Wednesday, December 30, 2009

A Debate for the Pigou Club

Why health consumers aren't cost conscious

The Temporarily Disappearing Estate Tax

In an odd twist of legislative history, the U.S. estate tax is scheduled to expire on January 1, but for one year only. This article describes people responding those peculiar incentives.
Rich Cling to Life to Beat Tax Man
Nothing's certain except death and taxes -- but a temporary lapse in the estate tax is causing a few wealthy Americans to try to bend those rules.
Starting Jan. 1, the estate tax -- which can erase nearly half of a wealthy person's estate -- goes away for a year. For families facing end-of-life decisions in the immediate future, the change is making one of life's most trying episodes only more complex.
"I have two clients on life support, and the families are struggling with whether to continue heroic measures for a few more days," says Joshua Rubenstein, a lawyer with Katten Muchin Rosenman LLP in New York. "Do they want to live for the rest of their lives having made serious medical decisions based on estate-tax law?"
Currently, the tax applies to about 5,500 taxpayers a year. So, on average, at least 15 people die every day whose estates would benefit from the tax's lapse.
The macabre situation stems from 2001, when Congress raised estate-tax exemptions, culminating with the tax's disappearance next year. However, due to budget constraints, lawmakers didn't make the change permanent. So the estate tax is due to come back to life in 2011 -- at a higher rate and lower exemption.
To make it easier on their heirs, some clients are putting provisions into their health-care proxies allowing whoever makes end-of-life medical decisions to consider changes in estate-tax law. "We have done this at least a dozen times, and have gotten more calls recently," says Andrew Katzenstein, a lawyer with Proskauer Rose LLP in Los Angeles.
Of course, plenty of taxpayers themselves are eager to live to see the new year. One wealthy, terminally ill real-estate entrepreneur has told his doctors he is determined to live until the law changes.
"Whenever he wakes up," says his lawyer, "He says: 'What day is it? Is it Jan. 1 yet?'"...
The situation is causing at least one person to add the prospect of euthanasia to his estate-planning mix, according to Mr. Katzenstein of Proskauer Rose. An elderly, infirm client of his recently asked whether undergoing euthanasia next year in Holland, where it's legal, might allow his estate to dodge the tax.
His answer: Yes.

Tuesday, December 29, 2009

AEA Humor Session

For those of you attending the meeting of the American Economic Association next week, here is a session you might want to attend:

AEA Economics Humor Session in Honor of Caroline Postelle Clotfelter
  • Sunday Jan 3 at 8 pm at the Atlanta Marriott Marquis [] room A704. Free and open to the public!
  • Merle Hazard [] ("Busted Dreams and Cheatin' Hearts: The Credit Crisis, Nashville-Style")
  • Hugo Mialon of Emory University ("The Economics of Faking Ecstasy")
  • Jodi N. Beggs [] of Harvard University ("Economists Do It with Models")
  • Stand-up economist Yoram Bauman [] ("What to Expect When You're Expecting the Nobel Prize").
  • Kenneth West of the University of Wisconsin will be presiding.

Monday, December 28, 2009

The Monetary Base is exploding. So what?

Click on graphic to enlarge.

An article in Saturday's Wall Street Journal says that some big-league investors are betting that inflation will rise significantly.  The reason?  "The nation's exploding monetary base is a harbinger of inflation."  Is this right?  Probably not.

It is true that the monetary base is exploding.  See the above graph.  Normally, such surge in the monetary base would be inflationary.  The textbook story is that an increase in the monetary base will increase bank lending, which will increase the broad monetary aggregates such as M2, which in the long run leads to inflation.

That is not happening right now, however.  The broader monetary aggregates are not surging.  Much of the base is instead being held as excess reserves.

But, you might ask, won't the inflationary logic eventually take hold as the economy recovers and banks start lending more freely?  Not necessarily.  Recall that the Fed now pays interest on reserves.  As long as the interest rate on reserves is high enough, banks should be happy to hold onto those excess reserves.  That should prevent a surge in the monetary base from being inflationary.

Here is one way to think about it.  The standard way of reducing the monetary base is open market operations.  The Fed sells Treasury bills, say, and drains reserves from the banking system, reducing the monetary base.  But consider what this means in the monetary current regime.  An open market operation merely removes interest-paying reserves from a bank's balance sheet and replaces them with interest-paying T-bills.  What difference does it make?  None at all.

Both reserves and T-bills are interest-paying obligations of the Federal government (including the Federal Reserve).  They are essentially perfect substitutes.  The monetary base, however, includes one of them but not the other, largely for historical reasons.

The bottom line is that when reserves pay interest, the monetary base is a pretty uninteresting economic statistic.

Does this mean that investors should stop worrying about inflation?  No.  Yet the worry should stem not from the monetary base but from the political economy and difficult tradeoffs facing monetary policymakers.  As the economy recovers, interest rates will likely need to rise.  Will the Bernanke Fed, feeling the political heat, get behind the curve and allow inflation to take off?  Will it decide that a little bit of inflation is not so bad compared with the alternative of risking an anemic recovery, a double dip recession, or (gasp!) congressional action to reduce Fed independence?   Maybe.  This is, I think, the right way to argue that higher future inflation is a plausible outcome.

I don't know whether such inflation worries are justified.  But I am pretty sure that the exploding monetary base is not, by itself, a reason to fear a coming surge in inflation.

Gruber on the Cadillac Tax

Sunday, December 27, 2009

Can you name this economist?

P/E Ratio

This chart, from Jim Hamilton, shows the ratio of a stock market price index to the average of the previous ten years of real earnings.  The red line is the historical average.
By this metric, popularized by Bob Shiller, the market is now slightly above its historical average valuation.

Saturday, December 26, 2009

Smoot-Hawley Revisited

According to a view common among macroeconomists, the Smoot-Hawley tariffs of the 1930s were a poor policy choice, but they were not a main reason for the severity of the Great Depression.  In an interesting blog post, economic historian Scott Sumner calls the second half of this conclusion into question:
In the period around March and April 1930, there were a few “green shoots” in the economy. The stock market recovered a significant chunk of the huge losses in 1929. (I recall the Dow fell well below 200 during the famous crash, and got back up over 260 in April. The 1929 peak had been 381.) Then in May and June everything seemed to fall apart, and stocks crashed again. So what happened in May and June?
The headline news stories during those months were the progress of Smoot-Hawley through Congress. Each time it cleared a major legislative hurdle, the Dow fell sharply. This pattern was obvious to those following the markets, and was frequently commented upon. After it cleared Congress it went to Hoover. The President received a petition from over 1000 economists pleading with him to veto the bill. (A veto would not have been overridden.) Over the weekend Hoover decided to sign the bill, and on Monday the Dow suffered its biggest single day drop of the entire year.
Scott then goes on to propose an explanation of these events that can be viewed as consistent with the textbook Keynesian model. In particular, I interpret Scott as saying that the retreat from free trade reduced business confidence, shifted the investment function I(r) to the left, and thereby reduced aggregate demand.

One general lesson from his discussion is that it is often hard to distinguish shocks to aggregate supply and shocks to aggregate demand.  Policies and events that adversely affect aggregate supply (e.g., trade restrictions) will often reduce the marginal productivity of capital, decrease investment spending for given interest rates, and depress aggregate demand as well.  In the short run, the indirect demand-side effects of "supply shocks" could potentially be larger than the direct supply-side effects.

This is something to keep in mind as our economy enjoys the beginnings of a recovery.

The Ten Principles Down Under

Wednesday, December 23, 2009

A Reading for the Pigou Club

Tuesday, December 22, 2009

The Case Against the Millionaire Surtax

The Price of Christmas

Monday, December 21, 2009

Sachs on the Copenhagen Summit

Rolling the Dice on Medicare

The latest from the Congressional Budget Office:
CBO expects that Medicare spending under the legislation would increase at an average annual rate of roughly 6 percent during the next two decades—well below the roughly 8 percent annual growth rate of the past two decades (excluding the effect of establishing the Medicare prescription drug benefit). Adjusting for inflation, Medicare spending per beneficiary under the legislation would increase at an average annual rate of roughly 2 percent during the next two decades—well below the roughly 4 percent annual growth rate of the past two decades. It is unclear whether such a reduction in the growth rate could be achieved, and if so, whether it would be accomplished through greater efficiencies in the delivery of health care or would reduce access to care or diminish the quality of care.

Sunday, December 20, 2009

Epstein on the Reid Bill

Legal scholar Richard Epstein opines on the current version of health insurance reform.  An excerpt:
At this point, there is a near mathematical certainty that the scheme of health insurance market regulation contemplated by the Reid bill will reduce the risk-adjusted rate of return below the level needed to keep these firms in the individual and small-group health-insurance markets. I am not aware of a single provision in the Reid Bill that looks to ensuring a minimum rate of return. And there are countless provisions in the bill that impose new obligations to cover services while eliminating the revenue sources to deal with them. It is just this combination of regulatory programs that leads the CBO to treat private health insurance issuers as part of a federal program—as though they have been subject to de facto nationalization.

Readings on Financial Regulatory Reform

Saturday, December 19, 2009

The Big Questions

Looking for a Christmas gift for that special econonerd in your life?  Try Steven Landsburg's new book, The Big Questions

I recently finished it, and it is much fun. Reading it is like having dinner and sharing a bottle of claret with a smart, creative, iconoclastic friend.  The conversation jumps from topic to topic in math, physics, philosophy, economics, public policy, etc., in a seemingly random fashion, and your friend does not always convince you of his point of view.  But throughout you are entertained, and in the end you are even edified.

Friday, December 18, 2009

Reinhardt on Drug Reimportation

The policy debate about drug reimportation brings up a lot of interesting questions, touching on the topics of free trade, price discrimination, and protection of intellectual property rights.  Princeton economist Uwe Reinhardt has a good discussion of some of the issues.  For an old post of mine, click here.

Thursday, December 17, 2009

Mankiw vs Pinker

We reached different conclusions about a new educational technology.  I am not at all confident that I am right about this one.

Wednesday, December 16, 2009

Nine Observations about Investment

1. Above is a chart of the growth rate, from four quarters earlier, of real investment in equipment and software.  Notice the left scale.  Investment spending is very volatile.  This is one of the standard stylized facts about the business cycle.

2. Investment has been particularly weak during this economic downturn.  Weak residential investment is not a surprise, as the downturn was started by events in the housing market.  But as this graph shows, business investment has also been very weak.  Indeed, by the metric used in this graph, it is far weaker than in previous deep recessions, such as 1982.

3. Why is business investment so weak?  Part of the reason is that the downturn is severe and investment responds to the overall economy.  Part of the reason is that the credit crunch makes financing more difficult.  Part of the reason is that the policy environment seems adverse to business.  I am referring here to a group of policies that include higher minimum wages, the seeming retreat from free trade, proposed mandates to provide employees health insurance, higher prospective energy costs from climate change regulation, and the likelihood of higher future tax rates resulting from the huge fiscal imbalance we are now experiencing.  All of these factors have worked in concert to depress business investment.

4. The recent weakness of business investment was one of unstated reasons why, in my recent NY Times column, I suggested that an investment tax credit (ITC) might have been a better form of fiscal stimulus than what we in fact are getting.  Given the amount of money being spent on stimulus, the ITC could have been sizable.  The measure of investment used in the chart above is about $1 trillion per year.  So, to give a very rough example, if Congress had passed a 20 percent ITC in 2009, 10 percent in 2010, it would have cost the Treasury about $300 billion.  Essentially, the Treasury would have picked up 20 percent of the cost of all of these investments if done this past year, and half that amount next year.

5. Some readers might wonder if this policy would work in the presence of the zero lower bound on interest rates (aka the "liquidity trap").  The truth is that we don't fully understand the role of the zero lower bound, and most of what we do know is based on stylized theoretical models with scant evidence to back them up.  But those models suggest that an ITC would work just fine.  The zero-lower-bound whiz kid Gauti Eggertsson in fact endorses the ITC as a plausible policy in that environment.

6. In my most controversial NY Times column, I said that what the economy needed was negative real interest rates, which could be accomplished via inflation.  A temporary ITC does something similar.  By temporarily reducing the effective price of capital goods, it creates expected inflation in this particular price.  Under the numerical example above, the effective price of new capital would immediately fall by 20 percent, and expected inflation would rise by 10 percent.  If nominal rates stay at zero, the real interest rate measured in units of new capital goods would become negative 10 percent.  That is one way to view the way in which a temporary ITC stimulates investment spending.

7. So much for theory, but would it work?  The cash-for-clunkers program is thought by many to have promoted, or at least accelerated, car purchases.  An ITC would be similar, but it would apply to business investment rather than personal cars.  Instead of targeting a very narrow, politically favored industry, it encourages investment broadly.  It should have positive effects on aggregate demand in the short run and positive effects on aggregate supply in the medium and longer run.

8. Recall that an investment tax credit was part of the Kennedy plan to get the economy going again back in the early 1960s.  According to historical reports, Kennedy came to this idea of tax cuts with the advice of economist Paul Samuelson, who just passed away.  In memory of Professor Samuelson, if the Obama administration wants to switch gears and try a sizable investment tax credit, I propose that we call it the Paul Samuelson Memorial ITC.

9. Update: Intrigued by this idea? Try these further readings on the subject by Bruce Bartlett and Hal Varian.

Tuesday, December 15, 2009

Memories of Paul

Like many students of my generation, I started my studies of economics with Paul Samuelson.  When I took econ 101 as a freshman at Princeton, Paul's textbook, then in its 9th or 10th edition, was the assigned reading.  I recall the book well, and I give it a lot of credit for fostering my interest in economics.

A few years later, as a grad student at MIT, I sat in some of Paul's lectures.  They were mainly about "reswitching" and the Cambridge-Cambridge capital controversy.  A few years after that, when I was an assistant professor, Paul was part of the effort that tried to recruit me to join the MIT faculty.  (In the end, I decided to stay at Harvard--persuaded in large measure by Paul's nephew, Larry Summers).  Over the past decade or so, I saw Paul off and on, mainly at the Federal Reserve Bank of Boston, where we both served on an academic advisory panel.  He remained engaged and insightful well into his years of retirement.  He will be missed, in that meeting and many other places as well.

A few years ago, I had the good fortune of running across a first edition of Paul's textbook (not the recent reprint of the original text, but an actual 1948 edition).  It was a real find.  I bought the volume in an online auction for, if my recollection is correct, $35.  Talk about consumer surplus!  I would have gladly paid many times that.

At the next Boston Fed meeting, I took the book along to get Paul to sign it.  Below is the book's title page, along with Paul's gracious inscription.

Click on images to enlarge.

Why Keynesians drive Scott Sumner nuts

Sunday, December 13, 2009

Paul Samuelson has died

Saturday, December 12, 2009

Fiscal Stimulus Revisited

Click here to read my column in tomorrow's NY Times.

Friday, December 11, 2009

Joe Stiglitz

Prakash Loungani profiles the Nobelist.  Click here to watch Joe's recent congressional testimony.

Chip Case retires

Wednesday, December 09, 2009

Colbert on the Fed

Tiger Woods as a Natural Experiment

Chapter 21 of my favorite textbook discusses the role of income and substitution effects in determining labor supply, including a case study about lottery winners. UCLA economist Matthew Kahn applies this kind of thinking to the Tiger Woods saga.

Before reading Matthew's analysis, ask yourself this question: Does economic theory predict that Woods will play more or fewer tournaments next year?

The Transactions Tax

Tuesday, December 08, 2009

My Freshman Seminar

Sadly, my freshman seminar is now over. Above is a group shot from our last meeting, held over dinner at my house. (Note the shirts, which the seminar participants arranged.)

I took a poll of the students' favorite readings. The winners were
  1. Capitalism and Freedom by Milton Friedman
  2. Nudge by Richard Thaler and Cass Sunstein
  3. The Worldly Philosophers by Robert Heilbroner

Click here for the full reading list.

I also asked the students how their views had changed over the course of the semester. Those who started out liberal said they came to appreciate market mechanisms more. Those who started out conservative said they came to appreciate the market's limitations. In other words, after a few months of reading and discussing economics and public policy, most of them moved toward the political center and closer to agreement.

Monday, December 07, 2009

The Pigou Club talks to the Senate

Club Member Ted Gayer makes five points:

1. Either a carbon tax or a cap-and-trade program will result in substantially lower economic costs than command-and-control regulations that mandate technologies, fuels, or energy efficiency standards.

2. Given the uncertainty of the future costs of climate policy, a carbon tax is more economically efficient than cap-and-trade.

3. Carbon allowances in a cap-and-trade program would be susceptible to price volatility. Price volatility causes economic disruptions and complicates investment decisions. It also could lead to political pressure on Congress to repeal or substantially loosen the cap.

4. A carbon tax, in which the revenues are used to offset economically harmful taxes or to pay down our deficit, would substantially lower the cost of climate policy compared to a cap-and-trade program that gives away allowances for free.

5. The currently proposed climate bills rely heavily on offsets to reduce the overall costs of cap-and-trade. Given the substantial potential value of offsets, there is a very real concern that offset integrity will not be maintained. This would result in a weakening of the cap, undermining its environmental benefits.

Continue reading here.

Saturday, December 05, 2009

What I've been listening to

I am bit embarrassed to admit this, but the answer is Lady Gaga. Her music reminds me Blondie, which I enjoyed back in my student days. I particularly like the Lady Gaga song Bad Romance.

Update: If you wonder about my comparison, listen to Gaga's Summerboy and Blondie's Heart of Glass.

Friday, December 04, 2009

What responsibilities should the Fed have?

Vincent Reinhart opines:

As a result of legislative convenience, bureaucratic imperative and historical happenstance, a variety of responsibilities have accreted to the Fed over the years. In addition to conducting monetary policy, the Fed also distributes currency, runs the system through which banks transfer funds, supervises financial holding companies and some banks, and writes rules to protect consumers in financial transactions. Mr. Bernanke argues that preserving this mélange is not only efficient but crucial to protecting the Fed's independence.

Apparently, the argument runs, there are hidden synergies that make expertise in examining banks and writing consumer protection regulations useful in setting monetary policy. In fact, collecting diverse responsibilities in one institution fundamentally violates the principle of comparative advantage, akin to asking a plumber to check the wiring in your basement.

There is an easily verifiable test. The arm of the Fed that sets monetary policy, the Federal Open Market Committee (FOMC), has scrupulously kept transcripts of its meetings over the decades. (I should know, as I was the FOMC secretary for a time.) After a lag of five years, this record is released to the public. If the FOMC made materially better decisions because of the Fed's role in supervision, there should be instances of informed discussion of the linkages. Anyone making the case for beneficial spillovers should be asked to produce numerous relevant excerpts from that historical resource. I don't think they will be able to do so.

The biggest threat to the Fed's independence is doubt about its competence. The more the Congress expects the Fed to do, the more likely will such doubts blemish its reputation.

Thursday, December 03, 2009

Glaeser on Financial Regulation

Take Out Your Pencils 4

This week's problem:

A friend of yours is considering two providers of cell phone services. Provider A charges $120 per month for the service regardless of the number of phone calls made. Provider B does not have a fixed service fee but instead charges $1 per minute for calls. Your friend’s monthly demand for minutes of calling is given by the equation Qd= 150 – 50 P, where P is the price of a minute.

a. With each provider, what is the cost to your friend of an extra minute on the phone?

b. In light of your answer to (a), how many minutes would your friend spend on the phone with each provider?

c. How much would he end up paying each provider every month?

d. How much consumer surplus would he obtain with each provider? (Hint: Graph the demand curve and recall the formula for the area of a triangle.)

e. Which provider would you recommend that your friend choose? Why?

If you enjoy this kind of thing, click here for the previous installment in this series. As always, I will not post the answer, so instructors can use the problem as homework.

Tuesday, December 01, 2009

Predicting Honors

In a new NBER working paper, Daniel Hamermesh and Gerard Pfann estimate the probability that an economist will be honored by his peers (by receiving a Nobel Prize, being elected President of the American Economic Association, being named a Distinguished Fellow of the AEA, or winning the AEA's Clark Medal).

The bottom line: An economist's citation ranking is a strong predictor. Given citations, an economist's number of publications has no additional predictive value for whether he will obtain such an honor.

FYI, here is an up-to-date citation ranking of more than 20,000 economists.