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January 13, 2012 conversableeconomist

New Fed Nominee Jeremy Stein, Rethinking Monetary Policy

Jeremy Stein is always worth reading, but when President Obama nominated him in late December for a seat on the Federal Reserve Board of Governors, he became must-reading. In the latest issue of the
American Economic Journal: Macroeconomics (2012, 4(1), pp. 266–282), Stein and co-author Anil Kashyap discuss \”The Optimal Conduct of Monetary Policy with Interest on Reserves.\” In particular, they are thinking about how it might be possible to use monetary policy for two purposes: both in its traditional role of keeping inflation low and stimulating the economy in recessions, and also in an untraditional role of reducing the chance of future financial crises. The article isn\’t freely available on-line, although many students and faculty will have access to it through library subscriptions or membership in the American Economic Association.

When teaching the basics of monetary policy a few years ago, the emphasis was on how the Fed used \”open market operations\”–that is, buying and selling government bonds to banks–to make interest rates rise or fall. When the Fed bought bonds from banks, then the banks had more cash to lend out, and interest rates would fall. When the Fed sold bonds to band, and received cash from the banks, then the banks had less cash to lend out, and interest rates would rise. Through these open market operations, the Fed reacted to risks of higher inflation or economic slowdown, adjusting the lendable funds available to banks to achieve its desired level of interest rates.

This basic exposition pointed out that in theory the Federal Reserve had other policy tools, like adjusting the level of reserves that banks were required to hold with the Fed, but because those tools received little use in recent decades, little attention was paid to them.

But when the financial crisis hit in fall 2008, the Fed got a new policy tool: it can pay interest on the reserves that banks are require to hold at the Fed. Kashyap and Stein explain: \”In October of 2008, the US Federal Reserve announced that it would begin to pay interest on depository institutions’ required and excess reserve balances, having just been authorized by Congress to do so. The Fed thereby joined a large number of other central banks that were already making use of interest on reserves (IOR) prior to the onset of the global financial crisis. Given the Fed’s current policy of keeping the federal funds rate near zero, IOR has not been a quantitatively important tool thus far. As of this writing, the rate being paid is only 25 basis points. However, IOR may turn out to be extremely useful going forward …\”

Thus, in the future, when the time comes for the Fed to raise interest rates, how should it do so? As Kashyap and Stein write: \”When the Fed seeks to tighten monetary policy, should it raise the rate paid on reserves, contract the quantity of reserves, or some combination of the two?\”

I had not known before reading this article that many central banks around the world have both tools available to them. Of course, because it’s a research journal of economics, Kashyap and Stein feel compelled to explain algebraic labels rather than using words: in particular, they discuss the level of interest on reserves, which they label r_IOR, and the “scarcity value of reserves,” which they label as keep y_SVR and can be thought of as the interest rate that would result from the level of reserves created by the traditional system of open market operations. They write:

\”This question can be further motivated by observing the diversity of central bank practices before the financial crisis. At one extreme of the spectrum was the Federal Reserve, which set r_IOR to zero, so that any variation in the funds rate had to come from quantity-mediated changes in y_SVR . At the other extreme was the Reserve Bank of New Zealand, which in July 2006 adopted a “floor system” in which reserves were made sufficiently plentiful as to drive y_SVR to zero, meaning that the policy rate was equal to r_IOR . And in between were a number of central banks (e.g., the ECB and the central banks of England, Canada, and Australia) which used variants of a “corridor” or “symmetric channel” system. One approach to operating such a system is for the quantity of reserves to be adjusted so as to keep y_SVR at a constant positive level (100 basis points being a common value), with r_IOR then being used to make up the rest of the policy rate.\”

\”Note that these corridor systems share a key feature with the floor system used by New Zealand. In either case, all marginal variation in the policy rate comes from variation in r_IOR , with no need for changes in quantity of reserves. In this sense, the pre-crisis US approach was fundamentally different from that in many other advanced economies.\”

Kashyap and Stein point out that with these two separate policy tools–that is, the new tool of interest paid on reserves and the old tool of managing the level of bank reserves–it becomes possible for a central bank to tackle two goals. \”We argue that, in general, it will be optimal for the central bank to take advantage of both tools at its disposal by varying both r_IOR [the level of interest paid by the Fed to banks on their reserves] and y_SVR [the \”scarcity value\” of reserves], with the mix depending on conditions in the real economy and in financial markets. The two-tools argument begins with the premise that monetary policy may have an important financial stability role in addition to its familiar role in managing the inflation versus output tradeoff.\”

During the financial crisis, banks and other financial institutions found themselves in trouble because they had all ramped up their level of short-term debt–that is, debt which came due quite soon on a daily or monthly basis and was commonly being rolled over (and over and over) each time it came due. When the financial crisis hit, it became impossible to roll over all this short-term debt, and so many financial institutions suddenly found themselves without funding. Kashyap and Stein argue that financial institutions will often have a tendency to take on too much short-term debt from society\’s point of view, because individual financial institutions are looking only at their own finances and not taking into account the risk that if they all take on too much short-term debt, the risk of a system-wide financial crisis goes up. Thus, a way to reduce the risk of financial crisis is to put limits on bank holdings of such short-term debt.

One way to do this is to use a broad notion of \”reserve requirements.\” In theory, banks wouldn\’t just hold reserves based on the deposits from customers, but on any debt that they are depending on renewing in the short run. Kashyap and Stein explain: \”First, within the traditional banking sector, reserve requirements should in principle apply to any form of short-term debt that is capable of creating run-like dynamics, and hence
systemic fragility. This would include commercial paper, repo finance, brokered certificates of deposit, and so forth. … Going further, given that essentially the same maturity-transformation activities take place in the shadow banking sector, it would also be desirable to regulate the shadow-banking sector in a symmetric fashion. This suggests imposing reserve requirements on the short-term debt issued by nonbank broker-dealer firms, as well as on other entities (special investment vehicles, conduits, and the like) that hold credit assets financed with shortterm instruments, such as asset-backed commercial paper and repo. Alternatively, to the extent that many of these short-term claims are ultimately held by stable value money market funds that effectively take checkable deposits, a reserve requirement could be applied to these funds.\”

Kashyap and Stein explain that central banks around the world have been using changes in the reserve requirement as a policy tool to limit bank holdings of short-term debt, and to assure that banks have a sufficient capital cushion. \”[A] number of central banks around the world use changes in reserve requirements as a key policy tool. For example, the Chinese central bank changed the level of reserve requirements six times in 2010, while moving their policy interest rate just once. … India offers another intriguing case study. Since November 2004, the Reserve Bank of India has operated a corridor system of monetary policy. In the aftermath of Lehman Brothers’ bankruptcy filing, the Reserve Bank cut reserve requirements from 9.0 percent to 5.0 percent in a series of four steps between October 2008 and January 2009…. Finally, Montoro and Moreno (2011) study the use of reserve requirements in three Latin American countries: Brazil, Colombia, and Peru. They note that central banks in these countries raised reserve requirements in the expansion phase of the most recent credit cycle, and then, like the Reserve Bank of India, cut them sharply
after the bankruptcy of Lehman Brothers. They also argue that the motivation for this approach was explicitly rooted in a financial stability objective …\”

However, Kashyap and Stein suggest that rather than varying reserve requirements to limit short-term debt of financial institutions, instead the same goal can be accomplished by using the quantity of reserves that the Fed encourages financial institutions to hold. They conclude: \”The introduction of interest on reserves gives the Federal Reserve a second monetary policy tool that, used properly, may prove helpful for financial stability purposes.By adjusting both IOR [interest paid to banks on their reserves] and the quantity of reserves in the system, the Fed cansimultaneously pursue price stability, as well as an optimal regime of regulating the
externalities created by short-term bank debt. Though to be clear, the latter would also require, in addition to the use of IOR, a significant expansion in the coverage of reserve requirements, as well as possibly an adjustment to their level.\”

Assuming that Stein makes it through the confirmation process and ends up on the Fed Board of Governors–which in a just world will happen more-or-less instantaneously–it will be interesting to see how these issues emerge. Will the Fed begin to focus on how to reduce the systemic risk of another financial crisis? Will it revive changes in reserve requirements as an active tool of monetary policy? Will the Fed\’s reserve requirement be expanded so that it is based not just on deposits but on all forms short-term borrowing, and for all financial institutions (not just banks)? Will it start to use interest paid on bank reserves as a way of moving interest rates, while controlling the quantity of bank reserves as a way of holding down on the amount of short-term debt in the financial sector? Will the central bank perhaps decide to pay different rates of interest on those bank reserve it requires from those bank reserves that are held in excess of the requirement?

Leave aside all the potential complexities here, many of which are discussed in the article, and which are certainly real enough. The most basic ways that we have thought about and taught monetary policy in the last few decades may be on the verge of change.

(Full disclosure: Jeremy Stein was a co-editor of my own Journal of Economic Perspectives from 2007-2009.)

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January 12, 2012 conversableeconomist

Robert Frank on Context Externalities and Positional Goods

Romesh Vaitilingam has in informative interview with Robert Frank at the VoxEU website, recorded November 2011, posted December 23, 2011. It is in podcast form, or if you prefer, there\’s a transcript. I\’ll first offer some excerpts in which Frank explains his position, and then offer some observations and criticism. Here\’s Frank:

On Darwin\’s exposition of why competition doesn\’t always lead to socially desirable outcomes

\”I\’ve made a fearless prediction that in 100 years time, people like you and me will check Darwin\’s name when they\’re asked to fill out a survey identifying the father of modern economics. … It will eventually be seen as an encompassing vision that includes Adam Smith\’s invisible hand theory as an interesting special case. … So the antlers of the bull elk, for example. They are primarily to help males battle successfully against other bulls for access to mates. Darwin saw that males in most vertebrate species took more than one mate if they could. The qualifier obviously is the important step because if some succeeded, that means others don\’t take any mates at all, which is the real loser slide in the Darwinian scheme of things. So of course males fight bitterly for access to females. Antlers are the weapons for that particular species. And some mutations that coded for bigger ones were strongly favored in each case. They spread quickly, the mutations accreted. Now we get animals with antlers four feet across, weighing 40 pounds. That\’s too big for bulls as a group. Antlers don\’t grow forever, that\’s true. Natural selection puts a stop to the growth. There\’s an equilibrium, but it\’s not an optimum size when viewed from the perspective of bulls as a group. They\’d much rather be half as big, because they\’re such an encumbrance when they\’re chased into a wooded area by wolves. They\’re easily surrounded and killed. If they could take a vote or put their hoof on a red button at the count of three, “all antlers shrink by half”, they\’d have compelling reasons to do that. It\’s relative antler size that matters in battle, so it wouldn\’t affect the outcome of any fight. But they\’d all be more mobile. They\’d all be better able to escape from predation by wolves. From the perspective of the bulls themselves, that would be a good thing.\”

On \”context externalities\”

\”I think more in terms of “context externalities”, I would call them. Is my car OK? Is my house OK? … They\’re not socially scarce, but people\’s evaluations of them are very heavily context dependent. Is my house OK? I lived in a two room house in Nepal when I was a Peace Corps volunteer. It didn\’t have any plumbing. It didn\’t have any electricity. The roof leaked when it rained hard. It was nonetheless a perfectly OK house in that context. If you lived in that house here in the UK, you\’d be ashamed for your friends to know where you lived. Your kids wouldn\’t want their friends to know where they lived. It would be a house that was by no stretch of imagination conceivably evaluated as being OK. It\’s just an inadequate house by the current standards. If you look at context externalities, they\’re not here or there, they\’re everywhere. They\’re more intense in some domains than others. …[O]ne of the main results of looking at the world this way is you get arms races always that focus on the categories where context matters more. And they suck resources out of the categories where context matters less. In the house and leisure example, people would work longer hours thinking they\’re going to get ahead by being able to buy a bigger house. … It\’s that kind of arms race that leads to the misallocation. That\’s why the invisible hand doesn\’t steer things to the best uses. … Now the US family, on average, spends $28,000 on a wedding. That\’s in 2009, the most recent figure I could find. In 1980 the inflation adjusted figure was $11,000. Nobody could pretend that the people getting married in 2009 were happier because of that extra spending. It was just that the people at the top spent more. That led the people just below them to spend more. There was a cascade.\”

Policy implications?

\”I focus almost exclusively on remedies of the sort that try to make behaviors that cause harm to others less attractive to individuals by making them more expensive, usually by taxing them. That doesn\’t prohibit somebody from doing anything, so if somebody has got a really important stake in continuing to do what he\’s doing, he can but he pays the fee. … Tax harmful behavior is the mantra that I repeat again and again …. Mainly the biggest remedy is to tax consumption at a steeply progressive rate.\”

Some reactions
As Frank says, he sees what he calls \”context externalities\” everywhere. I\’m queasy about thinking of these social pressures as \”externalities,\” that is, as market failures in which a tax reflecting the social costs of the externality would improve social welfare. Claims that social pressures are making most of us consume items or do things we otherwise would not do are of course true, as they have been for every society since the dawn of time. But implicitly claiming that people\’s \”optimal\” decisions are the ones they would make if they had no social pressure at all, and social pressures must therefore drive them away from what would have been their optimal choice, seems like an offbeat claim for an avowedly \”social science\” like economics.

After all, the range of behaviors influenced by social pressure is very large: not just conspicuous consumption, but also many other decisions in various social groups: about working, or not; focusing on finishing certain levels of education, or not; taking certain drugs, or not; worshiping in a certain church, or not; becoming a parent at a young age, or not; and many others. In all of these cases, local and social pressures probablyl cause people to alter their behavior from what they would otherwise have done. But it would seem overly broad to call these all \”context externalities\” that are potentially ripe for policy intervention.

The alternative position usually taken by economists is that people are treated as having the autonomy and individuality to form their own preferences in a context that is mysterious and largely unexamined (by economists)–but a context that includes social pressures–and then economists study how demand based on these tastes and preferences interact with supply based on technology and production in the market. If some people work harder because they want to outdo their neighbors, that\’s not usually considered a \”market failure.\” If a certain social group decides to live a highly simple life where they strip their consumption down to as little as possible, that form of social pressure isn\’t considered a \”market failure,\” either.

I do like the idea of a progressive consumption tax that Frank emphasizes, but not because of any argument about \”context externalities.\” The emphasis on progressivity–that is, those with high incomes paying a greater share of their income in taxes–is to pursue goals of social equity. (Indeed, it seems to me that Frank\’s \”context externalities\” are best-understood as a way of saying that the marginal utility of income for those with high income levels is low, and so higher tax rates with those on high incomes are justified.) The emphasis on consumption, rather than income, is because the U.S. economy would benefit from a higher rate of saving, and a consumption tax falls only on what is consumed, not on what is saved.

January 11, 2012 conversableeconomist

For What Majors Does College Pay Off?

Anthony P. Carnevale, Ban Cheah, and Jeff Strohl of the Georgetown Center on Education and the Workforce have published \”Hard Times: College Majors, Unemployment, and Earnings.\”
The main focus of the report is to look at what people majored in in college, and then to compare unemployment and earnings between majors. Before showing some highlights, two warnings are appropriate.

First, the data behind these figures is from 2009 and 2010. The study compares recent college graduates who are 22-26 years of age, experienced workers who are 30-54 years of age, and graduate degree holders who are limited to 30-54 years of age–all from the 2009 and 2010 data. But how things looked in 2009 and 2010 may not be a good predictor of the future: for example, recent architecture graduates were doing poorly in the aftermath of the housing market collapse in 2009 and 2010, but that wasn\’t true back in 2005.

Second, the classic problem in thinking about benefits of education is to isolate cause and effect. The problem is that those who go on to get additional years of education may well be different in a number of ways: for example, they may have more persistence in their work habits, or they may come from a social background with higher expectations of educational achievement, or they may have higher intelligence in a way that makes it easier for them to perform well in school, or they may be better at deferred gratification, or they may have other personality types that flourish to greater extent in an educational setting. Thus, when you see that, on average, people with a college degree have higher income than those with a high school degree, or that those who major in chemistry have higher income than those who major in English, it would be highly unwise to attribute all of the income gap just to what courses they took. If you could somehow transplant the characteristics of all the chemistry majors into English majors, and vice versa, the resulting income gaps might look quite a bit different.

So here is one figure showing unemployment rates by major, and another figure showing earnings rates by major. In each figure, there are separate marks for recent graduates, experienced graduates, and those who hold graduate degrees.

As noted earlier, one shouldn\’t overinterpret these results. But when looking at unemployment rates, along with the architects, those who majored in humanities or in in the arts have relatively high rates, while those who had majored in health and education had relatively low unemployment rates.

When it comes to income, the highest income levels are for those who majored engineering, computer science/mathematics, life sciences, social sciences, and business. The lower income went to those majoring in arts, education, and psychology/social work.

January 10, 2012 conversableeconomist

Iceland, Ireland, and Latvia: Three Stories of Banking Crisis and Recovery

Zsolt Darvas offers a useful meditation in \”A Tale of Three Countries: Recovery After Banking Crisis,\”a December 2011 working paper for Bruegel, a Brussels-based think tank. In effect, Darvas offers a case study approach by picking three small economies that went through a broadly similar banking crisis, but reacted with different policy choices.He starts this way (footnotes and references to tables and figures omitted):

\”Three small, open European economies —Iceland, Ireland and Latvia with populations of 0.3, 4.4 and
2.3 million respectively—got into serious trouble during the global financial crisis. Behind their problems were rapid credit growth and expansion of other banking activities in the years leading up to the crisis, largely financed by international borrowing. This led to sharp increases in gross (Iceland and Ireland) and net
(Iceland and Latvia) foreign liabilities. Credit booms fuelled property-price booms and a rapid increase in the contribution of the construction sector to output – above 10 percent in all three countries. While savings-investment imbalances in the years of high growth were largely of private origin, public spending kept up with the revenue overperformance that was the consequence of buoyant economic activity. During the crisis,
property prices collapsed, construction activity contracted and public revenues fell, especially those related to the previously booming sectors. All three countries had to turn to the International Monetary Fund and their European partners for help.\”

Darvas points out that \”the crisis hit Latvia harder than any other country, and Ireland also suffered heavily, while Iceland exited the crisis with the smallest fall in employment,despite the greatest shock to the financial system.\” What policy difference across the three countries might explain this pattern?

Iceland let its currency depreciate as part of its policy response, while Ireland was locked into the euro and Latvia stayed fixed with the euro.
\”Ireland has been a member of the euro area since 1999, and therefore adjustment through the nominal
exchange rate against the euro was not an option. Latvia has had a fixed exchange rate with the euro since 2004, and Latvian policymakers chose not to exercise the option to devalue. Both Ireland and Latvia decided to embark on a so called ‘internal devaluation’, ie efforts to cut wages and prices. Iceland has a floating exchange rate. When markets started to panic and withdrew external lending, given the size of the country’s obligations, there was no choice but to let the currency depreciate. The Icelandic krona depreciated by about 50 percent in nominal terms– depreciation would have been sharper without
capital controls …\”

In Iceland, the banks were allowed to fail. In Ireland, the government assumed the liabilities of the banks. In Latvia, most banks were foreign-owned and absorbed losses.
\”In Iceland, where credit to the private sector reached 3.5 times Icelandic GDP, the combined balance sheet of banks reached an even greater number, and banks heavily borrowed from the wholesale market, the government did not have the means to save the banks. Therefore, there was no choice but to let the banks default when global money markets froze after the collapse of Lehman Brothers in September 2008….

In Ireland, the balance sheet of Irish-owned banks was 3.7 times GDP in 2007 … . The Irish government guaranteed most liabilities of Irish-owned banks. … Taxpayers’ money was used to cover bank losses above bank capital (which was wiped out) and subordinated bank bondholders (whose loss is estimated to be about
10 percent of Irish GDP in the form of retiring €25 billion subordinated debt for new debt or equity of
€10 billion). …

In Latvia about two thirds of the banking system was owned by foreign banks (mostly Scandinavian banks), which assumed banking losses and supported their Latvian subsidiaries, thereby making the lender-of-last-resort role of the Latvian central bank less relevant. … According to the ECB’s data on consolidated banking statistics, the loss incurred by foreign banks was about 5.7 percent of GDP and the loss of domestic banks about 3.6 percent of GDP by 2010 – a large amount, but well below the banking sector losses in the two other case study countries. IMF calculated that bank support boosted the public debt/GDP ratio by about 7 percentage points of GDP by 2010.

Iceland introduced capital controls; Ireland and Latvia did not.
\”Due to fear of further capital outflows and additional depreciation of the Icelandic krona, in late 2008 strict capital controls were introduced in Iceland. This has locked in non-resident deposits and government paper holdings in Iceland and locked out Icelandic krona assets held outside the country, in addition to prohibiting
transfers across the border by both residents and non-residents.\”

Lessons?
Comparing the outcomes across these three countries, Latvia\’s GDP fell 25%, with an employment drop of 17%. Ireland had a GDP decline of 10%, with a fall in employment of 13%. Iceland had the biggest shock to its financial system, but had a GDP decline of 9%, and a fall in employment of 5%.

Without overinterpreting the lessons to be learned from this three-country comparison, a few themes do emerge.

1) Latvia was fearful of allowing its currency to depreciate against the euro. But the Iceland example suggests that in time of crisis, if you have the flexibility to let your exchange rate fall, do it. Of course, Ireland was locked into the euro without such flexibility.

2) Think twice before socializing bank losses. Iceland didn\’t take this step; Ireland did. As Darvas writes: \”Little is known about what would have happened to financial stability outside Ireland in the event of letting Irish banks default, but one thing is clear: other countries have benefited from the Irish socialisation of a large share ofbank losses, which has significantly contributed to the explosion of Irish public debt.\” The result is that while Iceland and Latvia have their public debt under control, it has risen by much more in Ireland. Darvas writes: \”Before the crisis, gross government debt was below 30 percent of GDP in all three countries, but started to balloon quickly. … [B]ank support boosted Irish public debt by about 40 percent of GDP, Icelandic public debt by about 20 percent and Latvian public debt by about 7 percent. Since Iceland and Latvia gained bettercontrol over the budget deficit than Ireland – partly due to the difference in bank support –European Commission forecasts stabilisation of the debt ratio in the two countries, but in Ireland a further 20
percentage points of GDP increase is expected till 2012.\”
3) In the short run of the time during and immediately after the crisis, imposing capital controls hasn\’t seemed to hurt Iceland\’s economic recovery. But it\’s not clear when or how these controls will be loosened over time.

Of course, applying lessons from particular countries is always tricky. But economic recovery has started in all three of these countries. As Darvas writes: \”If the adjustment experiences of the three countries could be a lesson for other countries, such as the Mediterranean countries of the euro area, should be the subject of a different study.\”

January 9, 2012 conversableeconomist

Cancer Rates Continue Falling

My wife sometimes notes, with wry incredulity, that economists seem to feel as if they have a more-informed opinion than non-economists on every topic. Thus, I smiled when ran across this press release last week: American Cancer Society report finds continued progress in reducing cancer mortality.\” As they report: \”The American Cancer Society\’s annual cancer statistics report shows that between 2004 and 2008, overall cancer incidence rates declined by 0.6% per year in men and were stable in women, while cancer death rates decreased by 1.8% per year in men and by 1.6% per year in women. The report, Cancer Statistics 2012, published online ahead of print in CA: A Cancer Journal for Clinicians says over the past 10 years of available data (1999-2008), cancer death rates have declined in men and women of every racial/ethnic group with the exception of American Indians/Alaska Natives, among whom rates have remained stable. The reduction in overall cancer death rates since 1990 in men and 1991 in women translates to the avoidance of more than a million total deaths from cancer during that time period.\”

Of course, economists also believe that we have useful contributions to make to the debate over reducing cancer. (Cue wife and children, rolling their eyes.) In the Fall 2008 issue of my own Journal of Economic Perspectives, David M. Cutler wrote: \”Are We Finally Winning the War on Cancer?\” The article is freely available to anyone, like all issues of the JEP from the current issue back to 1994, courtesy of the American Economic Association. Here\’s the abstract:

\”President Nixon declared what came to be known as the \”war on cancer\” in 1971 in his State of the Union address. At first the war on cancer went poorly: despite a substantial increase in resources, age-adjusted cancer mortality increased by 8 percent between 1971 and 1990, twice the increase from 1950 through 1971. However, between 1990 and 2004, age-adjusted cancer mortality fell by 13 percent. This drop translates into an increase in life expectancy at birth of half a year–roughly a quarter of the two-year increase in life expectancy over this time period and a third of the increase in life expectancy at age 45. The decline brings cancer mortality to its lowest level in 60 years. In the war on cancer, optimism has replaced pessimism. In this paper, I evaluate the reasons for the reduction in cancer mortality. I highlight three factors as leading to improved survival. Most important is cancer screening: mammography for breast cancer and colonoscopy for colorectal cancer. These technologies have had the largest impact on survival, at relatively moderate cost. Second in importance are personal behaviors, especially the reduction in smoking. Tobacco-related mortality reduction is among the major factors associated with better health, likely at a cost worth paying. Third in importance, and more controversial, are treatment changes. Improvements in surgery, radiation, and chemotherapy have contributed to improved survival for a number of cancers, but at high cost. The major challenge for cancer care in the future is likely to be the balancing act between what we are able to do and what it makes sense to pay for.\”

January 9, 2012 conversableeconomist

How Republican and Democratic Professors Grade

Talia Bar and Asaf Zussman article explore \”Partisan Grading\” in the most recent issue (vol. 4, number 1) of the American Economic Journal: Applied Economics. The article is not freely available on-line, although many can get on-line access to it if your library has a subscription to the publications of the American Economic Association. As they explain in their abstract: \”We study grading outcomes associated with professors in an elite university in the United States who were identified—using voter registration records from the county where the university is located—as either Republicans or Democrats. The evidence suggests that student grades are linked to the political orientation of professors.\”

Their useful starting point is that they have data on SAT scores for students–which are on average a good predictor of college grades. Measured by this standard, they show that the distribution of students headed into the classrooms of Republican and Democrat professors is essentially the same. However, the grading outcomes are not the same.

They have data from \”the College of Arts and Sciences of an elite university in the United States between the spring semester of 2000 and the spring semester of 2004.\” More specifically, they have grades of 17,062 students taking 3,277 undergraduate level courses with 417 professors. They find:

\”[T]he variance of grades is higher in courses taught by Republicans than in courses taught by Democrats. Moreover, in additional analysis, we find that relative to their Democratic colleagues, Republican professors tend to assign more very low and very high grades. The share of the lowest grades (F, D−, D, D+, and C−) out of the total is 6.2 percent in courses taught by Republican professors and only 4.0 percent in courses taught by Democratic professors. The share of the highest grade (A+) out of the total is 8.0 percent in courses taught by Republican professors and only 3.5 percent in courses taught by Democratic professors. Both differences are highly statistically significant.\”

This general pattern holds up after adjusting for differences in grading across academic departments. Here\’s a graphical illustration of the same general theme. The horizontal axis shows SAT scored of students; the vertical axis shows the average grade received by students. Notice that students with low SAT scores–say, under 1200–receive an average grade of about 2.4 in classes taught by Republican professors, but 2.9 in classes taught by Democrat professors. At the higher end of the range, students with about 1400 on their SATs up to about 1600 get roughly the same grades on average from Democrat professors, at about 3.4. However, students with SAT scores in the top 1560-1600 range on average get grades of about 3.6 from Republican professors.

The authors are at pains to emphasize that there are multiple possible interpretations of these findings.

\”One interpretation is that it reflects a difference in grading practices but not in student performance. In other words, an identical distribution of student performance will translate into different distributions of grades, with Republican professors tending more than their Democratic colleagues to assign low grades to low-ability students and high grades to high-ability students.

\”An alternative way to interpret the finding is that it reflects a difference in student performance but not in grading practices. The difference in student performance could be related to the amount of effort professors are willing to invest in helping students of different abilities or in the extent to which professors encourage students of different abilities. For example, it is possible that Democratic professors would devote more resources (e.g., in office hours time) to helping low-ability students, while Republican professors would devote more resources to nurturing high-ability students. It may also be the case that Republicans have different teaching or testing styles than Democrats (for example, with different needs for memorization or creativity), and that student performance varies across these heterogeneous learning environments. An additional possibility is that Democrats differentially reward something other than pre-existing talent.

\”These interpretations are all consistent with our hypothesis. … The important point from our perspective is that the evidence suggests that Republican professors are associated with less egalitarian grading outcomes.\”

While Barr and Zussman are professionally cautious in their interpretation, readers are of course free to offer their own interpretations. Let the parade of anecdote, speculation, innuendo and overstatement commence!

January 6, 2012 conversableeconomist

The Southern Silk Road: HSBC Global Research

Last June, Stephen King of HSBC Global Research published a lively report called \”The Southern Silk Road: Turbocharging \’South-South\’ economic growth.\” Here, I\’ll mention a few points that especially jumped out at me, but the report is full of useful examples, background, and analysis.

1) Start with a quick reminder for readers who last course in world history is lost in the mists of time. What was the Silk Road?

\”The original Silk Road initially developed under the Han Dynasty in China, which ruled from 206BCE to 220CE. For the next 1000 years or so, the Road (or, more accurately, the various routes) linked China with India, Central Asia, Rome (for a while) and, eventually, the Arab Caliphate involving trade in everything from
spices and silk through to precious stones, ponies and slaves. The great Eurasian empires that developed during this period became mutually dependent. It all went wrong when the Mongols, under Genghis and Kublai Khan, managed to spread not just total brutality but also bubonic plague across the Eurasian land mass. Connections were severed and the various routes fell into disuse. Later, as the European nations
developed their ocean-going fleets, the case for expensive land-based trade across Asia economically collapsed. Unlike the original, the Southern Silk Road won’t only be confined to Asia and Europe. It stems
from connections over land, across the sea, through the air and within the electronic ether. And because the costs of transportation and communication have collapsed in recent decades, it is much more geographically diverse, offering the potential to create hitherto-unimaginable linkages between Asia, the Middle East, Africa
and Latin America. If it is able to advance, the Southern Silk Road will radically alter the dynamics of the global economy in the years ahead. The economic centre of gravity is about to undergo a major shift.\”

2) On a timeline of U.S. per capita economic growth, China, Mexico and Brazil have about the per capita GDP that the U.S. had in 1940. India has about the per capita GDP that the U.S. had in 1882.
Here\’s the figure. (On the vertical axis, GK$ refers to Geary-Khamis dollars, which is a purchasing power parity exchange rate.) However, in the last 10 years, India has caught up with 30 years of U.S. per capita growth, and China has caught up with 50 years of U.S. per capital growth.

3) Foreign direct investment has exploded in size, and the top recipients of inflows of foreign direct investment have changed substantially.

Using the standard UNCTAD data on foreign direct investment, the U.S. economy had the highest inflows in 1980, 1990, 2000, and 2009. But from 1980 to 2000, the level of those FDI inflows to the U.S. economy rose by a multiple of 18–before sagging back in the economic turmoil of 2009. But perhaps more interesting is that if one looks at the top 10 recipients of FDI inflows, one China and Hong Kong don\’t appear in 1980 or 1990. By 2000, China is 9th in FDI inflows and Hong Kong is 7th. By 2009, China is 2nd in FDI inflows and Hong Kong is 4th–and together, they would exceed total FDI inflows to the U.S. economy. Also by 2009, the Russian Federation, Saudi Arabia, and India are all in the top 10 for FDI inflows. Here\’s the table:

4) Predictions for continued long-run growth in China, India, Brazil, and elsewhere have a buried assumption that their growth will become far less dependent on the buying power of high-income countries, and instead far more dependent on growth generated internally or by trading with each other.

King writes: \”Excluding the possibility of trading with Mars or Venus, there are two primary options: either more of each emerging nation’s growth comes from internal sources or more comes from the emerging nations connecting economically with each other. The developed world simply won’t be big enough to accommodate the emerging world’s ambitions and expectations.\”

January 5, 2012 conversableeconomist

Donald Shoup and the Economics of Parking

Los Angeles Magazine has a lively and well-informed article, \”Between the Lines\” written by Dave Gardetta about the history and present of parking in Los Angeles with frequent reference to one of my secret heroes, although I\’ve never met him,: the economist Donald Shoup. (Thanks to Alex Tabarrok at Marginal Revolution for the pointer here.) Here are a few excerpts:

\”In the United States hundreds of engineers make careers out of studying traffic. Entire freeway systems like L.A.’s have been hardwired with sensors connecting to computer banks that aggregate vehicle flow, monitor bottlenecks, explain congestion in complicated algorithms. Yet cars spend just 5 percent of their lives in motion, and until recently there was only one individual in the country devoting his academic career to studying parking lots and street meters: Donald Shoup.\”

\”Shoup is 73 years old. He drives a 1994 Infiniti but for the last three decades has steered a 1975 Raleigh bike two miles uphill daily in fair weather, from his home near the Mormon temple to the wooded highlands of UCLA’s north campus. … This year Shoup’s 765-page book, The High Cost of Free Parking, was rereleased to zero acclaim outside of the transportation monthlies, parking blogs, and corridor beyond his office door in UCLA’s School of Public Affairs building. He wasn’t surprised—“There’s not even a name for what I do,” he says. Shoup, however, does not lack for acolytes. His followers call themselves Shoupistas, like Sandinistas, and on a Facebook page they leave posts suggesting parking meters for prostitutes and equations that quantify the contradiction between time spent cruising for free parking versus the “assumed time-value” cited to justify expanding roadways. (The hooker stuff is more interesting.)\”

\”After 36 years, Shoup’s writings—usually found in obscure journals—can be reduced to a single question: What if the free and abundant parking drivers crave is about the worst thing for the life of cities? That sounds like a prescription for having the door slammed in your face; Shoup knows this too well. Parking makes people nuts. “I truly believe that when men and women think about parking, their mental capacity reverts to the reptilian cortex of the brain,” he says. “How to get food, ritual display, territorial dominance—all these things are part of parking, and we’ve assigned it to the most primitive part of the brain that makes snap fight-or-flight decisions. Our mental capacities just bottom out when we talk about parking. …”

\”L.A. has been a wellspring for a parking guru like Shoup to become self-realized. Our downtown contains more parking spaces per acre than any other city in the world and has been adding them at a rate of about 1,000 a year for a century. … Whereas a skyscraper of a million square feet in New York may be required to have 100 parking spaces, an equal-size structure in L.A., like the U.S. Bank Tower, is compelled by the city to provide closer to 1,300 spaces. The maxim is wrong: L.A. wasn’t built around the car. It was built around the parking lot…. L.A. sits on a mountain-size surplus of parking it doesn’t know what to do with. … San Francisco or New York might have ten times the parking each has now if they had buildings like 1100 Wilshire, where the first 15 floors are all garage. But the downtown areas of those cities won’t allow it. L.A. mandates it. In Los Angeles we attend dinner parties and wish out loud for more pedestrian-friendly neighborhoods, increased urban density, more mass transportation, less congestion, less air pollution, less reliance on our cars—and cheap, abundant parking wherever we go.\”

For those who would like a taste of Shoup, but don\’t quite feel up to 765 pages on The High Cost of Free Parking, I recommend Shoup\’s lead essay in the April 2011 issue of Cato Unbound: Free Parking or Free Markets. Some excerpts follow, although for much more detail and vivid examples from specific cities you need to click through to the essay:

\”Cities should set the right price for curb parking, because the wrong prices produce bad results. Where curb parking is underpriced and overcrowded, a surprising share of traffic can be cruising in search of a place to park. Sixteen studies conducted between 1927 and 2001 found that, on average, 30 percent of the cars in congested traffic were cruising for parking. … Free curb parking in a congested city gives a small, temporary benefit to a few drivers who happen to be lucky on a particular day, but it creates large social costs for everyone else every day. To manage curb parking and avoid the problems caused by cruising, some cities have begun to adjust their curb parking prices by location and time of day to produce an 85 percent occupancy rate for curb parking, which corresponds to one vacant space on a typical block with eight curb spaces. …\”
\”Drivers want to park free, and that will never change. What can change, however, is that people can want to charge for curb parking. The simplest way to convince people to charge for curb parking in their neighborhood is to dedicate the resulting revenue to paying for added public services in the neighborhood, such as repairing sidewalks, planting street trees, and putting utility wires underground. That is, the city can offer each neighborhood a package that includes both performance-priced curb parking and the added public services financed by the meters. Performance pricing will improve the parking and the revenue will improve the neighborhood. …\”

\”Requiring ample parking does give us all the free parking we want, but it also distorts transportation choices, debases urban design, damages the economy, and degrades the environment. Some cities have begun to remove minimum parking requirements, at least in their downtowns, for two reasons. First, parking requirements prevent infill redevelopment on small lots, where fitting both a new building and the required parking is difficult and expensive. Second, parking requirements prevent new uses for many older buildings that lack the parking spaces required for the new uses. A search of newspaper articles about minimum parking requirements found 129 reports of cities that have removed off-street parking requirements in their downtowns since 2005. … Minimum parking requirements may be our most disastrous experiment ever in social engineering, and ceasing to require off-street parking is not social engineering…. If cities remove off-street parking requirements, they will have to charge performance prices for the curb spaces to prevent spillover, but this will produce another great benefit: All the money paid for curb parking will become a new revenue stream to pay for local public services. Curb parking will become too valuable not to meter. Removing the parking requirements for both housing and offices can produce a cascade of benefits: shorter commutes, less traffic, a healthier economy, a cleaner environment, and more affordable housing…. The upside of the mess we have made is that we have an accidental land bank readily available for job-adjacent housing. This land is now locked up in required parking, but if cities remove their unwise parking requirements we can reclaim land on a scale that will rival the Netherlands. … Some people assume that America has a freely chosen love affair with the car. I think it was really an arranged marriage. By recommending minimum parking requirements in zoning ordinances, the planning profession was both a matchmaker and a leading member of the wedding party.\”

January 4, 2012 conversableeconomist

Giffen Goods in Real Life

It\’s a basic pattern in economics, drummed into the head of every intro student, that when the price of a good rises, people tend to consume less of it; conversely, when the price of a good falls, people tend to consume more of it. Sure, there are some goods that are more responsive to changes in price than others. Sure, there may even be short-term exceptions like when a high price entices a few buyers looking for a high-status good. But even then, if the price keeps rising, the quantity demanded drops off.

But there\’s one exception to this rule, called a Giffen good, where a higher price causes demand for the good to rise. Until very recently, I had always told students when explaining this case that the example was a theoretical curiosity, without real-world application. I may have to change that.

The Giffen good was named by Alfred Mashall in his Principles of Economics, with the first edition published in 1890. Marshall explains the conventional wisdom that when the price of a good rises, quantity demanded falls, and vice versa. But he adds (Book III, Chapter VI): \”There are however some exceptions. For instance, as Sir R. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it. But such cases are rare; when they are met with, each must be treated on its own merits.\”

To spell out the underlying logic in modern terms, every price change has two effects on people: 1) it causes them to want to substitute away from what is now relatively more expensive and toward what is now relatively cheaper; and 2) it alters the buying power of their income. Most of the time, these two effects reinforce one another: that is, a higher price for a good makes people want to consume less of that good both because it\’s now relatively more expensive, and also because the higher price has reduced the buying power of their income.

But now consider what economists call an \”inferior good,\” which is a good that people tend to buy more of as their income falls. Standard examples of an inferior good might be something like hamburger or oatmeal. Imagine further a very poor society, in which people spend a lot of their income on one source of food: in Marshall\’s example, that one source of food is bread; in the example often used long-ago when I was in college, it was potatoes in Ireland in the 19th century. Imagine that the price of that staple food rises. Usually, a higher price means less of that good consumed. But Giffen good is an inferior good, and the reduction in the buying power of people\’s incomes as the price rises (together with the lack of cheaper food alternatives, because for poor people this is already the cheapest alternative) means that they shift toward buying more of the good, rather than less.

Alfred Marshall attributed this idea to Robert Giffen, who was a financial writer who moved from journalism (including a stint in the early years of the Economist magazine) to being a government adviser on statistical questions. The attribution may be overly generous. As far as I know, the concept has not been found in any of Giffen\’s books or writings. But the terminology stuck, along with the idea that this was a very rare occurence. In Chapter 8 of my Principles of Economics textbook (and I encourage teachers and students of economics to check it out here), I wrote: \”However, no study has ever found conclusive evidence of a Giffen good in the real world. A famous economist named Francis Ysidro Edgeworth summed up the situation regarding Giffen goods in this way in 1914: `Only a very clever man would discover that exceptional case; only a very foolish man would take it as the basis of a rule for general practice.`\” [My notes to myself say that the Edgeworth quotation is from p. 9 of a book called ”On the Relations of Political Economy to War.\”]

Well, it seems that the development economics literature has now produced strong evidence of a real-world example of a Giffen good. The December 2011 issue of the Region magazine from the Federal Reserve Bank of Minneapolis has a lively interview with Esther Duflo about her work. The whole interview is worth reading, but one point that jumped out at me was her commentary about the evidence for a Giffen good. Here\’s Duflo, taking the possibility of real-world Giffen goods quite seriously:

\”A recent example of this is an experiment by Rob Jensen and Nolan Miller, where they look at the effect on consumption of changes in the price of rice. If you decrease the price of rice, will people consume more rice or less rice? In the real world, it’s very difficult to know that because whenever the price of rice decreases, that’s the result of a combination of supply and demand factors, and isolating variation in the price of rice as purely exogenous is essentially impossible.So you need an experiment to know, and in fact they found something very interesting when they did this experiment in one place in China where rice is a very important part of the food basket for the poor. And they found that when the price decreased, people ate less rice, not more rice, which means rice is a Giffen good …

\”I think you can’t dispute the fact that rice, in this particular place in China, is a Giffen good…. Yes, it doesn’t mean that rice is a Giffen good here in the United States. I’m not interested in that question. But the fact that there is one Giffen good somewhere I think makes this interesting. It is incremental knowledge for how we think about the world and is very, very, very important for what we think about the poor and food. And in particular, in the policy domain, it shows that policies that subsidize the price of staples—which is quite common—might be counterproductive from the view of getting people to eat more. It still might be good for the poor, because they consume a lot of staples, and subsidizing a staple improves their income. But if the objective was to make people eat more, that’s not necessarily the way.

\”That does not mean that it would be true in India, but the very fact that there is this possibility means that we want to investigate this question more. And we can try a similar experiment elsewhere to see in what conditions this will reproduce. With a Giffen good, the advantage is that we have a very established theory that helps us think what’s likely to be a Giffen good. It has to be something that is a very big part of the budget so that the income effect is large. And it must be an inferior good. That gives us a sense of, in another place, how would we go about looking for a good that’s likely to have the same characteristics? Maybe there are no Giffen goods here because no goods have those characteristics. But maybe if we went to Ethiopia, it would be whatever is the staple food there. We can see what’s the share of this staple in people’s budgets and get some idea of what we are looking for.\”

The research paper to which Duflo is referring is Robert Jensen and Nolan Miller. 2008. “Giffen Behavior and Subsistence Consumption.” American Economic Review 98 (4): 1553-77.

January 3, 2012 conversableeconomist

India\’s Economic Growth: Puzzles, Issues, Sustainability

Economic growth has taken off in India. But among economists, there are a variety of puzzles about when growth really took off, why it took off, and thus about how sustainable the growth will be. Ashok Kotwal, Bharat Ramaswami, and Wilima Wadhwa seek to untangle these issues in \”Economic Liberalization and
Indian Economic Growth: What’s the Evidence?\” which appears in the December 2011 issue of the Journal of Economic Literature. (The journal is not freely available on-line, but many students and faculty will have on-line access through their library, or as part of their membership in the American Economic Association.)

Much of the controversy over India\’s growth arises because certain dates don\’t line up neatly. India undertook a highly publicized wave of deregulation and market-opening starting in 1991. Main steps included a sharp reduction in limits on imports and on foreign direct investment into India, as well backing away from state control of many industries, including notably banking, insurance, and telecommunications. However, the surge of economic growth in India predated that wave of reforms–thus leading to controversy over the role of those reforms in the surge of economic growth. The first figure shows the rising level of growth in India\’s overall GDP; the next figure shows the break from trend in per capita GDP. In both cases, it certainly looks as if the upswing started in the 1980s, rather than after 1991.

India\’s growth pattern is clearly not the same growth pattern that has worked across east Asia: including Japan, countries like Korea and the other east Asian \”tigers,\” and now China. Their growth was built on sky-high rates of national savings, which translated into enormous capital investment. It was also built on a widespread commitment to raising levels of education, and to transferring technology into the country. The governments of these countries then offered support for what started out as low-wage manufacturing directed at export markets, in which workers moved from agriculture to manufacturing, and then gradually worked up to higher-wage manufacturing.

In contrast, as the JEL authors explain (footnotes omitted): \”However, Indian economic growth, during 1980–2004, seems to have little in common with the so-called “Asian Model.” Its savings rate has improved over time but has not reached the East Asian level. Its growth so far has not been driven by manufactured
exports. Nor has it attracted massive inflows of foreign investment. There is no industrial policy targeted toward developing specific industries. On the contrary, it is the service sector that has led the charge in
the Indian growth experience. Another aspect of the Indian experience that makes it very different from that of other Asian countries is that, despite a fast growing nonagricultural part of the economy, the share of agriculture in the total labor force has declined very slowly. In fact, the agricultural labor force in absolute
numbers has increased since the 1980s, dampening the process of poverty decline.\”

There are competing interpretations of what happened to India\’s economy in the 1980s. One view is that the growth of that decade was largely an unsustainable bubble based on unsustainably high government deficits. Another view is that the country was already going to through an attitudinal shift away from the overt socialism of the 1970s, and so that even before the reforms of 1991, seeds of economic change were bearing fruit. Those who want chapter and verse on this dispute can start with the fair-minded presentations of both sets of argument in the JEL article.Here, I\’ll focus on the take-off of services in India, and the concern that growth from this source is not spreading across India\’s economy..

The cenrrality of services in India\’s economic growth is quite clear: \”Within the sector, business services (which includes software and information-technology-enabled services), banking, and communications have grown on average at more than 10 percent per year in the 1990s. On the other hand, some other services, such as railways and public administration, have grown more slowly … As a result, while the services share of GDP is nearly 60 percent, its share of employment is barely 30 percent. …However, the most noticeable feature of service sector growth has been the remarkable expansion of its exports, which grew faster (at 17.3 percent annually) than either GDP (at 7.5 percent) or the services GDP through the 1990s (at 9.2 percent). … Until the most recent financial crisis, this sector has been growing at 35 percent per annum. Though as yet software sector is only a small part of the GDP and a negligible part of the total employment, it has been the most dynamic sector in India …\”

It seems clear that the wave of deregulation in 1991–which allowed imports of high tech equipment, investment by foreign companies (like software companies), along with economic connections to other countries in telecommunications, banking, and finance– was essential to the growth of India\’s services sector.
But India\’s surge of economic growth also came out of some other factors. The country had built up a reservoir of highly-skilled engineers back in the 1970s and 1980s, many of who had educational and commercial connections in high-income economies, and who were thus ready to take advantage of the economic openings when they occurred. A huge number of potential workers in India spoke English, and thus could provide various kinds of administrative support and staff \”call centers.\”

The ironic outcome is that India is typically referred to as a development success story, while at the same time the country has a larger number of the world\’s poor than any other.Indeed, there are concerns that India is not educating much of its population nearly well enough for it to have any hope of participating in this form of economic growth. In a phrase I once heard, India is part southern California, and part sub-Saharan Africa. Here is a flavor of the summing up from Kotwal, Ramaswami, and Wadhwa:

\”It is clear from the earlier sections that the growth episode in India since the 1980s is not another instance of state-driven growth in Asia. Instead, it is the coincidence of the ready availability of new technologies and having the skilled manpower that would be necessary to take advantage of these new technologies. Technology transfers in the 1980s and early 1990s took place mostly through easier and cheaper access to imported machinery that was made possible by trade liberalization. Improved communications (especially cell phones) and the diffusion of the Internet were other technologies that played a big role in driving growth from the mid-1990s on. It is inconceivable that, without the breakup of government monopolies and the advent of competition in the communication sector, there would have been a revolution in communication technology in India. …

\”Indeed, one major feature of India’s development pattern is that the share of agriculture in employment has not come down rapidly. In fact, the absolute amount of labor in agriculture has risen continuously in India while it fell in all countries now developed during their comparable development phases. An important component of growth—moving labor from low to high productivity activities—has been conspicuous by its absence in India. Also, as the labor to land ratio grows, it becomes that much more difficult to increase agricultural wages and reduce poverty. …

\”If we consider double the poverty level ($2.16 per day), a staggering 80 percent of India’s population was poor in 1983 and the number is about the same in 2004. This is a startling fact and indicates that there are two Indias: one of educated managers and engineers who have been able to take advantage of the opportunities made available through globalization and the other—a huge mass of undereducated people who are making a living in low productivity jobs in the informal sector—the largest of which is still “agriculture.” The most direct impact on the second India could only come about through improvements in agricultural productivity. … In general, the productivity improvements in the informal sector depend crucially on access to credit, know-how, and skills and therefore on the quality of institutions. India’s future will depend a great deal on how these institutional improvements shape up.\”