What would Alan do?

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

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

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

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

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

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

Set your TiVo!

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

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

Mishkin to the Fed

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

On Energy Independence

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

Professor Mankiw,

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

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

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

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

How is "energy independence" any different?

[name withheld]

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

Does this make any sense? Consider this passage:

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

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

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

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

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

Define "Hack"

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

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

I couldn't agree more.

Define "Rich"

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

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

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

On Arthur Burns

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

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

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

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

Wages and Work Hours

Here is an intriguing fact from a new NBER study:

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

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

Credos of the Left and Right

From Barbara Ehrenreich:

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

From Jeff Taylor:

Nothing is more dangerous than a lunatic with government letterhead.

Wessel on the Fiscal Challenge

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

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

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

Another Reason to Envy Brad Pitt

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

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

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

Thanks to New Economist for the pointer.

Is the Gas Tax Regressive?

Today's Washington Post reports:

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

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

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

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

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

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

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

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

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

Behavioral Economics

A reader asks about hot topics in economics:

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

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

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

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

Case Study
How to Get People to Save More

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

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

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

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

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

Lazear on the Trade Deficit

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

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

Research on the Line-Item Veto

The Washington Post this afternoon reports:

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

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

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

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

From the same journal in 2003:

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

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

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

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

Send Ted a Secret Decoder Ring

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

He is right. Welcome to the Club, Ted.

Leadership Change at Harvard

Consider this description of a great, visionary leader:

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

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

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

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

Debating Wal-Mart

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

Consumption vs Income Taxation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

W*[1+r]^T

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

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

Classic Milton Friedman

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

Friedman discuss the minimum wage at 2:40.

Always Glad to Be Helpful

The Republic of Heaven blog endorses my book:

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

Application Rejected

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

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

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

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

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

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

Philanthropy vs Free Trade

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

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

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

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

On Inequality

A student asks a broad question:

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

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

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

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

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

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

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

Steve Levitt is no macroeconomist

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

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

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

Salinger on Price Gouging

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

The bottom line is no surprise:

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

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

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

He offers this interesting tidbit:

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

Finally, he leaves us with this observation:

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

Really? I never noticed.

Al Gore in the Pigou Club

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

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

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

We are always looking for more members.

Crook on Health Care Reform

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

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

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

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

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

Hillary vs Bastiat

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

Krugman on the Minimum Wage

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

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

Thanks to Mark Thoma for the pointer.

Niskanen on Monetary Policy

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

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

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

Careers in Law and Economics

A student emails me a question about being a lawyer:

Hi Professor Mankiw,

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

[name withheld]

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

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

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

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

Toward a World Language

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

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

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

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

Self-Control and Academic Success

The Australian reports:

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

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

Sperling on the Minimum Wage

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

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

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

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

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

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

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

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

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

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

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

Textbook Economics

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

Dear Professor Mankiw,

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

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

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

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

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

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

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

Sincerely,
[name withheld]

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

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

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

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

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

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

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

Four Worries

New things to read:

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

Rogoff on Russia

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

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

Peer Effects in Education

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

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

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

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

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

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

Can 500 economists all be wrong?

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

An engineer seeks career advice

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

Hi Dr. Mankiw,

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

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

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

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

Keep up the great blogging,
[name withheld]

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

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

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

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

Who earns the minimum wage?

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

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

An old study from the CBO reports:

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

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

Question about Sticky Prices

A student emails me a question about price adjustment:

Dear Professor Mankiw:

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

I have some comments on "Sticky prices."

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

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

[name withheld]

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

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

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

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

A Possible Estate Tax Compromise

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

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

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

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

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

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

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

How to Fix Social Security - update

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

The next Fed chair

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

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

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

Hmmm....That gets me thinking.

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

Furman on Health Insurance

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

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

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

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

Kling, Gore, and Pascal

Arnold Kling writes:

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

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

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

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

Surprise!

George Bush at the 2004 Republican Convention:

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

Paul Krugman in today's NY Times:

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

Parents are people too

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

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

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

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

The lesson: Always remember the Ten Principles.

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

On Means Testing

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

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

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

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

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

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

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

Things to Read

Here are a few items worth reading:

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

CAFE Standards

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

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

The Pigou Club

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

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

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

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

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

Senator Obama's Twofer

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

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

I will let readers complete the equation:

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

On Forecasting Inflation

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

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

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

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

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

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

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

Krugman vs Cecchetti on Inflation

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

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

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

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

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

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

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

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

Altman misses a chance

Roger Altman, deputy Treasury secretary in the first Clinton administration, has an op-ed in today's Wall Street Journal in which he worries about energy dependence and global warming. I agree with him about this:

Recent talk of price gouging, windfall profits and CEO pay is a distraction.

However, I am less attracted to what he proposes:

Corporate average fuel efficiency standards (CAFE) must be raised sharply, perhaps together with a stretch-out of legacy costs for the U.S. auto producers. Owners of the oldest, least efficient vehicles should be paid to turn them in. And we need much deeper tax incentives for production of hybrid and clean diesel engines and for consumer purchases of them. The expected growth in our oil consumption could be cut by 25% to 50% with these steps.

The permanent solution to oil vulnerability and climate change, however, lies in technology. My generation has seen breathtaking technologies emerge, but they will pale before the next ones. Thus, we should aim for technologies to truly end our use of oil and gas. The front-end risks must be financed at the federal level.

From my perspective, this all sounds like micro-managing the problem with more government regulation and more government spending.

In my view, the solution to the problems Altman identifies is simple: higher Pigovian taxes, such an increased tax on gasoline or a tax on carbon. Policymakers could then sit back and let market forces figure out the rest.

Altman's avoidance of this policy option is all the more surprising because the first Clinton administration proposed a BTU tax, which as I recall was a lot like a carbon tax. The BTU tax failed politically, and since then former Clinton administration officials have stopped pushing for it in the public debate. That is a shame. It was one of their best ideas.

By the way: Does Altman mean by a "stretch-out of legacy costs" what I think he means? It sounds like he is saying that GM can take its time funding its obligations to retirees. If I am interpreting him correctly, that is a troubling piece of advice.

Excessive Fed watching is a bad sign

Today's Wall Street Journal reports on yesterday's stock market:

Stocks rose sharply Thursday, building on the previous session's late-day rally, with the Dow Jones Industrial Average retaking 11000 as traders cheered somewhat dovish remarks on inflation by Federal Reserve Chairman Ben Bernanke.

This quotation is symptomatic of what appears to be an increased emphasis on Fed watching in recent months. It is hard to quantify, but financial markets seem to be extraordinarily focused on remarks coming out of the Fed and, in particular, on those by Ben Bernanke.

Perhaps increased Fed watching is inevitable whenever we have a new Fed chairman, but it is nonetheless troubling. Fundamentally, Fed watching is a symptom of ambiguity in monetary policymaking. Fed insiders do not have significantly more data on the economy than everyone else. When financial markets react to Fed statements, therefore, they are not incorporating news about the economy. Instead, they are incorporating news about policymakers' intentions. So if a speech or testimony by a Fed official moves financial markets, it means that the intentions of monetary policymakers were not clear before the speech or testimony.

Most modern monetary economists, including Ben Bernanke, are advocates of transparency in monetary policymaking. I agree. We can gauge how close we are to the goal of transparency by noting how much speeches and testimony of Fed officials move markets. Under perfect transparency, markets would react to Fed remarks with a yawn. Traders would say, "Of course, he would say that, given the data we have all seen lately. None of that verbiage changes my view about the course of monetary policy." Macroeconomic data would move markets; remarks by Fed officials would not.

The ideal would be a completely boring Fed chairman whose speeches are regularly ignored by financial markets. Apparently, we are not there yet.

On Jeffrey Sachs

A student emails me a query about my erstwhile colleague Jeffrey Sachs:

Professor Mankiw,

I have been debating with a friend of mine (we are both graduate students in economics) about Jeff Sachs. To me he seems to ignore the power of incentives--an unforgivable error for an economist. The article you recommended on your website shows this lamentable trait. Sachs blames Africa's problems chiefly on "the lack of aid promised 36 years ago and repeatedly since by rich nations." That isn't the real problem is it? Perhaps you would comment on Sachs' ideas on your blog.

[name withheld]

P. S. Like many others, I have high praise for your textbooks, from which I have profited greatly.

Development is not my field of specialty, but I do follow the debate from afar. Here is my take, as an outsider.

I have long admired Jeff for his energy and idealism. I believe that he is truly working hard to make the world a better place for the least fortunate among us.

Nonetheless, I often find myself skeptical about Jeff's prescriptions and the confidence he places in their success. The article on Jeff I cited yesterday in a previous post said:

Jeffrey Sachs is at once a scientist and a preacher in the field of economics.

As a description of Jeff's career, that sounds about right. Jeff delivers his policy advice with so much zeal that I am frequently knocked off my feet, as if I were listening to a particularly forceful fire-and-brimstone sermon.

But consider: Are these two roles compatible? Don't scientists and preachers have very different approaches to life? Scientists understand that much knowledge is tentative; they are always open to doubt. Preachers take much on faith; they approach the world with certitude. When I hear Jeff talk, I hear more preacher than scientist, and that makes me apprehensive. Unlike Harry Truman, I like two-handed economists. I don't often hear Jeff start a sentence "On the other hand,...."

I am sympathetic to Bill Easterly's critique of Jeff's work. Bill's approach has a compelling humility and eclecticism. In light of how little we know about economic development and how divided the economics profession is on the key issues, I am suspect of those who are extraordinarily confident in their views, as Jeff is. I wonder if Jeff is on the wrong side of the rhetorical Laffer curve: If he pushed his opinions less forcefully, he might be more persuasive.

Finally, I cannot help but mention Jeff's greatest asset: his wife, Sonia Ehrlich. Sonia is a doctor, and for many years she was my children's pediatrician. In that capacity, I got to know her fairly well, and I can attest that she is one of the most wonderful people I have ever met. The best thing I can say about Jeff is that he had the good sense to marry Sonia.

Cowen on Charitable Giving

In today's NY Times, economist Tyler Cowen describes recent research on charitable giving. His take:

DONORS to charities, it seems, do not behave rationally. Increasing evidence shows that donors often tolerate high administrative costs, fail to monitor charities and do not insist on measurable results....

donors often give to charities for reasons of pride. Monitoring a charity means worrying about the wisdom of contributing to that charity. Many donors would instead prefer simply to feel good about their generosity and thus they deceive themselves into thinking that all is going well. Furthermore, many donors seek a sense of affiliation and wish to be a part of large and successful organizations — the "winning team," so to speak. Again, these donors do not focus on how, or if, they actually end up improving the world.

Somehow, I suspect that Adam Smith would not be surprised. If anyone finds just the right Smith quotation, please post it among the comments.

Am I immortal yet?

"If all else fails, immortality can always be assured by spectacular error." So said economist John Kenneth Galbraith.

You can read about my bid for immortality in the first few sentences of this Fed document, which a loyal reader calls to my attention.

Three from New Haven

The summer issue of the Yale Economic Review has several articles of interest for students of economics:

• A profile of Nobel laureate Paul Samuelson
• A piece on the economics of online video games
• A cover story that asks "Can Jeff Sachs Save the World?"

Republicans and the Minimum Wage

Some Republicans in Congress are apparently worried about the midterm elections. They are so worried, they are starting to vote like Democrats.

According to today's Wall Street Journal,

Breaking with its Republican leadership, the House Appropriations Committee approved a $2.10-an-hour increase in the minimum wage as part of a budget bill that adds $4 billion to President Bush's requests for domestic programs.

The 32-27 vote is certain to be challenged when the $596.5 billion measure comes to the House floor. But the seven Republican defections underscored the growing prominence of the wage issue going into the November elections.

The minimum wage is, I admit, controversial among economists. But many economists, and surely most allied with the Republican party, take the view that Linda Gorman expressed so succinctly:

Unfortunately, neither laudable intentions nor widespread support can alter one simple fact: although minimum wage laws can set wages, they cannot guarantee jobs. In reality, minimum wage laws place additional obstacles in the path of the most unskilled workers who are struggling to reach the lowest rungs of the economic ladder.

Consistent with this assessment, here the abstract of a NBER study by David Neumark and Olena Nizalovaof on the long-run effects of the minimum wage:

Exposure to minimum wages at young ages may lead to longer-run effects. Among the possible adverse longer-run effects are decreased labor market experience and accumulation of tenure, lower current labor supply because of lower wages, and diminished training and skill acquisition. Beneficial longer-run effects could arise if minimum wages increase skill acquisition, or if short-term wage increases are long-lasting.

We estimate the longer-run effects of minimum wages by using information on the minimum wage history that workers have faced since potentially entering the labor market. The evidence indicates that even as individuals reach their late 20's, they work less and earn less the longer they were exposed to a higher minimum wage, especially as a teenager. The adverse longer-run effects of facing high minimum wages as a teenager are stronger for blacks. From a policy perspective, these longer-run effects of minimum wages are likely more significant than the contemporaneous effects of minimum wages on youths that are the focus of most research and policy debate.

Housing Bubble?

A student emails me to ask about the housing market:

Do you think there is a housing bubble in the US?

I have not myself studied current market valuations, but I did take note of this article on the housing market in the Financial Times a couple days ago:

Housing boom will not end in a crash, says Harvard

“Although housing prices are stretched, it is hard to see the catalyst for a crisis in the market,” says Nicolas Retsinas, director of the Joint Center for Housing Studies at Harvard. “The overvaluation looks pretty well balanced by longer term supports for house prices, so we may just see a few years with little action. Houses will revert to being something to live in rather than money makers.”

Okay, so the housing market has "reached what looks like a permanently high plateau." Now that's reassuring.

On Russia

A student emails me a question about Russia:

Dear Professor Mankiw,

I am one of the many students that has been introduced to your blog by a Pomona Professor and have ever since enjoyed it greatly!

I am currently in Moscow.... I know that you do not specialize on the Russian Economy, but what is your personal opinion on the way Russia is developing and its short and long term perspectives?...

Thank you very much for your time and keep up the GREAT work (the blog is indeed addictive)!

Respectfully,
[name withheld]

p.s.I forgot to mention that your Intermediate Macro textbook was EXTREMELY helpful. Thanks a lot!

The student is right: I am not an expert on the Russian economy. Recognizing the principle of comparative advantage, I will outsource this question to someone who is.

I recommend that you read A Normal Country: Russia After Communism by Andrei Shleifer and Daniel Treisman from the Winter 2005 issue of the Journal of Economic Perspectives. Their bottom line:

although Russia’s transition has been painful in many ways, and its economic and political systems remain far from perfect, the country has made remarkable economic and social progress. Russia’s remaining defects are typical of countries at its level of economic development.

By the way, Shleifer is my colleague at Harvard and is one of the best economists I know.

One for the "I told you so" file

The new issue of the IMF Survey reports:

A recent IMF Working Paper by Mary Amiti and Shang-Jin Wei explores the offshoring phenomenon and finds evidence that a small number of jobs have, indeed, been lost in manufacturing industries. However, it also finds that offshoring has boosted labor productivity in the United States and that, partly because of this, there has been offsetting job creation elsewhere in the economy.

This sounds right, but from my personal perspective, it is about 28 months late.

I wonder if Denny Hastert reads the IMF Survey.

McCain on the Economic Challenges

John McCain gave a speech to the Economic Club of New York yesterday. According to the betting at Tradesports.com, McCain is the leading candidate to win the Republican nomination in 2008. (Full disclosure: I was among a handful of economists working for Senator McCain during the 2000 presidential primary, and I even rode the campaign bus with him for a couple days, but I have not talked with him since then.)

The whole speech is worth reading. Here are my two favorite passages:

A tsunami of entitlement spending is threatening our economy, while providing no real security to retirees. We have made promises that we cannot keep. Under moderately optimistic scenarios Social Security, Medicare and Medicaid will in the decades to come grow as large as the entire government is today. Someday the government will be forced to make drastic cuts in these programs, or crippling increases in taxes on workers – or both. The longer we wait to make the hard choices necessary to repair these programs, the harder the problem becomes. My children and their children will not receive the benefits we will enjoy. That is an inescapable fact, and any politician who tells you otherwise, Democrat or Republican, is lying....

A global rising tide of protectionism and a retreat from market-based economic policy is threatening the entrepreneurs of developed and developing countries alike. Free trade is the key to global economic growth, and a key to U.S. economic success. We need stand up for free trade with no ifs, ands or buts about it. We let trade and globalization be politicized at our own peril.

By my reckoning, any candidate who is not willing to put some version of these two paragraphs into his or her speeches doesn't pass the test of intellectual seriousness. McCain passes with flying colors.

What the speech does not do, however, is propose specific policies consistent with these admirable generalities. But maybe that is too much to hope for at the beginning of a presidential campaign.

Kristof on Foreign Aid

Nicholas Kristof has a great column in today's NY Times about what we can expect from foreign aid. The short answer: Not much, but not nothing. Kristoff gives a nice plug for Bill Easterly's book, The White Man's Burden, as well as for a lot of other economic research.

Here are a few excerpts from Kristof:

I disagree with many of Professor Easterly's arguments, but he's right about one central reality: helping people can be much harder than it looks. When people are chronically hungry, for example, shipping in food can actually make things worse, because the imported food lowers prices and thus discourages farmers from planting in the next season. (That's why the United Nations, when spending aid money, tries to buy food in the region rather than import it.)...

It's well-known that the countries that have succeeded best in lifting people out of poverty (China, Singapore, Malaysia) have received minimal aid, while many that have been flooded with aid (Niger, Togo, Zambia) have ended up poorer....

But cheer up....whatever the impact on economic growth rates, aid definitely does something far more important: it saves lives. For pennies, you can vaccinate a child and save his or her life. For $5 you can buy a family a large mosquito net and save several people from malaria. For $250, you can repair a teenage girl's fistula, a common childbirth injury, and give her a life again.

What does an inverted yield curve mean?

A student emails me a question about the yield curve:

Dear Professor Mankiw,

I'm a senior economics student at Pomona College and I've been enjoying your blog quite a bit since one of my professors recommended your summer reading list to our class after our final this Spring....

I've been hearing a lot about the inverted yield curve and how it has historically portended a recession. I understand the basic intuition, but I haven't been able to really find the historical context that CNBC keeps blabbing about all day.

Keep up the good work.

Best regards,
[name withheld]

Let me explain, in steps, one way to think about it:

Q: What is the yield curve, and what is an inverted yield curve?

A: The yield curve is graph of the interest rate on bonds as a function of time to maturity. Normally, long-term interest rates are higher than short-term interest rates to compensate for their greater riskiness, so the yield curve slopes upward. Sometimes, the situation reverses: short rates rise above long rates, and the yield curve is said to be inverted.

Q: Why would the yield curve ever invert?

A: The yield curve inverts when bond investors expect short-term interest rates to fall. They are willing to hold long-term bonds, despite the lower current yield, because they are locking in the yield. In other words, current long rates reflect both current short rates and expected future short rates. When investors expect a significant decline in short rates, long rates will be below current short rates.

Q: When would bond investors expect short rates to fall?

A: Remember that short rates are set by the Federal Reserve. So when the yield curve is inverted, investors expect the Fed to be loosening monetary policy.

Q: And why might they expect the Fed to be loosening?

A: Perhaps because they think that the economy is slowing. They expect the Fed would react to a slowdown with looser monetary policy in order to stimulate aggregate demand. As a result, the perception of an upcoming economic slowdown leads to an inverted yield curve today. That is why the slope of the yield curve is one of the variables in the index of leading indicators.

Q: How well does the yield curve predict upcoming economic trends?

A: Pretty well, as compared with other indicators, but it is far from perfect. Remember that economic activity is only one thing the Fed looks at when setting interest rates. It also looks at inflation. So the yield curve also reflects investors' perception of inflation trends. And economic conditions have a great deal of instrinsic uncertainty, which makes even the best indicator far from perfectly reliable.

To learn more about the ability of the yield curve to forecast economic activity, you might read this recent Fed report and this speech by the Fed chairman.

My New Coauthors

When Paul Krugman and Robin Wells published their new economics textbook, I noticed some similarities to mine. So maybe I shouldn't be surprised to learn over at Amazon that they have added me as a coauthor.

I look forward to the extra royalties. But it's still not my favorite principles text.

Update: One of the comments points out an even more unusual coauthorial team.

Young vs Old in France

Economist Brigitte Granville reports on the French distribution of income:

Unlike most other OECD countries, where inequalities have increased over the last 30 years, in France pre-tax income inequality decreased slightly, or at worst remained stable, from 1970 to 2000. But this aggregate stability masks shifts in income distribution that have favored older age cohorts. Those around retirement age (51-65) saw their share in total income rise by three percentage points in the last ten years, while younger groups, particularly those aged 18-25, lost ground, with their income share falling by five percentage points. By 1995, relative poverty was increasing sharply for young adults, while the opposite trend occurred among the elderly.

So much for Equality. Maybe there is still hope for Liberty and Fraternity.

Cowen and Rothschild on Immigrants

In today's Washington Post, Tyler Cowen and Daniel M. Rothschild have an op-ed on the assimilation of Latino immigrants. Here is a tidbit that's new to me:

immigrants are 45 percent less likely than third-generation Americans to commit violent crime.

Starving the Beast

Does cutting taxes to reduce the size of government work? In today's LA Times, Jonathan Chait takes obvious glee in Bill Niskanen's claim that it does not work and that, in fact, it backfires. According to Niskanen,

In a professional paper published in 2002, I presented evidence that the relative level of federal spending over the period 1981 through 2000 was coincident with the relative level of the federal tax burden in the opposite direction; in other words, there was a strong negative relation between the relative level of federal spending and tax revenues. Controlling for the unemployment rate, federal spending increased by about one-half percent of GDP for each one percentage point decline in the relative level of federal tax revenues.

Some of Niskanen's regressions were recently presented and critiqued by economist Mark Thoma.

Here's a puzzle: Niskanen's claims seem patently inconsistent with this study by Henning Bohn from the Journal of Monetary Economics (one of the premier academic journals of macroeconomics):

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.

Niskanen's results suggest that the "starve the beast" hypothesis is completely wrong, whereas Bohn's results suggests there is a large degree of truth to it.

There are many differences in the two studies, including both data and methodology. Regarding data, Bohn includes much more of it, which is a plus, but he ends earlier, omitting the most recent experience, because his study was published in 1991. Regarding methodology, Bohn explicitly incorporates the government's intertemporal budget constraint into the analysis, whereas Niskanen apparently does not. This seems like a shortcoming of Niskanen's approach.

Until someone sorts out these apparently conflicting results, it is (as Thoma suggests) premature for anyone (like Chait) to conclude that Niskanen has the last, or even the most persuasive, word on the topic.

This may be important, but I'm not sure

Arnold Kling draws attention to an article Overconfident Economists Give Economics a Bad Name.

This is why I am naturally suspicious whenever economists offer policy advice too emphatically. I won't mention any names, but you know who you are.

My Family's Flatware

After reading a previous post about my educational history, Dennis Mangan writes, "One has the distinct impression that Professor Mankiw was born with an academic silver spoon in his mouth." I am not quite sure what that means, but in light of other bloggers' recent interest in class autobiography, let me offer the curious a few facts about my family and early life.

My four grandparents immigrated to the United States from Ukraine almost a century ago. None of them had more than a fourth-grade education. My mother was born and raised in Trenton, N.J., my father in Bayonne, N.J., in immigrant communities. Both finished high school, but neither had the opportunity to continue on to college. When I was growing up, my parents sensed that I was languishing in the public schools. (Halfway through second or third grade, the teacher called in my mother to tell her the results of a standardized aptitude test: "Greg did well. We were very surprised.") My parents made what must have been a significant financial sacrifice for them to send me to a good private school, where most of the other kids were from families higher up the socioeconomic ladder (doctors, lawyers, etc). Being reasonably successful at that school got me into Princeton (and also Yale, Stanford, and MIT, but not, alas, my first choice, Harvard, which wait-listed me). The rest of the story is told in the previous post.

Postrel on the Kidney Shortage

In today's LA Times, Virgina Postrel, an economics writer and kidney donor, makes the case for allowing the price to bring supply into balance with demand:

More than 66,000 Americans are languishing on the national waiting list for kidneys — 10 times the number of kidneys transplanted from deceased donors each year. And the list keeps growing, with a queue of more than 100,000 expected by 2010....

The most obvious way to increase the supply of any scarce commodity — paying more for it — is illegal. Federal law blocks transplant centers, patients and insurers from compensating donors in an above-board process, with full legal and medical protections. The growing and inevitable "transplant tourism" industry, and even shadier organ brokers, are the kidney equivalents of back-alley abortionists.

Legalized financial incentives would encourage more people to volunteer their organs. Donors would probably still be relatively rare, just as surrogate mothers are. Many, like me, would still help out without payment, just as some people get paid for giving blood or fighting fires while others do it for free.

Paying donors need not hurt the poor, any more than paying dialysis centers does. Compensation could, in fact, help low-income Americans, who are disproportionately likely to suffer from kidney disease.

For a previous post on this topic, click here.

The Maestro as Has-Been

The Washington Post reported on Thursday:

Shorn of his powers at the Federal Reserve, Alan Greenspan may have lost a tad of the aura and authority that until recently made his every word worth deciphering.

At the 9 a.m. start of the Senate Foreign Relations Committee hearing yesterday, in which Greenspan was testifying for the first time since retiring from the Fed, only two committee members had shown up. Half an hour later, eight members were there, but most of them soon drifted off for a roll call vote, to hear the president of Latvia speak or simply to go about their other business.

The story is yet another reminder that Washington values power over insight. Greenspan is just as good an economic analyst now as he was last year, but that was never enough to impress Senators.

The story also reminds us that the nation is now deprived of an economic-guru-in-chief to comment broadly on policy matters. Ben Bernanke is too new in his job to play the role that Greenspan played, and he may be temperamentally disinclined to venture too far from issues in monetary policy.

So where are people going to turn for impartial, insightful economic analysis of the pressing issues of the day? Oh, yeah, I almost forgot: the blogosphere!

Jeb Bush on Ticket Scalping

The Miami Herald reports:

Gov. Jeb Bush signed a bill into law Wednesday that removes penalties for ticket scalping....Under the measure, Florida's 60-year-old ticket scalping law, which forbids selling tickets for more than $1 above the face value, will be eliminated and in its place will be an open-market system that will allows ticket owners and Internet brokers to sell tickets at whatever price the buyer agrees to pay.

The only economists I know who might be opposed to the repeal of anti-scalping laws are textbook authors. If all states followed suit, we would have to find new examples of ill-conceived government meddling with market mechanisms. For now, those of you lucky enough to have a copy of my favorite principles text can read the box on ticket-scalping in chapter 7.

Despite the view of most economists, the bill was controversial. This editorial from another Florida paper encouraged Bush to veto it, on the grounds that anti-scalping laws

protect the consuming public and event promoters from the economic harm done to them by persons who artificially corner the market for tickets to public events.

Not a particularly compelling argument. But this line in the editorial caught my eye:

John Stoll, owner of a of West Palm Beach concert-promotion company, termed the bill "ridiculous" because it only "makes more money for scalpers."

This leaves me with three related questions:

1. Why would someone who makes a living putting on concerts object when ticket resellers get their products into the hands of buyers with the greatest willingness to pay?
2. Why do concert promoters often price tickets well below the equilibrium price in the first place?
3. If a concert promoter like Mr Stoll sold tickets with a "not for resale above face value" clause, should the government prohibit scalping as part of its duty to enforce private contracts?

The Judgment of Daniel Gross

What do I learn from this? First, that economics writer Daniel Gross is a man of his word. Second, that he is a man of dubious judgment.

What is supply-side economics?

Alan Reynolds takes me to task for writing this:

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.

Mr. Reynolds thinks the first sentence in this paragraph (from my Wall Street Journal op-ed last week) is an unfair caricature of what supply-siders have added to the policy debate.

Apparently, Mr Reynolds takes supply-side economics to be the proposition that the tax base shrinks when you tax something. As any passing student in ec 10 can explain, this is true whenever the elasticities of supply and demand for a good are non-zero. By this definition, virtually all economists are supply-siders.

I stand corrected. I am glad we cleared that up.

Three Observations on the Estate Tax

Consistent with this blog's subtitle, here are a few items that I thought were worth repeating:

1. Jane Galt notes that today's rich are different than those of the past:

America's widening income distribution cannot be blamed on bequests. According to Piketty and Saez, while in 1929 the wealthiest Americans derived more than 70% of their income from invested capital, and only 30% from wages or entrepreneurship, by 1998 the very rich got only 20% of their income from investments.

2. A commentator on a previous post warns about taxing small minorities:

One big problem I have with [the estate tax] is that it's a tax on a very small group of people. I'm not saying that no law should ever be narrowly tailored, but I think it's tempting in a democracy for a majority to pick on a minority. I'd be more comfortable with the estate tax if the exemption were lowered (especially if the rate were also lowered).

3. Johns Hopkins econ prof Larry Ball emails me a possible rationale for the estate tax:

Can one justify the estate tax as providing length-of-life insurance -- which markets don't do well because of adverse selection? If so, we should probably reverse current law and tax small estates but not big estates, which are intentional intergenerational transfers. Calling it a "death tax" actually makes it sound sensible. (Especially for a party that is "pro-life" and believes in tax incentives to achieve its goals!)

How should the Fed measure inflation?

In today's NY Times, Floyd Norris writes:

Since 1983, the government has measured the price of homes not by looking at house prices but by computing what it calls ''owner's imputed rent.'' That is the rental value of the house you own. It accounts for nearly a quarter of the entire Consumer Price Index.

When the change was made, the government provided statistics indicating that previous inflation rates would not have been very different under the new method, and that remained true until 1996.Since then the home price index maintained by the Office of Federal Housing Enterprise Oversight has doubled, while the imputed rent figure has risen by less than a third.

Had the government computed the Consumer Price Index using actual home prices since 1996, I estimate that it would have risen by an average of 4.1 percent a year, as opposed to the 2.5 percent reported. The core rate -- inflation excluding food and energy costs -- would be 4.2 percent, not 2.2 percent. Perhaps the Federal Reserve was too hesitant to raise rates, and thus allowed speculative bubbles to form, because it was seeing inflation through rose-tinted glasses.

Beyond the treatment of housing in particular, Norris's observation raises a broader question that has received too little attention from the community of research economists: If a central bank is to adopt inflation-targeting as a guide to policy, what inflation rate should it use?

The Fed seems to focus on core PCE inflation--that is, inflation in the prices of consumer goods and services excluding certain volatile sectors, such as food and energy. From the standpoint of practical monetary policy, this choice seems sensible. But it is hard to square this common-sense decision with standard monetary theory, which doesn’t readily yield a variable analogous to these empirical measures.

Steve Zeldes once observed that measures of core inflation are like the clues on the TV game show Jeopardy. The category is inflation. The answer is the CPI excluding food and energy. It is your job to figure out the question.

Some years ago, Ricardo Reis and I took a stab at this problem (published in the JEEA). We developed a framework for thinking about the issue and applied it to U.S. data. We found that the price of labor (that is, the nominal wage) should be given substantial weight in the index used for monetary policy. But I will be the first to admit that this conclusion was too tentative to take to the (central) bank.

Update: Mark Thoma points me to this recent summary by Mike Woodford of some of the relevant literature.

More Free Meals for Faculty

In the Harvard Crimson, a graduating senior has some advice about student-faculty interaction:

One of the biggest complaints at Harvard is that students do not have enough opportunity to interact with faculty members. Recently, several of my friends and I decided to invite a number of professors to dinner in Dunster House. Many “big-name” professors, like Lewis, Mansfield, Pinker, Damrosch, Mankiw, Dominguez, and Kirshner, agreed to join us for dinner. This demonstrates that a lot of the blame for the problem falls on the students. Nevertheless, I believe Houses would do well to institute more faculty dinners. They do not need to be fancy like the ones we already have, but they need to be institutionalized, regular, and casual to be more effective.

That sounds right to me.

Dirty Harry on Central Banking

“You've got to ask yourself one question: 'Do I feel lucky?' Well, do ya punk?”

Dirty Harry wasn't talking to Ben Bernanke when he spoke those immortal lines, but perhaps he should have been.

Here is an editorial in today's USA Today:

Pity Ben Bernanke, the new Federal Reserve chairman. His predecessor, Alan Greenspan, had the good fortune of holding office when low energy prices and soaring worker productivity combined to make inflation a non-issue.

Bernanke, in contrast, barely had a chance to unpack his boxes before confronting rising inflationary threats. In the first four months of 2006, consumer prices rose at an annualized rate of more than 5%. That's a troubling increase from recent years.

The emphasis on fortune is exactly right: For Fed chairmen, being lucky is half the job, as I emphasized in an open letter to Ben Bernanke (now published in the May issue of the American Economic Review).

Network Neutrality

It is rare for me to come across a major issue in economic policy that I haven't thought about enough to have at least a tentative opinion. But sometimes it happens.

In today's Washington Post, Lawrence Lessig and Robert W. McChesney have an op-ed arguing forcefully for the principle of network neutrality. If Congress fails to act, we are told, the internet itself is threatened! They conclude:

People are waking up to what's at stake, and their voices are growing louder by the day. As millions of citizens learn the facts, the message to Congress is clear: Save the Internet.

After reading this, I turned to a slightly older op-ed by Robert Litan, a smart, sensible, and moderate economist and lawyer, who takes the opposite view:

We all want our broadband and the benefits it can bring. Let's hope our policy-makers in Washington can resist the siren song of "net neutrality" and keep government out of Internet regulation so that the future that beckons becomes a reality.

The arguments in the two pieces are too subtle to summarize quickly (or maybe I just don't fully understand them), so I encourage those interested in the issue to follow the links.

After reading these two pieces, I am inclined to give the edge to Litan, in part because his piece is more infused with economic reasoning and in part because I am naturally suspect of the alarmist tone of Lessig and McChesney. But it is clear that I need to read more before I figure this out. If readers know of other pieces written on the issue, especially any by economists, please post a comment.

How to Fix Social Security

One of the more interesting ideas of the past year is the "Nonpartisan Social Security Reform Plan," proposed by Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick. Here is their description of the plan:

The three of us – former aides to President Clinton, Senator McCain, and President Bush – did an experiment to see if we could develop a reform plan that we could all support. The Liebman-MacGuineas-Samwick (LMS) plan demonstrates the types of compromises that can help policy makers from across the political spectrum agree on a Social Security reform plan. The plan achieves sustainable solvency through progressive changes to taxes and benefits, introduces mandatory personal accounts, and specifies important details that are often left unaddressed in other reform plans. The plan also illustrates that a compromise plan can contain sensible but politically unpopular options (such as raising retirement ages or mandating that account balances be converted to annuities upon retirement) -- options that could realistically emerge from a bipartisan negotiating process, but which are rarely contained in reform proposals put out by Democrats or Republicans alone because of the political risk they present.

The American Enterprise Institute will be hosting a discussion of the plan on June 19, including a great line up of discussants. If you live in the DC area, you can find information about attending here. If like me you live in boondocks, you can see the event later over the web. I hope C-SPAN is there and replays the event many times. The more voters think about how to deal with the upcoming entitlement crunch, the better.

Full disclosure: The program is filled with old friends of mine. Jeff Liebman is on the Harvard faculty, and Andrew Samwick was my Chief Economist when I was CEA chair. Among the discussants, Chuck Blahous was a colleague and ally while I was in the Bush administration, and Jason Furman and Kent Smetters are former students. So I won't be surprised if the symposium includes a few points I agree with.

The Passions of the Estate Tax

When it comes to matters of society and public policy, economists are normally more even-tempered (perhaps even cold-blooded) than your average person. They can discuss morally-charged issues such as abortion, prostitution, and selling human organs with a dispassion that, to noneconomists, can seem to border on pathology.

But when it comes to the debate over the estate tax, the dispassion often disappears, and the analysis becomes surprisingly moralistic and vitriolic. Here is Milton Friedman in 2001 advocating repeal of the tax:

Spend your money on riotous living — no tax; leave your money to your children — the tax collector gets paid first. That is the message sent by the estate tax. It is a bad message and the estate tax is a bad tax. The basic argument against the estate tax is moral. It taxes virtue — living frugally and accumulating wealth.

Back in 1997, the Washington Post reported a very different view from Larry Summers:

A senior Clinton administration official yesterday condemned congressional efforts to roll back inheritance taxes as part of this year's federal budget agreement, declaring proponents of such tax relief to be motivated by "selfishness."

"In terms of substantive arguments," the evidence put forth by lawmakers advocating repeal of the estate tax "is about as bad as it gets," Deputy Treasury Secretary Lawrence H. Summers said in a meeting with a small group of reporters yesterday. "When it comes to the estate tax, there is no case other than selfishness."

I doubt that Summers thinks Friedman is selfish, or that Friedman thinks Summers is immoral, but they are both quick to use such charged words to describe the other’s policy position. (Summers, a government official at the time, later apologized for his remarks, recognizing how impolitic they were.)

Milton Friedman and Larry Summers are two of the best economists I know. Isn’t it a bit odd that they both resort to overwrought language when discussing a tax that is paid only once a generation and that raises only a fraction of one percent of GDP? Given that there are smart economists are both sides of the debate, wouldn’t you expect a more even-handed treatment from both of them?

I don’t claim immunity from this disease, but I nonetheless find it puzzling.

Furman on PAYGO

My friend Jason Furman is a smart, reasonable Democratic economist. (Note to my Republican friends: No, that's not an oxymoron.) In response to a previous post, Jason emails me to lobby on behalf of PAYGO rules. While I ponder his arguments, he has graciously allowed me to share them with my blog readers. Here's Jason:

You don't need a lexicographic preference for deficit reduction to join Alan Greenspan, GAO Comptroller David Walker and me in supporting PAYGO rules for tax cuts and spending increases.

You should give sincere thought to this, you would have a positive impact on current debates and do tangible good. Sorry for the long e-mail, but I'm really not trying to score points or to win a debate but to convince you that this is consistent with your beliefs.

Helping to build future support for sensible spending cuts and base broadeners is worthwhile but it's also a bit of a parlor game that looks serious, impresses your friends, assuages your conscience, but doesn't have much immediate impact in improving our fiscal situation -- or keeping it from deteriorating further. (I don't think the parlor game is pointless, see here, just that it's not sufficient.)

In the 1990s, PAYGO was commonsense. Dole and Gingrich supported it -- that's why they proposed Medicare and Medicaid cuts to pay for their tax cuts. Clinton supported it when we had a deficit -- his original prescription drug plan was fully paid for and even the later versions were explicitly contingent on being enacted together with a plan to ensure Social Security solvency. And John McCain, who you traveled on the bus with in 2000, remains a strong supporter of PAYGO.

The 1997 Balanced Budget Act was one product of this consensus. You would be heartened to know that it included about $400 billion in Medicare and Medicaid cuts and $400 billion in gross tax cuts (including capital gains, estate tax, and IRA expansions you would like).

I wouldn't expect you to agree with Alan Greenspan and me that PAYGO should apply to the extension of the tax cuts already enacted. Instead, you could agree with George Bush and the implicit position of the Kerry-Edwards campaign budget that these tax cuts were never intended to be temporary, that not extending them would be a tax increase, and that the baseline should assume they are extended. (Ideally you would put the estate tax in the not yet enacted and thus subject to PAYGO category, but I won't let the good be the enemy of the decent.)

It would be consistent with your philosophy -- and helpful in actual debates going on in Washington and not just on economics blogs -- if you argued that PAYGO should apply to all new tax cuts and spending increases. Admittedly it would put some constraint on tax cuts, but it also might put more pressure on Congress to reduce spending -- since they would need to eat their spinach contemporaneously in order to have their desert.

Our political system needs simple rules to restrain itself and prioritize. Most responsible, good policy types -- liberal and conservative -- believe that PAYGO is one of those simple, easy to understand, black-and-white rules. Put another way, when you're in a hole the first thing to do is stop digging.

Think about it.

Jason

P.S. PAYGO won't, of course, reduce the fiscal gap. So even better would be to call for mutual sacrifice, including spending cuts and tax increases that you might not like but have a chance of being enacted. As you wrote in 2000, "More vital than choosing a President with the right tax plan is electing a President with the political courage to change course when events demand it."

The Estate Tax Abroad

Chris Edwards of the Cato Institute has a new brief on the estate tax. Here is an interesting tidbit:

Of 50 countries surveyed by PricewaterhouseCoopers in 2005, 24 do not have an estate or inheritance tax, including Australia, Canada, New Zealand, and Sweden. Of the 26 countries in the table that do have estate or inheritance taxes, the United States has the third highest rate at 46 percent.

Monetary vs Fiscal Policy

Professor Bryan Caplan emails me a good question about the short-run effects of monetary and fiscal policy on aggregate demand:

Hey Greg, since you're delving into New Keynesian theory on your blog, I was wondering if you'd weigh in on this:

Suppose the Fed had a rigid policy of 0% monetary growth. Do you think that increasing G or cutting T would have any affect on nominal GDP?

For a particularly stark case, think back to WWII, when the Fed accommodated massive deficits to hold nominal rates close to 0%. What if it had refused to accommodate at all? Would there have even been a nominal GDP expansion? Wouldn't interest rates have skyrocketed, choking off other spending?

Of course, as a textbook writer, you'll recognize that my question is equivalent to asking if the LM curve is vertical. Most economists seem to think that's implausible, but it's not to me. I've never adjusted my cash balances when nominal interest rates changed, and never heard of a person who did. Maybe institutional investors give the LM curve a little slope, but I doubt it's much.

The main reason most economists dismiss the vertical LM story, in my view, is that they aren't doing the right counter-factual. In the real world, fiscal expansion induces monetary expansion, leading to higher nominal GDP. But that's not because deficits are intrinsically expansionary in nominal terms, but because in our political system, monetary authorities feel some pressure to accommodate deficits. In contrast, monetary expansions are expansionary. Even if G and T stayed the same, printing more money raises nominal GDP.

I blogged on this a while back, but got little response.

There is a lot I agree with in Bryan's analysis. In particular, much of the short-run stimulus effect of fiscal policy comes about because it induces a monetary expansion. This monetary expansion is automatic if the Fed is holding the interest rate fixed or if it is following something like a Taylor rule, which is approximately what it is doing now. The effects of fiscal policy would be very different if the Fed were holding the money supply constant in response to a fiscal change.

I disagree with Bryan's suggestion that the LM curve is vertical, however. Introspection is not a particularly reliable way to measure elasticities. There is a substantial empirical literature on money demand that demonstrates that it is interest-elastic. Here is one example from Larry Ball. See his figures 4 and 5. According to Ball, the interest semi-elasticity of money demand is -0.05: This means that an increase in the interest rate of one percentage point, or 100 basis points, reduces the quantity of money demanded by 5 percent.

How far off is the vertical LM case as a practical matter? One way to answer this question is to look at the fiscal-policy multiplier. In chapter 11 of my intermediate macro text, I give the government-purchases multiplier from one mainstream econometric model. If the nominal interest rate is held constant, the multiplier is 1.93. If the money supply is held constant, the multiplier is 0.60. If the LM curve were completely vertical, the second number would be zero. To return to Bryan's WWII example, taking these estimates literally, if the Fed had held the money supply constant rather than keeping interest rates low, the WWII boom would about been about 1/3 as large as it was.

On Dogs, Names, and Boston

The mysterious knzn wonders why my dog is named Tobin. I won't opine on his conjectures, but his post motivates me to pass on two observations.

Because I live in Boston, when people hear that my dog is named Tobin, the most common first reaction is, "Oh, like the bridge?"

When I had a dog named Keynes, the reaction was, "Oh, like the mayonnaise?"

Plosser to the Fed

The Washington Post reports:

The Federal Reserve Bank of Philadelphia on Tuesday named Charles Plosser as its new president, effective August 1, bringing a policy hawk and inflation-targeting advocate to the Bernanke Fed.

This is, I believe, the highest-ranking policy position ever held by an advocate of the "real business cycle" school of macroeconomics. According to these theories, monetary policy can affect nominal variables such as inflation but is powerless to affect real variables such as production and employment. Some years ago, Charlie and I sparred over these theories in a Journal of Economic Perspectives Symposium, available through JSTOR here and here.

If I thought Charlie took these theories so seriously that he would rely on them as a guide to policy, I would be worried. However, I am not. Charlie is smart and sensible, and he will take the theories he has advanced with the requisite grain or two of salt.

Deficit Hawks for Estate Tax Repeal

A few loyal readers have asked how I reconcile my concern about the fiscal gap and my advocacy of estate-tax repeal. Let me answer by offering three observations:

1. I am skeptical that the estate tax raises as much revenue as official estimates suggest. (Officially, the revenue from keeping the estate tax is about 0.2 percent of GDP, assuming an exemption of $3.5 million and a rate of 45 percent). There are a couple reasons for my skepticism. As a general matter, capital taxation leads to larger dynamic effects than other taxes, so static estimates are particularly suspect for the estate tax. In addition, the estate tax induces a variety of avoidance behavior. A 1987 paper by Stanford economist Doug Bernheim, called "Does the Estate Tax Raise Revenue?,” argued that the estate tax encourages people to take avoidance actions, such as making gifts to their children, that reduce collection from the income tax. Standard estimates of the revenue raised by the estate tax fail to include its negative impact on income tax revenue.

2. Although I am concerned about the long-run path of fiscal policy, my policy preferences are not lexicographic. That is, reducing the fiscal gap does not trump all other issues. A lexicographic deficit hawk would oppose every tax cut and every spending increase and endorse every tax hike and every spending cut. By contrast, a balanced deficit hawk like me takes the fiscal situation seriously but weighs that concern against others.

3. In my Wall Street Journal op-ed from last week, I explained how I would like to see the long-term fiscal situation addressed. I offered about half a dozen different ways to reduce the fiscal gap. An estate tax is not part of my preferred package of policies. Instead of straight repeal of the estate tax, would I rather have Congress combine repeal with some of my other preferred policies? Of course. But I also don't want to make the best the enemy of the good.

Reasonable people can disagree about the advisability of repealing the estate tax. Acknowledging the long-run fiscal gap is an important part of the discussion. But no one should presume that this fact, by itself, ends the debate.

Why I write textbooks

A student emails me:

Hey Professor Mankiw,

I hope you're having a good summer. I took your ec10 course this year and really enjoyed it, and I'm sure it helped me get my current summer consulting job.

My father, a physician, has no financial background. However, he borrowed my copy of Principles of Economics and has been unable to put it down. He's in the macro section and is fascinated by the monetary system. He really likes your book, to say the least.

Best,
[name withheld]

My life will have been well-lived if I can help a few more physicians understand the intricacies of fractional-reserve banking.

In Praise of Sweatshops

A former ec 10 student calls to my attention a great article in today's NY Times by columnist Nicholas Kristof. An excerpt:

Well-meaning American university students regularly campaign against sweatshops. But instead, anyone who cares about fighting poverty should campaign in favor of sweatshops, demanding that companies set up factories in Africa. If Africa could establish a clothing export industry, that would fight poverty far more effectively than any foreign aid program....

The problem is that it's still costly to manufacture in Africa. The headaches across much of the continent include red tape, corruption, political instability, unreliable electricity and ports, and an inexperienced labor force that leads to low productivity and quality. The anti-sweatshop movement isn't a prime obstacle, but it's one more reason not to manufacture in Africa.

Imagine that a Nike vice president proposed manufacturing cheap T-shirts in Ethiopia: ''Look, boss, it would be tough to operate there, but a factory would be a godsend to one of the poorest countries in the world. And if we kept a tight eye on costs and paid 25 cents an hour, we might be able to make a go of it.''

The boss would reply: ''You're crazy! We'd be boycotted on every campus in the country.''

So companies like Nike, itself once a target of sweatshop critics, tend not to have highly labor-intensive factories in the very poorest countries, but rather more capital-intensive factories (in which machines do more of the work) in better-off nations like Malaysia or Indonesia. And the real losers are the world's poorest people.

Some of those who campaign against sweatshops respond to my arguments by noting that they aren't against factories in Africa, but only demand a ''living wage'' in them. After all, if labor costs amount to only $1 per shirt, then doubling wages would barely make a difference in the final cost.

One problem -- as the closure of the Namibian factories suggests -- is that it already isn't profitable to pay respectable salaries, and so any pressure to raise them becomes one more reason to avoid Africa altogether.

Tobin and the New Keynesians

A student emails me a question about the term "New Keynesian economics:"

Dr. Mankiw--

In an interview, James Tobin was once quoted that basic tenets of New Keynesianism (adoption of rational expectations, choice-theoretic foundations, general market clearing [except under imperfect competition], menu costs) concern formulating "a rationale that allows nominal shocks to create real consequences." Tobin argues that Keynes' concern was real demand shocks rather than nominal shocks and that the New Keynesianism conflicts with this fundamental idea. He is further quoted to say, "If I had a copyright on who could use the term Keynesian I wouldn't allow them [New Keynesians] to use it" (Snowdon 2005, p. 156).

As a leading figure in New Keynesianism, in your opinion what justifies the use of the term "Keynesian" (in general and for New Keynesianism)? And more broadly, do you think labels matter in (macro)economic thought? If most economists steer away from labels (if I'm correct to assume that), why do they still exist? Solely for historical purposes? Interestingly enough, in the interview Tobin claimed that early in his career he did not want any such labels only later in his career to accept himself as a leader of Keynesian economics.

Sincerely,
[name withheld]

PS: As an undergraduate econ major (UNC-CH), I am a big fan of your blog and an even bigger fan of your intermediate text. Thanks for not forgetting about the role of undergraduate economics!

[For blog readers not familiar with the "new Keynesian" literature in macroeconomics, you can read about it here and here.]

I knew James Tobin and have long been a fan of his work. My current dog is named Tobin (my previous one was Keynes). But Tobin (the economist) and I did not always see eye to eye on either macro theory or economic policy. His macroeconomics is probably closer to the original vision in Keynes's General Theory than mine is. So I understand why he objected when the work I and others did starting in the 1980s was called "New Keynesian." (Those others include Akerlof & Yellen, Ball & Romer, Blanchard & Kiyotaki, Rotemberg, etc.) But I think the label fits: Compared to the other leading business-cycle theory at the time, the real business cycle approach of Long & Plosser and Kydland & Prescott, this work is much closer to the tradition of Keynes.

You raise a good question: What is the purpose of such labels? Part of the answer is pedagogical. Macro theory can be confusing. It is hard for students to see how the different pieces fit together and how different points of view emerge. One way to approach the subject is by taking an historical perspective. Theories evolve from previous theories, and it can help to understand the evolution of thought. Labels like "New Keynesian" are intended to place a theory in historical context and to pay homage to intellectual antecedents. (For my most recent paper on the historical evolution of macroeconomic thought, click here.)

A few years after my intermediate macro textbook was first published, I was told that Tobin had come out of retirement to teach the course and assigned my book to his students at Yale. In all my years as a textbook author, I have never been more delighted by an adoption.

The Estate Tax Debate

The issue of estate tax repeal is heating up. In today's Washington Post, columnist Sebastian Mallaby writes,

It doesn't matter if you are liberal or conservative, Democrat or Republican.There is no possible excuse for doing what Congress is poised to do this week: Abolish the estate tax.

Mallaby suggests there is only one reasonable side in this debate. Brad DeLong makes a similar suggestion at this blog. In today's NY Times, Paul Krugman says the estate tax is "a moral issue."

In fact, the estate tax is controversial among economists. Economists Ed Prescott, Martin Feldstein, Gary Becker, and Jeff Miron are all on record favoring repeal. There is a vast literature in economics arguing against capital taxation in favor of consumption taxation. Anyone who takes that literature seriously would likely favor estate tax repeal, because the estate tax is just a particular form of capital taxation.

In the past, I have made the case for estate tax repeal on the grounds of (believe it or not) fairness. Here is the argument:

Consider the story of twin brothers – Spendthrift Sam and Frugal Frank. Each starts a dot-com after college and sells the business a few years later, accumulating a $10 million nest egg. Sam then lives the high life, enjoying expensive vacations and throwing lavish parties. Frank, meanwhile, lives more modestly. He keeps his fortune invested in the economy, where it finances capital accumulation, new technologies, and economic growth. He wants to leave most of his money to his children, grandchildren, nephews, and nieces.

Now ask yourself: Which millionaire should pay higher taxes?... What principle of social justice says that Frank should be penalized for his frugality? None that I know of.

Some young economists who favor estate taxation have been pursuing interesting new approaches to the topic. (I wouldn't use the word "interesting" to describe Krugman's suggestion that those who disagree with him are immoral.) Lately, I have been studying this work by the young econ stars Emmanuel Farhi and Ivan Werning. Maybe when I fully process it, it will change my mind. So far, it hasn't.

Immigration and Pareto

Economists who have a more favorable view of immigration (like me) emphasize that it enhances global economic efficiency: By allowing a mutually advantageous trade between the immigrant and his or her employer, the economic pie grows larger.

Economists who are more skeptical about immigration (like my Harvard colleague George Borjas) point out that some Americans, specifically those with fewer skills, are made worse off by increased competition from the new workers. Even if the overall pie gets larger, some people may end up with a smaller slice.

Here is a challenge for those us in the pro-immigration camp: Can we devise a system of taxes and transfers that turns the increase in economic efficiency from immigration into a Pareto improvement? In other words, can the winners from increased immigration compensate the losers so that, in the end, some people are better off and no one is worse off?

I recognize that "no one" is a strong word. The Pareto criterion, strictly construed, is probably not realistic. I will settle for a weaker solution, which I'll call an approximate Pareto improvement: a system of taxes and transfers such that, in the end, many people are better off and at most a very few people are only a little worse off. I want a practical solution--one that not only works on the blackboard but that you could propose to your congressman.

Here is a first-pass attempt at an answer: When immigrants come to the United States to work, they agree to pay higher payroll taxes. The extra revenue is used to finance a payroll tax cut for American workers. The immigrants are better off because they are allowed into this country. The Americans they compete against are better off because they get a tax cut.

I know: Some people will say, "There he goes again, thinking that tax cuts are the solution to all problems. Just what you'd expect from an ex-Bushie." But if a revenue-neutral system of payroll tax surcharges and rebates could be devised to turn immigration into an approximate Pareto improvement, the debate over immigration might become a lot less polarized.

Feldstein on Gasoline

My Harvard colleague Martin Feldstein is clever. In today's Wall Street Journal, he is too clever by half.

Marty proposes that the government set up a system of "tradeable gasoline rights" to reduce gasoline consumption. Here is how he describes it:

In a system of tradeable gasoline rights, the government would give each adult a TGR debit card. The gasoline pumps at service stations that now read credit cards and debit cards would be modified to read these new TGR debit cards as well. Buying a gallon of gasoline would require using up one tradeable gasoline right as well as paying money.

The government would decide how many gallons of gasoline should be consumed per year and would give out that total number of TGRs....

A key feature of these gasoline rights is that they are tradeable. Individuals with more TGRs than they need could sell the excess, while those who want to use more gallons than their allocation would have to buy extra TGRs. The gasoline companies could act as clearing houses for these trades, using their gasoline pumps to sell TGRs in the same way that they sell gasoline or to buy TGRs in exchange for the cash needed to purchase gasoline. Other institutions like banks could also trade TGRs for cash.

As I am sure Marty would agree, this system is functionally equivalent to an increase in the gasoline tax, with the tax revenue rebated lump-sum to the public. I have said many times that I like the idea of higher gasoline taxes, but Marty's scheme leaves me cold. Do we need to create a new administrative bureaucracy because politicians are afraid to use the word tax? I hope not.

The war on poverty is being won

As is often discussed, the US income distribution has been widening over the past few decades. A Rawlsian, however, would insist on a global view of the situation: Behind the veil of ignorance, you wouldn't know you were an American. He would take heart in this research, just published in the May 2006 issue of the Quarterly Journal of Economics:

The world distribution of income:
Falling poverty and ... convergence, period
Xavier Sala-i-Martin

We estimate the World Distribution of Income by integrating individual income distributions for 138 countries between 1970 and 2000. Country distributions are constructed by combining national accounts GDP per capita to anchor the mean with survey data to pin down the dispersion. Poverty rates and head counts are reported for four specific poverty lines. Rates in 2000 were between one-third and one-half of what they were in 1970 for all four lines. There were between 250 and 500 million fewer poor in 2000 than in 1970. We estimate eight indexes of income inequality implied by our world distribution of income. All of them show reductions in global inequality during the 1980s and 1990s.

With the rapid growth in China and India over the past few years, it is a good bet that this trend is continuing.

Update: Mark Thoma points me to a great graphic illustrating these results.

JD vs PhD: My Story

A student emails me a question about my offbeat journey through higher education:

Prof. Mankiw,

Love the blog, I've recently become hooked. I noticed you mention in an earlier post that you spent one and a half years at Harvard Law School before switching to economics and earning your PhD. I guess I'm in a similar situation now....

Anyway, I wanted to ask what ultimately compelled you to pursue economics instead of law, as I've been toiling with that decision myself. Did you intend to do a joint JD/PhD and focus your research on law and economics, or did you decide to leave law school entirely? I'm passionate about both fields and took a risk averse application strategy by applying to both types of programs, but most of the input I've received has been from those who abandoned economics to finish their law degree, not vice versa. If you have any input or advice you could share, I'd be grateful.

Thank you, best regards,
[name withheld]

Let me start by summarizing my own education and early career:

• June 1980: Graduated with A.B. from Princeton
• 1980-1981: First-year PhD student at MIT
• 1981-1982: First-year student at Harvard Law School
• Summer 1982: Worked in law firm as summer associate
• 1982-1983: Took year off to work on the CEA staff
• 1983-1984: Back at MIT, finished PhD
• Fall 1984: Back at law school, finished fall semester
• Spring 1985: Taught micro and statistics at MIT
• Sept 1985: Joined Harvard econ faculty as assistant professor

All this looks random and disjointed, and to some extent it was. But I look back at this period of my life as a time of experimentation, when I was trying to figure out my own tastes and talents. A large part of early life is trying to find your niche in the world. Open-mindedness and experimentation were crucial for me, and I believe they are for many others as well. That will mean some false starts (like spending a year and a half in law school), but those false starts are part of a process of learning about yourself.

To get back to the specifics of the question: My observation is that students who start both a JD and a PhD in econ are much more likely to finish the JD than the PhD. (A related observation is that those who finish both degrees are more likely to be law professors than econ professors.)

For most people, a JD is the easier degree to finish, as it is all course work, and it takes only three years. A PhD is typically five or six years, the second half of which is devoted to original research. By comparison to a JD, a PhD is a long, hard slog. That does not mean it's not worth it: some long, hard slogs end up passing a cost-benefit test. But it does require a greater degree of commitment and enthusiasm on the part of the student to finish the degree.

My case is somewhat abnormal. During my period of experimentation, I learned that I was only a middling law student. By contrast, I got my PhD with only two years of residence at MIT. (I turned back the third year of my NSF fellowship to the US taxpayer, but I won't claim any altruistic motive in doing so--I just didn't need it.) In the fall of 1984, I found myself a so-so second-year law student with a PhD under my belt and a small but growing list of academic publications. It finally dawned on me that my comparative advantage was econ, not law. Remembering the irrelevance of sunk costs, I moved across the parking lot from the Harvard Law School to the Harvard economics department, where I have now been on the faculty for over twenty years.

Update: After reading this post, one of my law school teachers emails me: "too modestly, you described yourself as only a so-so student. I recall you as far better than that."

It is nice to hear that I was a better law student than I recall being. In any event, while in law school, I decided, rightly or wrongly, that I had more natural ability in econ than law. I suspect that, while paying the law school's tuition, I spent more time writing econ papers for academic journals than studying the law books. That fact made me realize I was probably sitting in the wrong building on the Harvard campus.

Update 2: More on my story.

The World Cup

My foreign grad students recently alerted me to the fact that this is a World Cup year. The event appears to a focal point of their summer plans.

Although I am largely oblivious about spectator sports, I am intrigued by a report from Goldman Sachs "The World Cup and Economics: 2006." (Thank you, Daniel Drezner, for the pointer.) Goldman's figure on page 6 shows a strong correlation between World Cup ranking and GDP per person. Being rich and having a good team go hand in hand.

This raises a couple questions:

1. A few years ago, a study of Olympic outcomes found that total GDP, rather than GDP per person, was the better predictor of number of medals won. Shouldn't a similar result hold for the World Cup as well?

2. If economic prosperity leads to World Cup success, shouldn't this fact be enough to get more Europeans to vote for pro-growth economic policies?

Update: The causal link between the economy and sports seems to run both ways. A reader calls my attention to a paper forthcoming in the Journal of Finance, which shows that World Cup outcomes affect the stock market. Here is the abstract:

Sports Sentiment and Stock Returns
Alex Edmans, Diego Garcıa, and Øyvind Norli

This paper investigates the stock market reaction to sudden changes in investor mood. Motivated by psychological evidence of a strong link between soccer outcomes and mood, we use international soccer results as our primary mood variable. We find a significant market decline after soccer losses. For example, a loss in the World Cup elimination stage leads to a next-day abnormal stock return of −49 basis points. This loss effect is stronger in smallstocks and in more important games, and is robust to methodological changes. We also document a loss effect after international cricket, rugby, and basketball games.

Maybe I should be paying more attention to spectator sports after all.

Kyoto, Carbon, and Al Gore

Clive Crook has a nice piece in the National Journal on global warming, motivated by Al Gore's movie. His bottom line:

We know what has happened to the climate so far, and (with a good degree of confidence) we know why. Working out what is going to happen to it from now on is much more difficult. And that makes judging policy especially hard -- especially when you understand that the costs of ambitious front-loaded carbon abatement programs (such as the Kyoto Protocol, fully implemented) would have had (a) only a modest impact on our climate prospects, according to the current models, and (b) enormous economic costs. Yes, something must be done -- but need it be as costly and as ineffective as that?

Facing such huge but distant risks, the crucial thing is to think long term, the very thing that Washington does worst. An initially moderate carbon tax, an initially gentle scheme of mandatory caps on greenhouse-gas emissions, and an honest plan to promote long-term energy efficiency could nudge the economy with minimal disruption on to a path of much lower climate-change risk. At the same time -- anathema to many environmentalists -- serious thought should be given to policies for adapting to climate change. Whatever happens, we will have to live with higher temperatures. And, above and beyond the warming that is already, so to speak, in the pipeline, it will make sense to tolerate some more, and adapt to it, rather than aim or hope to stop it altogether.

Al Gore's movie is not intended to make people think that way. But if it forces politicians, at last, to think at all about the issue, that might be sufficient justification.

The Crook piece does a good job of summarizing where, to my knowledge, the majority of the economics profession is on the issue of global warming. Most economists I know would endorse

1. Rejecting the Kyoto treaty,
2. Imposing a modest carbon tax.

I include myself in this consensus (although I do not hold myself up as an expert on the issue).

My understanding is that the economists in the Clinton administration fought vigorously against the Kyoto treaty but lost the internal policy battle to the Vice President's office. I don't recall the full story of that battle ever being told. If any reader knows of a reference, please let me know.

Maybe former Clinton appointee Brad DeLong can enlighten us. Brad has lately been calling for greater candor by former administration officials. This is a good opportunity to lead by example.

Update: A loyal reader alerts me to an old Wall Street Journal article, which tells a bit of the story:

the president's economic team -- including Treasury Secretary Robert Rubin; Deputy Secretary Lawrence Summers; Janet Yellen, who heads Mr. Clinton's Council of Economic Advisers; and Gene Sperling, head of the president's National Economic Council -- is urging a go-slow approach for the economy's sake. Privately, some raise the specter that ambitious targets for reducing carbon emissions, say, to 1990 levels by 2010, could trigger economic upheaval and energy-price increases greater than the 1970s oil shocks.

Update 2: Brad DeLong fills in a few more details (with some gratuitous swipes at George Bush, natch). Thanks, Brad.

Penny Anti

In the June 2006 issue of the American Spectator, John Fund makes the case for getting rid of the penny. An excerpt:

Pennies are a nuisance that is proliferating. This year, the Mint will churn out nine billion of them. That exceeds twice the annual output of all other coins combined. Production is up in part because of hoarding, in part because more and more people are throwing them in jars or drawers and never taking them out again. Few people now bother to pick up a penny when they see it on the street. It's simply not worth the effort. More and more litter on our streets now consists of pennies.

A growing number of experts are concluding the penny is too picayune to bother with. "The purpose of the monetary system is to facilitate exchange, but the penny no longer serves that purpose," says Harvard professor Gregory Mankiw, a former chairman of President Bush's Council of Economic Advisers. "When people start leaving a monetary unit at the cash register for the next customer, the unit is too small to be useful."

When the half-cent was abolished in 1857 it was worth more than eight cents in today's currency. People afterward had no problem living and conducting business, even though the new smallest unit of currency -- the penny -- was worth more than our dime is today. No major problems with transactions were reported at a time that predated the many cashless means of electronic transaction we enjoy today and which, even after penny abolition, can preserve prices to the exact cent if people so choose. (emphasis added)

This is not some conspiracy of right-wingers like Fund and Mankiw. Alan Blinder, Princeton professor and Clinton economic adviser, made essentially the same argument in his Businessweek column back in January 1987.

The Rich and the Rent Controlled

John Tierney has a great column in today's NY Times about rich New Yorkers enjoying the benefits of rent control. It ends as follows:

No matter how much you love your rent-stabilized apartment, no matter how smug you feel bragging to your friends about your deal, in your heart you know it's not fair you're paying so little. It's like buying stolen goods: you can revel in the low price, but you know it comes at someone else's expense.

And you know exactly who that someone is. You're living on his property. You're a squatter, but you don't want to admit it. So you tell yourself it's not really his property anyway, and you're more worthy of it than he is, and you couldn't survive anywhere else, and anyway this is all about something far more profound than money. But it's not.

Reich on Taxes, Again

As I have noted before, former Labor Secretary Robert Reich has a way of expressing numbers that is so striking it makes me sit up and want to check the facts myself. Here is what he says at his blog now:

repeal [of the estate tax] would cost the U.S. Treasury $1 trillion in its first ten years. That's about equivalent to what's needed to save Social Security over the next 75 years.

Really? That is amazing.

Let's look a little harder at this and see if we can find some numbers that, at least approximately, back this up.

How much does repeal of the estate tax cost over its first 10 years? According to the Tax Policy Center, immediate repeal would cost about $300 billion from 2006 to 2015. That, however, appears to be an undiscounted number. The present value is probably around $250 billion.

What does it cost to fill the Social Security shortfall over 75 years? This report from the Social Security Administration shows the present value of the 75-year shortfall for OASDI of about $5 trillion.

Hmmm....Those two numbers don't seem "about equivalent" to me. In fact, the second one seems 20 times as big as the first.

Now I may have been unfair to Reich in the above calculations. Perhaps he means a different first ten years, rather than the ten years starting immediately. And maybe he prefers different Social Security projections than those I have cited. And maybe he prefers a different discounting convention (although I would insist that he treat the two numbers in a parallel fashion). I would not defend the factor of 20 to the death, or even to a brush burn. I can imagine whittling that number down to a factor of 10 or even 5. But can someone get these two numbers within the same ballpark? I doubt it.

Lastly, let me note that the comparison here is silly. Why compare a 75-year shortfall to a 10-year revenue loss? There is no reason to, other than for dramatic effect. But policy wonks are supposed to have less license in making up their drama than playwrights.

Extra comments for econ nerds and data geeks:

1. All this, of course, assumes static scoring. The footnote at the Tax Policy Center says: "Change in estate tax liability is a static estimate that does not include behavioral response." If you believe, as I do, that taxes on capital reduce capital accumulation and economic growth, the lost revenue from estate tax repeal would be even smaller. (For a related recent report, click here.) But I wouldn't fault Reich for not agreeing with me on this issue: The evidence is such that reasonable people can disagree.

2. I suspect that Reich got his $1 trillion figure for estate tax repeal from the Center on Budget and Policy Priorities, which says "Permanently repealing the estate tax would cost roughly $1 trillion over the first ten years of extension, 2012-2021. This cost includes $776 billion in lost revenue and $213 billion in increased interest payments on the national debt."

The 10-year period is different than the one I used, but more interesting is the treatment of interest. The present value of that $776 billion revenue loss would probably be around $400 to $500 billion. Instead of this calculation, however, the CBPP adds the increased interest to the lost revenue; in essence, they are calculating not a present value but a future value. That is, the lost revenue is expressed from the vantage point of 2021. This is an odd metric and certainly not comparable to those typically used to measure the Social Security shortfall.

Glaeser on City Congestion

Readers of my Principles text know that I have long sang the praises of road pricing (see the chapter on "Public Goods and Common Resources"). Charging for the use of public roads is a sensible Pigovian tax to deal with congestion externalities. As far as I know, economists of the right, left, and middle all think this is a good idea.

Matthew Kahn draws my attention to a nice article on the topic, published in the NY Sun last week, by my Harvard colleague Ed Glaeser. Here is how Ed makes the case:

The Soviet approach to markets set prices at some controlled price, and then let shortages ensue. Under this system, millions wasted hours queuing and goods went to consumers with the time to stand on line rather than to consumers who valued the goods most. Today, you don't need to go through the messy process of getting a visa to Cuba or North Korea to see the social costs of under-pricing. Right here in New York, we don't charge anything for using a particularly valuable resource: car access to Manhattan streets. We ration the limited access to streets through time wasted in traffic. New York's mean travel time to work was 40 minutes in the 2000 Census, almost 15 minutes more than the national average. We've set the price of driving at zero and inevitably too many people drive....

New York should follow London and charge drivers for driving in the city during peak hours. London's congestion charge system, introduced on February 17, 2003, requires drivers to pay eight pounds before they enter a congestion charging zone during peak hours. The zone is eight square miles in the heart of London.

Drivers pay either online or at one of many payment facilities. The system is enforced with a network of fixed and mobile cameras that take snapshots of license plates. Individuals who are caught driving without paying are fined 100 pounds. The fine system is computerized, and it is both reliable and inexpensive to operate.

According to London's "Third Annual Monitoring Report," the number of cars entering the charging zone during peak hours fell by 33% after the congestion charge. As traffic fell, speeds rose. Before the congestion charge, the average traffic delay was 3.7 minutes per mile during morning rush hour and four minutes per miles during the afternoon rush hour. After the congestion charge, delays per mile fell to 2.4 minutes per mile in the morning and 2.6 minutes per mile in the evening. Overall, there was a 30% decrease in time wasted in traffic delays.

Some critics of congestion charges argue that they are unfair to low income people, but in London, lower-income bus travelers were the charge's biggest beneficiaries. Bus riders didn't have to pay the charge and their travel times plummeted. As the time cost of bus travel fell, the number of bus passengers during morning hours increased by 38% (some of this is due to improved bus service provision). Like London, New York has many more people who commute by public transportation than by car, and New York's many bus travelers would particularly benefit from a congestion charge reducing their commute times.

My Worldly Philosophy

"I am only libertarian-ish, with a hefty dose of utilitarianism thrown in along with liberal lashings of quasi-Christian morality."

I didn't write that sentence, Jane Galt did, but I wish I had.

Big Blunder from Bernanke?

I think I may have identified Fed Chairman Ben Bernanke's most troubling misstep to date. Buried inside today's Wall Street Journal is this piece of news:

Greenspan’s retirement disappoints A-list journalists and politicians in a way unrelated to economic performance. It ends the Fourth of July fireworks party that the erstwhile Federal Reserve chairman and wife Andrea Mitchell threw annually atop Fed building, overlooking Washington Monument.

I have a fond recollection of these events, which I shared with my family during my time in DC. I am shocked and dismayed by the suggestion that Ben is not continuing the tradition. The Fed terrace is too great a venue to see the fireworks to have this scarce resource go to waste.

Impeach Ben Bernanke! Impeach him now!

Colleges vs Universities

My wife and I attended the memorial service for John Kenneth Galbraith held at Harvard on Wednesday. One of the speakers was George McGovern, who told this story (as reported in yesterday's Boston Globe):

McGovern said that when his daughter was applying to colleges, he once asked Galbraith "as a practical matter" what difference it would make if she attended Harvard rather than Wellesley. Galbraith, according to McGovern, replied: "Well, at Harvard, if you're lucky, you might get Galbraith once a week. At Wellesley, you might get one of my C-minus students three days a week."

The story is unfair to Wellesley, which has a good economics department. But if you change "C-minus" to "A-minus," Galbraith had things about right.

The most important choice a high-school senior faces when choosing where to be an undergrad is between research-oriented universities and teaching-oriented colleges. If you go to a place like Harvard, Princeton, or Yale, you get a famous faculty. But the first priority of that faculty is their own research and writing (and blogging!?), and they are more likely to shower attention on grad students than undergrads. If you go to a place like Amherst, Swarthmore, or Williams, you get a faculty whose first priority is undergraduate teaching. But you do not have a menu of graduate courses to sample from, and you do not have as vibrant a research atmosphere to experience. It is a tough choice.

Age and Academia

Over the past few weeks, I have received several emails from people now in econ grad school, or considering econ grad school, who are a bit older than most grad students. The most recent is from an electrical engineer, who wants to return to school to get a PhD in economics and then pursue an academic career. He writes:

My current concern is that another professor mentioned that getting an academic job is very difficult for a new phd who is around 40 (what I would be upon completion). What are your views on this? Do you think this is true, somewhat true, or does it just mean stepping down a tier or two?

There may be some truth to the claim, but if you are passionate about the field and ready to commit the roughly five years that a PhD takes, I would not be deterred by age.

An economist I know named Bronwyn Hall went back to grad school later in life after a career in computer software (admittedly, econometrics software, so it was not completely unrelated). She earned a PhD in economics in her early 40s and now has a distinguished career as a full professor at UC Berkeley.

Of course, stories like this are rare. One reason is that there is a life cycle to creativity, which may make it harder to start a research career at an older age. In addition, few people in middle age want to start leading the life of a grad student. (I know I wouldn't.) But age discrimination, while a real possibility, is not pervasive enough in my view to stop a person from getting a PhD and pursuing an academic career in economics if he or she has the talent, preparation, and drive.

If other econ academics out there have views on this issue, please post in the comments section.

Reich on POTUS and the PBGC

Pigs fly! Hell freezes over! Actually, not, but an even more remarkable event did occur: Robert Reich found something nice to say about George Bush. He begins as follows:

The President’s approval ratings are so low I thought I’d find something to compliment him on. It took a bit of a search, but here it is. Congress is debating what to do about corporate pension plans. The President wants a law that forces companies to fully fund their pension obligations to their employees. He’s right.

Corporate pension plans don’t have nearly enough money to pay what the companies have promised their workers. We’re talking big money here -- a shortfall of over $450 billion. And if companies can’t pay up, you know who’s left holding the bag? Not only 44 million Americans who won’t get the monthly pension payments they were promised. You and I and every other taxpayer will also be on the hook.

You see, there’s a government agency called the Pension Benefit Guarantee Corporation that’s supposed to insure most of these promises. But the PBGC itself is already deep in the red, to the tune of almost $30 billion.

Read the rest here.

Universal Preschool

Earlier this week, the Washington Post reported:

From coast to coast, states are pushing to get more 4-year-olds into classrooms...

A few states have made public pre-kindergarten open to all; others are debating the expansion. Virginia Gov. Timothy M. Kaine (D) proposed universal access to pre-kindergarten last year during his campaign. But debate over a universal pre-kindergarten proposal on the ballot June 6 in California shows that widespread disagreement continues over whether the education of all 4-year-olds should be a public obligation.

Proposition 82, pushed by actor-director Rob Reiner, would require California to offer three hours of preschool a day to all 4-year-olds, with funding obtained from a tax increase of 1.7 percent on individual income of more than $400,000 and on joint-filer income greater than $800,000.

This NBER report is therefore timely:

Canada's Universal Childcare Hurt Children and Families

In Canada, the province of Quebec introduced universal subsidies to childcare over the period 1997-2000.... In Universal Childcare, Maternal Labor Supply, and Family Well-Being (NBER Working Paper No. 11832), authors Michael Baker, Jonathan Gruber, and Kevin Milligan measure the implications of universal childcare by studying the effects of the Quebec Family Policy....

The authors first find that there was an enormous rise in childcare use in response to these subsidies: childcare use rose by one-third over just a few years. About a third of this shift appears to arise from women who previously had informal arrangements moving into the formal (subsidized) sector, and there were also equally large shifts from family and friend-based child care to paid care. Correspondingly, there was a large rise in the labor supply of married women when this program was introduced.

Disturbingly, the authors report that children's outcomes have worsened since the program was introduced along a variety of behavioral and health dimensions. The NLSCY contains a host of measures of child well being developed by social scientists, ranging from aggression and hyperactivity, to motor-social skills, to illness. Along virtually every one of these dimensions, children in Quebec see their outcomes deteriorate relative to children in the rest of the nation over this time period. Their results imply that this policy resulted in a rise of anxiety of children exposed to this new program of between 60 percent and 150 percent, and a decline in motor/social skills of between 8 percent and 20 percent. These findings represent a sharp break from previous trends in Quebec and the rest of the nation, and there are no such effects found for older children who were not subject to this policy change.

The authors also find that families became more strained with the introduction of the program, as manifested in more hostile, less consistent parenting, worse adult mental health, and lower relationship satisfaction for mothers.

Love Econ, Bad at Math

A student emails me seeking advice. To paraphrase a long letter, he asks:

I love economics and my economics courses, but I struggle with my math courses and am not doing particularly well in them. What graduate school and career path would be right for me?

I have met Harvard students with similar questions. This spring I talked with a Harvard senior who, because of a weak math background, was rejected by every econ PhD program to which he applied. At the same time, he had a strong academic record overall and was accepted by several of the very best law schools.

There are two possible paths for such a person.

1. Make extra effort to get a stronger foundation before applying to a PhD program in economics. One possibility is to spend a year or two at a master's program, such as the one at the LSE. Although one can go directly from an undergrad degree to a PhD program (such as Harvard's), some students get a master's degree first, and that background gives them a leg up when they start a PhD.

2. Stay involved in economics but through a different channel than graduate school in economics. Many people involved in economic policy are trained as lawyers rather than economists. Two examples that come to mind are Gene Sperling and Brink Lindsey. I don't know anything about their math backgrounds, but I imagine that a person could follow their admirable career paths without having studied all the math you need for an econ PhD. There are many areas of law that are filled with economic analysis, such as tax and antitrust. A person who loves economics can find many courses that would interest him in law school. (The same could be said about schools of business and public policy).

To decide which of these two paths is right for you, you have to look hard at your own tastes and aptitudes to figure out your comparative advantage.

I spent 1 1/2 years in the early 1980s as a student at Harvard Law School, and I think I could have forged a happy career with a law degree instead of a PhD. In the end, I decided that my comparative advantage was in economics rather than law, so I suspended my law studies. But I can always go back and finish the law degree if this economics thing doesn't work out for me.

Prescott on the Estate Tax

In today's Wall Street Journal, economist Ed Prescott defends the repeal of the estate tax:

Since an estate tax is really just another name for a tax on capital income, then there is certainly no justification for such a tax. I, and others, have written before in these pages about the inefficiency of capital income taxes, and there's no need to revive those arguments here, except to say that we can only grip the neck of our vibrant economic goose so tightly before it eventually dies and quits laying those golden eggs....

Yet what about all the money that is left in bequests to fund university alumni buildings, art museum wings and public broadcasting? If we abolish the death tax, won't charitable organizations be hurt? I admit to a soft spot for this argument, but the fact is that people will still give to charity. In 2003, charitable contributions reported on 1040 income tax forms totaled $145 billion, which is roughly 10 times the $14.6 billion charitable contributions reported on the estate tax forms.

I am puzzled by those who say that the repeal of the estate tax will hurt charitable giving. Repeal has two opposing effects: a substitution effect (it raises the relative price of giving to your favorite charity rather than to your heirs) and an income effect (you have more to give). Critics of repeal seem to assume that the substitution effect dominates the income effect. I am not convinced that is right.

Imagine a wealthy Harvard alum. His will says, "Give each of my 10 heirs $10 million after taxes, then the rest to Harvard." If he faces an estate tax rate of 50 percent, then funding the heirs will cost an extra $100 million, which will all come at Harvard's expense. Isn't something along these lines plausible?

If commentators know of relevant evidence about the size of income and substitution effects regarding charitable giving at death, please share it with us.

Update: I am alerted to a relevant CBO study of the topic. The CBO's bottom line:

The analysis finds that permanently raising the amount of wealth exempt from the estate tax to either $2 million or $3.5 million would reduce charitable giving by less than 3 percent, as increased giving by the wealthiest donors would partly offset lower giving by donors with wealth below those cutoffs. However, permanently repealing the estate tax would cause a larger decline in charitable giving—of 6 percent to 12 percent. For the federal government, reduced giving would directly raise income tax revenues by lowering the amounts claimed as itemized deductions for charitable contributions. That revenue gain would partially offset the loss in revenue caused by repealing the estate tax.