Friday, April 29, 2011

Change of address

In case I have any readers left after going AWOL for half a year, I'd like to direct you to my new digs: (RSS feed is here.) I'll be the same long-winded, scatterbrained, inconsistent blogger you all know and love, except that now I have my own domain name, and (lacking the cleverness to come up with a good blog title) I've turned proudly eponymous.

Naturally, you should all check it out.

Saturday, September 04, 2010

Why does paid vacation exist?

Amidst the discussion by Ezra Klein, Matthew Yglesias, and Reihan Salam about paid vacation, I think it's useful to ask a more fundamental question: in countries like the United States that don't require it, why does paid vacation even exist?

This is not a trivial question. Employers could simply offer an equivalent amount of unpaid leave, providing an option to employees who prefer to take time off while rewarding workaholics for continuing to contribute value to the company. Why doesn't this happen? As far as I can tell, there are four plausible stories:
  1. Per-hour productivity declines when stressed employees don't take any vacations. In an ideal world, this might be written directly into the contract ("if you work 52 weeks a year, you only get paid 50% for the 52nd week"), but for various reasons that isn't possible, and the second-best solution is to provide paid vacation.

  2. Paid vacation resolves a bad signaling equilibrium, where everyone feels obligated to put in full hours to signal that they are hard-working and deserve advancement in the company. Offering paid time off convinces enough people to take vacations to break this equilibrium, making virtually everybody happier and better off. (Of course, this could also make the signaling problem worse. How do you signal that you're really hard-working and really devoted to your employer? By not taking paid leave!)

  3. Paid leave makes leisure time more enjoyable, since you're not incessantly bothered by the fact that you're losing money by being away from work. Employees are willing to sacrifice wages and flexibility for this psychological comfort.

  4. By encouraging every employee to be away from work for a brief period each year, paid leave allows a "dry run" to see how the workplace might function without that person, ensuring that it's not overdependent on the contributions of a single individual. This reduces the risk from employee attrition and diminishes the bargaining power of workers who might otherwise claim they were indispensable.
Of course, signaling acts as a powerful force against paid leave as well. Suppose that two otherwise identical companies, A and Z, differ in their vacation policy: company A offers higher wages but no paid vacation, while Z has slightly lower salaries and paid leave. In general, who will choose to work at company Z instead of A? People who like to take time off! To the extent that this is correlated with general laziness (not easily detectable in other ways at the hiring stage), it will make company Z's labor pool less effective, discouraging it from offering paid leave in the first place.

Define "economists"

Really, Greg Mankiw? He writes on whether the Bush tax cuts should be extended:
This seems to be the economic policy question of the hour. It might be worth recalling that last month, the Wall Street Journal polled economists about this question. Of those who expressed an opinion, here are the results:
  • 6 percent said no, all the tax cuts should be allowed to expire,
  • 24 percent said yes, but only for those making less than $250,000 a year,
  • 70 percent said that all the tax cuts should be extended.
I'm not so much upset at the conclusion—temporarily extending tax cuts in the middle of a recession doesn't seem like a terrible idea, although the estate tax should be reinstated and some other rates should be allowed to climb upward. Rather, I'm upset that polls from the Wall Street Journal are presented as being surveys of "economists" when they're really surveys of a very particular subset of conservative private-sector economists, who believe things like:
Despite the continued challenging conditions, 30 out of 48 economists who answered the question said the economy didn't need any more fiscal or monetary stimulus. Six economists said more fiscal stimulus was necessary, while five want more monetary stimulus from the Federal Reserve and seven said that the economy could use both.
If the Wall Street Journal included academics (like Mankiw!) in the survey, I guarantee that this result would be different.

Wednesday, September 01, 2010

The actual effects of inflation

Via Matthew Yglesias, Josh Barro makes the case for indexing capital gains taxes:
But one likely barrier to a higher inflation target is a quirk of tax policy: non-indexation of capital taxation means that higher inflation causes a stealth rise in the real tax rate on capital gains and interest income...

Inflation has large impacts on the real capital gains tax rate. To understand why, consider an investor who buys an asset for $100 and earns a 40% real gain over seven years. In a world of 2% inflation, the investor’s nominal gain is $60.82, and he pays $9.12 in capital gains tax at a 15% nominal rate; this is a 19.9% effective tax rate on his real gain of $45.95 (equivalent to $40 at the start of the investment period).

But if the inflation rate had been 4%, the nominal gain would have grown to $84.23 and the real tax rate to 24.0% -- a 21% relative increase in the tax rate. This effect would be even larger if the real rate of return were lower, meaning the inflation penalty on capital gains grows when inflation is high or when asset markets are anemic.
I'm glad to see Josh Barro addressing this issue: although it's little understood, it's arguably the most important economic effect of inflation.

To see why, it's useful to look at the more commonly cited deleterious effects of inflation. These include:
  1. It hurts people on fixed incomes.
  2. More generally, it redistributes from lenders to borrowers.
  3. It lessens the incentive to save.
  4. It causes people to hold an inefficiently low level of real money balances.
  5. Adjusting prices incurs a transactions cost—for instance, in updating a menu.
Upon closer examination, none of these except the last two are really problematic effects of "inflation." Rather, they arise from unexpected and variable inflation. If high inflation is expected, it will be built into pension plans and interest rates; assuming it stays on target, no economic damage is done. Of course, if inflation moves in an unanticipated direction, we see an arbitrary redistribution from lenders to borrowers (or vice versa), and the resulting uncertainty will lessen the incentive to save. But the damage here is from the unexpected component of inflation, not inflation itself.

The direct effect of inflation on money balances is also quite small. 4% inflation won't cause any serious inefficiency in the use of cash for transactions; we carry so little actual cash that the small amount eroded by inflation is almost irrelevant, and when we pay via checking accounts inflation only matters for the fraction of our deposits that banks keep as reserves. (The required reserves ratio is at most 10% in the US for demand deposits and zero for certificates of deposit, money market funds, etc.) Moreover, inflation has no clear impact on the real returns to investment: the future nominal returns from an equity investment scale up along with inflation, with zero net real effect. And most firms change prices often enough that a moderate level of inflation doesn't lead to any serious logistical inconvenience.

To sum up: the commonly cited downsides of inflation are not really problems with inflation at all, but rather a lack of precision in our expectations of inflation.* Other negative effects are close to zero in practical terms, at least when we restrict ourselves to inflation levels that are plausible in the United States. So what is so bad about inflation—assuming it doesn't unpredictably lurch around?

As far as I can tell, interaction with capital gains taxes is actually the key issue here. Starting in the late 1970s, Martin Feldstein convincingly argued that the era's high inflation imposed an extraordinary burden on capital investment—which, of course, is critical for economic growth. This wasn't because inflation was inherently problematic. It was simply a result of the distortions imposed by a tax system that failed to index properly.

Given the central role of inflation in discussing macroeconomic policy, it is astonishing that this effect is so little understood by the commentariat.

*As Arnold Kling points out, the distinction blurs a little if high inflation itself causes expectations to be less accurate.

Sunday, August 29, 2010

Why no question-and-answer sites for economists?

To me, one of the most intriguing online developments in the last several years has been the emergence of sites like Stack Overflow and Math Overflow: online communities where reputation is important and highly technical questions are met with highly technical answers. These sites are clearly superior to the listservs of yore—it's much easier to search for relevant content, and the best answers are "voted up" and displayed at the top of the page. Top contributors are visibly distinguished from the rest of the pack, which encourages good contributions and makes the best answers even easier to find.

At the moment, however, there is no comparable site for economics. Why? It's possible that that one will emerge in time, but I think that economics faces difficulties unlike any in math or programming. Specifically, it's hard to wall off a community from non-experts.

In math, this is easy enough. Everyone has some academic exposure to mathematics (if only in grade school), and virtually everyone who is not qualified to comment on advanced mathematics is self-aware enough to realize it. The vocabulary alone is nearly impossible for an outsider to crack: at the moment, one of the top questions on Math Overflow is "Morphism Between Polarized Abelian Varieties." (Not very inspiring raw material for a troll!)

In economics, however, most people have opinions about the "big issues" regardless of their academic background. How much deficit spending can we tolerate? Is another round of trade liberalization warranted? Should the Fed be loosening monetary policy further? Any site advertising itself as a forum for economists would quickly be overwhelmed by outsiders preaching their own decidedly non-academic opinions. Good luck having a technical discussion about how to specify a vector autoregression when the board is filled with posts about impending hyperinflation and the evils of the Federal Reserve.

The only way to avoid an overwhelming influx of non-economists would be to label the site so that only economists have any clue what it's about. A site titled "Sunspot Equilibrium" wouldn't attract any aspiring investors searching for advice on Google, or monetary cranks chatting about the need to buy gold. With sufficiently aggressive moderation, it could remain the exclusive domain of experts almost indefinitely.

There's always the risk, of course, that a horde of ideologues would run in to do battle with mainstream economists, but I'm afraid that comes with the territory. Math Overflow has it easy; only the wildest cranks believe that the Evil Mathematics Establishment is ruining numbers. Inevitably, however, a lot of people believe just that about economists, and it'll be tough to develop the online institutions that are improving communication in so many other fields.

Saturday, August 28, 2010

Information and financial crises

No economics paper better captures the essence of the 2008 financial crisis than Ricardo Caballero and Alp Simsek's Fire Sales in a Model of Complexity. From the abstract:
In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous (payoff relevant) complexity: As asset prices implode, more "banks" within the financial network become distressed, which increases each (non-distressed) banks' likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. This complexity brings about confusion and uncertainty, which makes relatively healthy banks, and hence potential asset buyers, reluctant to buy since they now fear becoming embroiled in a cascade they do not control or understand. The liquidity of the market quickly vanishes and a financial crisis ensues.
This all underscores the centrality of information to the stability of the financial system. If everyone knew exactly which banks were insolvent, in theory the resolution to a crisis would be rather simple: insolvent banks would fail, and the rest of the financial system would keep chugging along. In reality, of course, the lack of any orderly way to liquidate large banks (now purportedly fixed by Dodd-Frank) leads to a long and costly bankruptcy process, but in a world with better legal institutions this arguably wouldn't be as much of an issue. So why should we be concerned with protecting "systemically important" institutions?

As Caballero and Simsek point out, the problem is that indirect exposure to risks is extremely difficult to measure. Even if banks have a reasonably good idea about which institutions are likely to fail, they may not know which additional banks have exposure to those highly troubled institutions. Banks lacking any obvious proximity to the crisis may nevertheless be in danger if they're dependent on institutions that were affected.

And this doesn't stop at the second degree! Even if you have a good handle on which banks are exposed to banks with bad assets, you're unlikely to know which banks are exposed to banks that are exposed to banks that are exposed to banks that are exposed to banks with bad assets. (Just writing the sentence gives me a headache.) The risks to any individual bank may fall as we move farther from the source of the original imbalance, but the vastly larger pool of banks connected in some way to the crisis makes risk management just as difficult.

Meanwhile, as Caballero and Simsek establish in their model, all this risk and complexity induces banks to hoard liquidity. This necessitates selling assets, but in a world where virtually every institution is in some way connected to the crisis, the pool of willing buyers isn't very deep. As a result, we see plummeting asset values and fire sales, which further damage balance sheets and introduce entirely new stresses into the system. This drives further liquidity hoarding and fire sales, and the vicious cycle continues until either the government steps in or our financial system is in tatters.

Friday, August 27, 2010

The strangest line in US immigration law

Take a look at Section 132(c) of the Immigration Act of 1990 (emphasis mine):
(c) DISTRIBUTION OF VISA NUMBERS- The Secretary of State shall provide for making immigrant visas provided under subsection (a) available in the chronological order in which aliens apply for each fiscal year, except that at least 40 percent of the number of such visas in each fiscal year shall be made available to natives of the foreign state the natives of which received the greatest number of visas issued under section 314 of the Immigration Reform and Control Act (or to aliens described in subsection (d) who are the spouses or children of such natives).
This begs the question: which foreign state received the "greatest number of visas issued under section 314", qualifying it for fully 40% of visas issued under this statute in fiscal years 1992 through 1994?

Ireland. The text of the Act obviously avoids mentioning the country by name, but as Anna Law explains in her article on the history of the visa lottery, the handout to Ireland was no accident. Apparently in 1990 there was still a substantial number of undocumented Irish immigrants in the United States. The visa lottery was primarily an attempt to legalize this population and restore the flow of legal immigrants from Ireland, who had difficulty competing with Asians and Latin Americans through the standard channels. To ensure that Ireland—and other supposedly disadvantaged European states—received the intended benefits, the bill's sponsors inserted a three-year transitional period that gave special visas to "adversely affected" states, most of which were located in Europe. 40% of these visas were reserved for Ireland specifically.

That's right: the "diversity" visa was originally a ploy to bring more white people into the country.

But here's the wonderful part. Since the visa's proponents felt compelled to disguise their handout as part of a general attempt to increase diversity, the visa they designed ultimately became a legitimate source of diversity. In 2009, the 5 largest sources of diversity visa immigrants were Ethiopia, Nigeria, Egypt, Bangladesh, and Uzbekistan. Immigrants from countries without a large preexisting population in the US—traditionally a group with no legislative voice whatsoever—were the unlikely beneficiaries of a bill intended to favor established ethnicities.

It's... oddly heartwarming?

Thursday, August 26, 2010

Asking the wrong questions about the minimum wage

Often discussions of the minimum wage center around its aggregate effect on employment—under a certain minimum wage, is total employment higher or lower than it would have been otherwise? Basic economic intuition says that the answer should be "lower", but alternative models are less clear, and empirical evidence is ambiguous.

Upon further examination, this isn't even the right question. Total employment isn't all that matters—among other things, we want to know who is holding the jobs. In a model of imperfect competition, a minimum wage has two effects. First, it decreases employment by putting a wage floor above some workers' marginal product of labor; second, it increases employment by inducing more people to enter the labor force. While the aggregate outcome may involve either higher or lower total employment, this will hide important shifts in the composition of the workforce.

What are the welfare effects of these shifts? Consider the group of people induced to enter the labor force by a small increase in the minimum wage. Since this group, by definition, consists of people who would opt to stay out of the labor force under a slightly lower wage, it gains relatively little utility from working—members of the group are still close to being indifferent toward work. Workers who lose their jobs because of the minimum wage, on the other hand, are likely to derive much higher utility from work. In particular, since they will tend to be individuals from poor backgrounds with little education, they are typically in special need of the income from a steady job.

This doesn't mean that the minimum wage is necessarily a bad idea. From a social welfare perspective, it's still possible that the direct income-increasing effects of the minimum wage will outweigh the disemployment effects. But it is critical that we know what those disemployment effects are, and looking at aggregate employment alone won't tell us.