Economics/Finance

Dan Drezner looks at the “FT”:http://www.ft.com/cms/s/0dc53342-af08-11db-a446-0000779e2340.html and “wonders”:http://www.danieldrezner.com/archives/003125.html why economists are debating whether the euro might become the world’s reserve currency at the same time that EU citizens say that they don’t much like it. Perhaps some of the answer lies in the different priorities of citizens and central bank economists, as described in another FT article “on the same topic”:http://www.ft.com/cms/s/0706b982-af3e-11db-a446-0000779e2340.html.

But the results at least offer the European Central Bank comfort on one front: expectations of inflation-beating wage rises are not widespread. Just under half of adults in employment across the countries surveyed expect to receive a pay rise this year. Of those expecting a pay rise, roughly 23 per cent expect a rise above the rate of inflation but 24 per cent expect an increase below the rate. … Fears about inflationary pressures from the labour market are a main reason why the ECB has signalled further interest rate rises are likely.

This suggests that under 11.5% of citizens in the countries surveyed expect that their pay will increase in real terms this year (this at the same time, by the way, that London City types are “writing op-eds”:http://search.ft.com/ftArticle?queryText=city%20bonuses&y=0&aje=true&id=061219007448&x=0 telling readers how “we can all profit from million dollar City bonuses.”) Wage-inflation spirals how are ya. While the average punter may not draw the precise causal connections between (a) the institutionalized imperative for the European Central Bank to avoid inflation at all costs and (b) high interest rates and slow growth, he wouldn’t be all wrong to suspect that there’s something decidedly funny about the ECB’s priorities in setting monetary policy for the euro.

My book, “Last Best Gifts: Altruism and the Market for Human Blood and Organs”:http://www.lastbestgifts.com, is “reviewed this weekend”:http://www.nytimes.com/2007/01/28/books/review/Postrel.t.html?ex=157680000&en=f390b3396e0ec28a&ei=5124&partner=permalink&exprod=permalink by “Virginia Postrel”:http://www.dynamist.com/weblog/ in the _New York Times_. Obviously, I’m delighted: Virginia’s review is generous and perceptive, and in many ways it’s hard to think of a better choice of reviewer. For one thing, as many readers will probably know, Virginia is herself an organ donor — she “gave one of her kidneys”:http://www.american.com/archive/2006/november/organs-for-sale to her friend “Sally Satel”:http://www.sallysatelmd.com/ — and now regularly writes about the organ shortage and market incentives. For another, she has also followed the growth of economic sociology as a subfield, writing “a very good piece about it for the Boston Globe”:http://www.boston.com/news/globe/ideas/articles/2005/07/24/market_share/ a while ago. And last, she has a generally libertarian point of view, and the stereotype is that libertarians and academic sociologists should be flinging abuse at each other on the topic of altruism, self-interest and the market — especially when it comes to markets in things like human organs. I wrote the book partly in the hope that it would advance the debate beyond some of the entrenched clichés that both sides cling to. Virginia’s review encourages me that I might have been in some way successful in this respect.

David Leonhardt has a nice piece in the New York Times on the opportunity cost of the trillion dollar Iraq war. Leonhardt does a good job of getting the concept across without actually using the economic jargon. Coincidentally, I have a piece in tomorrow’s (Thursday’s) Australian Financial Review, making the same point, not for the first time, along with a reference to the work Kahneman and Renshon on psychological biases to hawkishness.

On the side of this box of McCann’s Oatmeal here it says: “Tip: Add liquid to oatmeal a few minutes before cooking. It will cook faster.” Now, I can see the benefits of doing this in terms of energy conservation. But the fact is, I’m not going to get my oatmeal any faster, am I? Sure, it’ll spend less time on the cooker, but the amount of time I spend preparing it will be the same, or maybe even longer.

This tip seems related to that recent finding that people were irrationally much more tolerant of an increase in shipping fees than the same-sized increase in the price of the good being shipped.

In comments on an open thread on my blog, Michael Greinecker points to a truly strange response to arguments for a zero rate of social time preference.

Crucial quote

I found myself becoming very curious whether economists who support Sir Nicholas’s social discount rate of zero, such as econ bloggers John Quiggin and Brad DeLong, identify themselves as pro-choice or pro-life, and whether they had considered the Stern Report from this angle.

My response has been anticipated by a commenter who observes

Strange as it may seem to Economist writers, there are phenomena in the world that aren’t particularly illuminated by applying economic concepts. Attitudes towards abortion have nothing at all to do with discounting rates.

Others in the comments thread spell this out.

One odd feature of the Economist blog is that contributions are anonymous. I know that Megan McArdle (aka Jane Galt) has something to do with the site, but I have no idea whether she wrote this piece. While I’m used to pseudonymous commenters, most economics bloggers are (as Matt Yglesias puts it) proudly eponymous, or at least easily identified, and I find this a more satisfactory mode for arguing about issues like the Stern Review, though can’t exactly say why.

During the discussion of discounting and the Stern Review, I got an email raising a point that I had already been worrying about. In discussing costs and benefits in 2100, I and others routinely refer to future generations, and in a sense that’s right, since the people involved in the discussion won’t be around then. But, children alive now have a reasonable chance of living to 2100 – quite a good chance if life expectancy keeps rising. Economists often deal with this kind of thing by modelling a series of overlapping generations, but I haven’t seen much discussion of this in relation to benefit-cost analysis, though no doubt it’s in the literature somewhere.

I finally got around to thinking about this, and in particular the following question. Suppose we accept an ethical framework in which everyone now alive matters equally. Suppose also that as individuals we have a consistently positive rate of time preference, preferring to have higher utility now at the expense of less in the future, that is, more when we are young and less when we are old (this isn’t obvious by the way, but I’m assuming it for the sake of argument) . What is the appropriate pure rate of time preference for society as a whole?

My preliminary answer, somewhat surprisingly to me, is “Zero”. I’ll set out the outline of the formal argument over the fold, but the simple summary has two parts. First, since generations overlap, if, at all times, we treat all people now alive as equal then we must treat all people now and in the future as equal. Given this equality, positive individual rates of time preference translate not into a social preference for the present over the future but into a social policy that consistently puts more weight on the welfare of people when they are young than when they are old.

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Obviously, I’m not the only one who gets annoyed by pieces pointing to purchases of consumer goods as evidence that rising inequality isn’t really a problem. As Henry says, this is a tired shtick that lots of us are sick of.

But, as an economist, it particularly annoys me when this claim is put forward by people who claim to understand markets. I’ve been going on about this for yearsand years.

The most important thing that happens in markets is that relative prices change. If prices change, but income and preferences don’t, what we expect is that people will consume more of the goods and services for which prices have fallen and less of those for which prices have risen. So, when Jeff Taylor tells us that

With price points dropping below the $1000 mark, high-end TVs are moving down-market fast with Wal-Mart leading the way.

we can all cheer this renewed verification of the Law of Demand. But, of course, this tells us precisely nothing about what’s happening to inequality.

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Can you ask your siblings and friends how much they earn? Can you ask your co-workers? I guess in many or most places in the world, this is a taboo. This is regrettable, since there are many unjustified earnings inequalities, often related to factors such as gender, race and nepotism. Unjust earnings inequalities can only fade away if individuals demand equal wages for equal work, but therefore they first need to know how much those who are doing this ‘equal work’ are earning (and in many countries much more is needed, such as a shift in power between labour and capital, to put it in these grand terms).

In 17 countries, there exists an internet tool, called the “wage indicator”:http://www.wageindicator.org/main, that can tell us how much people in a certain profession (with the same age, seniority, etc. etc.) earn, which may be useful information if you need to negotiate your wage, or if you think you or your colleague should be earning more. For labour scholars, the information gathered by the tool can be used to investigate pay inequalities, and many other trends and facts related to earnings and the workforce. “The Dutch version”:http://www.loonwijzer.nl/main/ was launched in 2001, and at present the wage indicator is available in “many countries”:http://www.wageindicator.org/main/Partnersworldwide, such as “South Africa”:http://www.mywage.co.za/main/, “India”:http://www.paycheck.in/main/, “Finland”:http://www.palkkalaskuri.fi/, “the UK”:http://www.paywizard.co.uk/ and “the USA”:http://www.worklifewizard.org/main/.

Clearly the wage indicator has its limitations too. One limitation is inherent for almost all surveys: sometimes you feel that your experience does not fit the questions, and therefore that you can’t answer the question properly. For example, when I had to give the number of years I had been employed, I didn’t know whether I should count my years working on my PhD or not (in the Netherlands and Belgium doctoral students are – euh – not students but employees, whereas in England, where I got my PhD degree, they are students.) Another problem is that there needs to be a minimal number of respondents who have responded to the questionnaire before anything statistically representative can be said about the average earnings of people with your profile. Hence even if you have no personal interest in figuring out what the typical person with your profile earns, you can do labour scholars a favour by filling out this survey. And by reporting any oddities you come across, or your views about these tools, in the comments section. I don’t personally know the scholars who run them, but I’m sure they’ll find us.

Via “Dan Drezner”:http://www.danieldrezner.com/archives/003069.html, Greg Mankiw “accuses Deval Patrick”:http://gregmankiw.blogspot.com/2006/12/deval-patrick-is-no-pigovian.html of not understanding basic economics.

The money quote from Patrick:

“If we’re trying to cultivate here in Massachusetts an energy-smart economy, then the notion of relying for additional revenues on something we’re trying to break our dependence on doesn’t seem to me to be a formula for long-term success.”

Mankiw’s response:

Okay, let me get this straight: It is important that we reduce our consumption of oil. Therefore, we should not tax it.

Hmmm….Governor Patrick was Harvard class of 1978, and it’s a good bet that he took ec 10. I wonder what they taught about the slope of demand curves back then.

There usually isn’t much need to remind well known right-of-center economists of the importance of incentives, but it looks to me as though Mankiw is misreading an on-the-face-of-it-quite-reasonable claim here. Patrick is suggesting, as far as I can see, that if we want to move away from a petroleum based economy, it may be a bad idea _ex ante_ to make gas into an important source of tax revenues for the government. If the Massachusetts state government comes to rely on a gas tax as a significant source of income, then it will have an incentive over the longer term not to want to lower tax revenues, say, by introducing non-tax regulations that make hybrid vehicles more attractive and gas-guzzlers less so. It will have created a long term constituency that favors the status quo, and that is likely to resist vigorously attempts to move away from it that would threaten funds going to this or that favoured project.

This kind of feedback loop, in which policy shifts create and provide resources for new constituencies which then push for the maintenance of that policy, has been explored at length by Paul Pierson and others (see “here”:http://64.233.161.104/search?q=cache:LbUegaZYGqEJ:www.yale.edu/coic/pierson.doc+%22paul+pierson%22+%22effect+becomes+cause%22&hl=en&gl=us&ct=clnk&cd=9 for a nice and reasonably brief overview). Now it could be that this effect is swamped by the substitution effects and so on described in basic micro textbooks. But it also could be that it isn’t swamped – and I can’t think of any very good way empirically to test for which effect is likely to prevail under which circumstances. Mankiw and Patrick are on different sides of an argument about the appropriate instruments for changing incentives. But this in no sense means that Patrick is an economic illiterate.

Following the publication of this piece in the NY Times, I’ve had a string of email exchanges with Hal Varian, cc:ing Brad DeLong in the role of interested onlooker. I was surprised by the NY Times article since it included both a correct statement of the way in which Stern treats discounting and income redistribution (roughly speaking a 1 per cent change in income has the same value whenever it is incurred and whoever receives it) with a lot of statements that were either misleading or downright wrong, implying that the near-zero rate of pure time preference in the Stern Review implied a near-zero discount rate for cash flows.

Since Varian is one of the brightest and most technically careful people in the economics profession, I was unsurprised by the correct statement, but very surprised to see errors I’d already refuted when put forward by Arnold Kling, Bjorn Lomborg, Megan McArdle and others. Email revealed that the main problems arose from editorial attempts to ‘simplify’ things for readers, but we still have a lot of disagreements about the justifiability or otherwise of inherent discounting.

In any case, all this has spurred me on to produce my long-promised review of Stern on discounting, at least in draft form. Read, enjoy and criticise.

Reading an “article about the current snow shortage in Europe’s ski resorts”:http://news.bbc.co.uk/2/hi/europe/6185345.stm , I came across the following passage:

bq. “Already banks are refusing to offer loans to resorts under 1,500 metres as they fear for their future snow cover.”

This surely presents a tremendous money-making opportunity for global warming “skeptics”. If the banks won’t lend these resorts money, then there’s a gap which the denialists could exploit and thereby make themselves rich. What could possibly go wrong?

This is the first year that we’ve contributed to the local NPR affiliate. I listen to NPR a fair bit, and so does my wife, but, unlike her, I’d happily do without it myself. It enhances my life, but not in a way that I value enough that I would pay if they turned it into a subscription-only service (she made the contribution, then, obviously).

I probably spend a similar amount of time listening to BBC7. On my new website I mention that it could have been dreamed up just for me – the best of BBC radio’s irresponsibly depleted archives, and an old school friend of mine is their best presenter; a joy. I’d be embarrassed to admit how much I’d be willing to pay if they made it subscription-only.

So, what if some super-national governmental agency decided to charge me to pay for the enjoyment I get from NPR and BBC7? Would I have a reasonable complaint against it? Just to put one issue aside – I wouldn’t complain, in either case. But I think I would have a complaint in one case and not in the other. I’d have a complaint in the case of NPR because my relationship to NPR is like that of the shoemaker to the elves. They do something nice for me, which I enjoy, but I didn’t ask for it, and if I’d been offered the choice between paying for it or not getting it at all, I’d have chosen the latter. But BBC7 is quite different; not only do I plan around it, but if I’d had the choice between paying for it and not getting it I’d have chosen the former (at an embarrassingly high price).

So, I don’t think I’ve any complaint if they charge me for BBC7 but I do if they charge me for NPR. To say this is different from saying that the people who, in fact, pay for BBC7 and NPR, have a complaint against me if I don’t contribute. Suppose (counterfactually, but to keep the focus where I want it to be) that both are paid for entirely voluntarily by people who are producing them just for themselves and I only get the benefit from them because they don’t know how to exclude non-contributors. If the contributors are securing what they want at a price they are voluntarily paying, it might be a bit oafish of me to consume it without contributing when I could, but it is hard for me to see that I am doing something unjust to them. So my intuition is that even though there is no injustice when I do not contribute to the production costs of BBC7, there is no injustice, either, when I am forced to contribute as much as or less than I would have voluntarily contributed in order to secure access if that were the only way of doing it.

Am I right about this? I’m sure that David Schmidtz says something about it in The Limits of Government, and even surer that Tyler Cowen does in his wonderful In Praise of Commercial Culture, but some bugger walked off with my copies of both! And I’m impatient to hear your thoughts.

I’ll write a follow-up post explaining what this post is really about in a week or so.

Brad DeLong carries on the discussion about discounting and the Stern Review, responding to a critique by Partha Dasgupta that has already been the subject of heated discussion. As Brad says, all Dasgupta’s assumptions are reasonable, and his formal analysis is correct

But … The problem I see lies in a perfect storm of interactions:

This brings me to one of my favorite subjects: the equity premium puzzle and its implications, in this case for the Stern Review. I’ll try and explain in some detail over the page, but for those who prefer it, I’ll self-apply the DD condenser and report

Shorter JQ: It’s OK to use the real bond rate for discounting while maintaining high sensitivity to risk and inequality.

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In yet another round of the controversy over discounting in the Stern Report, Megan McArdle refers to Stern’s use of “a zero or very-near-zero discount rate”. Similarly Bjorn Lomborg refers to the discount rate as “extremely low” and Arnold Kling complains says that it’s a below-market rate.

So what is the discount rate we are talking about? Stern doesn’t pick a fixed rate but rather picks parameters that determine the discount rate in a given projection. The relevant parameters are the pure rate of time preference (delta) which Stern sets equal to 0.1 and the intertemporal elasticity of substitution (eta) which Stern sets equal to 1. The important parameter is eta, which reflects the fact that since people in the future will mostly be richer than us, additional consumption in the future is worth less than additional consumption now.

Given eta = 1, the discount rate is equal to the rate of growth of consumption per person, plus delta which is 0.1. A reasonable estimate for the growth rate is 2 per cent, so Stern would have a real discount rate of 2.1 per cent. Allowing for 2.5 per cent inflation that’s equal to a nominal rate of 4.6 per cent. The US 10-year bond rate, probably the most directly comparable market rate, is currently 4.44 per cent; a bit above its long-run average in real terms. So, Stern’s approach produces a discount rate a little above the real bond rate.

Arguments about discounting are unlikely to be settled any time soon. There’s a strong case for using bond rates as the basis for discounting the future. There are also strong arguments against, largely depending on how you adjust for risk. But to refer to the US bond rate as “near-zero” or “extremely low” seems implausible, and to say it’s below-market is a contradiction in terms. It seems as if these writers have confused the discount rate with the rate of pure time preferences.