Saturday, 24 October 2015

"Does the Wage Gap between Private and Public Sectors Encourage Political Corruption?"

A paper of mine (co-authored with Boris Podobnik and H. Eugene Stanley) got published in PLOS ONE! Since PLOS is an open-access journal you can read the whole paper here.

It is primarily a theoretical paper focused on designing a model of corruption networks in democracies. The intuition for the model was a growing disparity between public sector and private sector wages and how this corresponds with greater corruption. This is, naturally, only a correlation, but it served as a motivation to search deeper and uncover how corrupt networks can sustain themselves within a democratic environment. 

There were three main findings/contributions in the paper:
  1. The greater the public sector wage premium (higher public sector wages than private sector wages) in a given country, the greater the possibility of corruption
  2. We design and propose a new reward-to-risk ratio for labor economics (taking into account the relative riskiness of working in each sector)
  3. Democracy does not create corruption, but it can serve as a mechanism to preserve it in the long run. A transition from a corrupt to a non-corrupt state, and vice-versa, can only be purely random. 
And here is the full abstract:
"We present a dynamic network model of corrupt and non-corrupt employees representing two states in the public and private sector. Corrupt employees are more connected to one another and are less willing to change their attitudes regarding corruption than non-corrupt employees. This behavior enables them to prevail and become the majority in the workforce through a first-order phase transition even though they initially represented a minority. In the model, democracy—understood as the principle of majority rule—does not create corruption, but it serves as a mechanism that preserves corruption in the long run. The motivation for our network model is a paradox that exists on the labor market. Although economic theory indicates that higher risk investments should lead to larger rewards, in many developed and developing countries workers in lower-risk public sector jobs are paid more than workers in higher-risk private sector jobs. To determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the public sector wage premium increases with the level of corruption."
Findings in depth 

Much research in labor economics has been focused on uncovering whether workers in public sector occupations are overpaid or underpaid relative to workers in the private sector. However, many of these research efforts failed to take into account that occupations in private and public sectors generally have different rights assigned to them and more importantly different risks of losing a job. This implies that in labor economics we are faced with a similar problem that has existed in finance before Markowitz and Sharpe, where risk was not taken explicitly into account when assessing an investment. Markowitz revolutionized both investment theory and practice by accounting expected return and risk in portfolio construction ("Portfolio Selection", The Journal of Finance 7 (1): 77-91). Inspired by the Markowitz mean-variance model and the Sharpe ratio (The Journal of Portfolio Management 21 (1): 49-58), and in order to quantify how well wages compensate employees for risk in a given sector, we propose an analogous reward-to-risk ratio for labor economics as the ratio between annual wage and sector risk. We define sector risk as the reciprocal business lifetime in a given sector. If it is inappropriate to evaluate an investment return without taking into account its risk, it is equally inappropriate to discuss whether a job in a given sector is underpaid or not without taking into account the risk of that sector. 

Furthermore, according to economic theory, and related to the previous issue, higher risk investments should lead to larger rewards. In contrast to economic and common sense, there is a paradox on the labor market: in many developed and developing countries lower-risk public sector jobs are paid more than higher-risk private sector jobs. In order to determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the wage gap between public sector and private sector jobs in a country increases with the level of corruption. This result inspired us to propose an intriguing hypothesis that the wage gap between public and  private sectors can serve as a motivation for corruption. The greater the public sector wage premium, the higher the motivation for those without adequate skills and education to enter the public sector to achieve private benefits. Even in the US, jobs in the public sector carry greater advantages than jobs in the private sector. They are more secure, less stressful, offer a wider selection of health-insurance plans, better retirement benefits, flexible work arrangements, and more holidays and vacation days per year. The question is: how is this discrepancy, in which the less riskier sector is rewarded with higher wages, sustainable in the long run?

We hypothesize that a democratic system (understood under the principle majority rule), creates an enabling mechanism for corruption persistence, even though it is not responsible for creating corruption in the first place. If we operate under a plausible assumption that a large majority of people are generally uncorrupt, why can corrupt subjects in some countries prevail and take power? To resolve this question we apply a network concept based on the model recently published in Nature Physics (Majdandzic, Podobnik, Buldyrev, Kenett, Havlin & Stanley (2014) "Spontaneous recovery in dynamical networks." Nature Physics 10, 34-38). We propose a dynamic network model of corrupt and uncorrupt employees representing two states in the public and private sector. In our model, corrupt employees are more intra-connected to one another and more unwilling to switch their attitudes regarding corruption than the uncorrupt. Inter-links between corrupt and uncorrupt employees serve to switch the attitudes of agents in the competing group. With such inter- and intra-links, corrupt subjects can prevail and become a majority through sudden transitions even though they initially represented a minority. This way it is obvious that in many democracies corruption can be persistent over a long period of time, and the only way to break the mold and flip from a corrupt to a non-corrupt state is via random selection of a non-corrupt individual as head of state.

Wage gap and corruption

A potential criticism may be directed at the assumption of modelling the labor market as a securities market. This is a mere allegory. The point is to suggest that wages in any job have to take into account the relative riskiness of that job (potential of job loss, benefits received, industry risk, etc.), not just the usual factors like location, hours or level of education. Furthermore the standard economics literature linking the wage gap to corruption finds an opposite conclusion to our own - countries which have a greater public sector wage premium usually have lower corruption. These findings are however limited primarily to low-income, developing countries. Naturally, we factor for this difference and observe all types; low-income, middle-income and high-income countries. Here is how that looks:

Source: Podobnik, Vukovic, Stanley (2015) "Does the Wage Gap between Private 
and Public Sectors Encourage Political Corruption?" 
PLoS ONE 10(10): e0141211. doi:10.1371/journal.pone.0141211 
We can see three types of countries corresponding to a concave relationship between the public sector wage premium and the corruption index. There is a group of low-income countries where corruption is rampant and public sector wages are much lower than private sector wages. This phenomenon is well established and explained in the literature. Given the low public sector wages in these countries the bureaucrats, doctors, and teachers are naturally more open to corruption in order to earn some money on the side. However in the group of medium-income countries the situation is reversed; the public sector has higher wages than their private sector counterparts (read the methodological part of the paper to see how we make this comparison) and corruption is still high. Only in the group of high income countries where corruption is low is the wage gap low as well. Finally, only a few high-income countries have private sector wages higher than public sector wages (albeit by a small margin), and these countries are also the least corrupt in the world. Of course, we're talking about Scandinavian countries, Sweden, Denmark, Finland and Norway. Again, this isn't to say that their negative public sector wage premium is the cause of low corruption. But it is interesting to notice a trend in which rich countries with low levels of corruption do not bias domestic wages too much in favor of any sector. 

Saturday, 17 October 2015

Angus Deaton wins the 2015 Nobel prize in economics

Over the past two weeks, in the same schedule as always, we had the opportunity to enjoy the announcements of Nobel prize winners. Last but not least was the Nobel prize in economics (or to be more precise for all those doubters out there, the Sveriges Riksbank Prize in Economic Sciences in Memory of Albert Nobel). And once again the prize went into well-deserved hands. Angus Deaton from Princeton University, a brilliant academic with a distinguished career and list of contributions (recently a member of the National Academy of Sciences), a global fighter against poverty and inequality, and above all an economist with an eye for applicability of his research. What is surprising is that once again, the same as last year, the prize was awarded to a single recipient (a rare occurrence in the past 15 years in this field). However what hardly came as a surprise was the field of research that was finally acknowledged with a Nobel prize - inequality and development, for the first time since Amartya Sen in 1998. The public debate on inequality has gone long enough for the Nobel prize committee to overlook the major contributors in this field. Deaton is certainly one of the biggest. And what a great decision it was to recognize precisely Deaton as the man to shed some light on this enduring debate. After all, as The Economist has recognized a decade ago: "Mr Deaton is perhaps the only economist at work in this area who is acknowledged by all sides both as authoritative and as having no ideological axe to grind."

Deaton received the prize "for his analysis of consumption, poverty, and welfare". His research therefore focused around three seemingly different, yet very much interconnected issues: how consumers distribute spending between different goods, how much of society's income is spent and how much is saved, and what's the best way to measure and analyse poverty. Needless to say it's easy to see Deaton has applied methodological individualism to the study of consumption, welfare and poverty. 

The Committee summarized his main contributions: 
"How do consumers distribute their spending among different goods?Answering this question is not only necessary for explaining and forecasting actual consumption patterns, but also crucial in evaluating how policy reforms, like changes in consumption taxes, affect the welfare of different groups. In his early work around 1980, Deaton developed the Almost Ideal Demand System – a flexible, yet simple, way of estimating how the demand for each good depends on the prices of all goods and on individual incomes. His approach and its later modifications are now standard tools, both in academia and in practical policy evaluation. 
How much of society's income is spent and how much is saved? To explain capital formation and the magnitudes of business cycles, it is necessary to understand the interplay between income and consumption over time. In a few papers around 1990, Deaton showed that the prevailing consumption theory could not explain the actual relationships if the starting point was aggregate income and consumption. Instead, one should sum up how individuals adapt their own consumption to their individual income, which fluctuates in a very different way to aggregate income. This research clearly demonstrated why the analysis of individual data is key to untangling the patterns we see in aggregate data, an approach that has since become widely adopted in modern macroeconomics
How do we best measure and analyze welfare and poverty? In his more recent research, Deaton highlights how reliable measures of individual household consumption levels can be used to discern mechanisms behind economic development. His research has uncovered important pitfalls when comparing the extent of poverty across time and place. It has also exemplified how the clever use of household data may shed light on such issues as the relationships between income and calorie intake, and the extent of gender discrimination within the family. Deaton's focus on household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data."
A brief and very easy to understand explanation of Deaton's main contributions is available on the webpages of the Nobel prize committee, and a more technical explanation is here.

Poverty and inequality 

To present all of Deaton's main findings is quite a demanding task for a single article. His contributions vary from theoretical to empirical, from methodological to applicable. He had an important role in figuring out how to precisely measure poverty in some of the world's least developed countries. The World Bank database on developing countries relies to a large extent on his methodological solutions using household surveys to measure poverty. He basically transformed the field of development economics by giving it access to much better and far more reliable data than it had before. For example in his quest to improve the methodology of measuring poverty he was exploring how the amount of calories a person eats per day affects their productivity, and how the calorie intake will be affected as the poor get more money. Health was also an important part of his analyses of poverty, as was gender discrimination, and how to construct local market price indices to measure relative levels of poverty. 

His research on inequality testifies of his complete lack of any ideological bias. He realized that inequality is a necessary outcome of societal progress. However he never thought that more wealth in the hands of the elites is a good thing, not out of any envy for the rich, but purely from the possibilities of misuse of this power to serve particular interests at the expense of the rest of society. 

He refrained from doomsday predictions about how inequality is bigger then ever and particularly from proposing inapplicable policy solutions in dealing with it. In his fantastic, partially autobiographic (read this essay) book "The Great Escape: Health, Wealth, and the Origins of Inequality" (see here the NYT book review) published in 2013 he delivers a very important and quite an optimistic message:
"By the most meaningful measures — how long we live, how healthy and happy we are, how much we know — life has never been better. Just as important, it is continuing to improve."
A very true and very clear message. There is absolutely no doubt that living standards today are better than ever before (recall previous blog posts here, here and here), that the rate of people living below the poverty line is lower than ever and that even as inequality has increased in particular Western countries, the overall level of global inequality has declined - primarily due to the rapid growth of Asian countries. Deaton provides evidence for all of this. Just read his book

Perhaps it's due to his extensive scientific rigor and unwillingness to succumb to sensationalism that he avoided the media frenzy during the whole inequality debate. But as anyone who read any of his work would agree, Deaton is perhaps the biggest authority in the field precisely because he carries no bias and looks at everything from a purely scientific lens. 

Microfoundations: fixing the demand curve 

Another one of his essential contributions is to tempt economists to move away from aggregate macro variables and place a much higher emphasis on individual level data and evidence-based economics. He wanted to make economics look like a proper science (yes, moving it away from macro is precisely how you do it). The best example in how he managed to do so was via his first big breakthrough - his 1980 article with John Muellbauer called "An Almost Ideal Demand System" (the article was placed in the American Economic Review's top 20 published articles of all time - i.e. in its first 100 years). 

In this article the authors overcame the usual bias of aggregate demand models in which the center of the model would be a rational individual trying to maximize his utility, from which it follows that we can simply aggregate all of such rational individual preferences into an aggregate demand curve. However the theoretical construct was far from what the empirical evidence was showing. In particular older models failed to predict how demand varied with prices and income, nor was the empirical evidence consistent with the rationality assumption. This encouraged Deaton and Muellbauer to construct a better model, based on crude evidence, taking into consideration actual patterns of consumption and demand, and making it simple enough to be empirically tested. They describe how households allocate incomes towards different types of goods based on their total expenditures. With the difference in incomes for poor and rich households it is precisely this type of variation that corresponds to actual patterns of demand. 

The model's flexibility allowed for many modifications and improvements by a number of subsequent researchers and its end result was that it became a standard for evaluating some aspects of economic policy, for constructing price indices, simulating the effect of consumption tax changes, and even for estimating the effect of family size, age and gender on individual consumption choices. Their initial, simple model became a cornerstone for the rest of the academia in the study of consumer choice that was finally being done with micro-level data. And it revolutionized the economic science by making macroeconomic models more microfounded. 

Another big contribution was using individual behavior models to explain why aggregate consumption was less volatile than income (recall the following blog post). Opposed to Friedman's model which states that rational individuals should smooth out temporary income spikes and only react to permanent income increases, Deaton showed that consumption was more volatile than income. This was referred to as the Deaton paradox. 

In a number of other unique predictions and implications, he argued against foreign aid that can be very inefficient in eradicating poverty and famine if it is concentrated in delivering aid in terms of food (or money) to poor countries. He showed that only balanced economic growth achieved primarily by ensuring a proper institutional environment in poor countries will increase food consumption and hence eliminate famine (because ). Furthermore he doesn't believe that living standards and household wealth can be measured only via indicators such as income, but by a whole number of unobservable factors (like internet access for example) that altogether significantly improve living standards. 

In conclusion, a well-deserved prize for a brilliant economist. 

Selected publications:
  • Deaton, A. and J. Muellbauer (1980), “An Almost Ideal Demand System”, American Economic Review 70(3), 312-326.
  • Deaton, A. (1985), “Panel Data from Times Series of Cross-Sections”, Journal of Econometrics, 30(1-2), 109-126.
  • Deaton, A. and J. Muellbauer (1986), “On Measuring Child Costs: With Applications to Poor Countries”, Journal of Political Economy 94(4), 720-744
  • Deaton, A. and J. Campbell (1989), Why Is Consumption So Smooth?”, Review of Economic Studies, 56(3), 357-373.
  • Deaton, A. (1991), “Savings and Liquidity Constraints”, Econometrica 59(5), 1221-1248.
  • Subramanian, S. and A. Deaton (1996), “The Demand for Food and Calories”, Journal of Political Economy 104(1), 133-162.
  • Deaton, A. (2013) The Great Escape: Health, Wealth, and the Origins of Inequality. Princeton University Press