather than increases) equilibrium prices and increases equilibrium quantity. Therefore, all else being equal, selling free examination copies DOES NOT contribute to higher prices for textbooks for students.

Professor Mankiw, would you please let me know if my analysis is correct? If so, would it not be desirable that the publisher remove or revise the NOT FOR SALE note from the instructors edition of your textbook for economics majors? It might not matter in the case of textbooks other than economics textbooks, but it can confuse economics majors.

If my analysis is incorrect, I would appreciate your step by step explanation of how so.

Note that I do not wish to encourage anybody to sell free instructors examination copies. I put this matter to you only in respect to the economic principles involved.

Sincerely,
[name withheld]

I do not view the textbook market as well described by the model of perfect competition that underlies supply and demand curves. It is much closer to the world of monopolistic competition. Fixed costs are high, marginal costs are low, and products are differentiated. In equilibrium, price is well above marginal cost, and there is free entry, which dissipates economic profits.

How does the sale of free examination copies affect this kind of market? It is a hard question. The person at the publisher who wrote that warning probably reasoned that the sale of the free examination copies by professors would reduce the company's sales, that fewer sales would drive up average costs (remember those large fixed costs), and that higher average costs would have to mean higher prices in the long run.

The story, however, is not that simple. The initial impact is of the sale of the examination copies to reduce profitability. Because lower profits discourage entry, there are fewer products in equilibrium. Fewer products would mean reduced variety and a larger market share for those products that do exist.

The hard part is figuring out how a smaller number of products translates into prices and consumer welfare. Less variety is certainly bad for consumers. Some "niche" books (for small courses, for example) might not exist at all. Fewer products could also mean less competition and higher prices, although I could imagine that this need not be the case. It would seem to depend on the form of the demand curve and the nature of post-entry competition. One would have to write down a formal model to figure it out.

Here is an analogous situation: If a person makes bootleg copies of movies and sells the pirated DVDs, is he making consumers better off or worse off? In the short run, consumers might enjoy lower prices, but because making movies is now less profitable, fewer movies are made, and consumers most likely end up worse off in the long run. The economic forces at work when professors sell their free examination copies are similar.

If you don't believe that examination copies of textbooks and bootleg copies of movies are the same, change the bootleg copies into free examination DVDs given to theater owners to help them decide which movies to show. Does it really matter how the free copies get out into the marketplace? Maybe from a legal standpoint, but probably not from an economic standpoint.

Of course, I am not a disinterested player in all this. So think it through yourself. Do these arguments make sense? Comments even more welcome than usual.

Four Worries

New things to read:

• Martin Feldstein worries about capital taxation.
• Robert Samuelson worries about inflation.
• Kevin Hassett worries about government spending.
• Larry Kotlikoff worries about economists' smarts.

Rogoff on Russia

My colleague Ken Rogoff opines about the Russian economy. An excerpt:

Most economists advocate rich countries’ replacing their complex and antiquated tax codes with a simple low flat tax, and they bemoan the fact that so few countries have tried it. Putin, however, implemented such a policy a few years ago, and the results have been nothing short of miraculous.

Peer Effects in Education

From the NBER comes a new study of educational outcomes using data from China. Here is an excerpt:

We find that students benefit from having higher achieving schoolmates and from having less variation in the quality of peers in their schools.... The marginal effect of a one percent increase in the quality of peers on student achievement is equivalent to between 8−15% of a one percent increase in one’s own earlier achievement.

We find that peer effects operate in a heterogeneous manner. High ability students benefit more from having higher achieving schoolmates and from having less variation in peer quality than students of lower ability.

In other words, there are three findings. You should want your kids to be in a class with (1) high-achieving kids and (2) low variance in achievement. And (3) you should care more if you have a smart kid.

Effect (2) suggests that ability tracking is generally beneficial, because it puts all kids in low-variance environments. However, because tracking raises the average peer for high-ability kids and lowers the average peer for low-ability kids, effect (1) makes high-ability kids achieve more and low-ability kids achieve less. Effect (3) then compounds the increased inequality.

In short, ability tracking appears to be a policy that increases efficiency and decreases equality--another example of the Big Trade-off.

Can 500 economists all be wrong?

Actually, yes, we can, but in this case I don't think we are. An open letter on immigration signed by five Nobel Laureates (Thomas C. Schelling. Robert Lucas, Daniel McFadden, Vernon Smith, and James Heckman) plus a several hundred less notable economists has been released by the Independent Institute.

An engineer seeks career advice

A graduate student in engineering emails me to ask for some advice about his educational plans:

Hi Dr. Mankiw,

I've been reading your blog for a while now, and since you seem to be so wonderful about responding to email asking for comments and advice, I thought I'd give this a try especially after reading your post about how you ended up as an economist and not a lawyer.

I'm an engineering student, currently one year into graduate studies. I suppose I was one of those people who applied to grad school "by default," without thinking enough about what it was I really wanted to do with my life. One semester in, I realized I'd made a big mistake, that although I was still interested in academic research, engineering wasn't for me. I almost quit, but decided to stay with it until I either finished a Masters or decided what else to do. So right now (to the unfortunate detriment of my thesis research) I'm looking at a few other options.

I've always been interested in economics, and I'm beginning to think it might be the right fit for me. I believe I naturally think like an economist, and I have a very strong math and stats background to go with my interest. I've also done a lot of reading on the subject (including your wonderful macro textbook). The only problem is I have absolutely no formal education in economics--not even a single course, since I thought the first year economics courses I had the prerequisites for in undergrad seemed a little too basic to spend my precious electives on.

Do you have any advice for someone like me who wants to transition into graduate studies in economics from another field?

Keep up the great blogging,
[name withheld]

In your situation, I would recommend applying directly to graduate schools in economics. As an engineer, you have the necessary background in math and statistics. If you have done as much econ reading as you say, my guess is that admissions committees will forgive you for not having taken formal economics courses.

Admissions committees for econ PhD programs are often more forgiving of a weak econ background than a weak math background. That might seem odd, but it is easily explained. As economists, we think we can help you catch up if you need help in econ. After all, econ grad school is all about studying econ. But if you have a weak math background, you will start behind and have a harder time catching up.

Another option, instead of applying directly to an econ PhD program, is to apply to a master's program, such as that at the LSE. With a master's under your belt, a subsequent application to PhD programs will look stronger.

I have met several students in the Harvard econ PhD program with stories like yours. They were "refugees" from technical fields like engineering and physics who discovered late in life their interest in economics. It was not too late for them to switch, and it is probably not too late for you. Your education may end up taking a year or two longer than it would have if you had figured out your interests earlier, but that is a small cost to pay compared with the cost of ending up in the wrong field.

Who earns the minimum wage?

The minimum wage is heating up as a political issue, so some readers might want to learn more about the characteristics of minimum-wage workers. The Labor Department has a good fact sheet on the topic.

One fact missing from this sheet, however, is the percentage of minimum-wage workers who are in families below the poverty line. Although the minimum wage is often considered an anti-poverty program, in fact many minimum-wage workers are teenagers from middle-class homes. For example, my first full-time job (exactly 30 years ago) was a minimum-wage job; although my family wasn't rich, we also weren't poor.

An old study from the CBO reports:

Four-fifths of all minimum wage workers are not poor.... Part of the explanation for why so many minimum wage workers are not poor is that over two-thirds of them are in families in which at least one other member has a job.

I am sure someone has updated this fact, but I don't know a source. I checked with one of my empirical labor economist friends, and he said this CBO number still seemed about right to him.

Question about Sticky Prices

A student emails me a question about price adjustment:

Dear Professor Mankiw:

My name is [name withheld], a student of financial economics. Today I immensely enjoyed your Macroeconomics book (2000) at a library. Your book should be among the best in its category.

I have some comments on "Sticky prices."

Although 39% of firms may change prices once a year, doesn't the economy demonstrate continuous or smooth changes? Don't CPI, PPI, and other indices change every month, every week, and everyday? Today, hundreds of firms would have changed their prices. Tomorrow another hundreds of firms would do so. Each firm changes their prices at different time.

Would you please make a brief response. Thank you very much.

[name withheld]

Your letter raises an important question: how can we go from the firm-level observation that many prices are adjusted only intermittently to the economy-wide issue of adjustment of the price level (as measured by the CPI) to macroeconomic shocks? This question, it turns out, is hard, and there has been a lot of research on it.

One famous paper, by Caplin and Spulber, showed that under some conditions, the overall price level will not be sticky in response to monetary shocks, even though individual prices are sticky. The reason is that those prices that are changed move by a large amount. So when the money supply rises by 1 percent, the overall price level rises by 1 percent immediately, even though many individual prices are stuck at old levels. For example, under the Caplin-Spulber conditions, 90 percent of prices could be sticky, while 10 percent of prices are adjusted upward by 10 percent. The overall price level parallels the money supply without any delay.

The Caplin-Spulber paper was important for illustrating that individual price stickiness need not imply aggregate price stickiness. Yet these results require strong assumptions about the economic environment. A subsequent paper by Caplin and Leahy relaxed the Caplin-Spulber assumptions and reached very different conclusions. And there has been considerable work on the topic since then.

The subsequent literature is too vast to explain in a brief blog entry. I assume you were reading my intermediate macro text. If you want to pursue the subject further, I recommend you continue your studies with the graduate-level textbook Advanced Macroeconomics by David Romer.

A Possible Estate Tax Compromise

When I was in Washington, I got to like Ways and Means Committee Chairman Bill Thomas. Not everyone working in the White House shared that view. Some people found him hard to work with, but I was impressed by his intelligence and by the fact that he was usually fighting for good policy, as he saw it.

Last night, Thomas introduced a bill, Committee on Ways and Means H.R. 5638, the Permanent Estate Tax Relief Act of 2006. Here are some details:

• Increased Estate and Gift Tax Exemption: The Permanent Estate Tax Relief Act of 2006 would increase the exemption amount to $5 million per person effective January 1, 2010.
• Lower Estate and Gift Tax Rates: The Permanent Estate Tax Relief Act of 2006 would reduce the rate of tax on estates up to $25 million to the capital gains tax rate (currently 15 percent, set to increase to 20 percent in 2011 unless extended).
• The bill would reduce the rate of tax on estates of $25 million or more to twice the capital gains rate (currently 30 percent, set to increase to 40 percent in 2011 unless extended).

I continue to favor repeal of the estate tax, as Thomas probably does. But this bill is a good faith effort to find a compromise with those who hold the opposite view. This legislation could get the necessary 60 votes in the Senate and put an end to the tremendous uncertainty now surrounding the future of the estate tax.

Update: Today's Wall Street Journal reports on the Thomas bill. It includes this tidbit:

To appeal to a few key Senate Democrats, Mr. Thomas included incentives for the timber industry. The legislation includes a new 60% deduction for qualified timber capital gains.

It would be good for some journalist to figure out who those Senators are and to ask them why they think a special timber tax break is good policy.

How to Fix Social Security - update

The video on the LMS Social Security plan (discussed in a previous post) is now available.

The next Fed chair

Steve Liesman has an intriguing idea about what it takes for the chairman of the Federal Reserve to establish credibility:

This may sound absurd (but might not be in the context of Bernanke), but think of the Biblical story of Abraham and Isaac. Only by showing that he was willing to sacrifice his son could Abraham prove the credibility of his faith. This is the test that markets are putting Bernanke through.

Note, he doesn't have to cause a recession, just make markets believe 100% that he will to fight inflation. And I mean 100%. There is no wiggle room.

Hmmm....That gets me thinking.

If we really need a Fed chair who is willing to make any sacrifice, ruthlessly do whatever it takes, no matter how draconian, to further the national interest, I know the perfect candidate: Jack Bauer.

Furman on Health Insurance

Economist Jason Furman, a frequent adviser to Democratic candidates, has a new article on health insurance that is well worth reading. In this excerpt, Jason points out that our tax code leads to excessive use of health insurance:

if your employer pays $1,000 in premiums to your insurance company, that money is effectively tax deductible to you. But if your employer raises your salary by $1,000 and you use the extra money to pay for medical bills, you generally will not get a tax deduction. As a result, many people end up with more-generous health insurance plans than they would otherwise choose to have. These plans have lower deductibles, lower co-payments, and lower co-insurance and are often focused around providing first-dollar coverage for routine medical expenses, rather than genuine insurance. As a result, individuals in the health system are often spending someone else’s money, which is never a recipe for cost consciousness. Unfortunately, ultimately it is not really someone else’s money: the cost is paid in higher premiums, which in turn are reflected in lower wages.

Most economists agree with this analysis (see my previous post on health insurance).

Jason suggests several policy responses, such as limiting the amount of health insurance that is tax-deductible. That proposal has my vote.

Kling, Gore, and Pascal

Arnold Kling writes:

I do not think that economists ought to be bullied into believing in human-caused global warming. Paying a big carbon tax "just in case" is sort of like an agnostic making a big contribution to a church "just in case."

I am not a scientist and am therefore agnostic about a lot of issues surrounding global warming. Suppose I assign a probability p that Al Gore is right. The optimal policy from my perspective is not to oppose a carbon tax unless p exceeds some threshold. Instead, the optimal tax is increasing as a function of p and is positive for any p>0. A person who thinks p is small would not want a big carbon tax but should endorse a modest one.

On giving money to a church "just in case," Pascal might argue with Arnold, but I won't offer an opinion. I want to stay clear of religion on this blog. Economics is controversial enough.

Update: Bryan Caplan notes that a positive tax for all p>0 need not hold if there are fixed costs of setting up the tax system. Point taken. I was implicitly making some standard continuity assumptions that ensure that small taxes have small effects. A fixed cost would be a counterexample to those assumptions.

Surprise!

George Bush at the 2004 Republican Convention:

We must strengthen Social Security by allowing younger workers to save some of their taxes in a personal account -- a nest egg you can call your own, and government can never take away.

Paul Krugman in today's NY Times:

in 2004, President Bush basically ran as America's defender against gay married terrorists. He waited until after the election to reveal that what he really wanted to do was privatize Social Security.

Parents are people too

One of the Ten Principles of Economics is that "People Respond to Incentives." On this father's day, here is a story to remind us that this principle applies to would-be parents.

As Joshua Gans tells it, in May 2004, the Australian government announced that it would give a $3000 maternity allowance for babies born on or after July 1, 2004. So what happened?

No surprise: a decline in births just before the cutoff and a surge in births just afterward. Economists call this intertemporal substitution. Gans reports:

Indeed, the 1st July, 2004, had the most number of births in a single day over the entire 30 years of data we had (almost 11,000 days). The 2nd July was no slouch either, being the 7th highest day. This was a big effect.

The lesson: Always remember the Ten Principles.

FYI, Gans is one of my coauthors for the Pacific Rim adaptation of my introductory text.

On Means Testing

The mysterious knzn makes a good point about means-testing entitlement programs for the elderly, such as Social Security and Medicare. He notes that from the standpoint of incentives, means-testing is equivalent to a tax increase. As a result, economists worried about the adverse incentive effects of taxes (like me) should be also worried about the adverse incentive effects of means-testing.

Knzn is exactly right about the equivalence. (I was once in a conversation about possible Medicare reforms, where a bunch of policy wonks were discussing the idea of making co-pays rise steeply as a function of income. I asked, "Aren't we in effect talking about an income tax surcharge levied only on old, sick people?") As a general matter, those of us who think the incentive effects of taxes are large should be careful before we endorse means-testing.

Beyond the general equivalence of taxation and means-testing, two further issues make means-testing of Social Security and Medicare even less attractive.

First, for seniors, a higher fraction of their income is capital income rather than labor income. If capital taxes are less efficient than labor taxes, as many economists believe, then means-testing would seem to be less efficient than an overall increase in income taxes. In other words, means-testing Social Security and Medicare would largely be a form of a capital taxation and, as such, could provide a huge disincentive for saving.

Second, seniors can easily hide capital. Medicaid covers nursing homes for poor seniors, and a significant problem is asset shedding--giving assets to children in order to claim eligibility. A whole industry of Medicaid lawyers helps seniors structure their finances to become eligible for government handouts. More extensive means-testing would encourage that industry to grow even larger.

Is there a solution to these problems that would make means-testing less distortionary? One possibility is to define "means" not as income or assets in old age but, instead, as average lifetime earnings. The Social Security Administration is already collecting the necessary data, so this solution is feasible. In this case, means-testing would be like a lifetime earnings tax, which is still distortionary but probably less so.

Under this plan, a person who earns a lot throughout his life and blows it, ending up penniless, would not be eligible for generous benefits. Some people might view this outcome as unfair. However, any option that is kinder to such a person will inevitably provide disincentives for people to prepare for their own retirement.

Things to Read

Here are a few items worth reading:

• FT's lunch with Gary Becker
• An LA Times editorial on Fed watching
• Spending cuts proposed by Jeff Miron
• A view from Wall Street on Ben Bernanke
• A tribute to Larry Summers

CAFE Standards

Some commentators have suggested that I am too quick to reject corporate average fuel economy (CAFE) standards. Here is a good explanation of my view, courtesy of the CBO:

This issue brief focuses on the economic costs of CAFE standards and compares them with the costs of a gasoline tax that would reduce gasoline consumption by the same amount. The Congressional Budget Office (CBO) estimates that a 10 percent reduction in gasoline consumption could be achieved at a lower cost by an increase in the gasoline tax than by an increase in CAFE standards. Furthermore, an increase in the gasoline tax would reduce driving, leading to less traffic congestion and fewer accidents. This analysis stops short of estimating the value of less congestion and fewer accidents and, therefore, does not draw any conclusions about whether an increase in the gasoline tax would be warranted. However, CBO does find that, given current estimates of the value of decreasing dependence on oil and reducing carbon emissions, increasing CAFE standards would not pass a benefit-cost test.

The Pigou Club

As readers of this blog know, I am a fan of Pigovian taxes. These taxes allow us to correct market failures without heavy-handed regulations, while raising government revenue so we can reduce more distortionary forms of taxation.

I am not alone in this view. Here are a list of some economists and pundits who at times have advocated higher gasoline taxes or carbon taxes:

• Greg Mankiw (Fortune 5/24/99, WSJ 1/3/06, 5/31/06)
• Bill Nordhaus (Foreign Policy in Focus 3/27/06)
• Martin Feldstein (WSJ 6/4/92)
• Gary Becker (Businessweek 5/27/02)
• Robert Frank (NY Times 2/16/06, 6/8/06)
• Greg Easterbrook (NY Times 5/25/04)
• John Tierney (NY Times 10/4/05, 5/23/06)
• Jonathan Rauch (National Journal 2/9/02)
• Thomas Friedman (NY Times 9/21/05, 2/8/06, 6/16/06)
• Joe Klein (Time 5/7/06)

I call this group the Pigou Club. We are looking for more members.

If commentators know of other economists and pundits who have publicly advocated higher Pigovian taxes, please let me know, including the relevant citation.

Senator Obama's Twofer

Here is an idea that I understand is gaining support in Democratic circles, as described earlier this week in the NY Times:

Sen. Barack Obama has proposed striking a bargain with American automakers to help them with retiree health care costs in exchange for higher fuel efficiency standards.

I will let readers complete the equation:

Unjustified corporate bailout + Increase in heavy-handed regulations = ????

On Forecasting Inflation

Several readers have asked me to weigh in on the Krugman-Cecchetti debate on whether inflation is about to calm down or take off. I don't have a dog in this fight. I posted the two views because it is interesting whenever two economists as smart as Paul and Steve reach diametrically opposite conclusions. It is always food for thought.

Paul's view, as I understand it, is that we need not worry about inflation until we see inflation in nominal wages. He points out (correctly) that labor is the largest component of costs. He reasons that if the cost of labor grows slowly, as it has recently, inflation in the prices of goods and services won't be a problem. The logic is almost, but not quite, compelling.

Steve has a more purely data-oriented approach to the issue. His thinking is informed more by time-series econometrics than by a particular theoretical model of wage-price dynamics. Here is what econometricians say about Paul's hypothesis:

Lags of nominal wages do not seem to add information beyond that contained in lags of prices.

That quotation is from "Forecasting Inflation" by James H. Stock and Mark W. Watson (Journal of Monetary Economics, Volume 44, Issue 2, October 1999, Pages 293-335). Stock and Watson are two of the best applied econometricians around.

How should one reconcile Paul's observation that wages are a large part of costs with this time-series result that wages don't help forecast inflation? I don't know. (Students looking for thesis topics: Your ears should perk up now.)

One possibility is that nominal wages are a lagging indicator of inflation. Maybe the prices of goods and services have a dynamic of their own, perhaps described by some kind of Phillips curve, and nominal wages respond with a lag to prices. This is consistent with a view of labor markets in which wages are not allocative in the short run but, instead, are more like installment payments on long-term contracts. If that is the case, then one should not take much solace in Paul's observation that nominal wage inflation has been contained.

Krugman vs Cecchetti on Inflation

In today's NY Times, economist Paul Krugman writes about the outlook for inflation and monetary policy:

Over the last few weeks monetary officials have sounded increasingly worried about rising prices. On Wednesday, Richard Fisher, the president of the Federal Reserve Bank of Dallas, declared that inflation ''is running at a rate that is just too corrosive to be accepted by a virtuous central banker.'' I'm worried too -- but not about recent price increases. What worries me, instead, is the Fed's overreaction to those increases....

Much of the recent rise in core inflation probably represents the delayed effect of the big run-up in fuel prices a few months ago. And unless something else happens to drive up oil prices -- like, to give a wild example, a military strike on Iran -- inflation will probably subside in the months ahead.

Two days ago, economist Steve Cecchetti offered a different take on the situation:

This morning's CPI report confirms many people's worst fears. Inflation is up. The all items CPI rose 5.5% at an annual rate for the month of May, and is up 4.2% since May 2005. This is well above recent (or acceptable) trends. Core measures faired little better, with the CPI excluding food and energy up 3.6% (a.r.) in May, and 2.4% over the past 12 months. The Median CPI computed by the Federal Reserve Bank of Cleveland increased 4.3% (a.r.) for the month, and is up 2.7% for the year. Importantly, the trends in all of these numbers are up. This time around, the detail of the report is worse than the headline numbers....

The implications for monetary policy are pretty clear. With inflation at 3%, one percentage point above the 2% implicit target of the FOMC, we can now expect the federal funds rate to rise to at least 6%. But the risk is that it will not stop there. I could easily see the inflation trend rising to 3.5% over the next 6 months, and then the federal funds rate will have to go much higher.

For those who don't know him, I should note that Steve is a professor at Brandeis and author of a leading textbook on money and banking; he was previously Director of Research at the Federal Reserve Bank of New York. This does not mean that he is right about the inflation outlook, but it does mean that his view is worth taking seriously.

Update: Read more in my next post on forecasting inflation.