Saturday, 31 May 2014

EU elections comment: Marginal parties do well in marginal elections

The success of extremist parties in the latest vote for the EU Parliament shouldn’t come as a surprise, even though it is a slight reason for concern. The agendas and activities of some of these parties such as the French National Front, the Greek Golden Dawn, or the Hungarian Jobbik are just too gruesome to comment. Far from their anti-immigration agendas and their protectionist economic approach, they are examples of the exact sort of thing the foundation of the EU was supposed to avoid – the rise of Nazism.

In addition to their almost identical national-socialist pleas, one thing all of the marginal right-wingers have in common is a Eurosceptic agenda, which in most cases calls for the abolition of the EU itself. To stress the absurdity of the situation, imagine that one fifth of the national parliament of a country consists of people who despise the country itself and seek to destabilize it. Their Euroscepticism is the glue holding their interests together and by using it they’ve managed to build a big enough support group of disillusioned citizens tired of Europe’s bureaucracy and the perception of political dysfunctionality in times of crisis. 

Source: The Economist
The reason for their success is primarily low turnout. European Parliament elections are a second order election. They are insignificant in their importance, in their scope, and in their effects. They represent a perfect platform for marginalized political parties to grab some attention as it is in such elections where their supporters tend to turn out in large numbers, while the majority of other voters rather stay home (on average across the member states). It would have been even worse had turnout been lower, since these elections for the first time ever averted a declining trend, with total turnout being a still low 43.1%. 

The second reason for success is their perception as an anti-establishment movement. In times when most European countries are suffering from an ill-advised austerity approach where everything but credible institutional reforms has been tried, the electorate has gotten fed up with the dominant establishment centre-left and centre-right parties. Their response isn’t to vote against them as they have no one good enough to turn to, their response is simply to stay home and avoid participation, thus non-intentionally leaving more room for extremists to be heard. 

The voters realize that in terms of economic recovery one should look far beyond the scope of the EU Parliament and the EU Commission. The role of the Parliament and the Commission are developmental and redistributive, not reactionary; the EU budget is focused on agricultural subsidies, structural funds and investment into education, which are all noteworthy goals, but neither can help Europe achieve a robust recovery. The Commission simply doesn’t hold any mechanisms to resolve structural problems of member states. They can propose regulatory solutions that may prevent future shocks (such as the banking union idea), and can facilitate free trade and movement of labour and capital, but they cannot solve member states’ structural problems in lieu of their governments. One cannot expect things such as the Single Supervision Mechanism or the euro-wide Deposit Guarantee Scheme to be the key for kick-starting economic growth. They are a good response to the problems of a currency union, which should have been addressed earlier, but they aren’t policy measures that can help solve crises. For economic recovery national elections are still much more important than EU elections. 

In that perspective one cannot really expect much from any of the Parliament members, or the so-called euro government, but precautions still lie ahead in terms of domestic politics. 

It seems that the long-lasting consequences of a deep economic crisis have finally resulted in their most dangerous consequence – a rise in popularity of previously marginalized extremist political parties across Europe. Even though they’re still not strong enough to influence national policies, Europe should take caution as this is exactly how the Nazis in Germany started in the 1920s. After a decade of political marginalization and ridicule from the mainstream media, the German hyperinflation had finally made the electorate cave in and gave them power. This may seem as a distant scenario in terms of domestic national elections today, but it is precisely the European Parliament where the extremists are given a chance to stand in the limelight and advocate their economically backward and failed ideas (nationalization, protectionism of domestic industries, modern mercantilism etc.) which tend to attract a surprisingly large amount of people in times of economic hardship. The extremists won’t dissolve the EU, nor will the EU Parliament be the place where one might expect an origination of economic recovery, but the economic reforms in member states should start quickly before it is too late and Europe once again loses hope and descends into nationalism. 

Wednesday, 28 May 2014

Democracy and the causal growth link

Is democracy good for growth? The ultimate question of political economy of growth to which we'll hardly get a clear answer. A lot of academics would emphasize that empirically higher level of political rights need not necessarily translate into economic growth. Furthermore, many academics would agree that even if we accept the argument that democracy works for rich countries, it doesn't work in poor (low-income) ones. This goes back to the argument that some countries just aren't culturally or even geographically fit for a capitalist democratic system. They need to have a dictatorship to produce growth. 

Most of these arguments are false.

Democracy perhaps doesn't cause growth, but it is the key necessary precondition for growth and development. Many will point to China and say this isn't true - China seems to be a prime example of a non-democratic system (state capitalism) achieving exuberant growth rates in the past few decades. I've written so much on China's economic potentials (here, here or here) and the real problem with China is the lack of inovativeness, or more precisely the lack of trial-and-error that characterizes most capitalist democracies. Democracy implies innovation. It strives on trial and error. Both of these categories are the essential ingredients for the driving force of capitalism - creative destruction. Without it technological progress wouldn't be possible. And if anything is important for long-run economic development of a society, than it's technological progress (after all, remember which countries are technological innovators, and which are the followers).

Furthermore, democracies can be much more efficient in providing public goods and educating their population. And even though it's not immediately obvious, democracies are arguably more successful in implementing institutional reforms necessary for systemic adaptation to change. Even though such reforms are usually faced with a number of interest groups preventing change (examples range from fights for worker rights in the 19th and 20th century to modern-day unions preventing the necessary restructuring of industries, or politicians preventing reforms aimed at disturbing their winning coalitions), making the process extremely hard and long, democracies do in the end succeed. And it all works to the benefits of the economy and long run growth.

With respect to this debate there is new evidence proving the aforementioned arguments wrong. Acemoglu, Naidu, Restrepo and Robinson find that democracy does indeed cause (lead to/result in) higher economic growth. The argument is summed up in the following figure:
Source: Why Nations Fail blog
"This figure shows the evolution of GDP per capita following a democratization event compared to nondemocracies (all democratizations are lined up to date 0 so as to visually trace out average growth following democratization relative to the control countries in which there is no democratization). The first thing that jumps out from the figure is that a typical democratization takes place when a country is undergoing an economic crisis ... Our baseline estimates suggest that a country that democratizes increases its GDP per capita by about 20% in the next 20-30 years. Not a trivial effect at all."
However note also that the first five to ten years are crucial in a painful consolidation process. The first five years are extremely fragile and on average the population cannot see any of the immediate benefits of a democracy. This is because it takes time for the proper institutional consolidation to yield its effects. As I've mentioned earlier, people get preoccupied with elections before they set up the proper legal and constitutional framework. This often results in negative selection at the very top of society, which can easily lock the country up in cronyism and state capture. The lesson is that after the democratic consolidation process stabilizes, which takes time and patience, it will lead to higher growth. Perhaps not directly, but it will indirectly accumulate all of the necessary preconditions, such as the rule of law and a proper legal system, which will first and foremost lead to a higher accumulation of capital, improved labor productivity and send a signal of positive investor confidence. Economic growth is a necessary consequence. 

Sunday, 25 May 2014

Week links (7)

The best from the rest:

1. The news bomb of the week in economics actually came on Friday: Chris Giles from the Financial Times found serious errors in Piketty's argument on inequality:
"The data underpinning Professor Piketty’s 577-page tome, which has dominated best-seller lists in recent weeks, contain a series of errors that skew his findings. The FT found mistakes and unexplained entries in his spreadsheets, similar to those which last year undermined the work on public debt and growth of Carmen Reinhart and Kenneth Rogoff.
The central theme of Prof Piketty’s work is that wealth inequalities are heading back up to levels last seen before the first world war. The investigation undercuts this claim, indicating there is little evidence in Prof Piketty’s original sources to bear out the thesis that an increasing share of total wealth is held by the richest few. ... In his spreadsheets, however, there are transcription errors from the original sources and incorrect formulas. It also appears that some of the data are cherry-picked or constructed without an original source. For example, once the FT cleaned up and simplified the data, the European numbers do not show any tendency towards rising wealth inequality after 1970. An independent specialist in measuring inequality shared the FT’s concerns."
The accusations are pretty serious. The full text is here. Well, if this is indeed true then it's a big deal. Interpreting with a slight bias is one thing, but cherry-picking data is completely unacceptable in academic work. He claims to have used a multitude of sources to get the data and he also claims that he doubts his conclusion would be changed with an improved dataset (see his response here). In other words, he is convinced his theory holds. However, explaining inequality is much more difficult than many believe, as it's volatility can depend on so many things, as I've shown in a series of texts (see here, here, here, here, here or here). Adhering blindly to only one view and attempting to find data that fits into one's hypothesis is an unfortunate way of furthering one's political views that have little to do with the facts. And the facts are the following: today we arguably have the lowest level of inequality than ever before. Just recall the lessons of economic history and the great rise in living standards
Disclosure: I still haven't read the book, I've only read reviews (both positive and negative), so I won't comment any of the findings yet. I just find it unfortunate that the database is apparently rigged. 

2. Hans-Joachim Voth: "Nazi pork and popularity: How Hitler's roads won German hearts and minds", VoxEu

Does this require any further clarification?
"In modern democratic elections, ‘political budget cycles’ may be driven by politicians’ need to signal their competence. Similarly, the Autobahn served as a convincing proof of Nazi Germany’s ability to get things done – a project to showcase the ruthless energy and organizational capabilities of the new regime, as Hitler promised in his speech inaugurating the project. Sold as a key factor for economic revival, the rapid fall in unemployment after 1933 convinced many that road-building had ‘worked’. After the perceived incompetence and gridlock of Weimar politics, many Germans were undoubtedly impressed by the rapid progress in road-building. The propaganda machine took particular care to connect the roads in the public imagination with Adolf Hitler himself – the motorways were called ‘roads of the Führer’, piggybacking off the leader’s popularity and enhancing his image still further."
Perhaps it can serve as yet another warning against socialism (or national-socialism) and its temporary economic effects. 

3. Arnold Kling: "David Brooks Plays Fantasy Despot", askblog
"The process of change would be unapologetically elitist. Gather small groups of the great and the good together to hammer out bipartisan reforms — on immigration, entitlement reform, a social mobility agenda, etc. — and then rally establishment opinion to browbeat the plans through. But the substance would be anything but elitist. Democracy’s great advantage over autocratic states is that information and change flow more freely from the bottom up. Those with local knowledge have more responsibility."
4. "Capitalism thrives by looking past the bottom line", Financial Times.

5. Scott Sumner says "The middle class is doing fine" at EconLog.

6. And finally, an old video by Milton Friedman on regulation and public choice theory: (HT: Cafe Hayek)

"All too often people who are well-meaning and have good intentions end up creating results which are the opposite of the very thing they are trying to fix." - just as I've pointed out in one of my first posts on the blog.

Thursday, 22 May 2014

Graph of the week: "Academic" salaries

Well this is interesting:
It seems the best job you can get at a University is that of a football coach. Not only do you massively outperform the tenured professors, but you also outperform the deans and the university president.

How can this be? Is this fair? Is it fair for a football coach to get a higher salary than highly-respected academics and even their own bosses? Yes, it is.

It's all about supply and demand. Fairness has nothing to do with it.

There is a lack of supply of high quality coaches (and high quality players in general, in any sport). If one wants a good result which is usually accompanied by a large amount of money flowing in to the winning team (e.g. in terms of sponsorship deals) then one needs to pay the price for such quality. In college sports the players are cheap - they're students after all so they get scholarships, but that's why a coach must be expensive. 

A football coach with a good performing team brings in a lot of revenue to the University. I was actually surprised to see how much (see the link) - there's a lot of money moving around in college sports. It's a business. Sporting facilities are top quality (better than most professional clubs in Europe for example), every game is packed with fans, while tickets are not cheep. The salary that get's paid to the coach is actually only a minor expense the Universities give out to sports. 

Here's a list from Forbes of the top 25 revenues and expenses in just college football by University.

Total Football ExpensesTotal Football Revenue
Ohio State$34,026,871$58,112,270
Texas A&M$17,929,882$44,420,762
South Carolina$22,063,216$48,065,096
Notre Dame$25,757,968$68,986,659
Florida State$22,052,228$34,484,786
Oklahoma State$26,238,172$41,138,312
Boise State$8,537,612$15,345,308
Oregon State$11,903,213

For each University listed, money invested in college football pays back substantially. Texas for example gets a fourfold return for every dollar spent on college football. That's a good investment. And this is how one justifies such large salaries of football coaches, which are however still lower compared to professional football salaries in the US. But that's a different story. 

Monday, 19 May 2014

Cash for review: improving journal referee performance

Here's a paper that will raise a few eyebrows among academic economists - how to improve performance of journal referees. HT: MargRev.

Any self-respecting member of the economics profession (and the scientific field in general) has at some point dealt with long-lasting review processes. As you send a paper to a journal hoping to get it published it needs to go through a double-blind peer review process where it is usually sent to two referees (if it passes the editor) who decide whether the paper is good enough for a given journal and if so provide comments and suggestions for improvement. If they give you a go and suggest a few minor or major changes, the paper goes back and forth several times. These things take time, sometimes even a few years. And that can indeed be a real problem. I've heard of stories where people send their article to a journal, and in the mean time - during the three years waiting for the article to actually get published - the main assumptions they've employed have changed completely. Imagine writing about Arab dictatorships before the Arab spring. Or about the oil industry before the shale gas revolution. Certain events can completely offset one's hypothesis. 

Another good example were academic papers being published even in the top journals as the crisis was unfolding in 2008, 2009 and 2010. The range of topics was so diverse it included wine economics, online advertising (?) and wikipedia bias. I recall Scott Sumner being baffled by the fact that no single paper at an AEA economic conference in 2011 was on contemporary monetary policy or crisis-related economic policy. In a time when the public was seeking answers from the economists, no answers were being provided in terms of top-notch academic research. But that's why there were blogs. And many ideas bounced around through them, so the economists did respond in a timely manner. It's the policymakers who decided to adapt a selective approach to economic policy, accepting selected signals from economists but ignoring the rest.

The experiment

Anyway, three economists, Raj Chetty and Laszlo Sandor from Harvard and Emmanuel Saez from Berkeley, ran an experiment with journal referees at the well-respected Journal of Public Economics (JPE). They wanted to see whether they could improve the speed/quality of a peer review. In particular they wanted to test which types of economic and/or social incentives could be used to improve pro-social behavior of referees

They ran the experiment for 20 months (2010-11) and have included 3000 referee invitations for the JPE. They (Chetty and Saez are editors of the JPE) have randomized the referees into one of the following four groups - (1) giving them a 6 week deadline (the control group), (2) giving them a 6 week deadline plus having their turnaround time posted at the journal website by the end of the year (this was the social incentive), (3) giving them a 4 week deadline, and (4) giving them a 4 week deadline plus a $100 Amazon gift card for meeting the deadline (this was the cash incentive). Those randomly selected in the first group are the control group, while the three others were treatment groups: social treatment, early deadline treatment and cash treatment. There was no punishment imposed for not reaching the deadline. Only positive incentives were given. 

Source: Chetty, Saez, Sandor (2014) How can We Increase Pro-Social Behavior?
The conclusions are very interesting (see the graph above): Short deadlines are extremely effective for increasing the turnaround speed. As the deadline was shortened by two weeks, they received reviews two weeks earlier on average, which is a great result. They also state that attention matters: reminders and deadlines are very effective and have great impacts on speeding up the process. The cash incentive (the dashed red line) is the most effective method provided that reminders are being sent just before the deadline. On the other hand the social incentive of posting one's turnaround time online (the full read line) was not much different from the control group and the regular 6 week deadline effect, however in both cases the nudge from the editor (the horizontal dashed lines) helps in speeding up the whole process. This personalized approach from the editor was particularly successful at reducing review times with tenured professors who respond less to cash and regular deadline incentives. 

In terms of a faster review process they also tested for review quality, being afraid that a tighter deadline might provide a lower-quality review. But this didn't happen. Quality was tested via the average rate at which the editors follow the advice in the review report and the median number of words in the report. Both were unaffected by any of the given incentives. 

The normative, 'policy' implication for journal refereeing is that editors can indeed affect the length of the review process, without affecting its quality. Even though the cash incentive proved to outperform the rest of them (which is hard to impose even though journal publishers could finance it), simple methods such as lowering the deadline coupled with a personalized reminder approach can indeed be effective. Kudos to the authors for such a great experimental design. 

Monday, 12 May 2014

Graph of the week: Correlation doesn't imply causality vol. 2

Or Which is more important in competitive sports, money or talent?

The Economist once again paired an interesting relationship which could be suspect to the most obvious mistake in social sciences - interpreting correlation as potential causality. As I've pointed out in my earlier text on a similar topic linking wine consumption and academic performance, just because we inferred a pattern in the data doesn't mean that there is an actual causal link between the two observed variables. 

This time they look at the English Barclays Premier League (BPL) and compare club performance in the league (points) for the past 20 years with the money spent on player wages as a percentage of the season's median. Basically the question is how much does money matter? 
Source: The Economist
According to the graph above it seems that it matters a lot. The more money the club spent on player wages, the higher, on average, the points they gain by the end of the season and hence the higher the likelihood of them lifting the trophy when the season ends. When one looks at all the money spent by clubs on their players one can't help at agreeing with this obvious conclusion. Just last year the BPL wage bill was £1.7 bn, or close to 75% of club revenues. No company pays so much to its employees. But on the other hand it's all justified, as top-class players who get paid astronomic wages attract the most people to the stadiums who are prepared to pay a big price just to see these players in action. No wonder some fans are getting more and more aggravated at the poor performance of their clubs' biggest stars (just think of Man Utd this season - at least those who watch the BPL). 

Anyway by their calculation wage spending explains around 55% of the total variation in club performance. Which basically means that money matters but it's far from being the most important factor. As the authors of the text point out themselves good managers also matter, and to a large extent: 
"Sir Alex Ferguson, who retired as Manchester United’s manager last year, was remarkable in his outperformance: over 19 seasons his teams gained 15 points more on average than would have been expected given the amount the club spent on wages. These margins matter. Had he been an average manager, he would have won just one title. Instead, he won eleven."
I would say that good managers are actually crucial. Just look at any sports club when a good manager replaced a bad one (or vice versa) and had the same team at their disposal - the good manager outperforms the bad one often with the exact same squad (that's a good treatment effect). It's all about tactics and a winning mentality. Money can help retain a powerful presence on the transfer market, but it's hardly the key factor behind success. If this were to be true, then super rich clubs would just blow their competition away, but they don't. If this were true then we would never have an underdog story in sports. But we always do. 

I'll stick to football (the European one) as this is what I know best, but similar examples can surely be found in all sports. In the BPL, this season Liverpool has been outstanding with no one giving them a chance even to reach the top 5 (they came 7th last season and had a very poor last 5 seasons), but in the end they have only themselves to blame for not winning the league. Their wage budget however was the lowest among the top 4 (and Man Utd who came in 7th). In Germany Borussia Dortmund was on the brink of bankruptcy and battling for relegation only 4 years before they won two titles in a row and reached a Champions League final. In 2004 Jose Mourinho defeated all the richer clubs to win the Champions League with Porto. This season Atletico Madrid has a chance of gaining a double: the La Liga (domestic league) and the Champions League, punching above both super-rich Real Madrid and Barcelona. The underdog unsettled the duopoly of the Spanish Primera. 

And don't we all love a good underdog story in sports? Any sports. When a team or an individual outperforms his/her/its opponents not by amount of money they splash, but by the spirit and passion they posses about the game. That's after all what sports is all about - competition. It is a market game where many compete, some with better resources, some with fewer, but everyone is given a fair chance to put up a fight. And very often we can see underdogs unsettling the richer and "more powerful" teams. On the field, each team starts with the exact same position, every game. No one loses in advance.

The above correlation perhaps can point to an interesting observation but it's far from conclusive that money wins you titles. It surely can help but it's not a guarantee of success. Take a look at any football club when they were bought by an eccentric super-rich owner - not before they got the right manager and the right coaching team to support the manager did they enjoy some success. This too can of course be attributed to the money the owner was willing to pay for getting a great manager, but it only means that it takes more than money to build a winning team. After all not all rich owners can attract a good managerial name to their newly acquired toy. 

In addition the world's richest football club Real Madrid have spent astronomical amounts of money on buying players as well as their wages (they broke the world transfer record twice) only to win 3 trophies (1 Liga and 2 Cups) in the past 6 years (however this year they have a chance of winning the Champions League - which would make it all worth while, wouldn't it?). Also Manchester United, the second richest football club in the world, and yet this season, the first in 24 years without the guidance of Alex Ferguson, was dreadful, despite them awarding their best player an enormous pay rise. Managers and their surroundings (support they have from chairmen, the facilities they enjoy and the team of expert coaches they have) matter.

Or to put it into economic terms; institutions matter! It's just like the story with rich and poor nations. People like to say that today's rich nations are rich simply because they were rich to begin with (they had a colonial heritage). But having a colonial heritage or being rich in natural resources has nothing to do with being a wealthy country today - the relative strength of a country's institutions provides a much more precise answer as to why some nations today are rich while others are poor. 

Tuesday, 6 May 2014

In memoriam: Gary Becker

One of the world's most influential economists, Nobel laureate Gary Becker has passed away this week at the age of 84. Becker was a professor at the University of Chicago, Department of Economics and Sociology. He was an active economics blogger with his last post dating from only two months ago. He held the blog together with his friend and colleague Richard Posner, also a professor at the University of Chicago. It was a very good blog and I for one will surely miss his insightful posts. 

"My teachers taught me that economics was not a game played by clever academics, but a serious subject that helped us understand the real world we lived in."

Becker received the Nobel prize in economics in 1992 for “having extended the domain of economic theory to aspects of human behavior which had previously been dealt with—if at all—by other social science disciplines such as sociology, demography and criminology.” Essentially he introduced economic thinking and reasoning into mostly sociological and psychological issues such as family, marriage, discrimination, crime or addiction. He was focused on expanding the logic of economic analysis into all fields of social science. He advocated a common approach to all social sciences. 

His Nobel prize lecture called "The Economic Way Of Looking At Life" perhaps best epitomizes this view:
"My research uses the economic approach to analyze social issues that range beyond those usually considered by economists ... Unlike Marxian analysis, the economic approach I refer to does not assume that individuals are motivated solely by selfishness or gain. It is a method of analysis, not an assumption about particular motivations ... Behavior is driven by a much richer set of values and preferences. The analysis assumes that individuals maximize welfare as they conceive it, whether they be selfish, altruistic, loyal, spiteful, or masochistic. Their behavior is forward-looking, and it is also consistent over time. In particular, they try as best they can to anticipate the uncertain consequences of their actions. 
By applying such simple yet thoughtful analyses of many of life's situations Becker was able to influence many fields and topics, even far beyond economics itself. 

His most famous papers on crime (called "Crime and Punishment") presented criminals not as socially depressed or mentally deficient, but as rational agents capable of calculating the benefits of a crime vis-a-vis the penalties that they might incur, in addition to evaluating the probability of getting caught. Tim Harford points to an interesting anecdote with Becker who told him he had parked his car illegally while rushing to meet with him. Becker explained that after carefully weighing the risks and the benefits he made a rational crime. Economists love to do things like this - not illegal parking, but applying an economic reasoning to, well, everything.

He also defined the so-called marriage market, in a very interesting paper called "The Theory of Marriage".
"It's not an organized market the way the stock market is or a bazaar is in the Middle East, but it's a market nevertheless with the property that there are different people in this who are looking to get married. Not everybody can marry the same wonderful man or woman, and they have to make choices. And they may have met somebody who they're pretty happy with. They wonder about whether if they'd waited they'd meet somebody better, and these are the kinds of choices one makes in other markets. So using market as a metaphor, but I think it's a very good metaphor for what goes on here."
His famous contributions were also in the area of discrimination - he showed that discrimination is economically costly to the discriminator more than to the discriminatee. If an employer refuses to hire a productive worker due to gender or skin color, the employer loses a valuable worker. In a fully competitive industry discrimination would be too costly since companies which discriminate would soon lose out to those who are willing to open the possibility for a productive worker regardless of such insignificancies as one's skin color or gender. However in heavily regulated industries characterized by monopolies or cartels, discrimination is more pervasive.

Today we might take some of these findings as given since we face an abundance of economic and sociological literature that likes to place things in different perspectives. But Becker was arguably the pioneer of this approach.

Becker also carried a very interesting point on inequality, linked with his arguably most important theory of human capital. He claimed that inequality in earnings was an inequality of the "good kind". We aren't all the same, some are more capable at doing certain things than others (have a higher level of human capital) and this reflects in our income. Human capital to him was just like physical capital - they both carry a rate of return and they both require investment. In an environment where knowledge is seen as an important asset that determines one's potential income, if a person doesn't invest in his/her knowledge he/she will inevitably lose out. If we allow more high-educated workers to earn more money and keep more of their income this will encourage others to get more education and thus increase the quality of human capital in general (and likely increase productivity as well). The rising trend of getting college degrees testifies to this argument, as the people who chose to invest in getting a college degree were thinking this was a sure way to prosperity in a knowledge-led economy. It has worked for many so far in the long run, despite a temporary setback of the current crisis. 

The testimonial to Becker's influence to the field was best summed up by his former student Steven Levitt, economics professor at Chicago and coauthor of Freakonomics (a great book that emulates Becker's approach to using economics to describe non-economic social phenomena):
"About ten years ago, Pierre-Andre Chiappori and I analyzed which economic theorists have had the greatest impact on empirical research by looking at the key motivating citations in papers published in top journals in recent years. Becker was by far the most influential theorist by our metric. What was most remarkable was that thirteen different works of his were cited; no one else had more than three or four. He published influential research in every decade from the 1950s to the present – incredible longevity. No one else had longevity like that."
Some of his selected and recommended books and papers are:

1958. "Competition and Democracy." Journal of Law and Economics 1: 105-109.
1962. "Irrational Behavior and Economic Theory." Journal of Political Economy 70(1): 1-13.
1965. “A Theory of the Allocation of Time.” Economic Journal 40, no. 299: 493–508.
1968. “Crime and Punishment: An Economic Approach.” Journal of Political Economy 76, no. 2: 169–217.
1971 [1957] The Economics of Discrimination. Chicago: University of Chicago Press.
1974. "A Theory of Social Interactions" Journal of political Economy, 82(6): 1063-93.
1975 [1964] Human Capital. 2d ed. New York: Columbia University Press.
1981. A Treatise on the Family. Chicago: University of Chicago Press.
1983. "A Theory of Competition among Pressure Groups for Political Influence". Quarterly Journal of Economics 98: 371–400
1988. (with Kevin Murphy) "A Theory of Rational Addiction" Journal of Political Economy. 96 (4): 700.
1992. "The Economic Way of Looking at Life." Nobel Prize Lecture
1996. Accounting for Tastes. Harvard University Press

Thursday, 1 May 2014

Why no inflation?

"Inflation is always and everywhere a monetary phenomenon."

Thus spoke Milton Friedman.

In the long run expansive monetary policy (measured via changes in money growth) can only deliver higher prices (one cannot print their way into prosperity - just look at Zimbabwe). If a country's central bank prints too much money its value goes down so prices go up, while the opposite - deflation - occurs if the central banks fails to supply enough money. However in the short run the connection is not as strong. 

Not all price changes result in (or a consequence of) inflation. It is usually also important to look at the velocity of money in explaining the movements of prices. Sure the majority of inflationary pressures can be attributed to monetary growth but in times of a liquidity trap the velocity of money will paint a much clearer picture of expected inflation.

To define it precisely velocity of money represents the average rate at which money circulates in the economy, i.e. the rate at which goods and services are bought and sold. Usually if consumption is low velocity is likely to be low as well - people spend less so money circulates slowly. Furthermore as I've pointed out earlier velocity of money tends to move very closely with the employment-population ratio (the real labor market indicator), which also makes perfect sense - if the labor market hasn't recovered neither will the rate at which people spend their money. 

Velocity is calculated simply: dividing nominal GDP by M2 money supply. Since we know that the denominator is growing much faster than the numerator, naturally the ratio is decreasing. As can be seen in the graph below - velocity is on its lowest ever level since WWII and the Great Depression (the full data is here).
Source: St. Louis Fed
This again does not mean that high velocity will lead to high inflation, but low velocity will surely prevent inflation from occurring. Basically we can say that the decline in the velocity of money has offset the average annual money growth. Or if you want, the decline in NGDP (fall in employment and consumption) has offset the money growth which is exactly why inflation hasn't occurred. 

Interest rates and tight money

What about low interest rates? How come they aren't causing inflation? Or at least higher inflationary expectations? Milton Friedman again has an answer: 
"Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy." 
"After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."
Friedman predicts that if interest rates are low, inflation will not tend to go up but down. This is exactly what Japan went through in the past two decades and exactly what Europe and the US are currently in. Inflation is low since interest rates are low - i.e. since money is tight! As Scott Sumner clearly says - monetarists don't think low interest rates imply easy money. 

Yes, it is somewhat strange to claim money is tight with all the QE being done, but there is an explanation for this as well. And it goes back to the velocity of money. Inflation hasn't kicked in since velocity is still low, or in other words the NGDP still hasn't really recovered. Plus all the QE didn't turn up in the real economy, it's still mostly stuck with the banks. Even the companies are hoarding mass amounts of cash.

If the economic recovery remains to be disappointing (the likelihood of which is very possible) then we can observe this "tight money" situation for a long time. Inflation will still be borderline deflation and monetarists will still be calling for "easier money". Not via raising interest rates of course, but by proposing things like NGDP targeting or credible signaling of easier long term monetary policy (I've summed up the gist of their ideas here).

For the record I'm even more convinced that the crisis was far from an AD shock and cannot be helped with either monetary or fiscal stimuli. If it could it would have already been helped - there is a reason why velocity is low and banks and companies are hoarding cash. 

This clearly is a structural shock. Pumping money in a low interest rate environment while debt ratios are still rising in addition to episodes of wrong austerity policies is a lethal combination that perfectly emulates Japan. And today even Abenomics can't help them. At least not the two arrow approach. Europe needs to be ready for at least one "lost decade" of stagnation. This is relatively easy to endure for rich countries like the UK or Japan, but much harder for relatively poorer countries in Europe which need their growth to catch up. 

So now we're actually facing deflation?

This appears the be the headline nowadays. Sweden is the latest country to experience a deflationary episode. Krugman reports:
"It’s amazing: Sweden, which at first weathered the crisis fairly well, and faced none of the institutional constraints of the euro area, has managed — completely gratuitously — to get itself into a deflationary trap."

However the interesting point about Sweden is that they've raised their interest rates during the crisis (remember, Sweden is not in the Eurozone), which has led to a temporary deflation episode. This is why Krugman criticizes the Swedish C.B. and how they failed to listen to Lars Svensson and his warning signs. So in this situation low interest rates will result in low inflation (however due to low velocity), while raising them will lead to deflationary pressures. 

I'm not sure this deflationary episode will last, however. Inflationary expectations in Sweden are still high (besides it didn't take long for Sweden's finance minister Andres Borg to react debunking the whole story). The fact that some EU countries were hit by a temporary deflation episode was primarily due to no major food or oil price shocks recently. I don't think Sweden or Europe are falling in a deflationary trap. Perhaps a slow-growth trap (not Sweden but Europe) with Japanese descent, but definitely not a deflation spiral, as some seem to claim. 

Finally to wrap this up, here's from an older blog post from Mark Thoma
"While many factors affect prices that are beyond the Federal Reserve’s direct control, eventually monetary policy tends to re-emerge as the key driver of inflation. After abstracting from short-term movements caused by economic disruptions, recessions, and wars, inflation is ultimately a monetary phenomenon: since 1929, the average annual percentage increase in the GDP deflator has been 2.8 percent, and the average annual growth in excess money has been 2.9 percent."
Good, in the long run the old story still holds. At least some certainty in today's uncertain world.