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.

A Primer on "Core" Inflation

When explaining its monetary policy decisions, the Fed often speaks of "core inflation" - that is, an inflation rate calculated without food and energy prices, which tend to be rather volatile. Of course, food and energy are major expenses for most people, so you wouldn't want to throw them out of a calculation of the "cost of living." For the most part recently, "core" inflation has been lower than overall inflation, or as Daniel Gross explained, "If You Don't Eat or Drive, Inflation's No Problem." On his blog, Berkeley's Brad De Long defends the Fed's practice of focusing on "core" inflation:

The Federal Reserve's mandate to maintain price stability requires that whenever significant inflation threatens it is supposed to hit the economy on the head with a brick: raise interest rates, and so discourage investment spending, lower capacity utilization, raise unemployment, and so create excess supply. The Federal Reserve would rather not do this unless it has no other option. If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

The Fed cannot, however, just say "we regard this rise in inflation as (a) transitory and thus (b) self-limiting, and so are going to let sleeping dogs lie." A Fed that does that quickly loses its credibility as an inflation-fighter, and a modern central bank with no inflation-fighting credibility is in a world of hurt.

However, when increases in inflation are confined to (i) energy and (ii) food prices, odds are that the increase is transitory and will be self-limiting. Hence the concept of "core inflation." If the Federal Reserve concludes that the current rise in inflation is transitory and self-limiting, it can point to the core inflation number as a principled excuse for not hitting the economy on the head with a brick.

The Fed's favorite measure is the "core" deflator for personal consumption expenditures (PCE) reported by the Bureau of Economic Analysis (in addition to the GDP deflator, the BEA calculates separate deflators for each component. Overall GDP statistics are quarterly, but the BEA provides monthly data on consumption). Here's how it looks (% changes from 1 year ago):

Clearly overall PCE inflation is more volatile than the "core" - taking out food and energy prices makes inflation appear more steady. Also, core inflation has mostly been lower than overall inflation - food and energy prices have been going up faster than the prices of consumption goods generally. That is, the inflation rate the Fed is responding to is less than the one we consumers are experiencing. (BEA data via FRED).

Marginal Utility of What?!

In 1930, Keynes predicted that economic growth would lead to a tremendous increase in leisure time. I recently had my principles students read a NY Times column by Bob Frank where he examined the failure of this prediction. Frank says "decisions to spend are also driven by perceptions of quality, the desire for which knows no bounds. But quality is an inherently relative concept." So, although productivity growth and capital accumulation mean that we could have had rising standards of living and more leisure, we find ourselves working to produce (and be able to afford) goods of ever-higher perceived quality. That came to mind when I read this in the Cincinnati Enquirer:

P&G Launches Smart Toothbrush

Oral-B, the toothbrush brand from the Procter & Gamble Co., announced on Friday it is launching Oral-B Triumph with SmartGuide, a wireless display that allows users to time their brushing....

The company says SmartGuide combines the brushhead, handle and visual display so users receive prompts from microchips. These prompts tell users when they are brushing too hard, when to move to the next quadrant of the mouth and when brushing has lasted two minutes. It also indicates when it is time to replace the brushhead.

One of the weaknesses of mainstream economic theory is the way that we think of preferences. In particular, we typically assume that preferences for particular goods or attributes are an intrinsic, or primitive, aspect of the individual. However, the example above reminds us of something that John Kenneth Galbraith pointed out: businesses are constantly working to create preferences for goods we never imagined we might want. (Here's Brad De Long's review of Richard Parker's fine biography of Galbraith, who passed away last year).