Whose Afriad of the Falling Dollar

There is plenty of hang wringing over what a weaker dollar portends for the US. Will it impoverish us? Reduce us to third-world status? End the US growth machine.

I am perhaps alone in thinking its one of the best things that could happen to the US. The big problem for America going forward is not growth. Its not entitlement spending. As much as I bemoan it, its not even directly our poor K12 educational system.

Its that an America with a strong university system, a strong financial infrastructure and a strong dollar has little use for strong backs. In the long run that's a good thing, but in the long run we are all dead.

Today, its a heartbreaker.

Its heartbreaking to see Americans who just don't have the financial or intellectual capital to compete in modern America fall behind.

Its also scary.

Its scary to see protectionist sentiment rise and the spectre of class warfare haunt Capitol Hill.

A falling dollar could change that. It could make American industry competitive. It will unwind the growing current account deficit - a process that while not without pain is also not without merit. It would not be such a bad thing for those of us who have done well to cut back in favor of gains among the working class.

And, it would be a great thing for that to happen through natural market mechanisms than government regulation or ill fated attempts at moral suasion.

Payroll Tax Hike

Greg discusses Obama and Clinton's proposal to eliminate the cap on Payroll taxes.

Of the many ways to raise substantial revenue I view this as among the best. My hunch is that hiking the payroll tax will have limited negative effects for several reasons

1) Upper income wages are mostly economic rent. Individuals who make more than 90K a year are primarily living off of the fact that they are significantly more talented than lower income people and have a preference for high productivity jobs¹. These factors are largely fixed by a combination of genetics and culture and unlikely to be influenced by marginal tax rates.

2) The possibility for tax avoidance or evasion is lower with payroll taxes than the income tax. There are few exemption and no deductions making tax avoidance really difficult with the payroll tax. Moreover, a business would have to be complicit to engage in tax evasion. Both of these factors make the payroll tax more efficient.

3) The payroll tax treats workers in the same household independently. Payroll tax exemptions for one spouse don't affect the payroll tax owed by the other spouse. For example, raising the husbands payroll tax makes the wife more likely to work, not less. The income tax probably does the opposite in high income families.

4) People hate the payroll tax. Karl's Law states that given equal size tax bases the economic destructiveness of a tax is inversely proportional to how much people hate it. That is, people hate taxes that they can't wiggle their way out of. Those are precisely the most efficient taxes.



I chose teaching and practicing economics over teaching and practicing painting not because the significant pay differential but because I prefer interpreting abstract art rather than creating it.

Sticky Price, Sticky Homeowners or Sticky Mortgages

Ed Leamer says that Housing IS the Business cycle. As I mentioned before I was struck by the comment in paper, the name and author of which escapes me, that "contracts could be indexed for inflation for instance mortgages could have variable rates"

After all, most mortgages didn't have variables rates and at the time and most people considered variable rate imprudent. I think most people still consider a One Year ARM imprudent and thats really what the author was getting at. So if housing IS the business cycle then perhaps, housing contracts or more specifically mortgage loans ARE the source of the monetary lever.

Now how does this account for the passage by Hume often quoted by Mankiw that increases in the supply of money first quick the work of every man and only later lead to a general increase in prices. The implication of that passage is that the effects of the money supply on the economy have operated the same way for at least four hundred years. Was mortgage stickiness a problem in 18th century England? Perhaps, there were other important nominal contract, bonds or agreements.


Now suppose that the source of the business cycle is owner occupied housing and long term mortgage loans (think of it as time-to-build communities). Then one question is why the devil is it such a bad idea to get variable rate loans? The empirical evidence suggests that is. I know that despite going way out on a limb and leveraging myself to high heaven, I have avoided them. Yet, I am not sure why. It has something to do with not being able to predict my expenses but why should that matter this much? Is it some form of extreme loss aversion? Is it as simple as neighbor capital? The longer I live somewhere the more painful it is for me to liquidate my holdings. I don't know.

Smart is as Smart Prefers

Picking up on another Cowen post I am sticking a flag in the sand and declaring my hypothesis that the genetic component of intelligence is preference. That is, smart people are people who like intellectually stimulating experiences. My guess is that they are more sensitive to the pleasure chemical released when successfully solving a hard problem. Thus they solve more hard problems.

In the process they build thinking strategies and increase neural efficiency. The result is that they are much better at performing mental tasks.

Ala Judith Harris I take the position of zero direct enzymatic influence. That is, there is no enzyme (remember gene's operate through enzymes) that produces more efficient mental processing without a change in environmental stimulus.

For those who have trouble seeing how this might work consider this: Obesity has a strong genetic component. Obesity like IQ has been rising over time. However, does anyone believe that obesity is not completely determined by your food consumption and exercise patterns? Genes can modify that function, in particular they can modify your equilibrium levels of food consumption but they cannot act outside of the environmental regime.

Four Biases

Bryan Caplan talks about four potential biases in popular thinking about economics. He has written a book on the subject that I embarrassingly have not read. However, I have read journal articles and blog posts by Bryan, so I think I have the gist of his point.

However, I am begining to wonder whether or not the "baises" are simply misstatements of real economic problems.

Anti-Foreign Bias: This is the easiest to see. Economists are found of equating differences between countries to differences between households, towns or states. However, the immediate problem is that nearly everyone would choose some Kaldor-Hicks inferior position if it shifted the distribution of goods towards a member of their household. Many people would even sacrifice their own consumption to increase that of household members. Put simply, the closer you are to someone geographically the more likely you are to be an input to their utility function.

In addition there are local economies of scale. Otherwise no one would be paying Manhattan rent. It benefits you to live near other successful people. Moreover, since this is the case it is reasonable to conclude that foreigners will attempt to collude against you so that there locality will grow at the expense of yours. Fighting over attracting residents is typically a zero sum game. Even more so if we are trying to attract the most genetically gifted residents.

Anti-Market BiasI think this is probably an expression of concern over asymmetrical information and cognition costs in general. People are afraid of being screwed in the market, and they should be. Not understanding how the market works causes lots of problems for people. Economists are not afraid because they have lots of information. It seems rational to be more concerned about asymmetric information problems when your information set is quite small.

Make Work Bias I won't go into detail but if you talk to people about this carefully it usually comes out that they are concerned about the growth of the money supply in response to economic shocks. They don't realize this is their concern but it is really what they are talking about. And they are right, if the money supply isn't managed there can be increases in unemployment from demand and productivity shocks.

Pessimistic Bias I think this is a symptom of rate of time preference inconsistency. Perhaps hyperbolic discounting. Most people's live are getting worse in that their opportunity cone, opportunity set over time, is shrinking because of consistently bad choices. Bad in the sense that people wish that they had not made them.

Yes, their opportunity set grows over time but at time T it is smaller than than it would have seemed looking into the future from T-1.

Modeling the Internal Princple-Agent problem

Tyler Cowen asks why "Call me naive but . . . " works better than "I am not naive." After all both are intended as signals that the person is not naive. This works because it takes advantage of the fact that a person is not a unitary entity.

Most of the time we can act as if people have a single well defined objective function. Indeed, much of the time we can act as if households have a single well defined objective function.

However, there are times when this model breaks down. Households disagree internally and people have personal internal conflict.

For the sake of this model lets say there are two entities within each person. A purely internal manager and a communications agent.

The communication agent wants to be trusted. The internal manager wants to feel self confident. If the internal manager is indeed naive, then he will become upset at the communication agent's statement "Maybe I am naive" and potentially shut him down.

The communication agent will have to deal with balancing the threat of being shut down with his desire to be trusted. Making the statement "Maybe I am naive" signals to other agents that the threat of being shut down is low and therefore the internal manager is probably not naive.

I believe nternal principle-agent problems are part of why deceit is more difficult and less common than traditional models might suggest.

Hawk No More

I tend to agree with KNZN's assertion that what is need is fast decisive action by the FED. Even as late as this spring I was a hawk, calling for increases in the funds rate by 25 -50 basis points. Now I am reversing course, looking for a 50 basis point cut now and a bias towards at least 25 more basis points if the September employment data is as bad as I expect.

Isn't this the kind of schizophrenic action that bankers are supposed to avoid?

The traditional approach says yes, but I am coming to believe that slow steady tightening with a tendency towards over-tightening and then dramatic easing might be the way to go.

Why?

Because the response pattern from monetary policy is humped shaped. We get real effects first, inflationary effects later. Moreover, the damage from recession is that people lose their jobs and can't pay their bill immediately. The damage from inflation occurs because the long term trend of prices becomes less certain.


Pumping loads liquidity into the economy as it tilts into recession has the potential to stop what is happening now and prevent the acute crises that comes from joblessness. On the contrary controlling the evolution of prices should be a much more gradual process that convinces financial entities that, whatever happens today, the value of long money is protected.

From a slightly nerdier prospective, the suboptimality of a recession occurs because liquidity constrains the equation of marginal cost and benefit. The suboptimality of inflation occurs because uncertainty drives a wedge between marginal cost and benefit. Setting the modal response towards over tightening combined with spikes of easing provides slack when constraints bind while keeping expected values in the target range.

Why NFP is even worse than it seems

You probably know the BLS job creation estimate was negative for the first time in four years. In my on going debate* with Barry I maintain that there is nothing fishy about the way the BLS uses its Birth Death model. The error comes from the fact that the Births and Deaths are estimated by looking at how the model performed last year. When times are changing fast the BLS model is likely to miss that. It under estimated the strength of the labor market when job creation turned around in late 2002 and it is overestimating job creation now.

As I thought the June / July numbers wererevised downward. I wouldn't be surprised if July was revised downward again and if the August estimate dipped even further in coming months.

Upshot no conspiracy, no willful misreporting, but a very week labor market.



*Debate in the sense that Barry graciously takes time off from being a super blogger-pundit to answer my objections.

What's So Special about U6

Barry Ritholtz repeats the popular line that "real unemployment" is much higher than headline unemployment.

U6 is indeed higher than U3. The problem is that value in unemployment stats comes from comparing different points in time and throughout time U6 has always been higher than U3.

When one says, if the "real unemployment rate" was 4.6 the labor market would be tight, you are using your familiarity with U3 to call 4.6 a tight market. Even in the heyday of the late 90s U6 was above 7%. If U6 was 4.6 today the FED would be talking about moving the funds rate upwards 50+ basis points per meeting.

The BLS has data on U6 going back to 1994. The gap between U6 and U3 is procyclical and as one might expect lower now than the average of the last 12 years and only slightly above the roaring 90s.

US Leads

In a new productivity study (still searching for the study itself) reported by MSNBC and the Associated Press.

The US comes out on top in total production per worker and second in hourly productivity. Norway edges us in part because of oil revenues.

I have long been concerned about productivity statistics. Typically my attitude towards statistics is that they are ultimately just the mathematical product of several measurements and should be treated as such, no more, no less.

However, productivity is a bit different. It is the closest a statistic comes to answering our most important question: How effective is an economy in allowing people to achieve the most goals in our fundamentally limited time on earth.

Production per hour is important because hours are the stuff of life. The fewer we have to spend toiling to survive the more we have to devote to whatever makes surviving worthwhile.

So what about hourly productivity. Well one problem is that it doesn't count people who want to work but can't find a job. In particular we could raise our productivity just by forcing less productive workers out of the market. This theoretical possibility wouldn't be important if it weren't for the fact some popular policies do exactly that.

Expanding unions and raising the minimum wage can both raise hourly productivity, but they do so by forcing out the weaker members of the workforce. This doesn't seem like the type of activity we want to capture.

Yet, simply averaging in the unemployed isn't right either. After all, they are likely unemployed because they are less productive. Simply slotting them into the denominator would suggest that they are just as productive as the average working member of society.

So at this point I am at loss for the "right" statistic on such an important matter.

The Diversity Paradox?

An Article in the Boston Globe highlights Robert Putnam’s research on diversity. The take home message is that diversity seems to lower social capital, yet increase creativity and possibly economic growth. This is labeled a diversity paradox.

However, it seems to me that there is no paradox at all, at least with respect to creativity. Diversity increases creativity because it lowers social capital.


A sketch of a model:

There are two levels of social goods: global and local.

Finding a cure for cancer is a global social good; building a children's center is a local social good.

People are compensated for the production of social goods through status.

Each ethnicity has a different preference ordering over local social goods.

In a mulit-ethnic community there are fewer people who prefer any one social good. Therefore, the status return is lower to producing local socials goods. The status return to global social goods is constant everywhere.

When communities become more diverse people substitute the production of local social goods for global social goods.

That is, it is more difficult to become famous and loved by all for being a civic leader so I tend to invest more time in becoming famous and loved by all through some national level accomplishment.

This might suggest that diversity itself is a public good but I am not sure. That is, it could be that homogenous communities are piggy-backing off of the global social goods produced by diverse communities.

Hat-tip Mankiw

Losses II

Losses 0.9 Beta.

Something like this is probably going out.

What's Next

The start from what I am working on now




A Contribution to the Theory of IQ and Economic Growth


This paper takes Garett Jones seriously. Forty years after Robert Solow’s classic article suggested that long run growth depends on increases in total factor productivity Jones and Schneider (2006) proclaim:

stylized facts related to IQ and productivity are ready and waiting for the theorist who seeks to explain a large part of the puzzle of cross-country productivity differences. Accordingly, persistent difference in national average IQ—regardless of their source—may play an important role in answering Prescott’s (1998) call for a theory of total factor productivity

In a series of papers Jones, twice with Schneider argues, that

1) IQ is one of, if not the most powerful predictor of economic growth

2) IQ is a proxy for and indeed may be the primary source of otherwise unobserved worker heterogeneity

3) IQ correlates heavily with a tendency towards cooperation

4) The effect of IQ is more powerful at the macroeconomic level than the microeconomic level

5) The effect of IQ on growth rates is persistent and likely associated with higher growth rates rather than higher steady states

6) The importance of IQ on economic growth has been increasing since at least the mid twentieth century

7) At least in a naive sense the growth does not appear to cause changes in IQ

My goal below is to provide a theory consistent with these facts.

Nice work if you can get it . . .

The jobs report disappointed today at 92K vs. a consensus 130K. I believe this number is likely to be revised downward in the coming months because of the birth-death adjustment.

Each month the BLS has to estimate how many jobs were created in new companies and destroyed when old companies went out of business. The way it does this is by looking at how far its count was off a year ago.

That is, if last year the BLS counted 150K new jobs in July but then, after all new companies were firmly established, they went back and counted 170K new jobs they say that the birth-death adjustment needs to be 20K higher. In other words, last time they guessed 20K too few so this time they will add 20K to their baseline guess.

Here is the problem. Last time the housing market was surging and all sorts of upstart companies were coming on to cash in. Fly-by-night organizations that support builders, suppliers, etc.

Clearly those extra jobs aren't being created now and so the BLS is likely to be overly optimistic. By how much, I don't know. If there was a reliable way of fixing this problem then the BLS would use it. However, there is not and so we are left to readjust on our own.

Bottom line . . . job growth is slowing.

UPDATE: Commentors on Ritholz report that the Birth-Death adjustment for July is 26K new jobs. Typically, we find that around 50K are lost from companies' Birth/Death in July as kids get ready to go back to school, housing sales slow, etc. However, this time we got an estimated 26K created from Birth/Death. I strongly expect that to be revised downward.

Fertility and the IQ of Nations

We have long known that economic growth was associated with decreasing family size. It appears the increases in IQ may also be associated with decreases in family size. The myriad of ways in which this trivariate correlation could be explained are tantalizing but for now I will leave you with the data itself.



P.S.

I can't help but mentioned that if low IQ caused larger families then we would expect IQs to decline over time. In fact they have been doing the opposite. What I wouldn't give for good measures of Chinese IQ before the 1-child policy.

Do Smart Guys Tell Better Jokes?

In the wake of the recent blog brouhaha over IQ and the Wealth of Nations I have been thinking about the general connection between intelligence and income.

My interpretation is that many people find it natural to conclude that IQ causes macroeconomic growth because IQ appears to cause microeconomic success. High IQ people are richer people, on average.

While I am sure that many smart people are quick to assert that their intelligence is what got them where they are, are we so sure? Height is correlated with individual success. I willing to bet height is also correlated with economic growth. And, we know that there is a height “Flynn effect.” That is, people have been getting taller over time. Do we think height causes growth?

The height correlation is usually settled by noting that height is a general sign of health and fitness, thus the correlation with macroeconomic growth, and therefore tall people are more likely to be chosen as spouses of successful people. Rich men and women have a greater choice in spouse and they tend to choose taller ones. Therefore, height and the genetic or cultural traits that produce wealth are commingled.

Could the same thing be true with IQ? That is, are smarter people more likely to be chosen as spouses to the rich and powerful? Now one possibility is that intelligence is just out and out attractive. Some people may agree with that conjecture.

Another, however, is that intelligent people are more likely to land a successful spouse because they are more clever at the dating game. My pet theory is that the human brain evolved through sexual selection. It’s just too big and mostly useless to have come about any other way. Looking at the monstrous and dangerous thing sitting a top most people’s shoulders one cannot help but be reminded of the Irish Elk.

It wasn’t so much that we impressed each other with our big brains, but that those brains busied themselves with devious plots to ensnare the objects of our affections. Most of us are aware of the modal thought among men and I would reason a guess that the modal thought among women is the dissection of the thoughts and intentions of men.

It seems possible then that IQ may simply be commingled with the attributes that produce success. My guess is that those attributes have more to do with perspiration than inspiration.

Why Trade?

So the common objection I have gotten to my draft both on and off line is, why trade? Doesn’t this apply to any policy, not simply trade? Or, we already know that people are afraid of trade?


I am sensitive to this but I think the trade argument is important because of the special status free trade has within economics.

Perhaps, my perception is way off but I think that most economists feel comfortable asserting that the gains to the winners from trade liberalization will outweigh the losses to the losers except in the following cases:

1) There are externalities.

2) There are unexhausted returns to scale.


I am offering a third and I believe more general critique. The very fact that there are winners and losers is inherently costly. Unless you know for certain exactly who those winners and losers are, you are imposing uncertainty on the world.

It is possible that the cost from this uncertainty outweighs the gains from trade liberalization.

In fact, it is possible that freer trade is unambiguously a social ill. That is, the increase in uncertainty could make every single person in the world worse off because of freer trade. In this case there is no social welfare function that would rate this as a good idea.

Since this is a theoretical possibility, the notion that the gains to the winners outweigh the losses to the losers becomes an empirical question that is almost impossible to rule out a priori.

Now, I think that distributional uncertainty is an issue that goes beyond trade. Indeed, I think it affects any policy we might consider. However, I do think that trade is unique in the level of confidence economists display about policy prescriptions.

In a survey reported by Robert Whaples 90.1% of economists disagreed with the suggestion that US should restrict outsourcing.My guess is that the 10% who agreed did so primarily on the grounds of equity and that most of those who disagreed felt that in the absence of externalities or a returns to scale argument trade unambiguously promoted the general welfare.

I am challenging that assumption.

Oldies but Goodies

So to finish working on Losses from Trade I am reading

The Foundations of Welfare Economics

and

Welfare Propositions of Economics

They are both fun reads, especially the first. It is wonderful just how careful these guys were.

Losses From Trade

A draft of the idea in the last post.

Tear it apart :)

Kaldor Hicks Preview

Gabriel says that I should post my ideas no matter how nascent because lets get real, whose gonna want my ideas.

So here is one that I have been kicking around promising myself that I would finish the write up on but haven’t gotten around to it.


Kaldor-Hicks tends to overestimate the net benefits of a policy whose distribution is uncertain.

That is, when we think about whether a policy is a good idea we do a cost-benefit analysis. We add up all the costs to whomever they occur and all of the benefits to whomever they accrue. If the benefits are greater than the costs we declare the policy to be efficient.

Perhaps, the policy is not equitable but it is efficient. The winners could compensate the losers and be better off.


Now the problem is that the winners don’t compensate the losers. And, that’s not just a problem for the reason you think it is. We all admit that the distribution of the gains may be such that the winners don’t personally value their gains as much as the losers personally value their losses. However, without the ability to do interpersonal comparisons we are stuck.

Yet, there is another problem. If the distribution of the gains is not certain then the individual agents will value them at less than their face value. Likewise if the distribution of the losses is not certain than the individual agents will value them at more than there face value.

This means that even if the total benefits outweigh the total losses with certainty, uncertain distribution can lead to individual agents perfering not to make the trade.

To drive the point home I create the following example:

There is a policy were the gains to the winners outweigh the losses to the losers with certainty but NO AGENT wants to see the policy enacted. That is, there is a policy which passes cost-benefit analysis but is uniformly rejected by each person affected by it.


The simplest example is easy. Suppose that the benevolent government is offered the following deal. One million of your residents will be selected and given $100,000. Another one million of your residents will be selected and charged $99,999.

To make matters simple only residents who have at least $99,999 will participate in this program. However, whether the resident is a winner or loser is chosen at random.

This program seems like an economic free lunch. The gains are guaranteed to outweigh the losses by $1 million. The selection process is completely random, so there are no economic distortions. In fact, there is no a priori reason to expect that the winners will have lower marginal utilities of income than the losers.

Yet, we could expect that every single agent will reject this program. Why? They reject it because the program exposes them to risk. The cost of that risk outweighs the expected benefit of program.

Perhaps, the agents could insure against the risk. Since the expected gains are positive they should be able to write a contract that splits the expected gains with an insurer so that everyone winds with more than what they started with.

However, what if I said that I am not going to announce the winners and the losers? I am simply going to subtract the losses from the losers net worth and add the gains to the winners net worth with no record of the transaction. How could one insure that?

If this seems a little far fetched and unrelated to real world issues, allow me to change the offer again. Rather than simply adding $100,000 or subtracting $99,999 I am going to do this.

The winners will receive an increase in the demand for their services and a pay raise. The losers will see their jobs outsourced to Asia. The winners won’t know for sure why they lost they received a raise. The losers won’t know for sure why they lost their job.

To add another layer of realism lets change the terms a little. I won’t change any of the expected values but this time instead of selecting 1 million winners and giving them each raises worth $100,000, I will select 100 million winners and give them each raises worth $1000.

The expected gains from this deal are still $1 million. Does anyone want to go for it?


There are two insights that I draw from this thought experiment.

1) That distributional risk is a real concern in policy. If the winners don’t know they will be winners and the losers don’t know if they will be losers the policy will seem better than it really is.

This was the idea that I started with. Workers I talked to disliked outsourcing not just because some people did loose there jobs but because they felt like any of them could loose their jobs. The difference is subtle but important. The first is just about direct costs; the second includes a notion of risk.

2) The second insight I take away is that just as Von Neumann / Morgenstern risk comparisons allow us to define cardinal rather than simply ordinal utility. Who-will-gain risk comparisons allow us to define a sort of interpersonal utility comparison. If you had an equal shot of being on any end of this policy would you still support it? Its not exactly interpersonal comparisons but it carries much of the intuition we want to gain from it.

Comments? Suggestions?