Dean's dough

natural rate of unemployment

2011-10-10T14:14:00.002-04:00

The concept of NAIRU^* is one of suspect theoretical validity, I think, in part because we don't really have a great comprehensive model of unemployment and inflation; that said, it often seems to have ontological value, insofar as high-frequency changes in the unemployment rate seem to lead high-frequency accelerations in nominal wages, suggesting a possibly changing unemployment rate above which wage inflation decelerates and below which it accelerates. One of the concerns with the length of the recent employment recession, and in particular with the number of people who have been unemployed for a long time, is that these people lose skills (in various senses of that concept), suggesting perhaps that these phenomena will lead to rising NAIRU. It seems to me that, particularly framed as I have done so, this might be a testable question: is the low-frequency component of nominal wage acceleration, with the high-frequency relationship to unemployment backed out, predicted by any combination of previous unemployment rates and previous rates of long-term unemployment?

*Non-Accelerating Inflation Rate of Unemployment.

bad statistics

2011-10-03T22:13:00.002-04:00

I was thinking today in my econometrics class that perhaps, a few years down the road, I would like to teach a course in bad econometrics. There would be a unit on data-mining (overfitting), certainly, and multiple comparisons; there could be some coverage of some of the weak IV literature from the '90's; cointegration, heteroskedasticity, colinearity, and other misspecification problems; and certainly the prosaic beginner-level material on comparing data series that have been made incomparable, for example by deflating with different inflation indexes. The hope, of course, is that students would learn to recognize and avoid these errors, but it would appeal to my temperament to try to present it "with a straight face", as it were.

If anyone else has any other suggestions, please offer them.

anti-trust law, incentives, and coordination problems

2011-08-31T14:00:00.004-04:00

When two companies merge, they sometimes achieve efficiencies of scope or of scale, but where they were previously competitors, the merger may reduce competition. If the former effect dominates the latter, the merger may benefit consumers, but if the latter dominates the former, consumers will be harmed, and frequently the net harm to consumers is likely to exceed the net benefit to other parties (e.g. stockholders). Even where this last inequality does not hold, it is frequently within the ambit of regulators only to consider the effect on consumers, and this may be a defensible principle. Regulators may, however, have less knowledge about the likely effects of the merger than industry sources. It would be nice if there were a way to induce industry sources to reveal useful information to the regulators.

Mankiw pointed out a couple years ago that, where a merger is likely to benefit consumers, it will do so by lowering prices and raising quality for consumers, while where it hurts consumers, the opposite will be true. Regardless of how it plays out, competitors of the prospective merger partners will be helped or harmed exactly inversely to the effect on consumers, thus, in this narrow context at least, the anti-business instincts of certain populists are actually well-justified; if competing businesses are lobbying in favor of a merger, Mankiw suggested, block it, while if they lobby against it, approve it. He noted, though, that it is necessary to keep such a policy quiet; if the companies know their lobbying actions have these perverse effects, they will no longer lobby in a way that reveals the relevant information. The policy is not, in this sense, incentive compatible.

On the other hand, what just occurred to me is that one might well be able to, openly and publicly, follow the evolution of the stock prices of competitors that are publicly traded. A potential shareholder in a competitor to the prospective merger partners will wish for the regulator to see a drop in share prices on the announcement of the potential merger when the merger would in fact benefit the company, but he still finds it in his own interest to buy ahead of other potential shareholders; similarly, if he would like regulators to see an increase, he may still wish to sell before others do. If all buyers and sellers in a particular stock could form a cartel, they would jointly find an advantage in acting to confuse the regulator; what they might narrowly view as a "tragedy of the commons" may in fact serve, in this case, to enhance the public good.

While there is a tendency to think of coordination problems as a bad thing, in fact they are frequently quite useful, if usually in combating the effects of other coordination problems (or private information problems). Most of forensic accounting, in fact, involves asking different parties to keep track of essentially redundant information; while a single agent might be able to forge all of its own records in a consistent way, getting all of its business associates to forge their records in the same way is more difficult, such that accountants can subpoena everyone's records and find inconsistency in the combined dataset. Indeed, perhaps the most famous illustration of a coordination problem, with the possible exception of the aforementioned tragedy of the commons, is the prisoner's dilemma, in which a mechanism designer has, according to the usual story, explicitly designed the coordination problem in order to turn the agents against themselves.

In the case of two agents, cooperation is more likely to obtain, especially where they know each other, than it is with multiple, anonymous agents; "incentive compatibility" as it is usually treated in the literature requires only that each agent find it unprofitable to unilaterally deviate from the prospective equilibrium supposing that nobody else does so. In actual practice, it seems likely that this condition is insufficient as long as the sets of agents required to coordinate to block such an outcome are both small and in a variety of senses are known to each other in such a way that they can solve their internal coordination problems — possibly creating what manifests itself as a coordination problem on a larger scale.

stimulative corporate tax policy

2011-08-26T10:58:00.003-04:00

Last month I turned 35, and noted that I am now old enough to be President. I was asked my platform, and gave sarcastic responses. I do have a couple of ideas of things I think would be worth trying to stimulate
The second idea is to allow companies to expense all investment for two years, and half of it in the third. Approximately, if a company spends $10,000 on a piece of equipment that will last ten years, it lists $1,000 as an expense each year for ten years; that is what it subtracts from revenue to calculate taxable profit. I'm suggesting that we allow companies to front-load the deductions; if you spend $10,000 on a piece of equipment this year, subtract the whole thing from your revenues. (You would then carry it at 0 value on the books; you would not deduct $1,000 per year in future years, and, if you sell it, the amount for which you sell it would be taxable revenue.)

The third idea is to cap each company's payroll tax contributions at, say, 80% of its level from some recent previous year; this provision, too, would hold for a few years. A company that is already paying less than that would, of course, not be affected; for a company that is affected, decisions related to changing payroll are now changed by the fact that another $1 in salary paid does not cost the company $1.075 (or thereabouts). Creating a new $30,000 job costs the company $2,250 less per year than it would have otherwise; creating a new $40,000 job costs $3,000 less; laying off a $40,000 worker will save $3,000 less than it otherwise would have. Further, again because of the declining corporate tax rate, a company that thinks it will want to hire two or three years from now has a bit more incentive to bump up its payrolls now.

Finally, while I view as a feature that the third idea encourages companies to create higher-paying jobs to some extent, we can also allow the wages of any hourly worker to be deducted as though they were $10 per hour; e.g. if a company pays an employee $7.50 for 20 hours, it lists an expense of $200 on its taxes rather than $150. This creates a little bit more incentive to create a job at the low end of the scale rather than not to create it, but it also means that raising the employee's pay to $9 per hour will not benefit the company through a lower corporate tax. This one is accordingly a bit dangerous, and is kind of intended to offset any harm done to especially low-skilled worker by recent increases in the minimum wage.

I should note that the second and third ideas in particular are not entirely my own idea; expensing investments is naturally what one would do in a more consumption-based tax system, and Mankiw has recently noted that temporary pro-investment tax provisions, such as an investment tax credit, would in many ways lower the effective interest rate that is used in investment decisions, thus giving a way around the zero-bound on nominal interest rates. Singapore actually uses a countercyclical employment payroll tax, reducing the employer's share of payroll taxes when unemployment is high (to reduce the cost of hiring) and raising it when unemployment comes down (to raise the necessary funds over the long-term). I've essentially taken the marginal rates all the way to 0, but with the 80% offset designed to mimic proposals by people who seek to raise more nearly the amount of revenue that is raised by current levels of payroll taxes.

* I want to emphasize that "stimulate" is supposed to indicate an emphasis on short-term; I'm not discussing here ideas that would focus on creating a good climate in the long-run for sustained growth. The ideas presented, though, should not do great violence to long-run growth, either, and are partly constructed with them in mind.

production of capital goods

2011-07-27T15:40:00.003-04:00

The whole philosophy of macroeconomics since Keynes more or less invented it has been to aggregate variables like "consumption" and "investment" and ignore differences between different kinds of consumption, as well as structural details about what specific goods are used to produce what other specific goods. The approach has its uses, and macroeconomists have shed some useful light on the workings of the economy this way, but even on what one would think of as a macro basis it seems likely that some details will make differences in some circumstances. One of the big changes over the past generation or two that might be important is the changing nature of the production of capital goods.

Forty years ago, "capital" meant heavy machinery — factory equipment, earth movers, that sort of thing. People who produced capital goods were to a large extent machinists and factory workers. Today a lot of "capital" is software. Software is "nonrival", meaning that producing software for 1,000,000 customers is not largely more expensive than producing the same software for 10 customers; it is also the case that a lot of software production builds on previous versions of similar software. "Fixed investment" has been supporting the recovery to a greater extent than in previous recoveries, but in 2011 that means more software and fewer tools than it would have 30 years ago.

Institutional capital, which I'm largely leaving out, may also be more important now than it was 40 years ago; more of the labor force consists of people for whom an important part of their value to their current employer is detailed knowledge of coworkers, workplace culture, and procedures than I think was the case forty years ago. This is especially true in the production of modern forms of capital as compared to production of older forms of capital; engineers and computer programmers working on projects too big for any one of them to complete alone are harder to replace with other experienced employees with the same generic training than is the case for machinists. (This is not an absolute truth, but is broadly the case; certainly any sizable company will benefit from employees who know the idiosyncrasies of that company, or even of its particular workplaces. I believe it to be more true, in general, of engineering kinds of work than of machining or factory work.) Related human capital is also likely to be more important for more modern forms of capital than for older forms.

Confident answers are not in the purview of this blog, but it seems reasonably likely to me that this contains a partial explanation for the slow recovery of employment after recessions that has been increasingly witnessed over the past 25 years. When demand shows its first signs of renewal firms may turn first toward replacing their capital, whose prices are more likely to drop than are wages; the producers of capital themselves need not hire a lot of new workers nor raise the prices of their products a great deal until demand is quite substantial, and (especially in times of uncertainty) may be slow to increase employment too quickly because of the investment this would require in institutional capital as well.

price changes

2011-07-15T12:38:00.003-04:00

I'm interested in markets, and one of the complicated things about markets is that they involve people. Netflix has gotten itself some flack recently for revamping its price structure, breaking apart (as I understand it) for sale separately (and without a joint discount) two services that were previously bundled, such that the total price of the original package, for those wishing to replicate it, has gone from $10 per month to $16 per month. One of the comments I saw was "this is too big a price change to implement all at once"; if we take this complaint at face value, it might have created less of a stir if they had offered a $3.50 discount on the bundle for a period of time. This is similar to something I heard at the annual meeting of my cooperative apartment; we're being hit with some big expenses in a year or two, so the board decided to increase our monthly maintenance payments this past year so that the increase next year won't be one big jump.

I'm curious as to what kinds of price changes strike people as "unfair" and what kinds don't. Stock prices change quite frequently, but the buyers and sellers are very dispersed and anonymous; I think people have less of an emotional "fairness" response to stock price moves than to other kinds. Gold, at least as traded on financial markets, is similar; so, though, is oil. Most people purchase their oil distillates, though, from recognizable brands, and even though they're usually mercenary about it themselves — most people, choosing between Exxon and BP, will go with whichever is cheaper on the given day — seem to object to higher prices than they're used to. This is likely also a function of the fact that people build their habits around consuming oil distillates at a constant rate, and don't like responding to prices; demand elasticity of gasoline, especially in the short run, is very low (which is precisely why the price is sometimes so volatile).

If the shop on the corner raises its prices, my understanding is that people tend to regard this more favorably if the retailer's costs have recently gone up than if it's simply an attempt to ration rising demand in the face of potential shortages. (It's worth noting in this context, though, that part of Netflix's decision seems to have been related to costs.)

And, as suggested at the beginning, it may be that increases of a certain size produce a certain amount of sympathy, especially in the face of rising costs, but that there are certain breakpoints where the customer would respond less viscerally if the change were phased in. What interests me in particular here is to what extent it's an abrupt change in expectations rather than an abrupt change in prices that creates the angst. If Netflix had announced this change 18 months ago, would it have produced as much complaint then as it is now, or as much complaint now as it is, or would it have spread it out or even reduced it? If the old rates had been (credibly) portrayed, as soon as the bundled items were being sold together, as a special, trial offer, would the new price structure have been more readily accepted? (If you give away an item for free for two months, any increase in price will exceed 60%, but would presumably be more accepted; there would be an expectation that this was a limited-time offer.) I note in this context that O'Hare airport some years back raised its parking rates by announcing, at the beginning of the holiday season, that it was offering "special holiday rates" that equalled the rates in October; they actually raised the rates at the beginning of January by allowing the "special rates" to expire.

Another anecdote: about ten years ago, I was a regular in a sandwich shop, and recognized as such; they increased the price of a sandwich by 10 cents at one point, but comped me a free sandwich when they made the change. I imagine them imagining me thinking, "They're nice people and they like me, so I understand that they have to raise their prices once in a while."

I'm not offering grand theories, but my speculative observations are that upset increases when

demand for the good is inelastic
price increases result from cost increases, rather than shortages
price increases are "big"
price increases are unexpected
markets are less anonymous.

informational complementarities of production

2011-07-06T11:56:00.003-04:00

I've had recent occasion to discover that there are certain brands of baby-good manufacturers that produce a number of different items for babies — my wife could tell you the names of some of the brands. These different items often seem to have relatively little in common other than being small consumer-grade manufactured items; it's not clear where a single company would have a production efficiency in producing this set of goods and why e.g. Black and Decker couldn't just as logically produce a stroller. (Perhaps there's some valuable cross-product knowledge about the range of shapes and sizes of babies bodies.) What seems, based only on anecdotal evidence and my own speculation, to drive this more is the reputational complementarity; it would, in fact, not surprise me to learn that the items are produced by third parties and rebranded. A new mother who studies up on products and develops a sense that a brand of one product is good can transfer that impression to other products under the same brand name.

parimutuel betting

2011-06-10T10:14:00.002-04:00

I was a bit shocked when I found out that, when betting on horses, if you make a bet when the odds are 7-2, and a bunch more people make that bet after you did, you can be stuck with a bet at 5-2 odds;* the odds quoted before bets close is not really a price at which an offer is being made, so much as what in certain finance contexts would be called an "indicative price", that provides a certain amount of information.

The biggest — by far — justification I can see for a parimutuel system is that it's the 1930's and nobody has ever heard of a computer†; rather than keep track of who bet what at what price, you just keep track of how much was bet on Runs For Miles and take (most of) the money that was bet and prorate it. There's less bookkeeping to be done than if you're making bets on different terms with different gamblers, as is done with most Vegas sports betting, and there's no chance whatsoever that the house loses money; if it puts out 7-2 odds and gets a lot of bets, it doesn't just move the odds of future bets to 5-2 to try to attract bets to other horses, it moves the past bets to 5-2,‡ in some sense devaluing their weight on the book.

The context in which stock exchanges provide an "indicative price" resembles horse gambling in that everyone is placing orders and they are being accumulated without any actual trades taking place; a single auction is ultimately held based on the orders accumulated. Some of the orders will be limit orders — "Buy at up to $45 per share" — and others will be market orders — "Buy at any price." When the auction actually goes off, a price is determined at which the amount bought will equal the amount sold; if you pick a particular price and there would be more buyers than sellers at that price, you can drop the price until some of the limit orders to buy becomes active and some of the limit orders to sell becomes inactive, decreasing the number of effective buy orders and increasing the number of effective sell orders. Before the auction has executed — while they're still be accumulated — an "indicative price" will be quoted, telling traders what price the auction would obtain if no more orders were placed (or, alternately, if all future orders were balanced at that price); if you place a limit order at that price, though, and it moves against you, your order won't be executed.

With the proliferation of computers to facilitate the process, I wonder whether potential horse gamblers would be interested in a system in which you could place limit orders. Current horse gamblers are presumably selected for people who don't loath the current system with a burning fire of rage, but I think at the very least that "let me out if it goes past 3-1" should not be confusing or offensive to people who are currently betting; they wouldn't be required to give a limit price, anyway. The house would still, by setting the price after the bets are in, make sure its books are always balanced, and in fact all bets on a given horse would still ultimately go off at the same odds, so the reporting system wouldn't be different. People who placed bets that ended up ineffective would have to have their money refunded, which could be a logistical nuisance. If it would attract any significant number of new betters, though, it seems like it could make horse gambling more popular. Which no doubt would be reason enough for some other people to oppose it.

* I'd be inclined to call the system "unfair" except that pretty much anything that's upfront about its unfairness when you're going in seems to me ipso facto not really that unfair. There are probably exceptions to this rule (of what seems to me to be fair or unfair), but they're very uncommon.

† This makes it a lot like the Dow Jones Industrial Average.

‡ Kind of like a terms-of-trade effect.

yield-curve targeting

2011-03-24T16:37:00.003-04:00

Scott Sumner's big idea is that the Federal Reserve should target expected values of nominal GNP. When he's been his most concrete, he suggests an automatic program to inject certain amounts of money through open market operations when futures on GNP drop below a certain level, and withdraw this liquidity when futures exceed the level. I've been thinking about this and related things for a while, and want to put forth an idea related to them.

First I want to discuss level targeting versus growth (which, in the case of prices, is called "inflation") targeting. I tend more toward the former camp because the time-consistency problems are less bad there; if, in response to 1% inflation in response to a stated 2% target, you continue to assert a 2% target, the market will continue to expect what it continues to expect; you can get self-fulfilling expectations. With a price level targeting system, targeting price levels along a path with 2% annual growth, if inflation comes in at 1% one year, you aim to make it up; markets can form better grounded expectations that, a few years from now, price levels will be around what you've promised, and to the extent that expectations are self-fulfilling will even help you get there rather than wandering off in persistent indifference to your stated policy.

Level targeting per se suffers from a different sort of time-consistency problem, though, or perhaps two different, though closely related, such problems. If prices move too far off the target path, the Fed may be under pressure to revise the target; the choice is then between insisting on remaining firm, possibly requiring deflation or high levels of inflation, or revising the target, in which case a lot of credibility goes out the window. (This working paper from 8 years ago titled "Tough Policies, Incredible Policies?" notes that imposing costs on oneself to generate credibility means one might incur those costs in an extreme event, making the situation worse; this is related.) On a related note, on adopting the regime, a target level has to be decided upon and announced; particularly early on, there will be speculation as to whether the Fed would, at some point, use whatever criteria it used to set the initial target path to set a revised target path.

What I support therefore lies somewhere between a level target and a growth target: revise the target level by some fraction of the deviation from the target path. If this fraction is 1, you have growth targeting; if it's 0, you have level targeting. If you use between 0.03 and 0.05 per quarter — a decay time of 5–8 years — your target is pretty rigid over the course of a year or two of ordinary noise, such that it invites self-fulfilling forces in its favor, but large deviations are partially accommodated, making it more credible that the Fed will continue to maintain the policy in the face of a crisis — abandoning (slightly) its target, but in a pre-determined way, such that markets can form expectations, and those should generally (again) be stabilizing. Further, this policy could be adopted today and would spit out the same target level as if it had been in use for 25 years; not only does this mean that "revising" the target, according to the same criteria, several years down the road would mean no revision, but it means that the Fed builds credibility for the regime more quickly, as it has no less reason to revise its target soon after adoption than it would in midstream, and can demonstrate that the target level wasn't simply chosen to be easier, for political reasons, to hit.

I like the idea of targeting nominal GNP better than targeting prices, partly because it feels like a change in real GDP should be met by an accommodating change in the level of inflation targeted — that is to say, the direction at least is right, that it makes sense to lower the inflation target when the economy is growing quickly and to run monetary policy that is looser than a strict inflation target would give when the economy is weak. I also like it because I think it can be measured better; price targeting requires deciding which prices to target, and measuring those prices requires hedonic adjustments and the like, while nominal GNP, at least in principle, is simple: just add up dollars for everything, regardless of how the goods or services for which they're exchanged have changed from the previous period. (I don't care as much between GNP and GDP, and seem to have gotten sloppy about which I use. They're close — at least as close as are the fed funds rate and the T-bill rate, which I'll implicitly conflate shortly — and I expect Scott has better reasons for supporting the one he supports than I would have for either.)

Over the short run, I would rather maintain the practice of targeting short-term interest rates rather than the quantity of money (any money); the difference between the two policies amounts to a difference in accommodation of short-term variations in liquidity demand as, for example, pay checks clear. It seems likely to me that putting this variation in the quantity, rather than price, of liquidity will impose less volatility on the real economy. I will, at the moment, simply ignore any problem this creates when interest rates are 0. This is part of the privilege of having a blog.

What I'm looking at, then, is a regime of calculating how far GNP is from a target that largely grows at a constant rate, but will absorb deviations over the course of a business cycle, and targeting an interest rate based on the deviation from the trend and expectations of growth in the near future. If growth has been too low lately, we lower interest rates; similarly, if it's expected to be too low in the near future, we lower interest rates.

What interests me — what triggered this post — is that, once you're in a credible policy regime of setting short-term rates based on recent deviations from your targeted long-term growth rate, you don't need to create a market for GNP futures; long-term interest rates are expected future short-run interest rates, which will depend on expected GNP growth. At this point I simply make short-term interest rates a function of the current deviation of GNP from its target and of, say, ten-year treasuries.

I'm not sure yet what relationship is required between the parameters to ensure determinacy, or to make this most nearly result in actually targeting expected GNP (at some given distance in the future), but I had an idea a few years ago — before I started taking macroeconomics classes — that perhaps the FOMC should direct the open market desk to target a certain steepness for the yield curve, just on the grounds that, hey, if long-term interest rates move down, we probably want short-run rates lower, too. I don't know that "1" is the right coefficient to put on any duration of interest rate (or a weighted average of such interest rates); perhaps it would not be. In any case, I have some aspirations at some point to try to write this down and solve for interest rates in terms of parameters and GNP expectations, but that should probably wait until the summer.

mutual underwriting

2011-03-18T16:08:00.002-04:00

A particularly weird idea that's popped up in my head in the last month is on some level an extension of the old idea of a mutual insurance company, wherein policyholders are also residual owners of the company; in caricature, everyone pays in somewhat more at the beginning of say a six month period than they expect to lose and everyone gets back a portion of what's left after paying losses incurred during the period. If the overall risk level was higher than initially estimated, people may not get back the rebate they were hoping for, but if the overall risk level is lower, people end up effectively paying a lower premium for the period in which they were covered. They thereby insure their risk by spreading it among their fellow policyholders, remaining exposed to unexpected levels of overall risk, but they don't face the problem of perhaps believing that the insurance company is being overly conservative in setting its premiums — if that's true, the policyholders will ultimately get back the difference.

These require, in some sense, less absolute underwriting, but still require relative underwriting; if 100 homeowners in identical homes are buying insurance, that's easy, but if 12 of them have propane tanks next to their houses and the other 88 don't, charging everyone the same premium doesn't seem as fair. One solution here is to subdivide the groups: let the 88 buy insurance from each other, and the 12 buy insurance from each other, without the cross-subsidy. Each time we sub-divide, though, the insurance becomes less useful — I don't have the law of large numbers working for me terribly effectively when there are only 12 of us, since the whole point of buying insurance was not to be exposed to a risk of large loss, and one twelfth of a house is a large loss — and, since any two houses are different, at the very least in location (e.g. distance from fire stations), this creates a problem in which someone has to decide which houses are similar enough that it is better to throw them in the same pool, and which differences are sufficiently salient that they should be in different pools, even at the cost of a higher variance of outcomes for the policyholders.*

The idea that popped into my head is essentially that we let groups decide on their own which groups to join. Obviously simply saying, "Here are two pools: the safe pool, and the risky pool. Which do you want to join?" isn't going to work — the safe people need to be able to exclude the risky people in some fashion. One idea is to cap the number of people in each group, and let members of oversubscribed groups vote on which of the other (attempted) subscribers to keep; this gets close to the self-underwriting flavor that I was looking for when I thought about it. The same sort of arrangement could apply to health insurance, or even to mortgage lending (in something like a credit union), though that introduces other complications.

The details of the voting would be interesting, though; does everyone in the pool list their favorite 99 co-poolers and the top 100 get to be in the pool? Or perhaps everyone gets to vote for as many as they like, and the top 100 are in. Or maybe rank applicants in order, and give a certain number of points for first-place votes, etc. Or perhaps we should do something recursive; what if the group of the top 100 applicants, as measured by the votes of all applicants, differs from the group of the top 100 applicants as those 100 applicants themselves vote (i.e. excluding the votes of the rejected applicants). What we'd really like is some sort of stable outcome in which everyone is in a group, and nobody would prefer to be in a different group that would be eager to swap that person in for some other current member of the group. Can we get that?

Well, the answer turns out to be "no". Imagine 4 people: Alice, Bob, Carol, and Doug. They are to be divided into two groups of two people. Alice prefers to be with Bob, Bob with Carol, Carol with Alice; Doug is the last choice of all three of them. Now consider a prospective grouping; the person who is grouped with Doug is the first choice of one of the other two, and can go to them and say, "hey, let me join your group." No matter how the four people are divided into groups, there is always someone from each group who would rather be with each other than with their current group; every possible grouping is, in this sense, unstable.

For large numbers of people, with large groups, and with highly correlated preferences — that is to say, if people largely agree on who are the safest risks — then the probability of this being a problem in actual practice get very small very quickly. You could probably use just about any system you want to get groups down to 105, let them whittle it down to 100, and you would almost always have a stable alignment. This theoretical curiosity, then, isn't the biggest problem with the idea, though it is, I think, one of the more interesting.

The bigger practical problem is that it requires, at least in its most naive formulations, that everyone have an opinion about everyone else's level of riskiness, and an easy means of conveying it. I can imagine ways of getting around it, but on some level underwriting is a service provided by the insurance companies, who are presumably more or less expert at it; I would rather let Geico figure out which of my neighbors are the better risks, and allow me to put my efforts toward blogging about interesting but largely impractical ideas.

* In practice, I imagine everyone is thrown in the same pool with some policyholders asked to pay e.g. 1.5 times as much as others; that clearly still leaves an underwriting problem, and leads less naturally to the idea I'm trying to present.

preserving corporate liquidity in a crisis

2011-03-18T16:06:00.004-04:00

Update: Apparently something like this has existed for asset-backed loans.

Buffett's letter got me thinking a bit more about liquidity and solvency, and I've slightly-more-baked an idea I had two years ago, in particular to the point where it now contains a policy prescription.

In another post here I mentioned maturity transformation, noting reasons corporations are induced to borrow short-term for long-term needs. The problem is that, if you need to roll over loans every day or two, a market event can put you in default even if you're unambiguously solvent. There's a level on which the obvious response to this is "don't do that", but it seems that the genuine benefit of being able to borrow short for some of your long-term money is of large value, and that the social cost of a large, solvent company having a lot of short-maturity debt in a financial crisis is a great deal less than the official penalty, which is bankruptcy. Aside from this is the time-consistency problem; I would prefer a set of rules that our regulators would be more willing to actually stick with in a crisis, rather than leaving harsh enough ex post consequences that they lack their intended ex ante effect.

At the same time, my leanings are still libertarian, and I prefer that privately negotiated contracts be taken seriously. I also prefer fairly incremental changes to formal rules. At the moment, the regulations relating to publicly traded debt securities are easier for instruments with maturities of no more than 270 days; I'm proposing that this include instruments with maturities of up to 450 days, provided that such instruments

are callable within 270 days, and
have a yield from the call date to the maturity date that is substantially — say 12 percentage points per year — above the yield to call.

The idea is to allow firms to write into their bonds that, in the event of extreme crisis, these private bond-holders, rather than the public, would be essentially providing emergency funding to the company, but under penalty terms of such a nature that the company will seek to avoid abusing this flexibility, or using it when it is not under simultaneous pressure to borrow at longer durations elsewhere.

If this really operates as intended, it may benefit money-market fund holders who own (beneficially) these bonds; if the company is solvent, this is results ultimately in some extra yield, and even for those who are seeking to cash out (perhaps because their own need for liquidity has risen at the same time as everyone else's), the values of the bonds are likely not to fall very much, and may even rise — as I envision it, the primary effect of this sort of clause is to solve a coordination problem, in which all lenders are profitable as long as the firm doesn't need to borrow money it can't borrow in the short term, but in which the last ones out lose if it becomes a race to the exit. The firm, facing a suddenly high cost of funds, would be induced to issue a 3 or 5 year bond a month or two later, whenever it can do so at interest rates even a couple of points above what it might hope to pay by waiting longer, because of the penalty rate on the commercial paper, which it would rather retire as soon as it can.

This may have an adverse effect on the credit profile of these instruments. If a firm is in actual trouble — its flagship product turns out to kill its users or something — it seems that the holders of these instruments will almost certainly lose money, though it seems likely that in a lot of these situations they would be likely to lose that money anyway.* I expect that, if these instruments started to appear, investors would quickly start to get used to them and would price the credit risk reasonably, rather than simply refusing to buy them at any price.

While it is certainly possible that these sorts of instruments would lead borrowers to skew more of their borrowing toward the short end and, more generally, to take fewer steps than perhaps they do now to take other steps to insure their access to liquidity, it seems likely to me that any systematic mispricing of these instruments is likely to make them less attractive to borrowers than they should be; these would be a cheaper mechanism of dealing with liquidity concerns only when they truly do less overall harm than other options available to borrowers. They create a new tool, ultimately, for doing maturity transformation, and solving some market failures associated with that at the present time.

* I have mixed feelings about the extent to which I think short versus long duration lenders should have effectively different seniority in a bankruptcy claim — short-duration lenders, in principle, are in a better situation to see problems coming, and in that sense are more at fault than long-duration lenders, but the problems often develop over long periods of time, and long-term lenders might be in a better position, through the imposition of covenants for example, than short-term lenders in imposing discipline to make sure the borrowers don't get into that trouble in the first place.

profits and regulatory regimes

2011-02-26T15:30:00.003-05:00

Warren Buffett's annual letter to the shareholders of Berkshire Hathaway is out, and includes the following paragraph, in the discussion of the regulated utilities Berkshire Hathaway owns:

In its electric business, MidAmerican has a comparable record [to those of gas pipelines discussed in the previous paragraph]. Iowa rates have not increased since we purchased our operation there in 1999. During the same period, the other major electric utility in the state has raised prices more than 70% and now has rates far above ours. In certain metropolitan areas in which the two utilities operate side by side, electric bills of our customers run far below those of their neighbors. I am told that comparable houses sell at higher prices in these cities if they are located in our service area.

I presume that the prices charged by regulated utilities with different "service areas" are set by a regulator, likely based on appeals by the utility to raise rates once in a while. "Cost-plus" contracts are not uncommon, even in purely private-market agreements, but they are pretty much ubiquitous in utility regulation, where regulators will set prices to insure some predetermined return to investment on capital by the utility. The reason for its use in both circumstances is that comparatively easy to negotiate, especially if the seller (i.e. the agent initially bearing this cost) is somewhat risk averse.

It also has terrible incentive effects, and, while I think it appeals to some people's sense of fairness, it grates terribly against mine. I have thought that if I were regulating utilities in New York, I would tell them I'm going to tie their prices to the costs of regulated utilities in California, Florida, Montana — not necessarily to say that the cost in New York should be the same as elsewhere in the country (I would allow a multiplicative factor, and perhaps an additive one, rather than simply use the average cost elsewhere), but if the costs go up uniquely in New York, I'm inclined to think the New York utilities are doing something wrong, and if they drop uniquely in New York, I think they're doing something right. So, Con Ed, cut your costs, and you get to keep the bulk of the savings as added profits; if your costs get out of line, don't call me in off the golf course to bail you out of your mess.* This encourages cost reduction, but it also frankly seems fairer to me than the current system where any cost controls are a function of the regulator micromanaging the utility or being reluctant for political reasons to raise prices too quickly.

Even within Iowa, rural areas surely cost more per kilowatt hour to serve than urban areas, and there may be factors between neighborhoods that affect costs, but I wouldn't expect any of these to change by a differential factor of 1.7 over the course of a decade — as Warren Buffett implies, it seems reasonable to infer that at least some, and probably most, of that change is attributable to factors under the control of the respective managements of the two utilities. It would make sense to me for the regulator to raise prices by 3% for MidAmerican, cut them by 7% for the other utility — assuming they're more than 20% different or so in apparently similar neighborhoods — and say to the higher-cost utility, "you figure it out."

Ideally, this is how a competitive market would work. There are reasons to believe that this sort of market can't be made competitive per se, but the textbook ideal of the competitive market gives us an ideal to aspire to when we're forced to step in, even to the point of setting prices for natural monopolies. In the ideal competitive market, a company is given the price at which it can sell its output and the prices at which it can buy its inputs, can enter and leave the market easily, and gets to produce as much as it can produce profitably. If it can't produce anything profitably, it drops out, leaving the market to firms that can; if it can produce profitably, those profits represent exactly the extent to which the firm is better than the "marginal" firm — one that's right on the edge between entering the market or not, or leaving the market or not — at doing what it's doing. This ideal is, of course, not going to be exactly met, especially in the case of regulated utilities (for which free entry and exit isn't going to be anywhere near true), and it would be a good idea at least to figure out how a bankruptcy would be handled if a company is run into the ground, but I think this sort of approach would yield fewer problems than the regulatory system we have now.

* Figuratively. I don't golf.

endogenous depreciation with specific capital

2011-02-02T11:58:00.002-05:00

This is even less developed than most of the thoughts I post here, but I've been thinking recently about models of specific capital — macroeconomic models tend to deal with aggregates, so that a factory that produces cars is the same as a stable of machines that produce houses, provided the factory and the machines cost the same amount, and Hayek in particular complained about the importance of limitations on repurposing of capital. This came into my head a couple of weeks ago when my macro professor noted that downturns in the economy tend to be short and sharp, with expansions longer and more gentle, and I noted to myself that specific capital with shocks to demand would produce this pattern. What occurred to me yesterday was that, if different forms of capital have different rates of depreciation, then the aggregate depreciation rate would tend to increase with uncertainty in future demand, i.e. that if you're buying/producing a capital good when you're not sure what demand will look like in 20 years, capital that will depreciate in 20 years looks more attractive compared to capital that will depreciate in 50 years than if there isn't that uncertainty.

margins and gerrymanders

2011-01-03T12:36:00.002-05:00

One of the fundamental principles of microeconomics that professors attempt to impart to introductory economics students is that what is most often economically relevant is what is taking place on the "margin" — what responds to small changes. For example, if the supply of milk goes down, people who will never buy milk, or will buy exactly half a gallon a week regardless of the price, aren't relevant to the analysis of how much the price will change; what matters is the "marginal consumer", the person who might decrease milk consumption if price goes above some relevant level.

Another tradition of economists is to apply economics to subjects that often aren't considered economic, especially if they are in the social sciences. What I want to discuss here is gerrymandering, but this is an economics blog, so I wrote the first paragraph as an excuse to address that topic.

Consider the task of a state legislature — taken as a unitary agent — that has no interest other than supporting the party of its majority as it draws Congressional districts. (One might hope our elected representatives would be more high-minded; one might expect they would be less high-minded, looking to disproportionately protect incumbents of both parties with the expectation that doing so with Congressional districts will facilitate coordination on doing so with state legislative districts. Abstract away from that.) There are traditionally two different approaches to take: try to put the same number of people from your party in each district, in an attempt to sweep the districts, or create a few districts that lean heavily to the other party, such that your party has a safer majority in a majority of districts. On some level there's a continuum here; how many districts do you give to the other party? In Massachusetts, where all 10 representatives are currently Democrats, the correct answer is surely 0 (for the Democrats). In other states, it might make sense to increase that number; each district conceded will, of course, reduce by 1 the number of districts your party could win, but may increase the number of districts will win.

The correct answer, in general, I think, is that you figure out what portion of the electorate in each precinct would be voting for your party when the House of Representatives as a whole is likely to come out about 218-217. In Massachusetts, where Democrats went 10-0 in a heavily Republican year, no district is likely to be vulnerable under any but the most extreme circumstances; a blindly partisan Democrat drawing Massachusetts's 9 districts for 2012 would see little value in conceding a district to the Republicans to make sure to have 8, instead of 7, votes in a tiny minority if the House moves further toward the Republicans. In most states, if there were no other barriers to arbitrary gerrymandering, it would seem like a similar result would obtain, if less dramatically; if one party has control of the redistricting, it is likely that that is the party that would see the most votes in an election year that was close nationally, in which case it would prefer to spread out its supporters in an attempt, for example, to give all 13 of North Carolina's house seats to the Republicans when the rest of the country is breaking 217-205 for the Democrats.*

In Pennsylvania, where Republicans control redistricting and the state leans slightly more toward Democrats than is the case nationally, it would make sense for (again, single-minded, otherwise-unconstrained) Republicans to create 2 safe Democrat seats so that the other 16 seats would give Republicans close to 10 point margins in a year like 2010, with perhaps 1 to 3 point margins in a year when control of the House was on the line.†

In most states, redistricting is not entirely in the control of one party, and even where it is, there is often an ongoing understanding that incumbents from each party are largely to be protected. Voting patterns shift over the course of ten years, as voters move, die or turn 18, or simply change their habits; people drawing district lines may have a form of loss-aversion, or perhaps simply a fear of embarrassment, that would make them reluctant to draw districts that could easily give the entire congressional delegation to the other party at some point in the next decade. There are also factors other than party that play into voting patterns, incumbency not least among them, that will have an impact on this analysis. In addition, it is at least nice to believe that too aggressive gerrymandering would be punished by voters, though I expect in practice that is much smaller than the other constraints.

* In North Carolina, Republicans control the redistricting process, and while North Carolina voted for Obama in 2008, Republican House candidates got a bit over 54% of the two-party vote in 2010, while the figure for the median house district nationwide was around 53%; similarly, Obama won North Carolina with a narrower margin than any other state. North Carolina's current districts were gerrymandered by Democrats; of North Carolina's current 13 House seats, 5 were won comfortably (a margin of at least 7%) by Republicans, 8 by Democrats. (One seat was within 1%, and was won by the Republican.) North Carolina is, however, subject to the Voting Rights Act, and, taking account of that and other constraints, it is likely that Republicans will draw a few heavily Democrat-voting--racial-minority districts and about 8 secure Republican districts.

† This year Republicans won more votes than Democrats in House races in Pennsylvania, but only by about 1% of the votes cast.

Rational Expectations

2010-12-31T01:48:00.000-05:00

I've recently read in a macroeconomics textbook a comment that the development of rational expectations models was necessary because other expectations models are ad hoc and not well grounded in theory. This is, as a historical matter, largely true of the models that Lucas critiqued 34 years ago; I'm not sure it's necessarily the case of any model that eschews expectations that are fully statistically accurate in the sense that "rational expectations" means to modern economists.*

By way of illustration, I was playing, a month ago, with a rational expectations model rather like the common modern Dynamic Stochastic General Equilibrium models; it linearized to a set of equations equating linear combinations of variables at a time with linear combinations of the agent-expected values of the same variables at the next time. As is the case in modern DSGE models, the coefficients of these linear equations were somewhat complicated functions of underlying parameters. Using rational expectations, agent-expected values were set to statistically-expected values, given the underlying parameters and the distribution of exogenous shocks. The linearized system, with this rational expectations assumption, could be fairly easily solved by finding stable and unstable modes and associating control variables with convergent expressions in expectations for the future, with state variables as convergent expressions in shocks from the past. This is all standard in modern macroeconomics.

Because state variables are expressed as linear combinations of one-period-before state variables plus shocks, however, it is the case in this model that the vector of state variables follows a VAR(1) process. If the state variables are directly observed, it's not remotely "ad hoc" for agents to form expectations based on a VAR(1) regression, especially if the relationship between the coefficients is such that, for any VAR(1) coefficient, there will be a set of underlying parameters that supports that coefficient. More generally, it would seem reasonable to expect that agents would infer the underlying parameters econometrically from past data. It is my understanding — though I am not perfectly clear on this — that rational expectations rejects this.

It may be that this is rejected because, with data going back far enough, agents in a model of this sort would have arbitrarily close estimates for the parameters. In this case, it's reasonable to note that the model, not being perfect or perfectly comprehensive, is, at best, an approximation that works well over finite periods of time, similar to what high-energy physicists would call an "effective-field theory". The underlying parameters may be robust to the Lucas critique, at least within a reasonable domain, and yet not perfectly stationary. It can be useful, even without bounded rationality, to suppose that expectations would be formed over a finite window, or one that weights more recent observations more heavily; with bounded rationality, of course, such an alteration to the model requires no other justification. In any case, asking agents to form expectations in a situation in which they are uncertain about the deep parameters of the model, and infer it only through the observation of macroeconomic variables, reintroduces nonlinearities that are very different from those that were linearized away in the first place, and it seems likely to me they would give behavior that would be interesting, whether or not it actually proved to fit the data better than the rational expectations models.

* I don't want to get sucked into recounting a full history of macroeconomics and macroeconometrics over the last 50 years; I will say that there are nice attributes of the assumption of rational expectations, and, as is so often the case, I tend to feel that its most ardent proponents understate its shortcomings, but its most ardent opponents underappreciate its benefits, and almost always fail both to appreciate its history and to actually understand the somewhat limited scope of what it is used to mean.

maturity transformation and the firm

2010-12-23T14:40:00.001-05:00

One of the primary roles that has traditionally been ascribed to banks is "maturity transformation"; interest rates for long-term loans are higher than those for short-term loans, presumably because (this sort of thing is often the cause of price differences) borrowers are more interested in borrowing for long periods and savers are more interested in lending for short periods. Banks borrow short and lend long, making money on the spread and matching the long-duration borrowers with short-duration savers.

There's a blog post from two months ago newly making the rounds questioning the benefits of maturity transformation, in part arguing that 1) more and more savings are now in the form of retirement planning, and thus are longer-dated, 2) that a lot of borrowing is by companies for working capital — and, he doesn't make this observation, but more investment these days goes into software and electronics, i.e. 3-5 year duration capital, compared to giant factories, i.e. 40 year duration capital, than was the case a generation and two ago — and 3) some of the borrowers are starting to borrow on the short end for the same reason banks traditionally have.

Well, point 3 I would argue is largely a substitution effect in response to prices; he's not so much arguing that there is no mismatch as that the pricing difference it sustains will be a bit more slack. Points 1 and 2 suggest that there should, quantitatively, be less mismatch. This, too, should tend to show up in yield curves, and, while it's hard to separate the noise from the signal, it's not clear that this is true either. It's hard to see his story in the macro data, and it's hard for me to imagine there's anything worth doing about it whether it is or not. (Not that there's anything wrong with that; a lot of interesting ideas are worthwhile even if they don't have immediate practical impact.) Ultimately he concedes — that this is a concession, too, is not his observation — that

the most significant proportion of the difference between long-end and short-end rates comes from the interest rate differential which most banks hedge out to a large degree (ironically with pension funds and insurers).

Which is to say, it is not ultimately so much banks that are doing the maturity transformation but "to a large degree" "with pension funds and insurers"; the long-term savers are finding the long-term borrowers, with banks as intermediaries.

It struck me, on reading this, that one obvious way in which savers, "who generally have a preference to be able to access their funds quickly," can lend long while maintaining this is negotiability of the loans, i.e. that a liquid market for corporate bonds essentially allows the corporate borrower to lock-in a rate while the lender, while not shielded from all risks, is at least able to sell the bonds for cash fairly quickly; as long as the need for cash is idiosyncratic, the lender is reasonably likely to get back about the amount lent (saved) with some accrued interest to boot. For a bank to lend instead of the ultimate saver amounts to the mediation of what might otherwise be a market transaction taken into a firm.

This brings us to Ronald Coase, who will be celebrating his 100th birthday next week. What determines whether activity is undertaken within a organized economic entity or between entities is a function of the relative costs of transactions versus management; if finding buyers for your bonds (or a bond issuer for your spare cash) is more expensive than managing a bank, then people can be expected to save at and borrow from the bank, while if it's relatively cheap to work through the bond market, that's what we should expect to happen. As it happens, much of the relevant "transaction cost" here is likely to be informational, related to credit risks — which is perhaps why that is one of the risks that is apparently, in practice, borne by the banks. It also seems like the bank-management cost is more likely to scale with the size of the borrower than is the case with a bond placement — a big borrower will be well-known, easier for lenders to appraise — and suggests that bank lending should predominate to small businesses and individuals, with more big companies borrowing more from decentralized financial markets — which, again, seems to be what we see.

the value of money

2010-11-09T13:38:00.000-05:00

I wonder whether there has been an attempt to estimate empirically the NPV of the liquidity value of a dollar in cash.

search theory and adverse supply

2010-11-09T13:33:00.000-05:00

I heard a hardware store owner on the radio saying that, the high unemployment rate notwithstanding, he's having trouble finding candidates who have the skills he needs -- knowing their way around tools, paint, etc., to be able to help customers. It seems superficially plausible that an increase in the number of people looking for jobs would adversely impact an employer if it induces applicants to look for jobs for which they are less well suited, imposing higher information costs on an employer.

money and bounded rationality

2010-09-17T13:57:00.001-04:00

The three functions of money, in freshman economics, are as a store of value, a unit of account, and, last but most, a medium of exchange. Writers occasionally construct examples of something serving one purpose but not another, but by and large crippling any of these functions will to some extent cripple all of them. This is especially true in the case of storing value. If a prospective currency can't store value, then users have to use it in a hurry, and the buying and selling process that a medium of exchange is supposed to allow to be separate are forced to be more temporally proximate; in the extreme, if you have to spend your money within minutes of getting it, you're largely stuck looking for someone who wants to buy what you want to sell and vice versa, and you're effectively back to a barter economy. Similarly, it becomes less useful as a unit of account if its value can't be counted on.

Money as a store of value is also a great technology for savings. A (closed) economy as a whole can "save" only by investing resources in capital — physical capital, intellectual capital (technology), human capital (education) — but an individual can "save" by lending to others who wish to borrow, and in a large economy with a well-run central bank and so on, this typically works better.* If I have a good year, and expect less year will be worse, I can simply pile up cash; if I get paid a lump sum for a contract job, I can spread my spending over the time until my next job. If I want to make a big purchase, I don't have to make a big sale at the same time; I can save up ahead of time — or afterward, by borrowing at the time of purchase and then paying back the loan. The ability to choose between spending today or tomorrow is as valuable as the ability to choose between apples and grapefruit.

It's often noted, and, especially recently, quite notable, that people who are bad at saving money often lose much of this ability. If you don't have the self-control to let hundreds of dollars go unspent for a few weeks, you can't trade spending now for spending later. (If you buy durable goods, you can stretch some of your consumption into the future, but not quite as effectively.) The money, in this case, doesn't provide an effective store of value. This also, as I noted in the first paragraph, will affect its ability even to function as a medium of exchange.

I recently read an example of this; unfortunately, I don't now remember it. It was something along the lines, though, of a person who had trouble saving, and was engaging in a certain amount of barter (and running into the attendant double-coincidence-of-wants problems) due to an inability to build up even enough "working cash" to engage in what I think of as normal quotidian economic activity. If I remember or otherwise reacquire the example, I'll probably update this post.

* It occurs to me I've taken for granted that holding onto currency is the equivalent of lending to the central bank (or "bank of issue", if we still had non-central banks of issue), and that keeping money in a bank account is making a loan to that bank. If that's not obvious, take my word for it.

search theory and prostitution

2010-09-14T13:45:00.000-04:00

There's a subfield of macroeconomics dealing with "search theory", though aside from the mathematics (which resembles macroeconomics) it's an issue that's closer in nature to microeconomics. Most macro models seem largely to ignore it, at least as a direct matter; there may be sticky prices or market power layered onto a model that might come from search issues but is typically simply taken as exogenous. There's a certain amount of demand, a certain productive capacity, and the people who want to buy stuff buy stuff from the people who want to sell stuff.

For a lot of goods, that's not an especially good description (though, to be fair, how good a description it is depends on exactly what you care about, and for a lot of macroeconomic treatments it may be adequate). One of the primary roles of advertising, and one of the benefits of being a large (and long-lived) firm, is in the ability of people who want to buy what you're selling to find you. If you open a new business selling erasers, and somebody needs to buy an eraser in your first month in business, there's a good chance they don't know about you. If they've walked by your store a few times a week for the past several years, seen your ads on the subway, and maybe bought an eraser or two from your shop in the past, when they need an eraser, they know where they can get one. Being the answer to the question, "Hey, do you know where I can get an eraser?" is enormously valuable capital.

For illicit markets, it's that much harder; you want people looking to buy to be able to find you, but you don't want the police to. This can be handled in a few different ways. One is ambiguity; you generate a signal that is understood, but perhaps is not explicit enough to be grounds for arrest, or, ideally, even especially heavy levels of suspicion. Word of mouth, where your position in the market is known disproportionately to people whom you have reason to trust, also helps, as do repeat business relationships.

A new paper by Steven Levitt and Sudhir Venkatesh, which apparently I'm not supposed to cite, but let's hope this is okay, discusses the market for prostitution in Chicago.

Even for a given sex act, however, the prices paid by black customers are systematically lower than for other customers. These differences appear to be attributable to price discrimination on the part of the prostitutes.

In a perfectly competitive market, "price discrimination" is unsustainable; if you try to charge less than the going rate to some customers and more than the going rate to others, you only get the customers whom you're charging less. There are a fair number of pimps and prostitutes in the given neighborhoods, and while it's possible they engage in collusion (tacit or explicit, concious or not), this seems likely to be evidence of the search problem; if you charge a white customer more, it's not that easy for him to go find another seller who will charge him the lower rate, so your only real competition is with his going without.

There have been some arrests of Indian actresses for prostitution, in part, it seems, because being an actress is one of these ambiguous signals:

Because of the sexualized roles they play, and the fact that many are in scandalous "live-in relationships"— meaning they move in with boyfriends before marriage—the blanket assumption is that all actresses are available for a price. This is obviously false, but it's an illusion that has been exploited by savvy pimps who have created a market for B-list and C-list "starlets"—often unsuccessful actresses from questionable backgrounds—for men who want to have what's sold as a glamorous sexual experience.

Being an actress is not per se actionable by the police, but it might help someone looking for prostitution to find you.

How information of this nature makes it through an economy is of particular interest to me, and is one of the things I can imagine myself studying over the next five years.

math -- adjoints and preimages

2010-08-31T13:45:00.000-04:00

This post is in large part me trying to remember math from 15 years ago that might be useful to me.

If I have sets V and W, I can define duals V* and W* as function spaces, V*={v|v:V→R}, i.e. the spaces of functions from the space into (in this case) R. Given a function f:V→W, then given w*∈W*, we can define v*∈V*: ∀ v∈V, v*(v)=w*(f(v)). Thus f implies a map f*:W*→V*, the adjoint of f.

In the case in which V and W have extra structure, I usually define my dual to be a restricted set of the duals defined above; in particular, if V and W are vector spaces, I can define V* and W* to include only linear maps. Then any linear map from V to W implies a linear adjoint from W* to V*. There exist isomorphisms between V and V*; choosing such an isomorphism is equivalent to choosing something of an inner product, ⟨v₁,v₂⟩=v₁*(v₂), though one would typically want to restrict the choice of isomorphism such that this is symmetric. Defined this way, V** is (canonically isomorphic to) V, at least for finite dimensions.

I also don't need to use R; in particular (and the main point of this post), if I use instead the set {0,1} then V* is (canonically isomorphic to) the set of subsets of V (the relevant subset being the set of elements such that v*(v)=1), and the adjoint f*:W*→V* takes sets in W to their preimages (under f).

credit risk on treasury securities

2010-06-21T11:11:00.000-04:00

I've heard for 20 years that US debt carries no credit risk because the government can just print dollars if it ever gets into trouble. This, on a large scale, would be expected to create massive inflation, reducing the real value of debt denominated in nominal dollars in addition to the direct effect of using printed dollars to pay whatever debt is coming due. The whole set of phenomena goes under the term "monetizing the national debt", and its possibility is part of the reason Treasury securities are considered "risk-free".

Of course, if you're owed $1 and are being repaid with $1 that buys what you expected 10¢ to buy you, you might well object to the notion that you faced no "risk". Indeed, you're in the same practical situation as if the Treasury had defaulted and declared that it would only pay 10¢ on the dollar to holders of its debt. In a technical sense the former is not "default", while the latter is, and the former possibility is not subsumed under the concept of "credit risk", while the latter is. (It's worth noting that, in the former event, dollar-denominated bonds issued by, e.g., GE would be paying 10¢ on the dollar in purchasing value as well, even with no complicity from GE; this is a logical reason to keep the concepts separate.)

Massive inflation would wreak a great deal of havoc on the economy, of course; the textbook purposes of "money" are to serve as a medium of exchange, a unit of account, and a store of value, but once its value becomes unreliable it becomes less useful as a unit of account and even its ability to serve as a medium of exchange is crippled, as people become more and more reluctant to hold it and tend to buy things less because they want them and more because they're available when one finds oneself in possession of cash. Hyperinflationary environments see a move toward barter, with the "double coincidence of wants" problem that money is supposed to solve, and make intermediation between savings and investment much more difficult, screwing up capital allocation.

Technical default, of course, would scare off future lenders, but so would inflationary "default"; indeed, if it affects lenders (and potential lenders' expectations of their subsequent treatment) in exactly the same way, it should scare them off to exactly the same extent, at least to first order. At higher orders, the fact that inflation destroys the tax base in ways that default does not — and this tax base underlies any value that lenders can actually be paid back — suggests that lenders should be more averse to the inflationary scenario than the default scenario.

If I were at the Treasury, and were abruptly confronted with the choice of monetizing a large chunk of debt or defaulting on it, I would prefer to default. If we're locking the government out of the capital markets, we might as well not take the whole economy down, too. If bond markets were rational, they would respond to this news by lowering (slightly) the interest rate the the government pays on its debts. I'm not entirely sure, though, that they are.

Malthusian traps -- jobs

2010-05-17T11:23:00.000-04:00

Jobs are in a Malthusian trap. Well, not so much right now, but over the long-term,

if you want to predict how many jobs the economy will create in the next two decades, I'd steer you to a demographic model. How many more people will want to be in the work force in 20 years than there are now? That's about how many jobs will be created.

Jobs, then, are constrained by the scarce resource of workers.

Most creatures in world history are and have been in Malthusian traps, with occasional exceptions. Immediately after a mass die-out, there will be fewer limitations on growth, supposing that an animal's food supply is returning more explosively than the animal is. Similarly, there has been a mass die-off of jobs in the past couple years, and so from a short-term perspective it might be reasonable to regard jobs as being free to grow as quickly as they can ... reproduce. Well, I'm not sure how useful the analogy really was, anyway.

Tiebout sorting and the rights of transients

2010-05-13T22:26:00.000-04:00

My brother, an MIT graduate, ran for the city council of Cambridge, MA, among other things criticizing a comment by another candidate that the local college students shouldn't vote because they were only there for a short period of time. On some level this felt fallacious to me, insofar as the college students represent a particular set of interests; if there are 20,000 students at any given time, the 20,000 students who are there might be expected to represent the 20,000 students who will be there in 10 years, and the short time that any one student is there is (exactly) balanced by the large number of different students rotating through.

On the other hand, increasingly as government gets more local, I can think of a compelling case for restricting the franchise to people who have been there a while. In particular, I think we should do so where Tiebout sorting might be expected to operate well — where people have reasonable choice among and information about different communities in which to live — and where the near term is to be traded against the long term in a significant way. Where there are decisions to be made with long-term ramifications — should we raise taxes to build more classroom space? — allowing people to move in, vote for the short-term expedient, and move out before the long-term (relative) cost of that decision is to be borne results in all communities emphasizing the short-term expedients, while requiring that people live in a place for a few years before they vote — or perhaps buy property, or otherwise commit themselves to the community — allows for real sustainable differences in priority (some people want lower taxes and less spending on education, even including the long term ramifications, while others want more) where people with different preferences can sort themselves as Tiebout described.

MIT students have a certain amount of flexibility to live in Boston or Somerville, even if we don't consider choosing a different school to be a real choice; on the other hand, MIT institutionally has much less such flexibility, and the students, faculty, and so on will be affected by the city's policies. It would be good to have that represented somehow, but on many issues, I can see the value to excluding the transients from the decision.

my bizarre market ideas

2010-05-12T13:00:00.001-04:00

Teacher evaluations in New York will finally be allowed to be based partially on results, which is a step in a positive direction, if not without any possible flaws. One fear I've heard expressed is that grading teachers based on student performance will make teachers all the more averse to taking on difficult students, and I certainly think that students' incoming performance should be taken into account as well. If it isn't, using exit test scores becomes more arbitrary than if it is, and if teachers can maneuver to select their students, that obviously creates an incentive problem. One of the ideas I've had floating in my head is not to directly take account of students' previous performance, and also to allow teachers (or schools) to select their students, but to do so by bidding on them. Each teacher/school sets, for each prospective student, a standard for success, above which the teacher/school is rewarded in some sense and below which the teacher/school is punished in some sense, and the student goes to the teacher/school willing to bid the highest level of performance for that student.

I could actually defend this against some of the first objections that occur to me, and I'm not averse to doing so, but one of the points of this particular blog is an emphasis on brainstorming, and I have other things I want to do with my time right now.

Election Reform in the UK

2010-05-11T13:09:00.000-04:00

One of the chief planks in the platform of the Liberal Democrats in the UK is a meta-plank, taking a position not on an issue directly but on the political process by which people who decide such things are selected. The Liberal Democrats have a middling amount of support spread widely over the UK, and routinely win fewer than 10% of seats available, while their candidates in aggregate get closer to 25% of the votes cast. They would like to, in effect, be able to take some of the votes that one of their candidates gets and shift them to other of their candidates, so as to elect more members of parliament.

Their prefered method of doing so is one of my favorite methods as well, Single Transferable Vote. Imagine that you group 10 districts together into one district that elects 10 people, subject to the rule that each voter gets one vote. Any candidate that gets at least 9.1% of the vote is guaranteed to win one of the positions. On a first pass, candidates might split the vote; perhaps two very similar candidates each get about 5% of the vote. If one the one with fewer votes drops out, leaving those voters to go to their second choice, they're likely to push the other candidate to 10%. Similarly, if one candidate gets 20% of the vote, some of those voters might be swayed to move to another, similar candidate, such that these 20% can elect 2 members of parliament instead of just one. Single Transferable Vote is a way of doing much of the necessary strategy automatically.

Instant Runoff Voting, which the Liberal Democrats call Alternative Vote, is the same process for a single member district. In this case, though, it simplifies to a process that many people find easier to understand: voters turn in ballots listing their top choice, their second choice, and so on; if no candidate has a majority of first-choice ballots, the candidate receiving the fewest votes is dropped from the race, and votes for that candidate are redistributed to the highest remaining choice, until a single candidate gets a majority. The Liberal Democrats have offered, as their second choice, that (for example) 10 districts would choose 15 members of parliament, with 10 elected using IRV in each district, and another 5 awarded to parties that received fewer members of parliament from those 10 districts than the proportion of their vote; if 3 parties each get 1/3 of the vote in those 10 districts taken as a whole, and two of them elect 4 members each in the district elections while the other only elects 2, then that last party gets to name another 3 members to parliament, and the other two each name 1 more. The exact numbers can be changed around, but this is roughly the way members of the Scottish National Parliament are elected. I dislike it because I think it gives parties too much power, but the UK is pretty far gone in that direction anyway.

For a single member district, IRV is worse in a number of ways than Condorcet's method and its variants. A "Condorcet winner" is a candidate who would get more votes than each opponent in a two-race against any of the other candidates on the ballot. If approximately 2/5 of the voters list their preferences as A, B, then C -- where A, B, and C are candidates -- and approximately 2/5 list C, B, then A, while 1/5 list B, A, C, then A will win an IRV election, while B would beat candidate A (with 60% of the vote) if C dropped out, or if C's voters ranked B first on their ballots in spite of their true preferences. If one of the objections to the current system is that people are given a single vote and often find it in their interest to vote for someone who is not their first choice, then IRV doesn't fully solve that problem. As might be clear from the example, Condorcet's method tends to pick compromise candidates; it also fully solves the "vote splitting" problem, in that if there is a Condorcet winner with a lot of candidates running, then if some of the candidates drop out that can't affect the winner of the race. IRV, like the first-past-the-post system, is prone to drop candidates because other candidates are like them. Still, I think IRV would be an improvement over FPTP.

core inflation

2010-05-11T11:22:00.001-04:00

It seems to me that one potential problem with using "inflation excluding food and energy" as a measure of core inflation is that food and energy both have particularly low income elasticities of demand. The core inflation measured may be more pro-cyclical than overall inflation. Perhaps it's not a big enough effect to be a concern; it should also be noted that any effect that is primarily linear with the overall level of inflation, as this may be, would simply suggest a different calibration by economic agents for the use of the information, and wouldn't actually change the informational content of the data.

rent-seeking cycles

2010-04-25T21:14:00.001-04:00

I wonder to what extent loss-aversion causes wars and other conflict. In times of growth, there seems to be relatively less in the way of attempts at rent-seeking, but when things grow scarce — not in any uniform absolute sense, but compared to where they were before — the rent-seeking picks up. For any given agent, it seems to me that whether rent-seeking is optimal is likely to be independent of whether the resources available from productive activity are growing or shrinking, at least supposing the rents to be sought are likely to be growing or shrinking at the same time.

It could be heterogeneity; perhaps the people whose fortunes are suffering the most are the ones doing the rent-seeking. Given that and incomplete information, perhaps people take the growth or recession of their own fortunes over periods of time as informative of their relative position; if everyone's fortunes become dimmer, but everyone only knows that their own fortunes are dimmer, they try to plunder their neighbors' fortunes, not knowing that they, too, have been shrinking.

The Nature of the Firm

2010-04-17T14:46:00.000-04:00

I've been reading my Coase lately.

Agency costs are sometimes raised as a limit to the size of a firm; as a firm gets larger, agency costs get worse, and for small firms agency costs are tolerated to realize the benefits of lower transaction costs of other natures. I wonder, though, to what extent agency costs could be a reason for a firm, rather than a net cost.

Suppose I'm producing a finished product from an intermediate created by someone else. I'm bad at determining the quality of the intermediate good; if the finished product is shoddy, I don't know whether I screwed up or whether he did. Someone else, though, is pretty good at motivating the other guy, in one way or another, to produce higher quality intermediates. By joining his firm, I'm outsourcing to him the job of handling the agency costs I face in the vertically separated market structure.

Insurance companies that deal with companies often actively help the companies reduce their risks; rather than pay $50,000 to the insurance company for insurance, the firm pays $40,000 and gives the insurance company the authority to inspect the premises, upgrade the sprinklers, and improve the security system. It doesn't make sense for each company to separately involve itself in becoming expert in loss mitigation of this nature, so they outsource it to a firm that is happens to have a great deal of financial interest in loss mitigation both for this company and for others like it. Any company will have to deal with agency costs, though, and it similarly makes sense for people whose expertise lies elsewhere to allow a firm to deal with their agency costs for them.

institutions and folk theorems

2010-04-13T12:47:00.000-04:00

I think a lot of institutions are responses to the folk theorem; a repeated game admits a large number of possible equilibria, for various senses of the term "equilibrium", and institutions are a way to coordinate on one of them.

teaching

2010-02-11T14:13:00.000-05:00

If I'm ever teaching introductory economics, I think I might get all of my exams from the internet. I'll print excerpts of blog posts, news articles, and the like, and ask the student to itemize the flaws in the economic reasoning.

10-Q

2010-01-20T14:47:00.000-05:00

The SEC should outlaw quarterly filings, on the grounds that they drive too much of a short-term mindset.

TTL cash

2010-01-15T11:46:00.001-05:00

There has been some recent move toward creating a bankruptcy chapter better constructed to handle financial institutions; Luigi Zingales was talking about such things in October of 2008 (search for "Bebchuk" — note that his proposal makes legacy counterparties senior to bondholders, who are nominally pari passu), but there now seems to finally be an interest in this in Congress. One idea I've been batting around in my head for perhaps a year now, at least as a tool to help with these things, is the creation of a new kind of credit that the government could issue, which I call TTL cash; I know I've shared it with my brother, but I don't think I've mentioned it here.

The idea is that when a highly-connected company (AIG) gets into trouble, the government lets it go bankrupt, but any creditor who is thereby impaired is given $1 in TTL cash for every dollar the creditor lost to the bankruptcy. The TTL cash is essentially nontransferable (and thus useless) except in bankruptcy, where, in the idea's simplest form, the government redeems it for actual money. The government has not bailed out AIG, or its creditors, but it has bailed out the creditors of AIG's creditors, insofar as they are impaired by AIG's failure; the chain reaction that regulators are eager to avoid is arrested.

The slightly more general case would allow different levels of TTL cash, each of which is redeemed for the next one down; the government could decide instead to bail out the creditors of the creditors of the creditors by issuing level 2 TTL cash, redeemable in bankruptcy for level 1 TTL cash, redeemable in bankruptcy for the real thing. "TTL" stands for "time-to-live", a term used in IP, the internet protocol; each time a router forwards an IP packet to another router it decrements a TTL counter, so that if some routing error causes the packet to wander off in the wrong direction or go around in circles, it eventually gets dropped rather than continuing to be passed around.

This is, of course, still a bailout, but on a practical level the moral hazard issues are much reduced from a standard bailout; everyone is responsible for assessing the credit quality of their debtors, at least to a significant extent. One of the major practical strengths of a decentralized economy vis-à-vis a centralized one is that it recognizes the information-handling limits of agents and asks them largely to make decisions based only on local information. If you lend entities money, or even just enter into contracts with them, you have to know something about their financial condition and their other dealings that affect it; if you have to know everything about their business, including everything about their potential creditors; capping this two levels down under certain circumstances seems to me a reasonable moral hazard price to pay for the benefits of a distributed system.

clever people

2009-09-30T13:45:00.000-04:00

Robert Shiller has long been a fan of increasing the "completeness" of markets, creating more and more derivatives to require that "the market" be explicit about its beliefs; for example, in his 2000 book Irrational Exuberance, he proposed long-dated S&P dividend futures so as to require a market forecast of future dividends and their growth, after which one could see whether anyone really bought the implications of the levels of stock prices. In principle, there are all kinds of problems of both self-delusion and private information that could be solved by more and more derivatives.

Of course, in the last few years it has become clear that relatively simple derivatives, like MBS tranches (or even credit default swaps), seem to have befuddled people well smarter than the median. It's not that a large number of people who do understand the derivatives is necessarily needed for them to have their benign effect — up to some solvency limits, some people out there can arbitrage really bad mispricings and should keep things grossly in-line. The problem, though, is the amount of damage people seem to be able to do to themselves and then, transitively, to their creditors, or to people whose reputation may be tied up with theirs, that is on some level independent of the good these things do. Mortgage credit derivatives did create a market price for mortgage credit risk, and even did help spread and diversify it, and yet some people got themselves into a lot of trouble taking on too much risk that they didn't understand, and a lot of other people got in trouble.

It's possible the mispriced supersenior mortgage tranches would have been better priced with even more complete markets, but we will never have complete markets (and we wouldn't have the solvency to correct them if we did). I'm a fan of more complete markets in general, but expecting them to solve all of our problems strikes me a bit like some leftist beliefs in government; the problem, we're told, is that our problems haven't been dealt with by sufficiently clever people, and yet neither the government nor the financial markets are populated entirely, or even mostly, by particularly clever people. Mankind is not perfectable, whether by government or by market.

monopolies and consumer surplus

2009-09-29T10:55:00.000-04:00

In a competitive market, each firm faces an inelastic demand curve; this means that the consumer surplus due to the existence of this firm is zero, so that having profitable firms stay in business and unprofitable ones exit passes a social cost-benefit analysis; the marginal benefit and cost of the firm's being in business are internalized to the firm. In a situation in which the firm has some monopoly power, however, the firm creates consumer surplus; from a social cost-benefit perspective, any profitable company produces net benefits, but so too may a somewhat unprofitable company, insofar as the consumers have fewer good places to turn if the company goes out of business.

Gerrymandering and equal-population districts

2009-09-29T10:15:00.000-04:00

On constraining gerrymanderers with convexity requirements (pdf):

a gerrymanderer can always create equal sized convex constituencies that translate a margin of k voters into a margin of at least k constituency wins. Thus even with a small margin a majority party can win all constituencies. Moreover there always exists some population distribution such that all divisions into equal sized convex constituencies translate a margin of k voters into a margin of exactly k constituencies. Thus a convexity constraint can sometimes prevent a gerrymanderer from generating any wins for a minority party.

The current congressional districts in Iowa are a bit wrapped around each other; an initial districting proposal with more "compact" districts was replaced with this one, which had more nearly equal numbers of voters in each district as of the 2000 census. (The numbers in the initial plan were themselves so close that there's simply no way that 10 years of population movements wouldn't expand the variance by a large factor.) As long as we have single-member districts, and political minorities are going to be stuck with a single representative chosen by others in their district, it seems proper to me to favor a bit of homogeneity in each district, and "compactness" may function as a proxy for that. (The "population distribution such that all divisions into equal sized convex constituencies translate a margin of k voters into a margin of exactly k constituencies" is a theoretical curiosity, and is not likely in the world of geographical homophily in which we actually live.)

The absolute equality of district size is something of a misguided fetish. If you drew congressional districts largely at random with only a vague interest in keeping populations within about 50% of each other, I expect that congressional elections would play out similarly to districts that were more punctiliously equalized; if the former were able to be drawn with more homogeneity than the latter, they would leave most people better represented by "their" representative. In actual practice, of course, you would have Democrats drawing more populous Republican districts and vice versa; I think the best argument for keeping Congressional districts approximately the same size is that it places a constraint on gerrymandering. In addition to the homogeneity motive, "compactness" has the virtue of creating an — in some sense random — additional constraint on people who are likely, left to their own devices, to be worse than random. While this paper shows that convexity and equal populations aren't themselves sufficient constraints, I'm still tempted by the intuition that something like convexity, combined with other constraints — probably related to other political lines — would have a salutary effect on protecting us from a self-propagating political class. (That intuition wouldn't have expected the results of this paper, though. If I were precise in my statement, I could well be proved wrong.)

smoothing data

2009-07-25T18:47:00.000-04:00

One of the more interesting developments this summer in my own set of intellectual tics is that I've become increasingly enthusiastic about using atheoretic time series models as smoothing functions. If I want the "smoothed" value for a function at a particular time, I use the atheoretic model to predict its value a few periods out, and I use that predicted value as the smoothed value; particularly if I'm using a model that will always predict a constant value for the series once it's taken more than a couple periods out — e.g. an ARIMA(0,1,n) model will give the same prediction for n periods from now as for n+1, n+2, etc. — then any change in the "long-run" value represents "innovation", i.e. a surprise; a large rise in unemployment claims that results in very little change in the prediction is mostly not new economic news, but simply an expression of the short-term dynamics that were anticipated from previous data points. A model that does a good job of capturing these short-term dynamics should therefore result in predictions that change much less than the series itself does, and so provides a smoother series than the input.

For longer-term periods of time, there's probably some philosophical value to separating the short-term smoothed data to a prediction of where the data will be later; in particular, a model that did a very good job of predicting the data five years out would not be suitable for "smoothing" if I'm hoping to use the smoothed data to observe the business cycle. Measurement errors aside, each time scale will have fluctuations that are to be viewed as material and shorter-term "noise"; the real purpose of smoothing functions is to eliminate the noise, preserving as much of the "signal" as possible. As long as my projections only go a few periods out, I imagine that's what I'm doing; again, changes in my projection represent changes in inferred "signal", while fully anticipated changes in the data series are identified as being due to noise.

I have, in the past, looked at smoothing functions that require future data points to construct today's value; for example, if I look at data from 2008 and I wish to smooth stock-market prices, my smoothed function might start decreasing substantially in August or September because of the lower values it needs to achieve to match the data in November. If the point is to look at data as it comes in and identify trends early, though, that doesn't work so well; hence my preference for looking at purely backward-looking measures, even when I have forward data sets available to me. There are good economic contexts in which it makes sense to use all available data to try to extract noise from signal and seek dynamics that may not have been ascertainable in real-time; in those situations, atheoretic ARIMA models are probably not your best choice.

liquidity

2009-04-08T11:47:00.000-04:00

In an economy with a single medium of exchange, "liquidity" of anything else represents the ability to convert that else into that medium. If I have two assets, one with a 5% bid-offer spread but very stable, the other more tightly bid but very likely to drop well over 5% before I'm looking to convert the asset to something else, it seems to me the former better serves any needs that tend to get lumped under the term "liquidity". This is how I model it mentally, is as a softish lower bound on the price for which I could sell it if the value of money to me (and its associated discount rate — i.e. where selling today might be better than selling at 1% more tomorrow) were to spike.

Stock price volatility tends to increase as stock prices drop, and this is usually couched in terms that suggest the latter causes the former, but it kind of makes more sense that it would run the other way: part of the value of stock is its "liquidity", i.e. one's ability to convert it, at little notice, into cash should that be necessary. When uncertainty increases, that, other things equal, is going to reduce the value of the stock.

frames and prospects

2009-02-25T13:20:00.000-05:00

When I think about "prospect theory" and behavioral economics in general, I tend mostly to think about loss-aversion and to be bemused by framing effects, but one of the other reliable findings is that agents who face losses become risk-seeking rather than risk-averse. Someone presented with a sure $25 or a coin-toss for $50 will usually take the bird in hand, but presented with losses of the same magnitude, people will frequently prefer the coin toss — any chance to maybe, possibly reduce the losses.

It occurs to me that this is something we observe on the macro level. Insurance companies do well for a while, rates start to come down, they start seeking out riskier insurees and refuse to give up share of unprofitable business, and eventually KABOOM! Financial institutions see risk premia or even just interest rates come down, they think they're entitled to higher returns, they go "yield-chasing" (buying up riskier assets) and increase leverage, and eventually KABOOM!

I wonder if there's a good institutional way to check this propensity for making a bad thing worse. Getting insolvent companies into bankruptcy before they can cause harm seems like a good start.

factors of production

2009-01-28T00:03:00.000-05:00

Are slaves labor or capital?

I was just reading the introduction to Hayek's "The Pure Theory of Capital" — a book I fully expect not to finish — and he ultimately decides to use the term "capital" to mean "the total stock of the non-permanent factors of production". Presumably this includes some of "natural resources", insofar as those are depletable; I typically think of "capital" as something in which one can invest. (What "human capital" and "physical capital" have in common; each represents the devotion of some economic resources in the past to enhance production in the future. Natural resources I suppose represent a decision not to have depleted them faster in the past than we have. Perhaps Hayek's distinction makes sense.)

Of course, I can gear my slaves toward reproduction rather than production of something else, thereby enhancing my future stock of slaves. This isn't so different from human capital in general, though. In many ways, labor simply looks like a particular kind of capital. I wonder how fundamental the "factors of production" are, and how much they rely on ontology to be useful.

The Wealth and Debt of Nations

2009-01-26T16:32:00.000-05:00

Consider an international economic system in which there is relatively little trade, and then it opens up to trade in goods and to mobility in one and only one factor of production. Assume the different nations have different total factor productivities, due to technology or institutions, but that such differences are factor-neutral. What one would see is that the mobile factor would tend to move toward productive nations, increasing (even further) the marginal product of the other factors in those countries, while reducing the comparative attractiveness of the now abundant factor in those countries. If domestic "supply" of factors is at all elastic, the domestic supply of the mobile factor should decrease as its supply from foreigners surges.

I just read a snippet suggesting that it is inappropriate or confusing that the wealthiest nation on earth should have become (based on net foreign investment) a huge debtor nation. That doesn't strike me as a paradox; it just tells me that capital is more mobile than labor.

GDP as a welfare proxy

2009-01-04T14:22:00.000-05:00

GDP growth is popularly spoken of as though it were the ne plus ultra of economic policy; if growth is high, policy is succeeding, and if it's low, it's failing. Exogenous effects aside, GDP is not a perfect proxy for what economists call "welfare", namely how well off everyone is. One illustration of the discrepancy was recently given by Mankiw; longer ago the misuse of GDP was decried by Bobby Kennedy *. The best defense of the use of GDP in these ways has been that, while it doesn't conceptually capture everything it should, it's likely to correlate with welfare, and that eras of high GDP growth tend to be better for welfare growth than other eras. (I've made this argument myself.)

As Robert Lucas noted, though, correlations can be true under certain policy regimes but not others; in particular, policy tailored to a historical correlation, by creating an incentive by policy-makers to optimize a single (imperfect) measure of welfare rather than (unmeasurable) welfare itself, is likely to reduce that measure's correlation with welfare. Just as a chandelier factory in the USSR, told it would be paid by weight for its product, produced the heaviest chandeliers in the world, the focus on a particular measure will optimize that measure, both in ways that optimize what it should be measuring, and in ways that do not. As Mankiw pointed out, it's possible to design stimulus that increases GDP but not welfare. If GDP is being optimized, those forms of stimulus will look like a good idea.

In every popular, simple, short-term policy model of the economy — I'm thinking in particular of a sticky-wages model for the effects of unexpected inflation, but I've also thought in the last couple days that this is likely true of a simple microeconomic analysis of Keynesian demand-pumping — a boost in GDP comes at the expense of welfare. Unexpected inflation reduces real wages, so that workers work more than they would prefer at that wage; a deficit reduces savings, boosting consumption at the expense of capital accumulation. Other sticky prices or other mechanisms that these models leave out might change things, and certainly a good argument for boosting GDP is the psychological effect it has — the recession-as-a-coordination-problem model — and I'm pretty sure that in both cases I give above, the GDP boost is first-order while the welfare loss is second-order, so that a small error of analysis is likely to change the qualitative outcome. Still, it seems worth remembering that there is a distinction, and worth occasionally asking whether something targeted at GDP as a proxy for welfare is actually welfare-enhancing or not. I'm not sure Keynesian stimulus usually or always is.

* I would quibble with some of what Kennedy says, e.g. that GDP counts "destruction of our redwoods and the loss of our natural wonder". A better welfare measure would subtract environmental losses; GDP does not include additions for them, but does include additions for products that entail those losses. In any case, his broad thesis is correct.

time-ordering and information-ordering

2009-01-02T14:39:00.000-05:00

There is a famous puzzle, which some googling suggests is known as Newcomb's paradox, involving an expert on human nature (or something) who presents each player of a game with two envelopes, one of which the player knows to contain $1000. The player is permitted to receive either just the other envelope, or both envelopes; if this expert believes both envelopes will be taken, the second envelope is empty, while if the expert believes that only that second envelope will be taken, then it contains $1,000,000. After observing several other players, for each of whom the expert's prediction was correct, do you choose to accept both envelopes, or do you decline the $1,000 to take just the second?

My answer is that I take only the second envelope. I don't know what's going on in precise detail, but it appears to me that, one way or another, my decision is available to the expert when the envelopes are sealed. I apparently take my action after the expert acts first, but, the way the game appears to me, the information I have available when I act is circumscribed — I don't know what's in the second envelope — but the expert's decision is made knowing what I will do. The game, in information order, is that I make my decision, and then the expert places the checks, even though that is not the time-ordering of events.

There are a lot of situation in which uncertainty is of importance in economics, and it is very rarely the case that it matters whether the uncertainty is due to a lack of knowledge about the present or a lack of knowledge about the future. If you and I are stuck together for six hours, and we know that a football game has taken place during that time but that neither of us knows how it has gone, it is just as reasonable for us to bet on it at the end of six hours as at the beginning; in the former case we are betting on an event that has, in a time sense, already happened, but for which we are just as uninformed as if it hadn't taken place yet. Similarly, if I am about to have a test done to determine whether I have a genetic predisposition to some disease, it seems reasonable to ask an insurance company to provide me insurance against an adverse result, provided I don't initially know any more than the insurance company does, even though the genes are already there and the information in some sense already exists.

Studying actions of policy-makers or financial markets is invariably complicated by causal relationships running both directions in time; the stock market may rise because the economy is likely to improve in six months, but the economy may improve because the stock market rose. In that case, the effects likely reintensify their own causes — a "positive feedback loop" — but there are negative (i.e. stabilizing) feedback loops as well. Monetary economists speak of a "price puzzle" when one does a naive analysis of the effect of monetary policy on the economy, where tighter monetary policy seems to be followed by an increase in inflation for a short period of time; this is what one would expect if monetary policy is being done competently — the monetary authority should tighten policy when an increase in inflation is coming. Because the earlier event is being taken on the basis of anticipation of the later event, the causal relationship runs backward in time (though, in these cases, it runs forward as well).

I think the real-world solutions to a lot of game theory conundrums — incidentally, I've done less reading on this than I should — involve effects of this nature. People will work out that a repeated Prisoners' dilemma can yield cooperation, at least for a while, so long as future results are discounted relative to current ones, or some such, but, while time-preferences can be screwy and extreme, it usually seems to require too big a discount to generate the results you see in experiments (or real life), and almost certainly isn't in accord with how the agents themselves would describe their rationales. They might talk in moral terms, but it seems likely to me that a certain amount of what is going on is that people know that other people are somewhat cooperative, and — especially in real life — they believe they can tell "what kind of person" some counterparty to some arrangement is. Insofar as one can be read ahead of time, one is at least partially precommitted before the game formally begins.

microspeculation

2009-01-02T14:37:00.000-05:00

I first used the term "microspeculation" to refer to people topping off their gas tanks in advance of a coming hurricane; clearly some of the demand for gasoline was being driven not by a consideration of immediate need as weighed against the current price but by the expectation that future needs could be better met now than at the price at which any gasoline might be available a few days later. The phenomenon is much more pervasive, though, in less blatant terms; many people will buy something because its price is lower than what they consider typical for the item, and, to the extent that this is rational, it is often on the presumption that one would like to consume some of the item occasionally at the given price, and that the given price is low relative to an alternative price at which one might be able to buy it at the future. Perhaps more clearly, someone will forego a purchase at a higher price than was expected, not because that price exceeds its value to the purchaser, but in anticipation of being able to get a better deal later. If the current price were expected to prevail for a long period of time, the buyer would be better off purchasing it immediately, but is holding off in speculation that the price will come down. By and large, microspeculation is characterized by its size (small), its pervasiveness, and by the lack of intention to sell; one is substituting a purchase at one time for a purchase at another time, rather than performing an actual sale on the visible market.

For goods that can be stored in a straightforward manner microspeculation can be effected through "stocking up" on an item at what seems to be a temporarily low price; insofar as an item cannot be stored, the only way this comes into play is in a taste for diversification over time. Consumption of fresh fruit, for example, may be more sensitive to price changes in the short run than in the long run because one can gain more pleasure from eating apples during some portion of the year if one is comparatively deprived of them the rest of the year than if consumption is steady. Canned fruit, on the other hand, can be more readily stored, and short-run price elasticity can be driven higher (relative to long-run price elasticity) because one can "stock up" in anticipation of rising prices; while the response of fresh fruit sales to price changes is limited to one's willingness to consume it now, canned fruit can be purchased now to be consumed later.

To some extent this is a question of technical substitutability; it is easy to turn a can of canned fruit now into a can of canned fruit tomorrow (just wait 24 hours), while fresh fruit will start to deteriorate, and can not be so substituted. This is different from the question of consumption substitution, but from the standpoint of the visible market, it looks the same, and any attempt to measure substitution of consumption is likely to include this as well.

While some price-stickiness is surely "behavioral", in the sense that it probably can't be put on a strictly rational basis, I imagine that a fair amount of price-stickiness originates in microspeculation on the part of market participants' responding much more elastically to changes in conditions than they might if they believed that every change was permanent.

financial catastrophe bonds and moral hazard

2008-12-30T22:03:00.000-05:00

Four months ago, at the Jackson Hole conference, Kashyap, Rajan, and Stein proposed something of a financial catastrophe bond scheme for financial companies, in which they be required to meet a more stringent capital reserve requirement conditional on a financial catastrophe; the expectation was that this requirement might be met with an insurance mechanism of some kind that would cause the financial company to receive an equity infusion in that situation. They suggested a kind of secured insurance, but it seemed to me that a financial catastrophe bond (which they mention late in their paper) was both simpler and otherwise superior; the company would have a liability that, in the event of crisis, would disappear, converting to stockholders' equity.

The usual problem with insurance is moral hazard, and there's some of that here. There is some hope that, to a reasonable approximation, the financial company would not be able to instigate a financial crisis, but it does seem as though some behavior can be expected to reap worse whirlwind in case of financial crisis than otherwise, and that this sort of private behavior on a large scale intensifies systemic fragility. Historically financial crises are frequently preceded by bursts of poor loan underwriting; this is the sort of macroeconomic misalignment that finds itself in need of wrenching correction when the mania abates. A bank that finds itself choosing between loans that are relatively uncorrelated with the likelihood of disaster and loans that are feeding a mania (and are likely to go bad when it ends) will find the latter partially insured by the KRS scheme, and may well find them more relatively attractive than they should.

What seems perhaps safer to me is, rather than to have the liability disappear altogether, to have the liability convert to preferred equity. Concerns about an effective bank run or even an unwillingness of banks to lend should be alleviated just as well in this case as in theirs, insofar as the assets and liabilities pari passu and junior to senior unsecured debt work out the same. The common equity, however, is not shielded from the losses; the catastrophe bond claim remains senior to it. If equity drops dangerously low, the large subordinated class allows for a straightforward nondisruptive prepackaged bankruptcy, wiping away the liability only by handing the ownership of the bank over to the holders of what were originally the catastrophe bonds. It might, in fact, be worthwhile to give that preferred stock voting rights even before control of the company might pass to it; in any event where the liability is converted, it is likely that a good portion of the marginal dollar in assets belongs to that class rather than common equity. To avoid a bank's being permanently stuck with a capital structure that it may not like, it might make sense that such a preferred stock also be callable — it would be expected that calling the preferred stock would not be allowed by regulators unless the equity position of the company were comfortable.

Such a catastrophe-bond-converting-to-preferred-stock would surely be more expensive than ordinary unsecured debt, with which it would be pari passu if the institution fails idiosyncratically, but would likewise be less expensive than preferred equity. Which it falls closer to would provide a hint as to market perceptions of the correlation between the bank's risk and financial sector disaster risk. It should be somewhat cheaper than the original financial catastrophe bond variant. It also, insofar as management can be trusted to exercise its fiduciary duty to the shareholders, also largely eliminates the moral hazard problem mentioned in the second paragraph. It's a little bit more complicated (though not more complicated than the original secured insurance suggestion that KRS made), and it's more complicated in such a way that I expect there are complications I've missed. (One I've not missed so much as glided past is the disposition of dividends on that preferred stock.) Still, I think this is a step in a positive direction from what I've read before.

instruments of fed policy

2008-12-22T14:41:00.000-05:00

I've been reading about the 1907 financial panic, and once again it looks as though a period of good times leads to leverage which serves both to intensify the correction and to make it more painful. I've come to believe that, where the Fed does see something that looks like a bubble, it should try to take steps that to thwart its being facilitated by debt; if it has fundamental support, the worst that removing leverage would do is to slow the equilibration. Likewise, the point of having reserve requirements for banks is that they be able to absorb some losses of capital without going below zero, but if you keep reserve requirements fixed, those losses of capital will result in going below the reserve requirements — you've simply moved the baseline from that standpoint. Zero is undoubtedly a special number, and solvency an important characteristic regardless of regulatory compliance — especially in terms of systemic stability — but in a time when banks are increasingly risk-averse of their own free will and many of them, while still solvent, don't have money to lend even to low-risk potential borrowers, it seems like we could benefit from lower reserve requirements.

The fed occasionally changes reserve requirements, perhaps most notoriously in 1937, when it felt the need to "mop up excess liquidity". That history notwithstanding, I wonder whether some interesting research could be done on whether the fed could effect policy with any greater success if it regarded regular changes in the reserve requirements as a normal tool to put to that service.

home ownership for the poor and boundedly rational

2008-12-22T13:32:00.000-05:00

It is obvious again that lending too much money to people with poor credit and financial means is a bad idea, and there is a resurgence in support for the traditional mortgage in which the purchaser makes a real down payment and a 30-year fixed-rate mortgage payment and won't be lent the money if those terms can't be met. Partly in response to this I've read and heard some sympathy expressed for poor people who have no savings but are "responsible people with good credit", suggesting that home-ownership is a privilege to which these folks should be allowed. I'm not a fan of home-ownership fetishization in general — there's nothing wrong with renting, folks, and there shouldn't be a moral opprobrium thrust upon it — but if we wanted to promote home-ownership in a responsible way for this class of people, there are almost certainly better and worse ways to do it.

I want to start by clarifying who we're talking about; I would suggest that anyone with no savings is not a "responsible person" unless — maybe — they have tenure or a government pension. (Someone just out of school has an excuse; the entirety of this discussion supposes we are talking about someone who is not inclined, on an ongoing basis, to put aside something easily regarded as "savings".) Supposing "responsible" means that they don't deliberately incur liabilities they can't meet, and supposing that in fact that whatever liabilities they do incur they will manage to meet — no unanticipated drops in income — then someone who can't save up a down payment but makes their bills almost certainly suffers from a form of impulse control in which money "lying around" is calling out to be spent. This impulse control also seems to be implicit in a lot of discussions of one value of homeownership (with a mortage) being "building equity"; if you can buy a house that costs $1000 a month in ownership expenses, including mortgage, of which $100 goes to "building equity", then (ignoring tax distortions for the moment) on average, over large expanses of space and time, you can rent a similar place for $900 and put $100 a month in savings, and build your equity in a savings account. The primary difference with the mortgage is that if you don't put in the $100, you're in default; you have somebody pressing you to build equity, which you don't have with the savings account. Economics types will sometimes refer to a "forced savings" component to a mortgage, and this is what one has in mind. Whether buying or renting is the better use of money is likely to be specific to the details of the situation — how long the individual expects to stay put, how much they value being able to remodel, whether there's a special reason to believe the house will appreciate in a way that's not priced into it, etc. — and is not simply a function of buying versus renting per se.

If we want to help people with this kind of impulse control, though, short of simply giving them money (which they would presumably spend anyway), it seems we need, one way or another, a forced savings mechanism. The obvious "solution", then, is a federal mandate that renters put money into a savings account every month, which money they couldn't touch unless they move. Perhaps better, though, would be a way to allow people to choose to commit to a forced savings plan. I have two variants that seem at least plausible to me.

One is essentially a no-money-down version of a shariah-compliant mortgage: the bank buys the house and rents it back to you, allowing you to purchase a share in the house on a pre-set schedule. This can be made to look very much like a regular mortgage, except that the bank goes into this explicitly aware that it is taking on the price-appreciation risk of the house. I'm not sure, in the United States, that banks are the most obvious institution to organize something like this; REITs are. They buy and sell and manage real estate as their regular business.

The second idea is more of a rent-to-own structure; the homeowner puts together the same sort of deal, in which a higher-than-market rent is charged over a five-year lease, and at the end of the five years the lease has an associated cash-out value and includes either the obligation or an option to buy with the cash-out value available as a down payment. This even more transparently lends itself to REITs.

In the former case the forced savings, as in a regular mortgage, was hidden in the ownership of the house in the form of home equity; in this case it's hidden in the cash-out value of the lease. In either case there's a long-run contract whose terms are breached by failing to make this conversion of liquid wealth into something less liquid. In both cases, the terms of the deal should be amenable to both a buyer and a seller on market terms, so that there should be no need for a government subsidy. It might be, though, that there's a status quo bias or coordination problem in the market, where there's little willingness to try these things because it isn't much done yet and wouldn't be worth working out for a one-off; it is also possible that the mortgage interest deduction and other terms of the tax code discourage this sort of thing. If the commanding heights in Washington think long-term home ownership for this class of people is a social good, creating some kind of tax incentive or subsidy to encourage REITs to do this might be an efficient way to do it with taxpayer money.

systemic risk

2008-12-08T15:40:00.001-05:00

Banks should be required to sell short large baskets of each others' securities so as to reduce the correlation of their own likelihood of failing with that of other banks in the system.

external effects of propensities to save

2008-11-22T18:58:00.000-05:00

There's reasonable concern by people — e.g. Warren Buffett — that low domestic savings rates for long periods of time will ultimately prove unsustainable, and will be corrected by a real depreciation in the dollar. This analysis takes place over a period of time for which money is typically supposed to be neutral; would a highly interconnected region of the United States experiencing a sustained (but unsustainable) low savings rate be expected ultimately to see local prices rise (and wages fall) relative to prices (and wages) nationally? I guess it seems reasonable. I might want to think about more details of the likely nature of such an imbalance.

If Arizona and Florida are, for some reason, less relatively conducive to productive work than to retirement than the rest of the country, you could see a sustainable low savings rate as current wealth flows to those states indefinitely. I suppose prices might end up higher there because of that, but if real wages rose to the same levels as the rest of the country, the comparative advantage in retirement would presumably wane.

The question of "sustainability" is likely more one of the stock of wealth accumulated than of purchase-related flows; in the case I just gave, the sun states are never in debt to the rest of the country. "Wealth", though, is hard to measure; net wealth is a concept related to expected future creation of consumer goods, not past flows (what you might call the "cost basis" of that wealth). In many contexts, especially on a large scale, one might expect one to proxy the other fairly well, but it is a macroeconomic fact that foreign investment from the United States tends to take the form of equity, while foreign investment from many other countries — certainly from Europe to the developing world, and from the rest of the world into the United States — more often takes the form of debt, such that observing changes in net flows of investment income makes the United States look like much less of a debtor nation than you would expect from looking at past trade deficits. (I.e. U.S. investors see a higher rate of return on their past investment than foreigners do.) Little in economics is very backward-looking; the past is relevant insofar as it informs the future. These forward-looking indicators should be more meaningful.

This still doesn't answer my title question, though; what is the impact on me of my neighbors' not saving enough money? I still need to think this one through.

Keynsian multipliers

2008-11-22T18:56:00.001-05:00

In a closed economy, savings = investment; if someone has a marginal propensity to consume of 70%, that's a marginal propensity to save of 30%, so if you give them an exogenous windfall, 30% of that feeds back into GDP through investment, giving them that extra 30% in income, which then becomes another 9% of the original sum, so that you get a multiplier of 10/7. Of course, the multiplier effect is hampered by the fact that so much leaks out through the consumption channel instead; as marginal propensity to consume goes up, this only gets worse.

liquidity traps

2008-11-22T18:27:00.000-05:00

When interest rates get quite low, the normal basic tool of monetary policy — lowering a targeted interest rate — becomes less effective. At low enough interest rates, simply hoarding any new money put into the system becomes inexpensive; this is the liquidity trap, where the central bank tries to flood the system with more currency and that extra currency heads promptly to mattresses.

Even injecting extra money into the system, once short-term interest rates are zero, requires something other than an interest rate target, but, as Milton Friedman noted and Ben Bernanke quoted, dropping enough money from helicopters ought to eventually trigger inflationary expectations. More fuel efficient and orderly is a process of quantitative easing, or simply a partial monetization of the national debt; these should have similar monetary repercussions. Once inflation is expected, the cost of putting money under a mattress instead of looking to purchase real goods (possibly investment goods) becomes higher.

Part of the problem is that real investments lock up resources for long periods of time; if short-term rates go to zero, leaving normal monetary policy feckless, long-term rates may still be high enough that investors are insufficiently confident that they can produce real returns in excess of the opportunity cost of capital. The mattress may be a less interesting destination for long-term savings than treasury bonds are; monetary authorities would rather neither be as attractive as real investment. Very long term real interest rates should not go negative; one can imagine fantastic projects — an oft-cited example would be to fill in some patch of water with land — that ought, given enough time, to produce returns that exceed the cost. If long-term nominal yields on treasury debt can be pushed down, and inflation expectations can be pushed up, such projects — or more likely ones — should start to attract investors.

One simple way to do this would be for the federal reserve to go about its quantitative easing by purchasing long-dated treasury debt, inflating the currency supply while reducing the relative attractiveness, even in nominal terms, of those modes of saving. The Federal Reserve (in the United States) could do this; alternatively, the same result should come from the Treasury simply shortening the duration of its debt issuances, effectively — relative to its previous policies — selling short term debt (which the fed has pinned to a zero yield) to buy up its own long-term debt. Much of the federal government's recent emergency borrowing for the recent programs to shore up the banking sector has taken the form of bills maturing in the next year, with most of it considerably shorter than that. I wonder, if one looks at the usual impact of monetary policy, whether including the duration of the federal debt, or something like that, adds any predictive value, particularly in times of low interest rates.