Rangel Tax Reform Proposal

Charles Rangel, the Chairman of the House Ways and Means Committee has proposed a tax reform plan (press release; Washington Post story). Although its not expected to pass this year, it may be an indication of where tax policy will go if/when there is a Democratic administration.

The plan is intended to be "revenue neutral" - the tax cuts in the plan are balanced by tax increases, so the total amount of revenue coming in stays the same. The plan would eliminate the Alternative Minimum Tax (see earlier post), and make up some of the revenue by increasing the marginal income tax rate on high earners. It would also eliminate a loophole on "carried interest" that has allowed some fund managers to treat their income as "capital gains" (thereby paying a much lower rate). The "standard deduction" - i.e. the tax deduction you get just for being you - would be increased by $425 ($850 for married couples). Modifications of the earned income tax credit and refundable child credit would benefit low-income households. As for corporations, the top corporate tax rate would be cut, but some loopholes would be closed.

The Journal's Real Time Economics blog has reactions from several economists. In the Washington Post, the Brookings Institution's Jason Furman praised the corporate tax provisions. The Tax Policy Center analyzed the distributional effects (summarized here by Mankiw).

Will Exports Prevent a Recession?

The troubles in the housing market create the risk of a recession for the US economy - a decrease in homebuilding reduces the "residential" part of investment, and the decrease in household wealth may reduce consumption (this effect is apparent in this NY Times story on the share prices of department stores). However, aggregate demand is getting a push in the opposite direction from net exports, as the declining dollar has increased foreign sales of US-made goods. Will this save us from a recession? At Econbrowser, Menzie Chinn has an interesting look at the historical evidence.

German Efficiency?

According to this fascinating NY Times story, in Germany, it is illegal to sell new books at a discount. This regulation helps keep small, independent bookstores and publishers in business:

In the United States chain stores have largely run neighborhood bookshops out of business. Here in Germany, there are big and small bookstores seemingly on every block. The German Book Association counts 4,208 bookstores among its members. It estimates that there are 14,000 German publishers. Last year 94,716 new titles were published in German. In the United States, with a population nearly four times bigger, there were 172,000 titles published in 2005.

At first glance, this is economically inefficient - high-cost retailers are not driven out of business, economies of scale are not realized, and Germans pay too much for their books. Three reasons come to mind about why the German regulations might make economic sense (i.e. improve overall welfare):

1. People like having bookstores in their neighborhood, and enjoy spending time there (even if they don't buy anything), and like variety, so the small bookstores have a positive externality for consumers.
   
2. A positive externality for national culture (which seems to be the argument of most of the people quoted in the story).
   
3. The utility of the producers themselves. Our customary models of profit maximizing firms ignore the obvious fact that many people - and I suspect this is particularly true of many small business proprietors - are motivated more by a sense of pride and accomplishment in their own work, than by wages.

The Germans are concerned by a recent decision by the Swiss competition commission to allow discounting. The director of the commission said:

It was a cartel. The German and Swiss booksellers said it was for a good purpose — they made a cultural argument, but we are an economic commission. They said the system fosters a broader, deeper market for books, that discounting will hurt the small booksellers who support the small publishers, and then you will have fewer books and more focus on best sellers...

I’m not quite sure they’re completely wrong. Nobody knows for sure yet. But nobody can read one million titles, so the question is, is it better that more people read fewer books or that fewer people read a lot of different books?

That's a good - and difficult to answer - question. However, being an "economic commission" is not a reason to disregard a cultural argument - good economic policy should be about improving the well-being of people ("welfare" or "utility"), much of which derives from difficult to quantify, non-pecuniary sources.

Professor Cringed (A Note on Ayn Rand)

One of the weirder aspects of Alan Greenspan's life was his association with Ayn Rand. In his excellent NY Times review of Greenspan's memoir, Michael Kinsley writes:

Freedom. For this proud square, this eager conformist and joiner of the establishment, freedom is nevertheless the supreme value of his life. Freedom and, he would add, rationality. In the early 1950s he joined the inner circle of Ayn Rand, the author of ''The Fountainhead'' and ''Atlas Shrugged,'' whose philosophy, known as Objectivism, was an extreme form of libertarianism that actually celebrated selfishness and greed. Many young brainiacs of dorkish tendencies go through an Ayn Rand period (her books are very popular at Microsoft). But Greenspan credits Rand as ''a stabilizing force in my life'' and was ''a regular at the weekly gatherings at her apartment'' through the early 1960s. She stood at his side when he was sworn in as chairman of the Council of Economic Advisers in 1974, and they ''remained close until she died in 1982.''

Occasionally I encounter students who are going through an "Ayn Rand period" - its just a phase, I remind myself. One I fortunately managed to avoid (I was more inclined towards Leon Trotsky), though one of my high school friends did make me read "The Fountainhead."

For Greenspan, though, it was more than just a phase. While I can excuse a central banker with questionable taste in literature, I always found it troubling to have a bona fide acolyte - a man who could say "objectivism" with a straight face - in such a powerful position. Lest I smirk too much, Paul Krugman's latest column is a reminder of the real consequences of Greenspan's worldview.

To the students I say: if you must be libertarian, its time to graduate to Hayek and "The Road to Serfdom," which is actually a good book.

As my for high school friend - he made it to the other side, and is now an attorney with a federal regulatory agency in Washington (take that, Ms Rand!).

No, We Don't Do That

Reuters reports: "Economists Smile As Greenback Drops." I realize its tough to write headlines, but surely the folks at Reuters know that economists never smile. It's the "dismal science" after all.

The Economic Consequences of Mr. Torre

The market for New York Yankee mangers was once a notoriously flexible labor market, but now it provides an example of the rigidity known as "sticky wages."

Joe Torre recently turned down a $5 million contract to return to the team. That's lots of money - more than any other baseball manager - but a cut from the $7.5 million he received this year. Torre explained his decision:

If your salary is such and it’s reduced, yeah, $5 million is a lot of money; I’m not going to sneeze at that. I’m not going to make that this year. So it’s nothing I take for granted. The fact that someone is reducing your salary is telling me they’re not satisfied with what you’re doing.

Sports Illustrated columnist Tom Verducci described it as a de facto firing of Torre. The Yankees made "a contract offer they thought would strike just the right balance: just good enough for public relations purposes, but insulting enough that no man of Torre's pride and accomplishments would ever accept."

The psychological response to interpret a nominal wage reduction as an insult - preferring to withdraw labor rather than accept a cut - means that wages cannot effectively adjust in a downward direction.

This type of behavior has implications for the macroeconomic aggregate supply curve. One standard version of Keynesian* aggregate supply is based on sticky wages: a nominal wage is set in advance, and the quantity of labor demanded increases with the price level, leading to an upward sloping AS curve. In a recession, the adjustment of nominal wages necessary to return to the full-employment (classical) equilibrium is downward, while in a boom when output is above potential (i.e. the economy is "overheating") wages should adjust upward. If the upward adjustment can be accomplished easily, while the downward adjustment is resisted - i.e. wages are more sticky downward than upward - the resulting aggregate supply curve is flatter below potential output (full employment) and becomes vertical when potential output is reached. This is described by Keynes in chapter 20 of the General Theory:

There is, perhaps, something a little perplexing in the apparent asymmetry between Inflation and Deflation. For whilst a deflation of effective demand below the level required for full employment will diminish employment as well as prices, an inflation of it above this level will merely affect prices. This asymmetry is, however, merely a reflection of the fact that, whilst labour is always in a position to refuse to work on a scale involving a real wage which is less than the marginal disutility of that amount of employment, it is not in a position to insist on being offered work on a scale involving a real wage which is not greater than the marginal disutility of that amount of employment.

In addition to the implications for aggregate supply, The Economist suggests Torre's behavior illustrates a problem with efforts to improve corporate governance and reduce obscene CEO compensation:

In theory, if executive pay rose too high because it was set in a market dominated by cronyism (ie, a board of directors who are chums of the boss, who appointed them), then shouldn’t a move to a system in which the board actually tries to get value for the shareholders’ money result in lower pay?

Mr Torre’s fate shows why the answer is probably no. Once a pay level has been reached, it becomes a minimum. Mr Torre may still have been the best paid manager in baseball under the new contract, but he would not have been as well paid as before. He is already wealthy and successful. He needs the extra money less than he needs respect—much like the typical boss of a big company after a few years in the job.

Or, as Keynes wrote in chapter 3 of the General Theory:

Though the struggle over money-wages between individuals and groups is often believed to determine the general level of real-wages, it is, in fact, concerned with a different object. Since there is imperfect mobility of labour, and wages do not tend to an exact equality of net advantage in different occupations, any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is a sufficient justification for them to resist it...

Of course, the alternative interpretation of his decision is that Torre places an extremely high value on leisure time activities, like watching the Red Sox play in the World Series on TV.

* There is some dispute regarding whether this is an accurate interpretation of what Keynes really meant.

Wage Insurance

The government provides unemployment insurance for workers who lose their jobs, but in the US, most unemployment spells are relatively short. In the Washington Post, University of Chicago public policy professor Robert LaLonde argues the more serious risk workers face is that they will be re-employed in lower-paying jobs and suffer a permanent decrease in lifetime income. Although this risk is often associated with trade and globalization in the popular imagination, such displacements are part of the job churn associated with a capitalist economy and can occur due to changes in consumer demand or technological change. The US currently has a limited program "Trade Adjustment Assistance" for workers displaced by international competition. LaLonde argues for replacing it with a broader wage insurance program. He writes:

This insurance would not discriminate between job losers from different industries. A manufacturing worker who loses his job as a result of free trade policies should not be treated differently than a service worker who loses his job as a result of automation. The insurance would pay beneficiaries a percentage of their earnings losses once they are reemployed, but it would not make up the whole gap; this would preserve the incentive for workers to search for better paying jobs. Benefits would be available to middle-class workers, and not just to the poor, since it is the middle class that is most exposed to the threat of downward mobility. Finally, the program would pay benefits so long as workers continued to suffer substantial reemployment earnings losses.

The argument, in part, is political - wage insurance might help increase support for trade agreements. LaLonde writes:

Congress has an opportunity to significantly reduce middle class workers' well-founded fears of catastrophic job loss. By replacing failed trade adjustment assistance with sensible wage insurance, it can start to rebuild support for free trade agreements and other policies that promote economic growth.

Viva AMT?!

One of the more prominent tax policy issues these days is the Alternative Minimum Tax (AMT). The AMT was enacted in 1969 as a way of ensuring that high-income earners would indeed owe some income taxes, even if, under the regular system, they could find enough loopholes, deductions and credits to reduce their obligations to zero. The AMT is an alternate, simpler, income tax - high income taxpayers are supposed to calculate their taxes under the regular system and under the AMT and pay whichever is greater.

The AMT has become a big issue because the number of taxpayers affected by it is expected to grow significantly. This reflects two things: (i) the thresholds for the AMT are not adjusted for inflation, so as nominal incomes rise with inflation, an increasing number of upper-middle-class taxpayers will be affected and (ii) the tax cuts of 2001 and 2003 have reduced the regular tax liabilities for many, especially high-income earners.

In the Washington Post, Michael Kinsley defends the AMT. He writes:

If you were designing the tax system from scratch, you might come up with something that looks a lot like the AMT. It resembles the "flat tax" of many reformers' dreams: a high basic exemption, so that low-income people don't pay it at all; very few deductions, credits or exclusions; and (because of that) a much lower top rate than the current system: 26 percent, compared with almost 40 percent in effect today. What makes it complicated is having to figure your taxes twice to see if the AMT applies to you. Of the two parallel tax systems we have -- the regular income tax and the alternative minimum tax -- it might make more sense to scrap the regular one and keep the AMT.

The Urban/Brookings Tax Policy Center has background on the issue.

Black Monday (and Gordon Gekko) Revisited

Wall Street marked the 20th anniversary of the largest-ever one-day percentage plunge in the Dow Jones Industrial Average with a 367-point (2.6%) drop. On October 19, 1987 - "Black Monday" - the Dow fell 508 points, which was a 22% decline from its previous close of 2247. The New York Times revisited its coverage (check out the screaming headline). The Wall Street Journal marked the anniversary on Monday with a comparison to today's market (and some nifty charts and a video interview with floor broker) and an interview with NYU financial historian Richard Sylla.

It was scary stuff indeed - certain middle-schoolers anticipated an economic depression - but the economy ultimately shrugged it off. Financial markets sometimes seem oddly disconnected from the real economy. The recovery that had begun in November 1982 continued until July 1990.

Though it was an economic non-event, perhaps it marked a cultural turning point - an end to the greedy, selfish materialism of the 1980's. In a recent Slate essay on the movie "Wall Street," which starred Michael Douglas as greedy corporate raider Gordon Gekko, Jessica Winter wrote:

Released in December 1987, two months after the Black Monday stock market crash and just one week before Ivan Boesky was sentenced to three years in prison for securities fraud, Wall Street appeared like the indignant coda to an era that had suddenly self-destructed. (Parts of Gekko's famous "Greed is good" speech are freely paraphrased from comments Boesky made in 1985.) "The eighties are over," Newsweek announced in its first issue of 1988, adding, "Maybe the best pop-culture indicator of the post-'80s spirit is the respectful reception given to Oliver Stone's dreadfully ham-handed Wall Street."

George Bush was elected in 1988 promising a "kindler, gentler America" - an implicit rebuke to the harshness of the Reagan era. Two decades later, as Winter notes, it seems like the 1980's didn't so much end in 1987, they just paused. "Corporate raiding" is now called "private equity," the second gilded age rolls on apace, and that Don Henley CD I'm listening to now seems oddly un-dated. Just as we did with "Born in the USA," we seemed to miss the point of Wall Street:

Douglas says he's still stunned by the number of people who tell him that his Oscar-winning role was the reason they went to work on Wall Street. "It's so depressing and sad," Douglas says.

A sequel, "Money Never Sleeps" is in the works.

Taxes: Fairness and Incentives

Former Labor Secretary Robert Reich makes a case for raising taxes on high earners. He cites the IRS data on growing inequality (see earlier post) and, what's more:

The biggest emerging pay gap is actually inside the top 1 percent. It's mainly between CEOs, on the one hand, and Wall Street financiers – hedge-fund managers, private-equity managers (think Mitt Romney), and investment bankers – on the other. According to a study by University of Chicago professors Steven Kaplan and Joshua Rauh, more than twice as many Wall Street financiers are in the top half of 1 percent of earners as are CEOs. The 25 highest paid hedge fund managers are earning more than the CEOs of the largest five hundred companies in the Standard and Poor’s 500 combined. CEO pay is outrageous; hedge and private-equity pay is way beyond outrageous. Several of these fund managers are taking home more than a billion dollars a year.

Here's why Reich argues the government needs more revenue:

Taxing the super-rich is not about class envy, as conservatives charge. It’s about the nation having enough money to pay for national defense and homeland security, good schools and a crumbling infrastructure, the upcoming costs of boomers’ Social Security (the current surplus has masked the true extent of the current budget deficit, but it won’t for much longer), and, hopefully, affordable national health insurance. Not to mention the trillion dollars or so it will take to fix the Alternative Minimum Tax, which is now starting to hit the middle class.

So, how high does Reich think top rates should go?

What’s fair? I’d say a 50 percent marginal tax rate on the very rich (earning over $500,000 a year). Plus an annual wealth tax of one half of one percent on net worth of people holding more than $5 million in total assets.

Greg Mankiw responds:

If I were a redistributionist, here is what I might propose: A large fixed payment to every citizen, paid at the beginning of every month, financed by a proportional tax on consumption, such as a value-added tax.

That's very sensible if one takes seriously the possibility that, because they effect incentives, high marginal tax rates reduce saving and investment. Under Mankiw's proposal, there would be no tax on income which is saved - in theory, this should encourage investment and capital accumulation. The large fixed payment would result in very low - even negative - average tax rates for low-income earners. In a recent NY Times column, Bob Frank also argued for taxing consumption, rather than income, but in a much more progressive way:

As taxable consumption rises, the tax rate on additional consumption would also rise. With a progressive income tax, marginal tax rates cannot rise beyond a certain threshold without threatening incentives to save and invest. Under a progressive consumption tax, however, higher marginal tax rates actually strengthen those incentives.

But how worried should we be about the effect of marginal tax rates on incentives and behavior? By instinct and training most economists are inclined to believe incentives matter, but as I noted earlier, the economy actually grew faster in the 1950's and 1960's, when the top marginal tax rate was higher.

On a related note, the OECD has compared tax burdens (i.e. taxes as a % of GDP) across member countries (the OECD is a group of rich countries). Of the 30 countries in the study, Sweden had the highest tax burden (50.7%) and Mexico the lowest (19.9%), and the US (27.3%) was below the average of 36.2%. Its hard to see a clear connection between taxes and economic performance in the OECD data - certainly, high taxes haven't prevented some countries from being prosperous (of course, overall tax burdens are not the same thing as marginal tax rates). The NY Times has a nice story on the OECD data.

Morning in America (Finally!)

Critics of the "supply side economics" employed to justify President Reagan's tax cuts sometimes refer to the idea as "trickle-down economics" (Reagan's opponent in the 1980 Republican primary, George H.W. Bush, called it "voodoo economics"). But now middle-income Americans are finally seeing the benefits - The Onion reports "Reaganomics Finally Trickles Down to Area Man:"

Twenty-six years after Ronald Reagan first set his controversial fiscal policies into motion, the deceased president's massive tax cuts for the ultrarich at last trickled all the way down to deliver their bounty, in the form of a $10 bonus, to Hazelwood, MO car-wash attendant Frank Kellener...

The [hilarious!] article details the path of the $10, and has reactions from Arthur Laffer, Ted Kennedy and Hank Paulson.

Taming The Twins

The trade deficit and fiscal (federal budget) deficits are sometimes referred to as the "twin deficits." They are linked by the identity: NX + NFP + Tr = NS - I; where NX is net exports (if negative, a trade deficit), NFP is net income from abroad and Tr is international transfers. Together, they are the current account, of which NX is by far the largest part - i.e. the US trade deficit drives the US current account deficit. The other side is national savings (NS) less investment (I), where national savings is private savings and government savings. The fiscal deficit is negative government savings; NS can therefore be thought of as the savings left after subtracting the part borrowed by the government. So, ceteris paribus, the trade deficit (-NX) and the fiscal deficit (which reduces NS) move together - hence the "twin deficits."

Last week brought news that both of deficits are shrinking. The CBO reported preliminary estimates that the federal deficit decreased to $161 billion in fiscal year 2007, from $248 billion the year before (the federal fiscal year ends in September). The biggest change in the spending side was a $65 billion decrease in "other programs and activities" (i.e. not defense or entitlement programs), which the CBO attributes to some one-time-only events:

The decrease in outlays for "other programs" was mainly due to unusually high spending in 2006 for activities related to the 2005 Gulf Coast hurricanes and for the subsidy costs recorded for student loans. Payments received in 2007 for licenses auctioned in 2006 for use of the electromagnetic spectrum further reduced net outlays. Excluding those three activities, spending for this category rose by about 1 percent.

On the revenue side, income tax revenue surged by $118 billion - partly this is the "automatic stabilizer" effect (taxes rise as incomes rise). A large part of the increase came from "nonwithheld income":

Nonwithheld income and payroll tax receipts gained about $55 billion (or 13 percent) in 2007. The two main components, quarterly estimated payments and final payments with tax returns, both grew at about that same rate. Nonwithheld receipts grew more slowly than the 19 percent rate recorded in 2006. The double-digit growth in 2007 probably reflects continued strong growth in income from sources other than wages and salaries.

Presumably, that would mostly be "capital income" like dividends, interest income and capital gains - growth in this type of income is consistent with the rising inequality reported by the IRS (see previous post).

As for the trade deficit - the BEA and Census Bureau reported exports of $138.3 billion and imports of $195.9 for a deficit of $57.6 billion for the month of August. That's $1.4 billion less than July and $10 billion less than August, 2006. This may, in part, reflect the continuing decline the in the value of the dollar, which makes US products cheaper to foreigners (increasing exports) and makes foreign products more expensive to Americans (decreasing imports). By country/region, the largest deficits were with China ($22.5 billion), OPEC ($11.4 billion) and Europe ($11.1 billion). Here's the NY Times story.

Income Inequality Update

The Wall Street Journal reports:

The richest Americans' share of national income has hit a postwar record, surpassing the highs reached in the 1990s bull market, and underlining the divergence of economic fortunes blamed for fueling anxiety among American workers.

The wealthiest 1% of Americans earned 21.2% of all income in 2005, according to new data from the Internal Revenue Service. That is up sharply from 19% in 2004, and surpasses the previous high of 20.8% set in 2000, at the peak of the previous bull market in stocks.

The bottom 50% earned 12.8% of all income, down from 13.4% in 2004 and a bit less than their 13% share in 2000.

International Agreements as Commitment Mechanisms

One argument for trade agreements is that they tie the hands of governments, and may provide a way to "lock in" market-oriented economic reforms. The reforms may lead to higher investment, but only if businesses are confident that the policies will stay in place - the trade deals improve the credibility of the policies (that is, they are a "commitment device"). A similar argument has been made for fixed exchange rates - they are a way for a previously inflation-prone government to credibly commit itself to a more stringent monetary policy (which is necessary to maintain the currency peg). Much of this argument derives from Kydland and Prescott's study of the "time consistency" problem - the Nobel Prize site has a good description. But isn't it anti-democratic for a current government to tie the hands of its successors? On his blog, Dani Rodrik explains how to tell the difference between "the good and bad kind of external discipline."

Can 'Free Traders' Handle Competition?

Dean Baker, an economist from a left-ish think tank, says that free trade is "The Best Weapon Against the Free Traders." He writes:

...[Trade Liberalization] has had exactly the effect that trade theory predicts. It has lowered the wages of less-educated workers relative to workers with college degrees and especially workers with advance degrees. We can reverse this upward redistribution by adopting trade policies that subject the most highly educated workers to the same sort of international competition that textile workers and autoworkers now face....

The big winners in this story are the workers who manage to keep themselves protected from international competition. As a result of recent trade and immigration policy, these highly paid professionals can buy low cost furniture, cars, and clothes. They can also have their homes renovated and their gardens maintained at low prices. They can even get cheap nannies for their kids.

But the key to the success of these highly paid workers is maintaining their own protection from international competition. There are long list of professional and immigration barriers that protect doctors, lawyers, and even economists and journalists from the same sort of international competition faced by textile workers and dishwashers.

There is a basic truth here: it is quite easy to be in favor of "competition," "free markets" and "capitalism" as long as its happening to somebody else, but when it happens to us, we suddenly become concerned about "fairness."

But Baker is mistaken on his trade theory (despite his Michigan PhD!). The Stolper-Samuelson theory, part of standard neoclassical trade theory, says that trade increases the returns to the "abundant" factor of production. If the US is abundant in skilled labor (i.e. compared to other countries we have a higher ratio of skilled labor to other factors like unskilled labor, land and capital) the theory predicts exactly that skilled labor will gain; no selective protection from trade is necessary.

And as for economists: while the immigration system certainly creates unconscionable hassles, we are competing in a global labor market (at least, those of us without tenure are!). Roughly 70% of the doctorates in economics awarded in the US (where most of the world's best programs reside) go to non-Americans, many of whom take jobs at American colleges and universities.

August Job Loss - Not!

Last month, we were spooked by a report from the Bureau of Labor Statistics that "nonfarm payroll employment" had declined by 4,000 in August. At the time, I noted that "the payroll employment figure is preliminary and subject to revision" (handiness with caveats is an important professor skill).

Revise they have - now the BLS reports that August saw a gain of 89,000 jobs (and September, preliminarily, 110,000). The unemployment rate edged up slightly in September - from 4.6% to 4.7% - but this partly reflects entry into the labor force; labor force participation increased from 65.8% to 66.0%.

The revision is a useful reminder that we - and, more crucially, policymakers - never know the true current state of the economy - the (imperfect) statistics we have are retrospective. This is part of what is sometimes called the "recognition lag" in economic policy.

On his blog, Paul Krugman looked at "The Revision Thing" (and found the appropriate Keynes bon mot - there's one for every occasion!).

A Big Problem We Ignore

The insanely high rates of incarceration in the United States may be our most unheralded social (and economic) problem - perhaps because there is very little political gain (and much political risk) in taking it on. Nonetheless, last week, Senator Jim Webb of Virginia held a Joint Economic Committee hearing on the subject. According to the committee:

The United States has experienced a sharp increase in its prison population in the past thirty years. From the 1920s to the mid-1970s, the incarceration rate in the United States remained steady at approximately 110 prisoners per 100,000 people. Today, the incarceration rate is 737 inmates per 100,000 residents, comprising 2.1 million persons in federal, state, and local prisons. The United States has 5 percent of the world’s population but now has 25 percent of its prisoners.

Senator Webb also posted some facts about the prison system in the United States. Among them:

The U.S. prison system has enormous economic costs associated with prison construction and operation, productivity losses, and wage effects. In 2006, states spent an estimated $2 billion on prison construction, three times the amount they were spending fifteen years earlier. The combined expenditures of local governments, state governments, and the federal government for law enforcement and corrections total over $200 billion annually. In addition to these costs, the incarceration rate has significant costs associated with the productivity of both prisoners and ex-offenders. The economic output of prisoners is mostly lost to society while they are imprisoned. Negative productivity effects continue after release. This wage penalty grows with time, as previous imprisonment can reduce the wage growth of young men by some 30 percent...
The prison system has a disproportionate impact on minority communities. African Americans, who are 12.4 percent of the population, are more than half of all prison inmates, compared to one-third twenty years ago. Although African-Americans constitute 14 percent of regular drug users, they are 37 percent of those arrested for drug offenses, and 56 percent of persons in state prisons for drug crimes...
Prisons are housing many of the nation’s mentally ill. The number of mentally ill in prison is nearly five times the number in inpatient mental hospitals. Large numbers of mentally ill inmates, as well as inmates with HIV, tuberculosis, and hepatitis also raise serious questions regarding the costs and distribution of health care resources.

As far as I can tell, the hearing didn't get any attention from the press (I learned about it from Ezra Klein's blog), but the Times has an article on the racial disparities in our legal system. The census recently reported that the number of Americans living in college dorms has surpassed the number in prison, but what does it say that this is considered news?

People Will Bet on Anything

including the Nobel Prize* in Economics, which will be announced Monday, Oct. 15. According to Ladbrokes, the favorites are:

Christopher Pissarides (4:1 odds)
Dale Mortensen (4:1)
Paul Krugman (5:1)
Peter Diamond (5:1)
Paul Romer (6:1)
Elhanan Helpman (8:1)
Gene Grossman (8:1)
Robert Barro (8:1)

Presumably Mortensen and Pissarides would receive the award jointly, mainly for their work on unemployment theory (if they win, someone might recall the copy of Pissarides' "Equilibrium Unemployment Theory" I have checked out from the library....). I'm pulling for Krugman, if only because we are studying his seminal "Increasing Returns, Monopolistic Competition and International Trade" paper in Econ 441 ("see, I told you it was important!"). Romer is one of the pioneers of endogenous growth theory - some of which relies on the same imperfect competition/scale economies mechanism used by Krugman (for an excellent account of Romer's contribution, see David Warsh's book "Knowledge and the Wealth of Nations"). The device they both use (and everyone uses now) - is the "Dixit Stiglitz" technology - Stiglitz already has a Nobel (can't get it twice), and the odds on Dixit are 20:1. Grossman and Helpman have both done important work (much of it together) in both growth and trade theory.

*The prize was established "in memory of Alfred Nobel" by the Swedish central bank in 1968, so its technically not a "real" Nobel Prize (if you look carefully at the Nobel Prize web site, you'll notice its referred to as the "Prize in Economics" not "Nobel Prize in Economics")

Wile E. Coyote Moments

As I mentioned recently, Paul Krugman has expressed a concern that we may experience a "Wile E. Coyote Moment" in regards to the dollar and the current account deficit. At VoxEU, Richard Baldwin responds to Krugman. Setting aside the substantive issue, I am intrigued by the possibility that "Wile E. Coyote Moment" may be entering the lexicon of economic jargon. Here's Baldwin's explanation:

...the markets are due for what Krugman calls a 'Wile E. Coyote' moment – a reference to the Warner Brothers’ cartoon where a greedy, shortsighted coyote chases a roadrunner off a cliff but doesn’t start falling until he looks down and realizes he’s left solid ground. Up until this 'Wile E. Coyote' moment, his belief that he’s on solid ground prevents him from falling. For investors in dollars, the 'Wile E. Coyote' moment comes when they realise that their expectations are inconsistent with any feasible adjustment path.

So, I wonder if in a few years I will be attending (or giving!) presentations at academic conferences with titles like "Wile E. Coyote Moments in a 2-Country DSGE Model," "Estimating the Probability of Wile E. Coyote Moments: A Bayesian Approach" and "Can Wile E. Coyote Moments Explain the Equity Premium Puzzle?"

If the "Wile E. Coyote Moment" becomes part of our language, it will eventuallly show up in our textbooks. I'm no theorist, but here's how I think the standard PhD micro text, Mas-Colell, Whinston and Green's Microeconomic Theory, which is beloved in some (but not all) quarters for its "rigor and generality," might define it:

If there are any theorists reading this, perhaps you can suggest some related theorems, lemmas and corollaries...

Krugman Gets an A

On his blog, Paul Krugman takes on Europe-bashing. "Its a fixed idea among Americans that Europe - France, in particular - is an economic wasteland," he writes. Among the bits of evidence he musters against the Euro-bashers (not to be confused with Euro-trashers):

French productivity – output per hour – is about the same as ours...
Now, it’s true that French GDP per capita is lower than ours. That reflects three things: the French work shorter hours; French people under 25 are less likely to be employed than young Americans, and the French are much more likely than Americans to retire early.

That would have been a good answer to question 3 on last Thursday's Econ 202 midterm:

(3 pts) France and the US have almost identical GDP per hour worked, but French GDP per capita is 27% lower than the US. How is this possible? In what regard does this imply that the French are better off than Americans?

Krugman goes on to explain:

Short working hours are a choice – and it’s at least arguable that the French have made a better choice than America, the no-vacation nation.

Low employment among the young is a complicated story. To some extent it may represent lack of job openings. But a lot of it is the result of good things: young French are more likely to stay in school than young Americans, and fewer French students are forced by financial necessity to work while studying.

Finally, the French retire early. That’s a real problem: their pension system creates perverse incentives. We, of course, have this superb program called Social Security, which does a much better job.

He did also mention that:

What’s more, even during the period 1995-2005 – the years when we Americans were boasting about our productivity boom – French productivity grew only half a point slower than US productivity. And the US productivity boom now seems to be over.

If he was in Econ 202 - and doing the assigned reading!* - he would also be aware that, while France lagged the US in labor productivity, it has actually done slightly better than the US in total factor productivity. [which, of course is not the correct answer to problem 3].

So maybe we shouldn't say that French economic performance is worse than the US, but we can still call them cheese-eating surrender monkeys! (though some might now think they were right about the Iraq war...)

*"A Productivity Primer," The Economist, Nov. 6, 2004.

Who Our Creditors Are

The corollary of massive borrowing by the United States - the current account deficit was $811 billion in 2006 - is accumulation of US assets by foreigners (a "capital inflow"). As I discussed recently, this has generated some worry about a crisis if our creditors lose their appetite for holding US assets.

On his outstanding international macroeconomics blog, Brad Setser looks at the data on official reserves (e.g. foreign asset holdings of central banks) and finds that "Central banks came close to financing the entire US current account deficit." He writes:

I estimate that the world's emerging economies -- if those emerging economies that don't report detailed data on the currency composition of their reserves acted like those who do report -- are now adding about $200b to their dollar reserves a quarter. That is a pace sufficient to finance the entire US current account deficit. Central banks continue to buy more dollars when the dollar is heading down than when it is going up to keep the dollar's share in the (aggregate) portfolio constant -- and effectively serve as the dollars buyers of last resort in the global financial system.

Private flows still matter, of course. But right now private inflows roughly match private outflows, so all the heavy lifting required to finance the US external deficit is being done by the world's central banks. Their willingness to hold dollars allows the US to finance itself in dollars even when there isn't a lot of global demand for dollar assets.

The tools economists use to examine exchange rates and current accounts are mostly based on optimal behavior of individuals - e.g. a European investor will make a decision about whether to hold a German bond or a US bond by comparing the return on the German bond to the expected return on the US bond, converted to euros, and the dollar-euro exchange rate is ultimately determined by the demand for dollars from such investors (and the parallel behavior of US investors on the other side of the market).

Setser's finding reminds us that governments play huge roles in foreign exchange markets, and their motives are very different. In particular, many countries - primarily "emerging markets," of which China is most prominent - intervene in foreign exchange markets to keep the values of their currencies artificially low, making their exports cheaper. This involves selling their currency (increasing the supply of it and lowering its value) for dollars. In the process, the governments accumulate dollar reserves.

We still need to be concerned that our creditors might reduce their willingness to finance our current account deficit, but it is crucial to bear in mind how much of that financing is coming from governments rather than private investors maximizing expected returns.