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.

Update: 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.

Update: Here is some advice from Susan Athey about applying to grad school in economics.

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.

----

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.

Bloggers on Immigration

Three of my favorite bloggers have new posts on the economics of immigration:

• Tyler Cowen
• Gary Becker
• Richard Posner

Krugman blasts Lieberman (unfairly)

In today's NY Times, Paul Krugman calls Senator Joe Lieberman to task for consorting with liars:

Mr. Lieberman repeatedly supported the administration's scare tactics. ''Every year we wait to come up with a solution to the Social Security problem,'' he declared in March 2005, ''costs our children and grandchildren and great-grandchildren $600 billion more.''

This claim echoed a Bush administration talking point, and President Bush wasted little time citing Mr. Lieberman's statement as vindication. But the talking point was simply false, so Mr. Lieberman was providing cover for an administration lie.

Blogger Don Luskin defends Lieberman:

According to the Social Security Trustees' Annual Report, 2006, Table IV.B5: the system's unfunded obligation stands now at $4.934 trillion. According to the same table from the previous year's report, it was $4.318 trillion. Thus the growth from year to year was $616 billion. Krugman may dispute the meaning or accuracy of this figure on technical grounds, but there is simply no way he can look at the numbers and characterize Lieberman's statement as an "administration lie."

So were Lieberman and Bush telling the truth or not? When answering this question, it helps to understand what that $600 billion figure represents.

The issue comes down to the economics of discounting. Let's say I have a $200 debt to a bank that is due in 10 years, and the interest rate is 7 percent. The present discounted value of that obligation is $100 today. That is, if I were to extinguish the debt right now, it would cost me $100. If I wait a year, the repayment obligation would then be only 9 years away. At that point, extinguishing the debt would cost me $107.

One might say that waiting an extra year costs me an extra $7. Or one might not. After all, paying $107 next year is equivalent in present value to paying $100 today. One might say I haven't cost myself anything by waiting.

Now suppose my friend Joe offers me some financial advice: "Greg, you should really pay off that debt now, because waiting a year will cost you an extra $7." How should I respond?

(a) "Yes, Joe, you are right."
(b) "No, Joe, that's not the best way to think about it."
(c) "Joe, you are a liar."

I think (a) and (b) are defensible points of view. But Krugman chose (c).

Time to Change Your Major?

Advice for my ec 10 freshmen: Freakonomist Steve Levitt explains why you should major in economics.

Update: Another reason.

The Harvard Paradox

In his last faculty meeting as Harvard President, Larry Summers told me and my colleagues the following:

I have been troubled, and I believe you should be troubled, by survey data suggesting that student satisfaction at Harvard is much closer to the bottom than to the top of any list of leading American colleges, and that the relative satisfaction of our students declines with each year that they are here.

Four days earlier, the Harvard Crimson reported:

Eighty percent of students admitted to the Class of 2010 will matriculate at the College next year, giving Harvard its highest yield in over a quarter century....Harvard’s yield this year will likely once again top its peers. Last year, Harvard’s 78.5 percent bettered Yale’s 72 percent, Princeton’s 67.7 percent, and the University of Pennsylvania’s 66 percent yields.

It is an odd business that has customers who are simultaneously unhappy about the product and eager to buy it.

Comments welcome, especially from my ec 10 students.

Hamilton Reads the Tea Leaves

UCSD economist Jim Hamilton is a smart analyst of economic data. Here is what he sees now:

Real yields are up about 40 basis points, while nominal yields are up 80. The increasing gap suggests that investors may be anticipating about a half a percent higher long-term inflation rate than they were anticipating at the start of this year.

Bernanke may think we've got a solid anchor, but this boat seems to be drifting.

If the only incoming data had been the new indications of a pending slowdown in real economic activity, the logical call for the Fed would be to hold the rate constant. If the only incoming data had been the new inflation numbers, the logical call would be for a rate hike. But just what is the logical thing to do when both come at the same time?

I'm not sure, but just for fun let me hazard a guess of what the FOMC might do. The rising gap between nominals and TIPS is a hard number already in hand that we can point to, while the rest we see through a glass, darkly. So I'll throw my hat in the ring by predicting another hike in the fed funds rate to 5.25% at the end of June.

Review Roundup

Today's Washington Post reviews economists Bill Easterly and Eddie Lazear.

Baker on the Dollar

Economist Dean Baker skewers a NY Times editorial on the value of the dollar in foreign exchange markets. His bottom line:

There are good arguments for reducing the budget deficit, but it’s just silly to pretend that the pain from a falling dollar is attributable to the budget deficit, or that a lower deficit will somehow prevent this pain.

The Daily Show on Taxes

As a former economic adviser to President Bush, I am not supposed to laugh at John Hodgman's send-up of Bush's Tax Cuts, but I couldn't help myself. (Thanks to Alex Tabarrok for the tip.)

Inequality and the Budget Balance

When the rich get richer, so do the feds.

Today's Wall Street Journal reports:

As America's rich get richer, the taxes they pay on their increasing income is yielding a windfall for the U.S. Treasury.

The Bush administration and its supporters point to a recent surge in tax receipts as vindication of the 2001 and 2003 tax cuts that critics say favored the wealthy. And even opponents of the tax cuts acknowledge that the surge in unanticipated revenue is coming from the rich.

With wealthy Americans taking an increasing share of total household income and paying a greater share of total taxes, "what we're seeing is a repeat of the late '90s, where you get a flood of tax revenues from the hyper-rich," said Rudolph Penner, a former Congressional Budget Office director now at the Urban Institute think tank. "It may raise some worries socially, but it certainly is good for revenue."

Penner is right: Part of the movement from budget deficit to budget surplus in the late 1990s was attributable to increasing income inequality, which naturally interacts with the progressive federal tax system.

I don't recall seeing a good analysis of how much changes in income inequality have historically driven changes in the budget balance. If anyone is aware of a study of the issue, please let me know.

Free Research Topic

I know some econ grad students read this blog, so let me offer them a suggestion for a dissertation chapter (or maybe for a Harvard undergrad senior thesis): More work on dynamic scoring, focusing on human capital.

In my paper with Matthew Weinzierl on dynamic scoring, we wrote in the conclusion:

Although we have explored several variations of the basic Ramsey model to evaluate the robustness our conclusions, there are surely issues still to be addressed. As we noted earlier, some economists have emphasized the short-run Keynesian effects of tax policy, and these effects may be important for dynamic scoring. In addition, much of the literature on economic growth has stressed the role of human capital, which is absent from the models considered here. How tax policy affects human capital accumulation and how human capital affects economic growth are hard questions, but they may be crucial for revenue estimation, especially over longer time periods. Finally, examining alternative financing regimes may also prove fruitful; our assumption that lump-sum transfers adjust immediately to revenue changes has usefully simplified the problem but may be empirically unrealistic. In light of all the open questions, the results presented in this paper should be viewed only as first steps.

The topic of financing has already been taken up by Leeper and Yang (although I am sure their paper is not the last word on the subject). But the other two suggestions we made are wide open.

In my previous post, I quoted a passage from Eddie Lazear in which he emphasizes the effect on taxes on human capital accumulation. It would be useful to expand on Eddie's insight by building the human capital decision into an explicit growth model and then using the model to perform dynamic scoring of tax changes.

Lazear on Taxes

CEA Chair Eddie Lazear gave a nice talk to the National Tax Association on Thursday. He laid out some principles of good tax policy:

First, an efficient tax system should not favor current consumption over future consumption....Second, all focus of capital investment should be treated similarly....Third, the tax system should not push any particular form of corporate governance....Fourth, the tax system should not discourage investment in human capital, which is so essential to economic growth.

A majority of economists would applaud these principles. Here is a passage that will likely prove more controversial:

To further investment in human capital, it is necessary that the progressivity of the tax system not become too pronounced. If high incomes are taxed at too high a rate relative to lower incomes, the incentives to invest in human capital decline. One can see the effects of tax created impediments to human investment in countries where salary compression was highly pronounced, such as the Eastern European economies around 1990. Many highly skilled individuals chose to drive taxis for tourists rather than to use their skills because the wages were higher in the tourist industry than they were in the professional occupations. Had that pattern persisted into the long run, it would imply chilling effects on investment in education. Indeed many of the professionals in those countries migrated to the West in order to take advantage of the higher wages associated with high skills.

The principle here is clearly right. Where economists disagree is over elasticities--that is, on the size of these incentive effects.

One topic missing from the talk is some ways to raise tax revenue without raising tax rates. Last November, the President's Advisory Panel on Federal Tax Reform (of which Eddie was a member) offered several good suggestions for base-broadening. In particular, they proposed eliminating the deductibility of state and local taxes and scaling back the mortgage-interest deduction. Both are good ideas.

Measuring Investment

A high-school economics teacher emails me the following comment:

In the traditional GDP equation of Y = C + I + G + NX all public expenditure is lumped together as one sum. It seems to me that we should consider whether the government expenditure is on consumption or capital goods. Doing so would give us a more accurate sense both of total investment and of the concept of "crowding out."

Yes, that is exactly correct. The traditional National Income Accounts identity separates private consumption C from private investment I but does not make the same distinction for public spending G. For many purposes, that decomposition is too crude, and it is useful to separate public consumption from public investment.

It is, however, hard to decide which government expenditures should count as public investment. Here are a few things that the government buys:

• Office buildings
• Roads
• Military equipment
• Education
• Healthcare for a child
• Healthcare for a middle-aged person
• Healthcare for a senior in the last days of his life

The top of this list is clearly investment, and the bottom of the list is clearly not. But in the middle, it is harder to say.

Education, for example, is a combination of investment and consumption. I suppose it depends on how much a person is enjoying school and perhaps on what he is studying. A person learning auto repair in a public vocational school is accumulating human capital, and the teacher's salary is arguably a government capital expenditure. But would you say the same thing for the salary of the soccer coach?

Some of the same ambiguities arise in the measurement of private investment. For example, spending on college tuition is counted as private consumption, not investment. If we counted spending on human capital as investment, U.S. saving and investment would be higher as a percentage of GDP than they are under current measurement conventions.

Human capital becomes particularly vexing once we recognize that the most important input into its production is students' time. Maybe your high-school students should be viewed as members of the labor force who are employed producing human capital. That perspective would require a very different measurement of GDP and its components.

How to Improve Journalism

Many economists have expressed dismay at the quality of economics journalism. Economist Brad DeLong, for instance, makes insulting journalists a staple at his blog (when he is not too busy insulting Republicans).

There are probably many reasons why the quality of economics journalism is not better than it is, but an article in today's Wall Street Journal suggests one of the problems:

According to the forthcoming book "The American Journalist in the 21st Century," 36.2% of journalists with college degrees were journalism majors. If you include journalism-related "communications" majors, the percentage jumps to 49.5....

So what do aspiring journalists learn in school? Undergraduate courses of study vary, but if you survey course catalogs, there's a heavy emphasis on process and theory. At Ohio State, for instance, a student majoring in journalism might take some substantive core courses, such as introductory American History, Math and Microeconomics. But a large portion of his coursework will be taken up with classes such as Principles of Civic Journalism, Topics in Public Affairs Journalism or Industry Research Methods.

In short, many journalists simply do not have sufficient training to do a good job.

Here's my radical suggestion to the editors of the world: Require all your economics reporters to have an undergraduate degree in economics. And give a raise to those who spent the extra year or two getting a master's in economics as well. (We don't have such a program at Harvard, but there is a good one at the LSE.)

Economics is a technical field that cannot be easily learned on the fly. Unfortunately, that is often what economics journalists try to do.

Update: Brad DeLong comments:

I'm sure Greg's proposal would produce articles I would like a lot more. While (somewhat) sufficient, however, is it necessary?

No, it is not strictly necessary. It is also not necessary to have a degree in economics to become a professional economist (as David Friedman proves), but it helps.

Blinder on Monetary Policy

In a new paper, Princeton economist Alan Blinder asks 16 questions about monetary policy and answers most of them. The article is a good primer for aspiring central bankers.

Rogoff on Wal-Mart

In a new op-ed, my colleague Ken Rogoff addresses the economics of Wal-Mart. The most striking paragraph:

Together with a few sister “big box” stores (Target, Best Buy, and Home Depot), Wal-Mart accounts for roughly 50% of America’s much vaunted productivity growth edge over Europe during the last decade. Fifty percent! Similar advances in wholesaling supply chains account for another 25%! The notion that Americans have gotten better at everything while other rich countries have stood still is thus wildly misleading. The US productivity miracle and the emergence of Wal-Mart-style retailing are virtually synonymous.

Poets and Plumbers

In my most recent paper, I divided macroeconomists into scientists and engineers. After reading this description of Paul Romer's contributions to growth theory in the current issue of the Economist, I began to wonder whether a better metaphor would be poets and plumbers:

Mr Romer is quoted comparing the building of economic models to writing poetry. It is a triumph of form as much as content. This creative economist did not discover anything new about the world with his 1990 paper on growth. Rather, he extended the metre and rhyme-scheme of economics to capture a world—the knowledge economy—expressed until then only in the loosest kind of doggerel. That is how economics makes progress. Sadly, it does not, in and of itself, help economies make progress.

This passage does a good job of capturing what many applied economists (like me) feel about economic theory: Too much of it is beautiful but useless.

Maybe I don't appreciate the beauty of economic theory sufficiently. I also don't have a well developed appreciation of poetry.

Making Illegals Pay Up

If the government wants to make sure that illegal immigrants pay their fair share in taxes, it should use sales taxes rather than income taxes. The reason: Sales taxes are harder to evade. So says economist Bruce Bartlett in today's Wall Street Journal:

Illegal aliens probably pay very little state income taxes, but close to their share of sales taxes. Therefore, states that rely more heavily on sales taxes than income taxes are going to get more revenue out of their illegal aliens to pay for the expenses they incur.

This helps explain why California is burdened much more by illegal aliens than Texas. The latter has no state income tax and raises almost all of its state-level revenue from general and selective sales taxes. In 2005, Texas obtained 79% of state revenue from these sources. By contrast, California raised a majority of its state revenue from income taxes, with just 38% coming from sales taxes.

Thus Texas gets the vast bulk of its revenue from sources that are most likely to be paid by illegal aliens, while California gets the bulk of its revenue from sources that they are much less likely to
pay.

Update: Jason Furman emails me a well-reasoned rebuttal to Bartlett:

There are a lot of good reasons to switch to consider switching to a consumption tax (although an X-tax would probably be preferable to an add-on VAT with all the unnecessary complications associated with multiple tax bases). But I would not include broadening the tax base to include the illegal sector in my list: my understanding is that this is an often repeated fallacy.

For the sake of illustration, consider switching entirely from an income tax to a sales tax. Drug dealers and nannies would pay taxes when they go to the grocery store. But the employees/owners of the grocery store will no longer pay any taxes on the portion of their income they spend on illegal drugs and nannies. Ignoring complications like the timing of consumption and progressive taxes, the income of drug dealers and nannies that goes untaxed under an income tax is exactly equal to the consumption of formerly taxpaying workers that would no longer be taxed under a sales tax. No new revenue is raised.

Moreover, the economic incidence of taxes wouldn't change either. Although drug dealers and nannies appear to pay sales taxes, they would also have the special privilege of selling their goods and services sales tax free. With competitive markets, a 20% sales tax would lead to a 20% markup in the price of legal goods (with the markup going to the government) and a 20% percent markup in the price of nannies or drug dealers (with the markup going to the nannies and drug dealers, effectively reimbursing them for the sales taxes they appeared to pay). Everyone would have the same consumption patterns as before.

I assume that progressive taxes, systematically different savings rates, imperfect competition, or behavioral issues could all change these results somewhat, but I don't think the change would be first order and I'm not even confident that the sign would be in the direction of the Bartlett claim.

Lazear says No to Rent Seekers

Economists define rent seeking as follows:

Rent seeking is the process by which an individual or firm seeks to gain through manipulation of the economic environment rather than through trade and the production of added wealth. Rent seeking generally implies the extraction of uncompensated value from others without taking actions which improve productivity, such as by imposing regulations or other government decisions harming consumers. [from Wikipedia]

Here is an example of rent seeking in action, from a report today by Reuters:

Detroit's Big Three automakers sought incentives from Congress on Thursday to broaden access to alternative fuels -- a step they hope will boost their sagging finances and cut reliance on imported oil.

Republican and Democratic leaders from the House of Representatives and Senate expressed support for helping executives from General Motors Corp., Ford Motor Co. and Chrysler Group with their agenda.

It was repelled by CEA chair Eddie Lazear:

The auto executives will make their pitch to President George W. Bush on June 2. Bush favors some incentives for developing alternative fuels but the White House basically wants the auto industry to fix its own problems....

White House economist Edward Lazear, who is chairman of the White House Council of Economic Advisers, said it was not Bush's job to tell the automakers how to run their companies.

"We're obviously hoping that things will work out so that those companies can get back on their feet and be productive. But I don't see any direct intervention by the president," Lazear told Reuters in an interview.

New Fed Vice Chair

According to Reuters,

President George W. Bush has nominated Federal Reserve Governor Donald Kohn as vice chairman of the central bank's Board of Governors, the White House said on Thursday.

I know Don, and he is an excellent choice. With Bernanke as #1 and Kohn as #2, the team at the helm of the Fed is as good as it gets.

To know them is to love them

Economist Bryan Caplan offers some intriguing evidence at his blog that direct observation of immigrants makes a person more favorable toward immigration.

Monuments as Natural Monopoly

A commentator on this blog once accused me of being a closet libertarian, and sometimes I feel that way myself, but reading the blog of my libertarian friend Jeff Miron usually cures me of that delusion.

Today, Jeff says we should privatize national monuments. He writes:

This approach ensures efficient use of the land areas in question. If the most profitable use is a cultural or historical monument, private owners will choose that option. If the most profitable use is oil and gas exploration, private owners will choose that instead. And if the most profitable use is a scenic area for hikers, private owners will choose that.

The last three sentences are true, but they do not prove the first. Efficiency requires maximizing the sum of producer and consumer surplus, whereas profit maximization considers only producer surplus.

National monuments, such as the Lincoln Memorial, are natural monopolies, in the textbook definition of the term. There is a large fixed cost of setting it up and approximately zero marginal cost of an extra person walking through and seeing the statue. Average cost is declining in the number of visitors. Depending on the demand curve for visits, it is possible that it is efficient for the Memorial to exist without it being profitable for a private firm.

One might ask: Doesn't the same argument apply to all public art? Yes, it does, and it can justify government subsidies to the arts. (The same argument cannot be used to justify subsidies to the arts enjoyed in private settings, such as opera.) The argument also explains why the government runs, say, Central Park in New York City, rather than selling it to Disney to turn into a theme park or to Donald Trump to build condos.

Jeff might be skeptical of using the natural-monopoly argument on the grounds that the government is not very good at figuring out what goods to provide. I would agree. But there is a clear market failure here, and we have to weigh the market failure against the government failure that arises when the government tries to fix the market failure. It is a tough judgment call. It seems unlikely to me that weighing the pros and cons will always lead to the small-government outcome, as Jeff seems to suggest.

The Pursuit of Happiness

Economists have become increasingly interested in data on self-reported happiness. (Examples: Here and here and here.) I therefore enjoyed a recent article in Slate. Here is an excerpt:

Economists David Blanchflower and Andrew Oswald have suggested that a lasting marriage produces as much happiness as an extra $100,000 a year in salary. This might sound like a strong case for getting hitched. But many economists have shown that happiness is expensive—$100,000 will buy you only a small amount of joy. Studies like these also hide individual variation. Marriage isn't worth $100,000 to just anybody. A recent German study found that matrimony's hedonic gains go disproportionately to couples who have similar education levels but a wide income gap. Worse yet, on average, people adapt very quickly and completely to marriage. As anyone who's ever consumed seven pumpkin pies in one sitting knows, we quickly get used to our favorite new things, and we just as quickly tire of them. As Harvard psychologist Dan Gilbert artfully puts it, "Psychologists call this habituation, economists call it declining marginal utility, and the rest of us call it marriage."

We submit that a relationship with a PlayStation 3 is worth at least $100,000 a year in happiness for all individuals. Unlike a nagging spouse, the PS3 doesn't care about your income or your level of education—it loves you just the way you are. It is true that you will eventually become accustomed to your sleek new PS3, but this will take an extremely long time. The PS3, after all, has been built expressly to keep mind-blowing novelty coming and coming and coming. Periodic infusions of novelty—new games—will keep the endorphins flowing.

My 11-year-old son would likely agree with this analysis. He is far more interested in his Gameboy than in girls. We'll see how long that lasts, but at least for now, his Gameboy seems to bring him endless hours of happiness.

What I, like many parents, try to impress upon my children is that there is a vast difference between between happiness and satisfaction, that a good life is more important than a happy one. As economists embark on happiness research, that is a lesson we should remember as well. It is tempting for economists to treat self-reported happiness as utility, which in turn enters the benevolent social planner's objective function. That assumption is appealing because it is so convenient, but is it right?

Here is the real puzzler: What if my son tells me that blogging is just my version of his Gameboy? I am not quite sure how I'll respond.

The Morality of the Global Economy

A student from Williston Northampton School emails me some questions about the global economy. He writes:

Is it fair for countries to have a comparative advantage because they compensate their workers in a different manner than we Americans do?...I think it can go without saying that corporations such as Nike are paying wages to factory workers abroad that provide a standard of living that most Americans would describe as intolerable....Can this new global economy ethically balance efficiency and equity without a way to standardize the minimum standard of living internationally, so that all people can eventually sustain an acceptable (tough to define) way of life?...It just seems to me that the exploitation of workers, while arguably good for economic efficiency, is in fact a market failure.

These are important questions. A brief off-the-cuff answer from me on this blog would be glib and unsatisfying. So instead let me direct you to a few of my favorite writings on this general topic.

1. I would begin by reading Two Cheers for Sweatshops by journalists Nicholas D. Kristof and Sheryl Wudunn. (alternate link)

2. Next, I would read the essay by Paul Krugman called In Praise of Cheap Labor. (alternate link)

3. Finally, for an article about why the theory of comparative advantage is so often misunderstood, I recommend Krugman's longer essay Ricardo's Difficult Idea.

After reading these three pieces, you will have some good answers to your questions.

Time for me to leave Harvard?

In a new paper, economists E. Han Kim, Adair Morse, and Luigi Zingales ask, "Are Elite Universities Losing Their Competitive Edge?" Their answer: Yes.

Here is the abstract:

We study the location-specific component in research productivity of economics and finance faculty who have ever been affiliated with the top 25 universities in the last three decades. We find that there was a positive effect of being affiliated with an elite university in the 1970s; this effect weakened in the 1980s and disappeared in the 1990s.We decompose this university fixed effect and find that its decline is due to the reduced importance of physical access to productive research colleagues. We also find that salaries increased the most where the estimated externality dropped the most, consistent with the hypothesis that the de-localization of this externality makes it more difficult for universities to appropriate any rent. Our results shed some light on the potential effects of the internet revolution on knowledge-based industries.

I doubt that the competitive edge has completely disappeared. From my experience, there are substantial spillovers from having good colleagues and students. But I have no doubt that the internet has reduced the benefit of being at a top school by making information about the state of the art more widely accessible.

Is economics a science?

Blogger Don Luskin takes exception with my description of economics as a type of science. He writes:

Where is the utterly essential ingredient of repeatable experimental verification of falsifiable hypotheses? Without that--and economics surely doesn't have it--there can be no claim to science or the scientific method.

I disagree, for two reasons (either of which is sufficient to refute Don's point):

1. Many sciences do not rely on experiments but, instead, use the data that history provides. Consider an astronomer studying the creation of galaxies or an evolutionary biologist studying the development of species. These disciplines, like economics, are primarily observational rather than experimental, but they are clearly scientific.

2. The field of economics does use experiments. Vernon Smith won a Nobel prize for "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms." Today, work in experimental economics is growing rapidly. (Several Harvard faculty are involved in this work, most notably Al Roth.)

One could argue that economics is a particularly underdeveloped science, that there is still much we do not know. Here I would agree. But telling today's students that the study of the economy is not a science is like telling a young Nicolaus Copernicus that the study of planetary motion is not a science, or a young Charles Darwin that the study of species is not a science. They will ultimately prove you wrong.

Brad and I agree

About the economics of immigration. And you can join us here. (But I bet it's only a matter of time before Brad is on my back again about something else.)

Gas and Guzzlers are Complements

More evidence on the incentive effects of high gas prices in today's Wall Street Journal:

Rising gas prices are leading to some funky economics at the rental-car counter: Prices are dropping on SUVs and big luxury cars, and increasing for the cramped, compact models that are now in greater demand.

Of course, there is nothing particularly "funky" here. The phenomenon could be explained by the average ec 10 student after about two weeks of classes.

United 93

The most powerful movie I have seen in many, many years.

Ce n'est pas bon

From today's Wall Street Journal:

France's passion for food culture and its policy of coddling farmers lies at the heart of a current deadlock in the World Trade Organization's global trade talks. The so-called Doha round of talks, which began in 2001, were designed to boost developing nations; among other things, they want lower barriers to their agricultural exports. France has vowed to veto any deal that doesn't protect its farmers. A pivotal missed deadline April 30 has led to predictions the talks could die by summer if countries including France don't change their stance....

Oxfam believes the EU's tariffs and farm subsidies, which total over €40 billion annually, are harmful to the world's poorest countries. High customs duties keep products from poor nations out of the wealthy EU market. At the same time, EU farmers overproduction is dumped cheaply abroad, driving down global prices and harming farmers in the developing world.

Scientists and Engineers

I have posted a new paper on my Harvard website. Here is how it begins:

The Macroeconomist as Scientist and Engineer

Economists like to strike the pose of a scientist. I know, because I often do it myself. When I teach undergraduates, I very consciously describe the field of economics as a science, so no student would start the course thinking he was embarking on some squishy academic endeavor. Our colleagues in the physics department across campus may find it amusing that we view them as close cousins, but we are quick to remind anyone who will listen that economists formulate theories with mathematical precision, collect huge data sets on individual and aggregate behavior, and exploit the most sophisticated statistical techniques to reach empirical judgments that are free of bias and ideology (or so we like to think).

Having recently spent two years in Washington as an economic adviser at a time when the U.S. economy was struggling to pull out of a recession, I am reminded that the subfield of macroeconomics was born not as a science but more as a type of engineering. God put macroeconomists on earth not to propose and test elegant theories but to solve practical problems. The problems He gave us, moreover, were not modest in dimension. The problem that gave birth to our field—the Great Depression of the 1930s— was an economic downturn of unprecedented scale, including incomes so depressed and unemployment so widespread that it is no exaggeration to say that the viability of the capitalist system was called in question.

This essay offers a brief history of macroeconomics, together with an evaluation of what we have learned. My premise is that the field has evolved through the efforts of two types of macroeconomist—those who understand the field as a type of engineering and those who would like it to be more of a science. Engineers are, first and foremost, problem-solvers. By contrast, the goal of scientists is to understand how the world works. The research emphasis of macroeconomists has varied over time between these two motives. While the early macroeconomists were engineers trying to solve practical problems, the macroeconomists of the past several decades have been more interested in developing analytic tools and establishing theoretical principles. These tools and principles, however, have been slow to find their way into applications. As the field of macroeconomics has evolved, one recurrent theme is the interaction—sometimes productive and sometimes not— between the scientists and the engineers. The substantial disconnect between the science and engineering of macroeconomics should be a humbling fact for all of us working in the field.

To avoid any confusion, I should say at the outset that the story I tell is not one of good guys and bad guys. Neither scientists nor engineers have a claim to greater virtue. The story is also not one of deep thinkers and simple-minded plumbers. Science professors are typically no better at solving engineering problems than engineering professors are at solving scientific problems. In both fields, cutting-edge problems are hard problems, as well as intellectually challenging ones.

Just as the world needs both scientists and engineers, it needs macroeconomists of both mindsets. But I believe that the discipline would advance more smoothly and fruitfully if macroeconomists always kept in mind that their field has a dual role.

Update: Economist Arnold Kling comments on the paper at his blog.

Compliments from the Blogosphere

1. Brian Hollar has a post that explains why I write textbooks. (Plus, of course, there's the money.)

2. Lynne Kiesling says:

One thing I like about Greg Mankiw is his sincerity. It resonates through all of the posts on his relatively new blog, which I am enjoying.

Thank you, Lynne. I always try to keep in mind this classic piece of Marxist wisdom:

The secret to success is sincerity. Once you can fake that, you've got it made.

By the way, that's Groucho, not Karl.

Immigration Speech Tonight

President Bush addresses the nation on immigration tonight at 8 pm EST. Here is some background reading by Tyler Cowen and Daniel Rothschild from today's LA Times.

Update: My favorite lines from the speech:

Our new immigrants are just what they have always been--people willing to risk everything for the dream of freedom. And America remains what she has always been--the great hope on the horizon, an open door to the future, a blessed and promised land. We honor the heritage of all who come here, no matter where they are from, because we trust in our country's genius for making us all Americans.

Outsourcing Education

A former student calls my attention to an article in today's Washington Post, which reports how American students are importing educational services:

Thousands of U.S. students such as Del Monte are increasingly relying on overseas tutors to boost their grades and SAT scores. The tutors, who communicate with students over the Internet, are inexpensive and available around the clock, making education the newest industry to be outsourced to other countries....

The response of domestic producers to foreign competition is predictable:

"We don't believe that education should become a business of outsourcing," said Rob Weil, deputy director of educational issues at the American Federation of Teachers.

My views on outsourcing are well known, and the economic issues in education are largely the same as in other industries. But the phenomenon raises an interesting question: What is the pedagogical value of face-to-face interaction?

Long before the internet allowed the possibility of overseas tutors, we could have replaced live lectures with videos of previously taped lectures. In very large courses, the opportunity for spontaneous give-and-take in lectures is often limited and sometimes nonexistent. But we still expect professors to give live lectures every year. Why? Couldn't we save the students a lot of tuition dollars by employing fewer professors and offering videos instead?

To take the argument one step further, why expect the professors to perform on the videos? Maybe my job as a professor should be like that of a playwright: I would write the lecture and an actor with better performance skills would give it. My college roommate, Richard Greenberg, is now a well-known playwright. As far as I know, Rich has never performed in his own plays. In the drama industry, as in Adam Smith's pin factory, there is division of labor, in this case between writing and performing. Why is the same not true in the education industry?

Of course, in the market equilibrium we observe, professors both write and give their lectures, and videos have not replaced live performance. The fact that old production methods persist in the face of alternatives suggests that there is good reason why. Higher education is, after all, a competitive market, so we would expect better products to drive out inferior ones.

Apparently, there is something extremely valuable, which I can't quite put my finger on, about live face-to-face interaction between teacher and student, even in large courses. The high value of face-to-face interaction suggests that outsourcing education, while workable in some situations, is likely to be limited.

But maybe I am wrong and will soon need to find another line of work.

Dynamic Scoring

In today's Washington Post, columnist Sebastian Mallaby gives my recent work with Matthew Weinzierl on dynamic scoring some free publicity, while using it to beat up my former boss.

Here is the abstract of the Mankiw-Weinzierl paper:

This paper uses the neoclassical growth model to examine the extent to which a tax cut pays for itself through higher economic growth. The model yields simple expressions for the steady-state feedback effect of a tax cut. The feedback is surprisingly large: for standard parameter values, half of a capital tax cut is self-financing. The paper considers various generalizations of the basic model, including elastic labor supply, general production technologies, departures from infinite horizons, and non-neoclassical production settings. It also examines how the steady-state results are modified when one considers the transition path to the steady state.

The article is forthcoming in the Journal of Public Economics. A nontechnical summary is available here.

The Kidney Shortage

In today's Wall Street Journal, University of Chicago Law Professor Richard Epstein has a nice article about the chronic shortage of kidneys and whether we should allow a market for them to develop. His bottom line:

The key lesson in all this is that we should look with deep suspicion on any blanket objection to market incentives -- especially from the high-minded moralists who have convinced themselves that their aesthetic sensibilities and instinctive revulsion should trump any humane efforts to save lives.

I address this issue in my principles text:

Case Study
Should There Be a Market in Organs?

On April 12, 2001, the front page of The Boston Globe ran the headline "How a Mother's Love Helped Save Two Lives." The newspaper told the story of Susan Stephens, a woman whose son needed a kidney transplant. When the doctor learned that the mother's kidney was not compatible, he proposed a novel solution: If Stephens donated one of her kidneys to a stranger, her son would move to the top of the kidney waiting list. The mother accepted the deal, and soon two patients had the transplant they were waiting for.

The ingenuity of the doctor's proposal and the nobility of the mother's act cannot be doubted. But the story raises some intriguing questions. If the mother could trade a kidney for a kidney, would the hospital allow her to trade a kidney for an expensive, experimental cancer treatment that she could not afford otherwise? Should she be allowed to exchange her kidney for free tuition for her son at the hospital's medical school? Should she be able to sell her kidney so she can use the cash to trade in her old Chevy for a new Lexus?

As a matter of public policy, people are not allowed to sell their organs. In essence, in the market for organs, the government has imposed a price ceiling of zero. The result, as with any binding price ceiling, is a shortage of the good. The deal in the Stephens case did not fall under this prohibition because no cash changed hands.

Many economists believe that there would be large benefits to allowing a free market in organs. People are born with two kidneys, but they usually need only one. Meanwhile, a few people suffer from illnesses that leave them without any working kidney. Despite the obvious gains from trade, the current situation is dire: The typical patient has to wait several years for a kidney transplant, and thousands of people die every year because a kidney cannot be found. If those needing a kidney were allowed to buy one from those who have two, the price would rise to balance supply and demand. Sellers would be better off with the extra cash in their pockets. Buyers would be better off with the organ they need to save their lives. The shortage of kidneys would disappear.

Such a market would lead to an efficient allocation of resources, but critics of this plan worry about fairness. A market for organs, they argue, would benefit the rich at the expense of the poor because organs would then be allocated to those most willing and able to pay. But you can also question the fairness of the current system. Now, most of us walk around with an extra organ that we don't really need, while some of our fellow citizens are dying to get one. Is that fair?

Becker vs Miron on Capital Punishment

Gary Becker, a Nobel laureate in economics, says in a recent column:

I support executing some people convicted of murder because – and only because – I believe that it deters other murders.

Jeff Miron, who teaches the Economics of Crime course at Harvard, says in a recent blog post:

Mountains of social science evidence have failed to uncover a substantial deterrent effect of the death penalty.

Now I don't feel so bad that macroeconomists seem never to agree with one another.

Selling Green Cards

Economist Larry Lindsey (former adviser to President Bush and former ec 10 head sectionleader) writes about immigration in the new issue of the Weekly Standard. This passage caught my eye:

Unlike some nations--Canada, for example--we do not "sell" residency to people who promise to bring in investment money and create jobs. As economists would say, if you're not going to ration by price, you're going to ration by queue.

This is correct, of course. But Larry does not then ask the natural next question for an economist: Why not ration by price?

There are two main complaints about increased immigration (beyond mere discrimination against foreigners). First, unskilled immigrants increase U.S. income inequality by depressing wages for Amercian workers with low skills. Second, unskilled immigrants can become a drain on the U.S. social safety net. Rationing by price addresses both concerns. A person willing to pay, say, $100,000 for the right to immigrate to the United States is unlikely to be unskilled and is unlikely to end up on the dole.

Questions for ec 10 students to ponder: Should we sell a limited number of immigration slots to the highest bidder (subject to a minimal background check, such as for a criminal record). Why or why not? If we increased the number of immigrant slots and auctioned them off, the U.S. taxpayer would benefit and the immigrant would benefit, as is typically the case when two people engage in voluntary trade. Is there some externality here? In other words, would anyone else be hurt by such a transaction?

Update: An email correspondent notes that "the U.S. does 'sell' immigration slots to some degree. See here."

This program demonstrates that policymakers prefer well-heeled immigrants. But asking these immigrants to invest in the United States is too indirect to be considered price rationing. A more direct form of price rationing would be to have immigrants pay domestic residents (via Uncle Sam) for the right of entry--like an admission fee to a theme park. It works for Disney!

Amartya Sen

Today's NY Times has a review of the new book by my Harvard colleague, the Nobel prize winning economist Amartya Sen. Amartya is a wonderful example of how broad, both substantively and methodologically, the world's best economists can be.

Reich on Taxes

I often enjoy reading Robert Reich, former Clinton Labor Secretary and now Berkeley professor. In the new 4th edition of my principles text, I reprint one of his articles. (If you're curious, it's an article on manufacturing employment, reprinted in the chapter on Earnings and Discrimination). But over at his new blog, Reich reports some "facts" about the current tax law that I found so surprising that I decided to check them out.

Here is what Reich says:

Some administration apologists, including the editorial page of the Wall Street Journal, claim repeatedly that the rich are paying a larger-than-ever share of income taxes, so it’s entirely fitting that they get the lion’s share of any tax cut.

This logic conveniently leaves out two facts. First, the rich are now paying a smaller percentage of their income in taxes than at any time in the last seventy-five years. That they pay a lot of taxes nonetheless is a by-product of the mind-boggling increase in their income and wealth relative to most other Americans. Second, if you consider not just income and capital-gains taxes but all the taxes people pay – including payroll taxes and sales taxes – you find that middle-income workers are now paying a larger share of their incomes than people at or near the top. We have turned the principle of a graduated, progressive tax on its head.

The best place to look to check these alleged facts is the Congressional Budget Office website. The CBO has one of the best staffs around, and it has a long history of being nonpartisan. The CBO regularly calculates average tax rates by income group.

Here is the Total Effective Federal Tax Rate for 2005, according to a CBO report (Table 2):

Lowest quintile 5.5 percent
Second quintile 12.0
Middle quintile 15.6
Fourth quintile 19.6
Highest quintile 26.3

Top 10 percent 27.8
Top 5 percent 29.0
Top 1 percent 31.1

These data (which include all federal taxes, not just income taxes) seem hard to square with Reich's second claim that "middle-income workers are now paying a larger share of their incomes than people at or near the top."

Reich's first alleged fact is that "the rich are now paying a smaller percentage of their income in taxes than at any time in the last seventy-five years." To evaluate this claim, I compared that 31.1 percent number for the richest 1 percent with historical tax rates, available from CBO here (Table 1A). CBO begins their series in 1979.

What I found is that the average tax rate for the top 1 percent was below the current 31.1 percent rate for 10 of the 11 years from 1982 to 1992. It reached a low of 25.5 percent in 1986. For better or worse, President Bush has not come close to reducing tax rates for the rich to the levels they achieved after President Reagan cut taxes.

One might be curious how the tax rate on the lowest quintile--5.5 percent in 2005--compares with historical data. The CBO data show that this tax rate has fluctuated since 1979 between 5.2 to 10.2 percent. Federal taxes on the poor at now near the low end of their historical range.

I don't know what data Reich was using when he made his claims. He does not post a link to a data source at his blog. If there are data backing up Reich's claims, it would be interesting to figure out why they are inconsistent with CBO data. Comments and explanations from readers are welcome.

---

Updates for data geeks

#1: Brad DeLong suggests that the CBO numbers for 2005 are imperfect because they fail to include AMT relief that was passed subsequent to the CBO analysis. A fair point. He then suggests looking at 2004 numbers instead. Here I am inclined to disagree, because the 2004 figures include the effects of temporary bonus depreciation. Neither year's data are ideal if we want to evaluate where we are right now.

In any event, Brad's point is moot. For the sake of argument, let's use the CBO figures for 2004 instead of 2005. One could then defend Brad's weaker claim that "President Bush has reduced tax rates for the rich to roughly the levels they achieved in the Reagan years." Nonetheless, it remains the case that neither of Reich's more striking "facts" appears defensible on the basis of CBO data.

#2: Phill Swagel helpfully points me to supplemental CBO tables where the effects of temporary bonus depreciation are removed from the data. Using this supplement, and Brad's preferred year 2004, we find (in Table B2) these average tax rates:

Lowest quintile 5.3 percent
Second quintile 11.3
Middle quintile 14.8
Fourth quintile 18.8
Highest quintile 25.2

Top 10 percent 26.7
Top 5 percent 27.9
Top 1 percent 30.0

The story using the corrected 2004 data is largely the same as I described in my original post using 2005 data.

Feldstein on U.S. Saving

"The only function of economic forecasting is to make astrology look respectable." This famous Galbraith quip makes most people smile, while discomfiting those of us who have found ourselves in the forecasting game from time to time.

My Harvard colleague Martin Feldstein boldly ignores this piece of wisdom in his article in the May/June 2006 issue of Foreign Affairs. Here is his punchline:

What can be safely anticipated is that the savings rate of American households will start to increase. It is not clear when that increase will begin, but household saving cannot continue indefinitely at a zero or negative level. Saving will begin to rise because the forces that have promoted rapid consumption growth and depressed saving over the past decade will not continue....

This coming rise in household saving will eventually be good for the U.S. economy. It will make the United States less dependent on capital from the rest of the world and permit American businesses to raise the rate of investment in the equipment, software, and structures that increase productivity and the future standard of living. But a higher U.S. savings rate will also pose a challenge for the rest of the world, because it will mean a reduction in the exports to and an increase in the imports from the United States.

Family vs Blog

My daughter draws to my attention this comic in today's paper. Is she trying to tell me something?

Galbraith as Leftist Intellectual

Clive Crook discusses economist John Kenneth Galbraith and his role in modern political discourse. His conclusion:

Much of the Left still longs to sneer at the very idea of capitalism, especially at the claim that it has real ethical foundations (all the more so, in comparison with the attempted alternatives). There is still a wish to regard the whole thing as a scam: gulled and witless consumers; scheming and rapacious businesses; phony markets and bogus "competition"; politicians, media hacks, and other assorted apologists for "the system," all cozily in the pockets of the people in charge. It is a comprehensively false diagnosis. From a narrower political point of view, it is also, most likely, a self-defeating sentiment, because in America (though not in Europe) this mind-set makes it harder to win elections, not easier.

Galbraith dignified that self-defeating sentiment, dressed it in professorial robes, and expressed it with wonderful wit and elegance. He did his followers, who loved him for it, no favors.

The Wonderful Wizard of Oz

The Wizard of Oz was one of my favorite movies when I was a child. So I was delighted when a student emailed me an article about the movie and book on which it was based from yesterday's Wall Street Journal. (updated link) An excerpt:

Down the Yellow Brick Road of Overinterpretation

This is a big year for Oz fans. Not only is it the 50th anniversary of the movie's first appearance on television, but it's also the sesquicentennial of Baum's birth....

There are several theories about how Baum came up with the name Oz, whose pronunciation initially seems to have rhymed with "was." These include the charming (he enjoyed stories that made children cry out with "ohs" and "ahs") and the unlikely (he borrowed it from "Ozymandias," the sonnet by Shelley). The most plausible explanation may be the one that Baum himself supplied: It came to him one day when he was staring at a set of filing drawers labeled "A-G," "H-N" and "O-Z."

Yet there is a long history of digging deeper into Baum's books and searching for hidden meanings. The most famous of these is to interpret "The Wonderful Wizard of Oz" as a parable of the Populist movement of the 1890s: Dorothy represents the American people, the Scarecrow symbolizes farmers, the Tin Woodman stands in for factory workers, and the Cowardly Lion is William Jennings Bryan, the three-time Democratic presidential candidate. One of the leading concerns of Bryan and the Populists was to get off the gold standard (the Yellow Brick Road) and replace it with the silver standard (the color of Dorothy's slippers in the book).

This hypothesis was first proposed by Henry M. Littlefield, a high-school history teacher. He tested it on his students and argued past their objections -- most notably, the fact that Dorothy's slippers in the movie aren't silver. The producers had gone with red because they wanted to show off their newfangled color technology. Littlefield published his ideas in 1964, and it wasn't long before reading the Oz books became a kind of parlor game.

Although many Baum enthusiasts were disdainful of these efforts, the challenge of trying to figure out exactly what Baum meant to imply when he wrote about Toto the dog (teetotalism?) and the Winged Monkeys (Plains Indians?) was too much to resist. According to one analysis, "Oz" is more than a nonsense word borrowed from a filing drawer -- it's a cunning reference to the abbreviation for "ounce," a common unit of measurement for both gold and silver.

No one really knows if Baum meant the story as an allegory, but it is a favorite for teaching economics nonetheless. Here is a case study from my intermediate macro textbook (the 6th edition of which is hot off the press--I just got my copy a few hours ago):

The Free Silver Movement, the Election of 1896, and the Wizard of Oz

The redistributions of wealth caused by unexpected changes in the price level are often a source of political turmoil, as evidenced by the Free Silver movement in the late nineteenth century. From 1880 to 1896 the price level in the United States fell 23 percent. This deflation was good for creditors, primarily the bankers of the Northeast, but it was bad for debtors, primarily the farmers of the South and West. One proposed solution to this problem was to replace the gold standard with a bimetallic standard, under which both gold and silver could be minted into coin. The move to a bimetallic standard would increase the money supply and stop the deflation.

The silver issue dominated the presidential election of 1896. William McKinley, the Republican nominee, campaigned on a platform of preserving the gold standard. William Jennings Bryan, the Democratic nominee, supported the bimetallic standard. In a famous speech, Bryan proclaimed, "You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.'' Not surprisingly, McKinley was the candidate of the conservative Eastern establishment, whereas Bryan was the candidate of the Southern and Western populists.

This debate over silver found its most memorable expression in a children's book, The Wizard of Oz. Written by a Midwestern journalist, L. Frank Baum, just after the 1896 election, it tells the story of Dorothy, a girl lost in a strange land far from her home in Kansas. Dorothy (representing traditional American values) makes three friends: a scarecrow (the farmer), a tin woodman (the industrial worker), and a lion whose roar exceeds his might (William Jennings Bryan). Together, the four of them make their way along a perilous yellow brick road (the gold standard), hoping to find the Wizard who will help Dorothy return home. Eventually they arrive in Oz (Washington), where everyone sees the world through green glasses (money). The Wizard (William McKinley) tries to be all things to all people but turns out to be a fraud. Dorothy's problem is solved only when she learns about the magical power of her silver slippers.

Although the Republicans won the election of 1896 and the United States stayed on a gold standard, the Free Silver advocates got the inflation that they wanted. Around the time of the election, gold was discovered in Alaska, Australia, and South Africa. In addition, gold refiners devised the cyanide process, which facilitated the extraction of gold from ore. These developments led to increases in the money supply and in prices. From 1896 to 1910 the price level rose 35 percent.

To learn more about the topic, see Hugh Rockoff's paper "The Wizard of Oz as a Monetary Allegory," Journal of Political Economy, August 1990.

Vickrey on Budget Deficits

An email correspondent reminds me of the Nobel Prize winning economist who campaigned for larger budget deficits:

Prof Mankiw,

I am a non-student fan of yours. I enjoy your blog immensely. Given that much of your postings there recently discuss budget deficits, I was wondering what you make of Vickrey's view that deficits should be substantially higher to recycle savings. Was Vickrey a kook that should have stuck to his bailiwick of congestion pricing? If not, what changed that guys like DeLong are now so deficit hawkish? Thank you.

[name withheld]

William Vickrey was indeed a defender of large budget deficits. In 1996, in what is perhaps his last written work, he wrote:

Deficits are considered to represent sinful profligate spending at the expense of future generations who will be left with a smaller endowment of invested capital. This fallacy seems to stem from a false analogy to borrowing by individuals.

Current reality is almost the exact opposite. Deficits add to the net disposable income of individuals, to the extent that government disbursements that constitute income to recipients exceed that abstracted from disposable income in taxes, fees, and other charges. This added purchasing power, when spent, provides markets for private production, inducing producers to invest in additional plant capacity, which will form part of the real heritage left to the future. This is in addition to whatever public investment takes place in infrastructure, education, research, and the like. Larger deficits, sufficient to recycle savings out of a growing gross domestic product (GDP) in excess of what can be recycled by profit-seeking private investment, are not an economic sin but an economic necessity.

In short, Vickrey thought that the U.S. economy suffered from a chronic problem of insufficient aggregate demand and that deficit-financed spending was the remedy.

You might wonder how large Vickrey wanted budget deficits to be. When he won the Nobel in 1996, he was interviewed on CNN. Here is part of the interview:

JAN HOPKINS: You have some controversial views. You think that the federal government should not be reducing the deficit but rather working on getting the unemployment rate even lower than it is today. [Unemployment was 5.2 percent in October 1996.]

WILLIAM VICKREY: Yes, in fact, the figures work out very roughly that for every $10 billion of deficit, which should really called the $10 billion reduction in the government creation of purchasing power - I'm getting tongue-twisted - creation of purchasing power - then, that means there's a $10 billion reduction in purchasing power, there's $8 billion reduction is sales, there's $8 billion eventually reduction in employment, and 100,000 employees out of work.

JAN HOPKINS: But if you work at getting unemployment down, then you have people spending money and the economy would be better off in your view.

WILLIAM VICKREY: Yes. In fact, what I would like to see is a budget deficit of about $500 billion averaging for the next five years, until we get from 5 percent unemployment down to 1 percent unemployment. Then we would-

JAN HOPKINS: -Very controversial views-

WILLIAM VICKREY: Then, then-

JAN HOPKINS: -Unfortunately we've run out of time.

He died a few days later.

Was Vickrey a kook? Advocating $500 billion deficits in 1996 certainly sounds kooky. Correcting for inflation and real growth, that would be about $800 billion today.

But no, he was not a kook: He was one of the last hard-core Keynesians, far more Keynesian than so-called new Keynesians like me, and maybe more Keynesian than Keynes himself would have been. In the view of most mainstream macroeconomists today (a group in which I include myself and Brad DeLong), insufficient aggregate demand can be a problem for short periods of time, as it was during the recent recession, but it is not a chronic problem facing the U.S. economy. It is not a problem we face now; the Fed is raising interest rates because it is concerned about excessive aggregate demand.

I should note that Vickrey's Nobel Prize was given for his contributions to the microeconomic theory of auctions, not to the macroeconomic analysis of fiscal policy.

Furman on Progressivity

My friend and former student Jason Furman has a letter in today's Wall Street Journal, taking on the CEA op-ed from earlier in the week. Here is an excerpt:

Edward P. Lazear and Katherine Baicker of the President's Council of Economic Advisers are correct in stating that a tax-policy change is progressive if it "narrows the difference in take-home earnings" ("America at Work," editorial page, May 8). But they are incorrect in stating that this is what the president's tax cuts have done.

According to the Tax Policy Center, the tax cuts passed since 2001 have raised the after-tax income of the top 1% of Americans by 5%, while raising the after-tax income of the bottom 60% of Americans by just 2%. In other words, the tax cuts have contributed to widening, not narrowing, the difference in take-home earnings.

In a previous post, I noted that there are different ways to frame the progressivity question. Jason says the first of the three frames I described is the "correct" one. Is he right? I report, you decide.

Jason would say that after-tax income is what people care about, so that should be the focus of our discussion. On the other hand, blogger Brandon Berg notes that, by Jason's preferred metric, a tax cut that completely eliminated the tax on the poor, leaving the rich bearing the entire tax burden, could be judged as making the tax code less progressive. Berg views this an odd use of language.

The framing really matters here; it is not mere pedantry. A little algebra is necessary to explain why. The number that Jason reports, which I will call x, is

x=dT/(Y-T),

where Y is before-tax income, T is taxes, and dT is the change in taxes. After slight rearrangement, we can write the percentage change in taxes as:

dT/T = x(Y/T - 1).

The percentage change in the tax burden is a function of Jason's x and the average tax rate T/Y. The average tax rate varies strongly with income.

I don't have the average tax rate for the data that Jason is using, but based on other data I have seen, I would guess that the top 1 percent pays about 31 percent of income in federal taxes, and the bottom 60 percent pays about 12 percent. (This includes all federal taxes, not just income taxes.) Let's use these figures for T/Y. With the above formula and Jason's numbers, we can estimate that taxpayers in the top 1 percent of the income distribution got a 11-percent tax cut while those in the bottom 60 percent got a 15-percent tax cut.

These figures are roughly consistent with figures in the 2005 Economic Report of the President (pages 78-79). Using CBO data, it reported that in 2004 the average tax rate for the lowest quintile was reduced from 6.7 to 5.3 percent (a 21 percent cut), while the average tax rate for the top quintile was reduced from 27.6 to 25.2 precent (a 9 percent cut). Once again, to avoid confusion, I should say that this includes all federal taxes, not just income taxes.

Jason in his letter brings up the intertemporal government budget constraint (not in the above excerpt). Because I addressed that issue in a previous post, I won't comment again.

Finally, I should mention that all of these numbers are based on simplistic assumptions about tax incidence. For example, to the extent that cuts in capital taxes increase capital accumulation, which in turn increases productivity and wages, the true incidence of tax changes could be very different from the incidence assumed in these data. So, even putting the framing issue aside, all of these numbers need to be taken with a grain of salt.

How to Win a Nobel Prize

In today's NY Times, economist Robert Frank asks why John Kenneth Galbraith never won the Nobel prize in economics.

There is no mystery here. The simple answer is that the Nobel prize committee does not reward economists for writing books for the general public, which is what Galbraith excelled at. The prize committee also ignores many other activities that occupy economists' time, including teaching, consulting, policy advising, forecasting, editorializing, textbook writing, and blogging.

The Nobel has a narrow focus: It rewards economists for writing scholarly articles that are widely cited by other economists. (Read this paper for some evidence.) Here is a question to ponder: Is this narrow focus good for the economics profession?

• Pro: It encourages economists to focus on the pursuit of knowledge.
• Con: It encourages economists to be more esoteric and less practical.

In my view, both positions have an element of truth.

FYI, if you want to predict future Nobel prizes in economics, here is a place to start.

The Government's Hidden Assets

The govenment's budget deficit and its accumulated debt might seem like easy things to measure. However, as I explain extensively in Chapter 15 of my intermediate macro text, that is far from the case. A variety of subtle accounting issues make interpretation of the government's finances less than straightforward.

Here is a fact from yesterday's Wall Street Journal:

Americans are increasing the size of their retirement nest eggs at a good clip, despite concerns that the country as a whole isn't saving enough. Data to be published this week by the Investment Company Institute show that total U.S. retirement assets grew about $1 trillion between 2004 and 2005, to $14.3 trillion at the end of 2005.

What does this fact have to do with government accounting? Some of that $14.3 trillion is, in essence, a government asset.

Income taxes were deferred when money was put into those retirement accounts. When the money comes out, it will be taxed. In other words, as you invest the assets in your 401k plan, the government is your silent partner. If the tax rate is, say, 25 percent, then $3.6 trillion should arguably be added to the asset side of the government's balance sheet. If we assume a rate of return of 5 percent per year on those assets, then the government budget deficit is arguably overstated by $180 billion.

That is a large number. Unfortunately, this implicit asset is not nearly large enough to finance the budget problems that will arise when the baby-boom generatation retires. But it will help.

Two updates:

1. Stanford economist Michael Boskin got in some hot water a few years back pointing out the implicit govenment asset inherent in deferred taxes. Boskin made some calculation errors that overstated the size of this asset; he suggested a number around $12 trillion, compared to the $3.6 trillion above. Even if he got the number wrong, Boskin was right about the principle.

2. Today's NY Times reports the following about the tax bill that just passed Congress:

It would also allow taxpayers to roll any money in traditional retirement vehicles into Roth IRA's, where all the gains are tax-free. This provision is treated in the legislation as a revenue-raiser because in the first two years, a large number of people are expected to roll over their traditional retirement plans and pay taxes on the gains. But once the investments have been moved into the Roths, they will never again generate taxes.

This provision of the law takes some of the government's $3.6 trillion implicit asset and makes it explicit, by collecting the tax revenue now rather than later. As a result, the provision reduces the currently reported budget deficit. From the standpoint of the more relevant present-value budget constraint, however, it does not improve the government's fiscal imbalance.

Summer Reading List

A student emails me asking for a summer reading list. Here are ten very different books I like that are fun enough that you would not be embarrassed (well, not too embarrassed) reading them at the beach:

• Milton Friedman, Capitalism and Freedom
• Robert Heilbroner, The Worldly Philosophers
• Paul Krugman, Peddling Prosperity
• Steven Landsburg, The Armchair Economist
• P.J. O'Rourke, Eat the Rich
• Burton Malkiel, A Random Walk Down Wall Street
• Avinash Dixit and Barry Nalebuff, Thinking Strategically
• Steven Levitt and Stephen Dubner, Freakonomics
• John McMillan, Reinventing the Bazaar
• William Breit and Barry T. Hirsch, Lives of the Laureates
  

Baker on the Conservative Agenda

Economist Dean Baker has a new book called "The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer." The theme of the book is related to my previous post on Crony Capitalism. Baker thinks that American conservatives are not in favor of capitalism with free, competitive markets, as is often claimed, but instead want to use the power of the state to make the rich even richer. Baker does not use the term "crony capitalism" to describe the conservative economic agenda, but it is surely in the spirit of his argument.

Baker writes on his blog:

The book argues that conservatives (or at least those in power) support a wide range of government interventions that have the effect of distributing income upward. This list includes a trade and immigration policy that places less-skilled workers in direct competition with workers in developing countries, while protecting highly paid professionals from the same sort of competition. Another item on the list is Federal Reserve Board policies that deliberately weaken the bargaining power of less-skilled workers in order to keep inflation under control.

Skimming through the book shows that, to a degree, cronyism is in the eye of the beholder. For example, Baker takes aim at copyright and patent protection, expressing a view of intellectual property very different from mine. Here is the beginning of his Chapter 4:

Bill Gates – Welfare Mom: How Government Patent and Copyright Monopolies Enrich the Rich and Distort the Economy

In policy discussions, patents and copyrights are usually treated as part of the natural order, their enforcement is viewed as being as basic as the right to free speech or the free exercise of religion. In fact, there is nothing natural about patents and copyrights, they are relics of the Medieval guild system. They are state-granted monopolies, the exact opposite of a freely competitive market.

Because my textbooks are copyrighted, I suppose that I am a crony, using the power of the "conservative nanny state" to enrich myself as the expense of poor students around the world.

Although I disagree with Baker on a wide range of topics, I will give him credit for one thing: He is not a hypocrite. Baker is distributing his new book free over the internet.

As for me, if you want one of my books, you will have to fork over the cash.

Crony Capitalism

Gary Becker and Richard Posner discuss at their blog the movement toward left-wing politics in South America. Becker writes:

One legitimate reason for the opposition to capitalism in Latin America is that it frequently has been "crony capitalism" as opposed to the competitive capitalism that produces desirable social outcomes. Crony capitalism is a system where companies with close connections to the government gain economic power not by competing better, but by using the government to get favored and protected positions. These favors include monopolies over telecommunications, exclusive licenses to import different goods, and other sizeable economic advantages. Some cronyism is found in all countries, but Mexico and other Latin countries have often taken the influence of political connections to extremes.

This analysis seems exactly right to me.

Indeed, the point applies broadly and provides a useful lens through which to view U.S. political debate. The political left in the United States sees pervasive crony capitalism in U.S. economic policy. While I don't agree that it is pervasive, it certainly does happen. Sugar quotas, for instance, are a bipartisan example of crony capitalism: I can't recall any impartial policy analyst thinking the quotas are good policy, nor can I recall a prominent politician of either party calling for their repeal.

Unfortunately, as recent actions in Bolivia show, opponents of crony capitalism in South America think the solution is less capitalism. A better solution is less cronyism.

The Post-affluent Society

Columnist Robert Samuelson (alternate links here and here) plays variations on a Galbraithian theme.

Update: Blogger Andrew Sullivan draws attention to this fact from the Samuelson column:

In 1954 defense accounted for 69.5 percent of federal spending and "human resources" (programs such as Social Security, Medicare, job training and food stamps) only 18.5 percent. In 2005 defense was 20 percent and human resources 64.2 percent.

It prompts this reaction from Sullivan:

Forget the military-industrial complex. Our new threat is the senior-entitlement complex.

Treasury's Foreign-Exchange Report

Today's Wall Street Journal (page A4) has a nice article on the debate among economists over the valuation of the Chinese currency. It includes a preview of upcoming events:

Tomorrow, the Treasury Department is scheduled to release its semiannual foreign-exchange report, in which it could formally accuse Beijing of manipulating the yuan's value to gain an edge in global trade.

I have previously posted on the topic of the Chinese currency (here and here), but the Journal article has a summary of all you need to know:

Administration economists don't buy industry's argument that U.S. manufacturing woes are caused by the yuan. But they know they have to cool the political heat.

Update: Wednesday's NY Times describes the tough situation John Snow is in.

Treasury Secretary John W. Snow has resisted demands to threaten Beijing...

C. Fred Bergsten, president of the Institute for International Economics, warned that Mr. Snow would lose credibility and cede control over the issue to members of Congress who support punitive measures against China.

"If they don't label the Chinese," Mr. Bergsten said, "they lose complete control of the issue to Congress, at which point you give Congress almost a free license to do what it wants."

John Snow is on the right side of this issue. A PhD economist, he understands the economics of the situation completely. But he also understands that some of the more xenophobic, less economically literate segments of the Congress are poised to do something crazy, such as large tariffs on Chinese goods.

During my two years in Washington, I saw this kind of thing often. For many issues, the economics is easy, and the politics is hard.

Update 2: Later on Wednesday, the Wall Street Journal reports online:

The Bush administration turned aside demands from Congress and industry that it formally accuse Beijing of "manipulating" its currency in order to give Chinese firms an unfair edge over American competitors.

Treasury Secretary John Snow chose the gentler tactic of announcing yesterday that it is "a matter of extreme urgency" that Beijing allow the yuan to rise faster and further against the dollar.

The decision to avoid labeling Beijing a currency manipulator means that while the U.S. is on record formally criticizing Chinese policy, Congress is deprived of a weapon it could use to justify legislation imposing economic retaliation.

Well done. Now let's seen how the xenophobe caucus reacts.

A Book for POTUS

Larry Kudlow interviews President Bush:

MR. KUDLOW: I know you're a reader. You enjoy reading books. A mutual friend, Greg Mankiw, formerly your top economic adviser, had said that he had sent you a copy of Milton Friedman's old book, Capitalism And Freedom. I didn't know if you recall that. I was going to ask you if you had read the old Friedman book.

PRESIDENT BUSH: I have not read the old Friedman book yet. I appreciate Mankiw's generosity. I did have a conversation with Milton Friedman when I was out at--in Palo Alto, I think two weekends ago. He's a really interesting speaker. He's a smart guy.

Miron on the SEC

My libertarian friend Jeff Miron opines today on corporate governance. He says that the Sarbanes-Oxley law is overly burdensome, which is probably true. He says that the corporate income tax should be repealed, an argument I can understand. But he loses me when he says the SEC should be abolished. Jeff writes:

Eliminating the SEC would make investors bear full responsibility for monitoring corporate behavior. This occurs to a substantial degree already, since the SEC cannot effectively monitor all the firms subjects to its regulations. But eliminating the SEC would spur additional private monitoring and strenghten investor incentives to engage in due diligence.

If Jeff is right about the SEC, then maybe his next post should be the following:

Eliminating the police would make people bear full responsibility for protecting their own safety. This occurs to a substantial degree already, since the police cannot effectively monitor everyone who might commit a crime. But eliminating the police would spur additional private monitoring and strenghten individual incentives to engage in due diligence.

I have sympathy for many libertarian arguments, but abolishing the SEC seems at least one step too far.

Update: Jeff responds.

The Progressivity of Budget Deficits

Bloggers Jane Galt and Brad DeLong have been debating my previous post on evaluating tax progressivity, focusing on the fact that deficit-financed tax cuts require lower spending or higher taxes in the future. Let me add to the discussion:

Economists are not good at judging redistributions of income. Indeed, they often claim that this issue is outside of the sphere of economics altogether. It is, therefore, somewhat surprising that economists decry budget deficits with such consensus and assurance.

One widely accepted standard for judging redistributions is the ability-to-pay principle: redistributions of income are desirable if they go from better-off to worse-off people. By this criterion, the redistributions arising from changes in factor prices are undesirable. Many people hold little wealth and consume the income from their wages, while a small part of society holds most of the economy’s wealth. When crowding out raises the returns on capital and reduces wages, the wealthy gain at the expense of the less wealthy.

Yet, from the standpoint of the ability-to-pay principle, the direct effect of budget deficits—the change in the timing of taxes—is harder to reconcile with the conventional view that deficits are undesirable. Because of technological progress, the income and consumption of a typical individual in the economy rises over time. Because budget deficits shift taxes forward in time, they benefit relatively poor current taxpayers at the expense of relatively rich future taxpayers. If reducing inequality is a goal of policy, shouldn’t budget deficits be applauded?

One way to answer this question is to go beyond neoclassical economic theory. Although standard models assume that people desire to smooth consumption evenly over time, popular discussions of economic policy presume that consumption should rise over time. Politicians often assume a moral imperative that the current generation sacrifice to ensure that future generations enjoy a substantially higher standard of living. This view suggests that it is undesirable to shift a tax burden onto our children, even though our children will be better able to shoulder that burden than we are.

Another possible answer is that levels of taxation should be based on the benefits principle, which holds that people should pay for the government benefits that they receive. For example, the use of a gasoline tax to pay for road repair is not based on the abilities to pay of drivers and non-drivers; instead, it is justified on the ground that drivers should pay for roads because they benefit from them. Similarly, one might argue that each generation should pay for the government it provides itself, regardless of its level of income.

These issues are not easily resolved. Yet one point is clear: saying whether and why deficits are undesirable requires judgments that are more philosophical than economic.

Brad may be tempted to read this post as further evidence of how low I have sunk as an economist. But he would be wrong: I have always been this bad! The above six paragraphs are an excerpt from a 1995 paper I wrote with Larry Ball.

Framing and Progressivity

In today's CEA op-ed, the sentence that will likely generate a blogosphere debate with the most heat and least light is this one: "The president's tax cuts have made the tax code more progressive."

The basic problem is that there is no single way to gauge changes in progressivity. As a result, people can take the same set of numbers, look at them from different angles, and reach very different conclusions.

Consider a simple example (which I used in a fall ec 10 lecture). There are two people. A rich guy earns $200,000. A poor guy earns $20,000. At first, the rich guy pays $50,000 in taxes, and the poor guy pays $1,000. Then a new President takes office and cuts the rich guy's taxes to $48,000 and the poor guy's taxes to $800.

Who is getting the better deal?

• You could say the rich guy gets the better deal: The rich guy gets an extra $2000 in take-home pay, while the poor guy gets only $200. After the tax cut, the difference in take-home pay between the two guys is larger.
• You could say the deal is evenly balanced: Everyone gets to keep an extra 1 percent of his income.
• You could say the poor guy gets the better deal: The poor guy gets a 20 percent tax cut, while the rich guy gets only a 4 percent tax cut. After the tax cut, the rich guy pays a larger share of the total tax burden.

It is impossible to say on purely economic grounds which of these perspectives is better. All of these statements are mathematically correct, even if they leave the reader with very different impressions. If you are a politician or a journalist trying to argue that this tax cut is good for the rich, good for the poor, or somewhere in between, you can do it!

The lesson: Be careful when you read debate about the progressivity of the recent tax changes. The conclusions that a commentator reaches depends on how the issue is framed.

CEA on the Income Distribution

In today's Wall Street Journal, Edward Lazear and Katherine Baicker have an op-ed. Lazear is chairman and Baicker is a member of the President's Council of Economic Advisers. An excerpt:

Over the last 25 years, the wages of the skilled have continued to grow faster than the wages of the less skilled. For example, the wages of the college-educated have grown by 22% since 1980, while the wages of high-school drop-outs has fallen by 3%.

This does not mean, however, that the rich are benefiting at the expense of the poor. Instead, it means that the return to investing in education and training continues to grow. Most economists believe that the increased divergence between the wages of the skilled and the unskilled reflects technological advancements that make workers' skills more valuable. Having an economy that places a greater value on skills and education is a good thing. Our economy can grow more quickly when the returns to investment are high, and human capital investment is the most important form of investment.

Gary Becker expressed a similar view on his blog a couple weeks ago.

How to choose a major

Many of my ec 10 students will soon be choosing a subject area to concentrate in. Today's NY Times has some advice from the Freakonomics team (alternate link):

when it comes to choosing a life path, you should do what you love — because if you don't love it, you are unlikely to work hard enough to get very good.

I completely agree.

Outsourcing Redux

About two years ago, while I was chairman of the Council of Economic Advisers, I had my 15 minutes of fame over the topic of offshore outsourcing. (I tell the story in a recent paper with my former chief of staff Phillip Swagel.) At the time, I drafted an op-ed on the topic. The article was never submitted, but it has been sitting on my hard drive ever since, where I recently ran across it. I thought the readers of this blog--an elite group--might enjoy it.

Adam Smith on Outsourcing
By N. Gregory Mankiw
March 25, 2004

If the American Economic Association were to give an award for the Most Politically Inept Paraphrasing of Adam Smith, I would be a leading candidate. But the recent furor about outsourcing, and my injudiciously worded comments about the benefits of international trade, should not eclipse the basic lessons that economists have understood for more than two centuries.

To avoid making the same mistake twice and clinching the award, I should let Mr. Smith speak for himself. Here is what he said in his 1776 classic The Wealth of Nations: “It is maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy...What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.”

This is the basic theory of international trade. Since Smith penned these words, economists have added rigor to the analysis (thank you, David Ricardo) and have conducted numerous empirical and historical studies of the effects of trade. The verdict is in: Smith was right. Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. Smith’s insights are now standard fare in Econ 101.

Yet, whenever the economy goes through a difficult time, as it has in recent years, free trade comes under fire. Some people now fear that trade is responsible for recent weakness in U.S. labor markets. The concern is understandable, but it is simply not true. Over the past three years, job losses are more closely related to declines in domestic investment and weak exports than to import-competition. To the extent that the rest of the world threatens U.S. prosperity, the main problem is not rapid growth in China and India, but slow growth in Japan and Europe.

Of course, global competition has caused employment declines in some industries. The world trading system is changing along with technology. Goods that could once be produced only domestically can now be produced abroad and imported over fiber optic cable. The Internet and advances in telecommunications have meant that more Americans are competing with workers in other nations. Even if more competition is good for consumers, it can produce very understandable anxiety among some workers and their families.

These technological changes, however, have not rendered Smith’s insights obsolete. The same principles apply to offshore outsourcing of services as to traditional trade in goods. This has been confirmed in a recent study by the McKinsey Global Institute. McKinsey researchers tallied up the costs and benefits associated with outsourcing and found that for every dollar the United States sends abroad, we get back about $1.12, resulting in a net gain of $0.12. Smith would not have been surprised.

Some people fear that Americans cannot compete with low-wage workers abroad, or that global competition will mean that wages will “race to the bottom.” The truth is that we can prosper in a global economy because our workers are among the best in the world. Our real wages are ultimately determined by our productivity, and American productivity growth has been spectacular over the past three years.

So, if trade is not the problem ailing the U.S. economy, what is? Smith again has the answer. “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things." This fits perfectly with three of the President’s priorities: defending the homeland against terrorist threats, reducing the tax burden on the American people, and reforming the tort system. (If Smith overlooked the importance of ensuring a reliable energy supply and reducing the cost of health care, we can forgive his eighteenth-century myopia.)

The President, like Smith, believes in the free enterprise system. The goal of policy should be to open up markets, not to retreat behind walls or throw rocks in our harbors. Economic growth is not zero-sum. Prosperity in one country is not a threat to prosperity in another. Free and open markets can mean better jobs both for Americans and for our trading partners around the world.

It may be a mere coincidence that Smith’s great book was published the exact same year that the Declaration of Independence was signed. But the founding fathers of the United States share an intellectual bond with the founding father of economics. They both believed that liberty and prosperity go hand in hand. Our founding fathers were well aware of Smith’s work. Benjamin Franklin knew Smith personally. When Franklin quipped that “No nation was ever ruined by trade,” he likely meant it as an understatement.

Perhaps quoting Adam Smith is risky. Smith was British, so some people may accuse me of outsourcing economic advice. But import competition is not a threat. I have great confidence that President Bush’s policies will grow the economy and create a job for every American who wants one, including his politically tone-deaf economist.

Now this is getting out of hand

Congress is taking a hard line on price gouging, even if they aren't quite sure what it is. According to today's Washington Post:

Congress Tells FTC to Define Price Gouging

If there's one thing that members of Congress can agree on when it comes to energy it's this: They're opposed to price gouging. American motorists aren't crazy about it either.

The only problem is figuring it out what it is.

In a measure passed overwhelmingly by the House this week, lawmakers proposed penalties for price gouging -- to $150 million for wholesalers, $2 million for retailers and two years in jail for either -- and ordered the Federal Trade Commission to put a stop to it. The House measure also called for the FTC to define price gouging.

Economists aren't making much progress elucidating the issue, so maybe it is time to bring in the cartoonists.

Is Fed Ambiguity a Virtue?

In today's Washington Post, columnist David Ignatius discusses the financial markets' recent confusion about the Fed's intended policy. Consider this paragraph:

Bernanke came to the Fed as an advocate of greater transparency, arguing for more public statements, news conferences and forecasts. I suspect he may be losing a bit of his enthusiasm for openness as he discovers just how closely (and often foolishly) the markets hang on a Fed chairman's words. The danger (as his comment to Bartiromo suggested) is that the markets adjust so quickly to what they think the Fed is doing that they leave the chairman little flexibility. Once the traders are convinced he's doing "x," he may have to do "2x" to achieve the desired result. Thus the value of Greenspan's public mumble -- it created just enough ambiguity to give him room to maneuver.

Does this analysis make sense in standard macroeconomic models? Should the Fed create extraneous uncertainty by having a mumbling Fed chair in order to increase its ability to influence the economy? Does a transparent Fed need to do more to achieve a given result than an opaque one? I think most monetary economists would answer these questions No, No, and No.

There is no point in creating extraneous uncertainty by purposeful lack of clarity. However, there is intrinsic uncertainty that Fed officials have to deal with and have been trying to explain. If there is now uncertainty about what the Fed is going to do, it is largely because Fed officials themselves don't know what they are going to do.

Three facts are clear about the current economic situation:

1. The economy is close to estimates of the natural rate.
2. Estimates of the natural rate are very imprecise, so we shouldn't take much solace in fact 1.
3. A lot of monetary tightening has already occurred, and the effects on the economy may not have been fully felt yet.

In light of these facts, Fed policymakers are not sure if they have done enough tightening (or perhaps even too much). They want to wait and see, keeping their options open, rather than conveying a false sense of clarity to the public.

Ambiguity is sometimes a fact of life in monetary policymaking. But I can't see why lack of clarity in itself is a virtue, as Ignatius seems to suggest.

Mufson answers Lucas

In a classic paper, economist Robert Lucas asked "Why Doesn't Capital Flow from Rich to Poor Countries?" The puzzle can be simply stated: Rich countries have a lot of capital, and poor countires have a little. Because of diminishing returns, the marginal product of capital should be low in rich countries and high in poor countries. So it should be profitable to move capital from rich to poor countries. But it doesn't much happen. Hence, the puzzle.

In yesterday's Washington Post, Steve Mufson (a friend of mine since the 5th grade and now a Post reporter) explains at least part of the Lucas puzzle:

Bolivian Gas Takeover Sets a Familiar Scene

By Steven Mufson

A new government in Bolivia, anxious to win public support, charges the big foreign oil companies with fraud and confiscates their local properties. The move generates applause among Bolivian citizens and attracts attention throughout Latin America.

The year: 1937.

Seven decades later, Latin America is experiencing another wave of nationalist fervor, fueled by old resentments and rising energy prices. Inspired in part by the economic nationalism of Venezuelan leader Hugo Chavez, new Bolivian President Evo Morales celebrated his 100th day in office Monday with a reprise of 1937: charging foreign oil firms with corruption and sending troops to seize control of the oil and gas fields.

In the end, say many foreign companies and economists, Bolivia -- and other countries that follow the same path -- might end up the loser. "The signal it sends is that no foreign investment is safe here," said Bernard Aronson, former assistant secretary of state for inter-American affairs and now managing partner of Acon Investments LLC, a private equity firm.

Good News about the Federal Budget

Today's Wall Street Journal reports modestly good news about the U.S. federal budget:

Surge in Tax Revenue Cuts Federal-Deficit Projections

A surge in federal tax revenue, mainly in payments from rich Americans, is driving down government and private-sector projections of this year's federal deficit to as low as $300 billion, well below current forecasts that are near or over $400 billion....That would be good news for President Bush and the Republican-led Congress....

But the brighter short-term outlook doesn't change long-run forecasts of unsustainable deficits as more Americans age and draw Medicare, Medicaid and Social Security benefits.In its annual long-term outlook in January, the CBO wrote that spending for those programs "will exert pressures on the budget that economic growth alone is unlikely to alleviate. A substantial reduction in the growth of spending and perhaps a sizable increase in taxes as a share of the economy will be necessary for fiscal stability to be at all likely in the coming decades."

The article strikes the right balance. One fear is that the good news about the short-run fiscal outlook will induce policymakers to ignore the longer-term fiscal outlook, which remains grim.

Related link: Economist David Henderson has an excellent new article (alternate link) on the long-term challenges facing fiscal policy.

Boys, Girls, and Teachers

The May NBER Digest is out, covering these topics:

• Economic Progress of Immigrants
• Unhappiness After Hurricane Katrina
• Matching Incentives Raise Saving
• Teachers and the Gender Gaps in Student Achievement

The last topic is particularly intriguing and provocative. Here is an excerpt:

In kindergarten, boys and girls do equally as well on tests of reading, general knowledge, and mathematics. By third grade, boys have slightly higher mathematics scores and slightly lower reading scores. As children grow older, these gaps widen....

[Researcher Thomas] Dee finds that gender interactions between teachers and students have significant effects on these important educational outcomes. Assignment to a teacher of the opposite sex lowers student achievement by about 0.04 standard deviations. Other results imply that just "one year with a male English teacher would eliminate nearly a third of the gender gap in reading performance among 13 year olds…and would do so by improving the performance of boys and simultaneously harming that of girls. Similarly, a year with a female teacher would close the gender gap in science achievement among 13 year olds by half and eliminate entirely the smaller achievement gap in mathematics."

Female science teachers appeared to reduce the probability that a girl would be seen as inattentive in science, though this had no discernable effect on girls' science achievement. However, female history teachers significantly raised girls' history achievement. And, boys were more likely to report that they did not look forward to a particular academic subject when it was taught by a female.

Overall, the data suggest that, "a large fraction of boys' dramatic underperformance in reading reflects the classroom dynamics associated with the fact that their reading teachers are overwhelmingly female."

Samwick on Tom Friedman

Dartmouth economist (and my former CEA colleague) Andrew Samwick dissects NY Times columnist Tom Friedman and doesn't like what he finds.

DeLong on the U.S. Trade Deficit

In monday's ec 10 lecture, I noted that there is a range of views among economists about whether the current U.S. trade deficit is a problem. In a new column, UC Berkeley economist Brad DeLong has a similar theme (although he is clearly on the side of those who are more worried). An excerpt:

As more time passes with neither the value of the dollar declining sharply nor market forces beginning to shrink America’s current-account deficit – which may well reach $1 trillion this year – two diametrically opposed reactions are emerging. Most international finance economists are becoming increasingly frightened that a major international financial crisis could erupt. Indeed, they fear that the scale of that potential crisis is becoming larger and larger.

Others – especially managers of financial assets – are becoming increasingly convinced that economists don’t know very much, and that what they do know is of no use to traders like themselves. They see little reason to believe that current asset values and trade flows are not sustainable....

In other words, the market is betting that the dollar will fall gradually in the next five years, and that the US current-account deficit will narrow without a financial crisis. That is what happened in the late 1980’s, and in the late 1970’s, too. After all, God, it is said, protects children, fools, dogs, and the United States of America. But the odds on a soft landing are lengthening with each passing day.

Red States and Blue States

In the business section of today's NY Times, economist Hal Varian discusses a recent study by Harvard economists Edward Glaeser and Bryce Ward. (Ec 10 students: Glaeser teaches ec 1011a, the more mathemetical intermediate micro course, so you may see him next year.)

Here is Varian's summary of modern American politics:

Republicans have traditionally appealed to those with higher incomes. The genius of Republicans, beginning with Ronald Reagan and continuing with Karl Rove, was to bring the religious vote into their party, forming a winning coalition of Main Street businessmen, the very wealthy and evangelical Christians. Strange bedfellows, to be sure, but they win elections....

The Economist magazine characterizes American politics as a contest between the incompetence of Republicans and the incoherence of the Democrats. But there is a reason for the Democrats' incoherence: they are feverishly trying to assemble their own collection of strange bedfellows, and no one quite knows what it is.

And here in their own words is a summary of the Glaeser-Ward paper:

In this essay, we revisit America’s political geography and ask what is true and false about the “red state/blue state” framework. We begin by identifying five myths associated with this framework: 1) American is divided into two politically homogenous regions; 2) The two parties are more spatially segregated than in the past; 3) America’s political geography is more stable than in the past; 4) America’s cultural divisions are increasing and 5) America is becoming more politically polarized.

But despite the myths surrounding the red state/blue state paradigm, there are two important truths captured by this framework. America is a country with remarkable geographic diversity in its habits and beliefs. People in different states have wildly different views about religion, homosexuality, AIDS, military policy and wildly different consumption patterns. The distribution of states along all dimensions is continuous, not bimodal, but this continuum should never be confused with homogeneity. Moreover, America’s ideological diversity is not particularly new. In the 1930s, New England was much more socially liberal than the South. The extent and permanence of cultural divisions across space is one of America’s most remarkable features.

Corporate Tax Rates

According to a new study by KPMG, the United States and Japan have the two highest corporate tax rates of the more than 80 nations examined. Their tax rates on corporate income are about 40 percent (including corporate taxes at the state and local level), while the rate in the European Union averages about 25 percent.

The report says:

Among nations that changed their statutory corporate income tax rates over the past 12 months, the overwhelming majority cut them, continuing a trend towards lower rates that has persisted for several years. Rate reductions were most pronounced in Europe....This may reflect intensifying tax competition within the EU as a result of the accession of 10 new member states last year and the encouragement EU law and jurisprudence has been giving to capital mobility within the EU.

These new facts are the perfect excuse to reprint a case study from my Principles textbook:

Who Pays the Corporate Income Tax?

The corporate income tax provides a good example of the importance of tax incidence for tax policy. The corporate tax is popular among voters. After all, corporations are not people. Voters are always eager to have their taxes reduced and have some impersonal corporation pick up the tab.

But before deciding that the corporate income tax is a good way for the government to raise revenue, we should consider who bears the burden of the corporate tax. This is a difficult question on which economists disagree, but one thing is certain: People pay all taxes. When the government levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer. The burden of the tax ultimately falls on people—the owners, customers, or workers of the corporation.

Many economists believe that workers and customers bear much of the burden of the corporate income tax. To see why, consider an example. Suppose that the U.S. government decides to raise the tax on the income earned by car companies. At first, this tax hurts the owners of the car companies, who receive less profit. But over time, these owners will respond to the tax. Because producing cars is less profitable, they invest less in building new car factories. Instead, they invest their wealth in other ways—for example, by buying larger houses or by building factories in other industries or other countries. With fewer car factories, the supply of cars declines, as does the demand for autoworkers. Thus, a tax on corporations making cars causes the price of cars to rise and the wages of autoworkers to fall.

The corporate income tax shows how dangerous the flypaper theory of tax incidence can be. The corporate income tax is popular in part because it appears to be paid by rich corporations. Yet those who bear the ultimate burden of the tax—the customers and workers of corporations—are often not rich. If the true incidence of the corporate tax were more widely known, this tax might be less popular among voters.

Ayres and Bulow on Lobbying Reform

The U.S. House of Representatives today passed a lobbying reform bill which increased disclosure requirements. Debate over the bill is part of a continuing struggle to draw the line between a person's democratic right to influence the political process and the possibility of implicit corruption that arises whenever cash flows from a private citizen to an elected official.

This might be a good time to recall an intriguing proposal for a better way to control influence-peddling, suggested several years ago by Ian Ayres and Jeremy Bulow. Paradoxically, the heart of their campaign-finance proposal is less disclosure.

Here is a brief description of the Ayres-Bulow plan, courtesy of Steven Landsburg:

What do you get when you cross a law professor with an economist? An idea that's both expensive and impractical? Maybe, or maybe you get just the opposite--an idea that's both practical and efficient. Or maybe you just can't be sure.

The law professor is Ian Ayres of Yale Law School, the economist is Stanford's Jeremy Bulow, and their idea is to reform campaign finance by turning conventional wisdom on its head. While traditional reformers demand full public disclosure of campaign contributions, Ayres and Bulow want to make all contributions anonymous. If you want to give $100,000 to George Bush, go right ahead. You just can't let him know you did it. And therefore, your cash can't buy his favors.

Here, in brief outline, is how the plan would work: A trusted financial institution--say Vanguard--sets up accounts in the names of all recognized candidates. If you want to contribute to Bush, you write a check to Vanguard with instructions to deposit it in the Bush account. Once a month, Bush can see his total--and make withdrawals to fund campaign expenses--but he never sees the deposit slips. If you want to prove you're a big giver by waving your canceled check in Bush's face, there's nothing stopping you--but all he'll see is a check to Vanguard, which for all he knows went directly into your personal account.

Help me save my job!

Ec 10 students: Please take a few minutes to evaluate ec 10 on the online CUE guide.

Robots

Insightful post by Tyler Cowen on the economics of robots.

Home Production

When economists think about labor supply, they traditionally emphasize the tradeoff between working and enjoying leisure. Increasingly, however, we have come to appreciate that another part of the story is the tradeoff between working in market production and working in home production. GDP, of course, includes only the value of market production.

Today, Reuters has a story about the home production of American mothers. It begins as follows:

Study: US mothers deserve $134,121 in salary

NEW YORK (Reuters) - A full-time stay-at-home mother would earn $134,121 a year if paid for all her work, an amount similar to a top U.S. ad executive, a marketing director or a judge, according to a study released on Wednesday.

A mother who works outside the home would earn an extra $85,876 annually on top of her actual wages for the work she does at home, according to the study by Waltham, Massachusetts-based compensation experts Salary.com.

To reach the projected pay figures, the survey calculated the earning power of the 10 jobs respondents said most closely comprise a mother's role -- housekeeper, day-care teacher, cook, computer operator, laundry machine operator, janitor, facilities manager, van driver, chief executive and psychologist.

"You can't put a dollar value on it. It's worth a lot more," said Kristen Krauss, 35, as she hurriedly packed her four children, all aged under 8, into a minivan in New York while searching frantically for her keys. "Just look at me."

Employed mothers reported spending on average 44 hours a week at their outside job and 49.8 hours at their home job, while the stay-at-home mother worked 91.6 hours a week, it showed.

An estimated 5.6 million women in the United States are stay-at-home mothers with children under age 15, according to the most recent U.S. Census Bureau data.

Harvard, as seen by a Yalie

Ec 10 students will enjoy today's Doonesbury.

Fairtrade Coffee

An ec 10 student asked me a few weeks ago about "fairtrade coffee." Today, economist Mark Thoma has a post on his blog about the topic.

Neither Thoma nor the Peter Singer article he cites, however, sufficiently answers the key question: If you have a charitable motive, is it better to (1) distort your consumption patterns to buy more "good goods," or (2) satisfy your own desires in a self-interested way and donate the money you save to your favorite charity? When helping others, we should act as efficiently as possible in order to provide the greatest good to the greatest number. Does fairtrade coffee do that? Or does it just make the consumer feel better about himself? Singer's analogy that buying fairtrade coffee is like buying a Gucci label suggests the latter, although I know that was not his intention.

Lazear on the Gas Tax

CEA Chairman Eddie Lazear calls it right. Here is a report from the Associated Press:

Bush Economist: Gas Tax Cut Not the Answer

WASHINGTON -- Cutting gasoline taxes is not a good way for the country to deal with soaring energy prices, President Bush's top economist said Tuesday.

"One of the things we worry about when we cut the tax on gasoline is that it basically stimulates additional use," said Edward Lazear, chairman of the White House's Council of Economic Advisers.

"Over a longer period of time, it would be a significant problem ... because what it would do is it would encourage us to use more oil, not less and that is the way we got to the situation right now," he explained. "That probably is one of the policies that we would like to avoid," he said.

In a related article in the Times of London, columnist Gerard Baker implicitly agrees with Eddie (and all other economists) that people respond to incentives:

Sales of the thirstier heavy sport-utility vehicles fell 13 per cent last year and are down again this year. The popularity of hybrids is rising sharply and the big US car manufacturers are hastening their production schedules to get them on the market.

This has been driven by the simple fact of higher energy prices — caused by that old, brutal combination of rising demand and tight supply.

Tierney and Rawls on Immigration

In the fall in ec 10, we talked about philosopher John Rawls's theory of justice. In today's NY Times, columnist John Tierney applies Rawlsian logic to the immigration debate. He writes:

Even if you accept the debatable economic premise that low-income workers are significantly harmed, the argument [against increased immigration] fails on moral grounds. It flunks the famous ''veil of ignorance'' test of John Rawls, the quintessential liberal philosopher who stressed protections for the least fortunate members of society. Social rules are fair, he wrote in ''A Theory of Justice,'' if you would endorse them without knowing what your position in society would be.

Suppose you were setting immigration policy from behind that veil of ignorance. Which of these would you choose?

(1) Restricting immigration to protect some of the lower-paid workers in America from a decline in wages that would be no more than 8 percent, if it occurred at all.

(2) Expanding immigration to benefit most Americans while also giving some non-Americans living in dire poverty the chance to quadruple their income.

You don't need to slog through ''A Theory of Justice'' to figure out this one.

Bodman vs Russert

On Meet the Press, Secretary of Energy Sam Bodman discusses supply and demand with TV journalist Tim Russert. Watch the clip and decide for yourself who would get a better grade in ec 10.

Hyperinflation in Zimbabwe

The first page of today's New York Times has a good article reminding us how bad monetary policy can be. Here is an excerpt:

How bad is inflation in Zimbabwe? Well, consider this: at a supermarket near the center of this tatterdemalion capital, toilet paper costs $417.

No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single two-ply sheet. A roll costs $145,750 — in American currency, about 69 cents....

Mr. Mugabe's government has printed trillions of new Zimbabwean dollars to keep ministries functioning and to shield the salaries of key supporters — and potential enemies — against further erosion. Supplemental spending proposed early in April would increase the 2006 spending limits approved last November by fully 40 percent, and more such emergency spending measures are all but certain before the year ends....

Inflation, about 400 percent per year last November, edged over 600 percent in January, but began to soar after the government revealed that it had paid the International Monetary Fund $221 million to cover an arrears that threatened Zimbabwe's membership in the organization.

In February, the government admitted that it had printed at least $21 trillion in currency — and probably much more, critics say — to buy the American dollars with which the debt was paid.

By March, inflation had touched 914 percent a year, at which rate prices would rise more than tenfold in 12 months. Experts agree that quadruple-digit inflation is now a certainty.

Monetary Music

In tomorrow's ec 10 lecture, I will be discussing issues in monetary policy. As background, ec 10 students might enjoy this parody (alternate links here and here) prepared by students at Columbia Business School about their Dean, economist Glenn Hubbard. Glenn had been rumored to be on the list of candidates considered for the job as Fed chair.

By the way, that is not the real Glenn Hubbard in the video (as some bloggers mistakenly thought at first) but a student playing him. However, Glenn may have musical genes: His younger brother, Gregg Hubbard, is the keyboardist for the country-pop band Sawyer Brown.

I will leave it up to you to decide which brother has the cooler job.

Galbraith and Friedman on the Draft

Economist David Henderson has a piece in today's Wall Street Journal on John Kenneth Galbraith's contributions to economics. It concludes with a nice reminder that economists of Galbraith's generation played a role in ending in the draft:

Galbraith was also one of the chief price controllers during World War II, as head of the price section of the government's Office of Price Administration. Unlike other economists involved with price controls, such as George Shultz during the Nixon administration and Frank Taussig during the Wilson administration, Galbraith emerged as an advocate of permanent price controls, an unpopular position among economists.

But there is one price control that John Kenneth Galbraith joined Milton Friedman in opposing in the 1960s: military conscription. He wrote, "The draft survives principally as a device by which we use compulsion to get young men to serve at less than the market rate of pay."

Milton Friedman once said, "In the realm of policy, I regard eliminating the draft as my most important accomplishment." And he did have a very direct role in ending it, as a member of the President's Commission on an All-Volunteer Force. Here is a story about Friedman and General William Westmoreland, who was then commander of U.S. troops in Vietnam.

In his testimony before the commission, Mr. Westmoreland said he did not want to command an army of mercenaries. Mr. Friedman interrupted, "General, would you rather command an army of slaves?" Mr. Westmoreland replied, "I don't like to hear our patriotic draftees referred to as slaves." Mr. Friedman then retorted, "I don't like to hear our patriotic volunteers referred to as mercenaries. If they are mercenaries, then I, sir, am a mercenary professor, and you, sir, are a mercenary general; we are served by mercenary physicians, we use a mercenary lawyer, and we get our meat from a mercenary butcher."

So, ec 10 students, in this time of war, you have to thank this older generation of economists for their role in ensuring your freedom.

Sugar Quotas

An ec 10 student emails to ask for some information about U.S. sugar quotas. I am not an expert on the subject, but here is what I know.

Most economists view U.S. policies toward sugar as a deplorable departure from the principles of free trade. About a year ago, The Economist magazine summed up the situation as follows:

Outrageous import quotas keep the domestic price of sugar at double that of the world price. CAFTA [the Central America Free Trade Agreement] would allow more imports in from Central American countries, but still less than 2% of US sugar production. For the sugar lobby—and the 15 or so Republican politicians who follow its bidding—that is still too much.

See also George Will's old column on the topic and this Reuters article on the current situation.

The economics here is straightforward. It is a standard case of protectionism for the benefit of politically powerful domestic producers (including the producers of sugar substitutes, such as corn syrup). The losers are American consumers and farmers in developing nations.

One interesting wrinkle is that sugar is used to make ethanol. If the United States had truly free trade, we would be enjoying not only cheaper soft drinks but also cheaper fuel, as Harvard historian Niall Ferguson (alternate link) pointed out in yesterday's LA Times. In a column called "Put some sugar in your tank," he writes:

Unnoticed in the northern hemisphere, one country is pioneering a transportation revolution by switching from petrol to ethanol. That country is Brazil. Today, ethanol accounts for 40 per cent of all automobile fuel in Brazil, while 80 per cent of new Brazilian cars are flexible-fuel cars that can run on either petrol or ethanol.

What's preventing the northern hemisphere from following Brazil's lead? The answer is not so much Big Oil -- though American oil companies have fought tooth and nail against the introduction of ethanol, even as a fuel additive -- as Small Agriculture. To protect northern farmers, huge tariffs are currently imposed on imports of Brazilian-produced ethanol by both the United States and the European Union.

Tabellini on Italy

Italian economist Guido Tabellini on the challenges facing his country:

The budget deficit is again out of control, and well over the 3%-of-GDP Maastricht ceiling. The aging population is straining the public pension and healthcare systems beyond sustainability. The manufacturing sector, squeezed by stagnating productivity and competition from China and other low-cost producers, is no longer competitive. Many services remain inefficient, because they are either in the domain of an archaic public administration or enjoy monopoly rents created by regulatory barriers.

Fiscal Crisis Ahead

In my lecture in ec 10 today, I spoke about the long-run outlook for fiscal policy. (Summary: Ugly.) This Washington Post article is, therefore, timely:

Social Security, Medicare Trust Funds Sink
By MARTIN CRUTSINGER

The Associated Press
Monday, May 1, 2006; 5:43 PM

WASHINGTON -- The trust fund for Social Security will be depleted in 2040, a year before expected, and Medicare will exhaust its trust fund reserves just 12 years from now, trustees for the programs said Monday....

The trustees, who include the head of the Social Security Administration and three members of President Bush's Cabinet, painted a sober assessment of the health of the two programs in advance of the looming retirements of 78 million baby boomers.

"We do not believe the currently projected long-run growth rates of Social Security or Medicare are sustainable under current financing arrangements," the trustees said in this year's report....

Treasury Secretary John Snow, who is the chairman of the trustees' panel, told a news conference that the country faced a "looming fiscal crisis as the baby boom generation moves into retirement."

Swagel on China

My former CEA colleague Phillip Swagel reports via email about his recent trip to China:

Being there gave me an interesting window on demographics and the problem of the aging society. You see it just walking on the street: there are just hardly any children around. It's eerie. The 1-child policy has been in place for 3 decades, and as a result China is heading into a snap demographic transition; they've created their own aging society but without putting into place social welfare systems or pensions. They actually went the other way by allowing state enterprises to jettison their former pensions (the so-called "iron rice bowl"). And their problems don't end there, since the demographic change means as well that they will soon be a society with near-vertical family trees -- no brothers or sisters means in a few generations there will be no more cousins either. So there's no formal social safety net and they are putting an end to the informal safety net of the extended family. No wonder they save so much -- it's all precautionary. We heard stories about the fee-for-service health system -- hospitals won't take out a new bag of plasma for a transfusion until the cash is handed over. And who knows what all of this will do to the social fabric in China, as the family structure of 1,000+ years comes to end.

Globalization, Immigration, and Poverty

In the April 2006 issue of Scientific American, Pranab Bardhan (econ prof at UC Berkeley) asks "Does Globalization Help or Hurt the World's Poor?" In the process of answering this question, he offers this input into the immigration debate:

A program to permit larger numbers of unskilled workers into rich countries as "guest workers" would do more to reduce world poverty than other forms of international integration, such as trade liberalization, can. The current climate, however, is not very hospitable to this idea.

Hamilton on Gasoline Taxes

UCSD economist Jim Hamilton has a good post discussing the current Congressional debate on gasoline taxes. It will remind Ec 10 students of our analysis of tax incidence from the fall term.

The Best Book I've Read Lately

The Myth of the Rational Voter: Why Democracies Choose Bad Policies
by Bryan Caplan

Caplan offers readers a delightful mixture of economics, political science, psychology, philosophy, and history to resolve a puzzle that, at one time or another, has intrigued every student of public policy. (Bryan: You can use that as a blurb!)

To give a flavor of the book, here are a few lines that caught my eye:

In a secular age, politics and economics have displaced religion itself as the focal point for passionate conviction and dogmatism.

Before studying public opinion, many wonder why democracy does not work better. After one becomes familiar with the public's systematic biases, however, one is struck by the opposite question: Why isn't democracy far worse?

What happens if fully rational politicians compete for the support of irrational voters--specifically, voters with irrational beliefs about the effects of various policies? It is a recipe for mendacity.

Put bluntly, rule by demogogues is not an aberration. It is the natural condition of democracy.

To get ahead in politics, leaders need a blend of naive populism and realistic cynicism. No wonder the modal politician has a law degree.

Having spent a year and a half as a student at Harvard Law School, I had to smile at that last line.

The book is forthcoming from Princeton University Press.