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.

Daron Acemoglu Interviewed

Daron Acemoglu is amazingly wide-ranging, productive, and thought-provoking. A nice sample of his work and thinking emerges from a recently published interview with Douglas Clement of the Minneapolis Federal Reserve.

On the Dodd-Frank financial reform legislation

\”I think the problem with the Dodd-Frank Act is that the amount of good it contains seems to be dwarfed by the amount of additional minute details it contains. That fails to achieve the intent of the regulation. It also gives better regulation a bad name, because people who are opposed to regulation can easily point to the page after page after page of paperwork and procedural things that Dodd-Frank wants you to do. And I am not convinced that the Dodd-Frank Act is going to prevent the next financial collapse if the financial system actually continues on its current trajectory. I don’t think anybody can claim that they know what’s going to happen in the next five years in the financial sector, but the financial sector has become more concentrated. It’s very profitable, it is still investing in highly risky assets and, in fact, it hasn’t really cleaned up its balance sheet to a great degree. The bonus culture, for example, was one of the elements that contributed to the crisis—not by any means the only one, or the most major one, but it was certainly an important factor. It has remained the same. And the Dodd-Frank Act doesn’t really do anything to deal with that. …

I think something that’s much more effective—and again, I view it as a speed- bump-type of regulation—is to increase capital requirements. … If you increase capital requirements, you’re essentially putting in speed bumps because the rate at which a bank can expand its balance sheet is going to be limited by the capital it has to a much greater extent than currently required. Those are the kinds of things that, as long as they’re not very detail-oriented, I think hold more promise. When they are detail-oriented, they are easier to overcome and thwart, and they are also much more costly to the daily functioning of banks.\”

On directed technical change and reducing carbon emissions

\”Essentially, the bulk of the literature in environmental economics has been about how we have to tax economic activity to slow it down so that we don’t damage the environment. If you think of a single-sector economy, with one sector that depends on coal, or on gas, that’s the only thing you can do: slow down that one sector. If you want to reduce carbon emissions, you just have to slow down that sector. Now, you don’t directly slow it down; you change its composition of factors, perhaps, but you can’t let that sector take off at a very rapid rate and still, at the same time, limit carbon emissions.

Our perspective was, well, the economy has several technologies; some of them are cleaner than others. How should we shift toward the cleaner ones? When you look at the climate science, there’s a lot of emphasis precisely on this and on questions such as, When is it that nuclear power will become economical? When will geothermal or wind or solar solve both their cost and their delivery problems?

Therefore, the perspective shouldn’t be, How can we slow down economic activity? Instead, it should be, How can we shift the composition of economic activity away from dirty technologies to cleaner technologies? Now, that’s a very directed-technical-change-related question, but it already comes with a very important implication: The focus shouldn’t be on slowing down economic activity, but on changing its composition and changing the type of technological changes that the market generates.

Moreover, and importantly, we expect there to be a distinctive cumulative aspect to research. Different technologies often build on past successes in the same line of technology. So when you’re building a new car, you build on the past advances in car technology; you don’t as much build on advances in solar technology. In the same way as when you build new solar panels, you’re building on the previous solar panels, not on the diesel engine. What that means is that there’s going to be strong self-reinforcement in changing the direction of technological change. So when technological change shifts away from the dirty technologies that are so fossil-fuel-dependent to the cleaner technologies, it will also make it potentially cheaper to produce these innovations, these cleaner technologies, in the future.\”

On the relationship from political structures to economic growth

\”But later in college and graduate school, I started working on issues related to human capital, economic growth and so on. But then after a while, I sort of realized, well, you know, the real problems of economic growth aren’t just that some countries are technologically innovative and some aren’t, and some countries have high savings rates and some don’t. They are really related to the fact that societies have chosen radically different ways of organizing themselves.

So there is much meaningful heterogeneity related to economic outcomes in the political structures of societies. And these tend to have different institutions regulating economic life and creating different incentives. And I started believing—and that’s reflected in my work—that you wouldn’t make enough progress on the problems of economic growth unless you started tackling these institutional foundations of growth at the same time.\”

Some applications to \”Arab Spring\”

\”The big question is, Is this going to be a political revolution in the same way as the Glorious Revolution in England, which unleashed a fundamental process of transformation in the political system with associated economic changes? Ultimately, such political revolutions are fundamental to the growth of nations. That’s one of the arguments we make.

Or is it going to be the sort of revolution like the Bolshevik Revolution or the independence movements in much of sub-Saharan Africa in the 1960s, where there was a change in political power, but it went from one group to another, which then re-created the same system and started the same sort of exploitative process as the previous one?…

So, there is no guarantee that such movements will translate into a broad-based political revolution, as opposed to sort of a palace coup where one group takes control for another.\”

Bruce Yandle on environmental economics

David A. Price of the Richmond Fed has an interview with Bruce Yandle.

On the difference between a “systems approach” and a “process approach” to environmental policy issues: 
\”A systems approach is where the “brightest and best” get together and look at a problem and come up with
what they believe to be the best solution. They describe the system that can be installed that will lead to a solution of the problem and so it tends to be top-down.  In a process approach, you identify goals and outcomes, develop some rules of the game, and then let the process take hold, holding accountability with respect to outcome. You don’t tell people how to do things; you say this is the outcome that must be achieved, or it’s going to be costly for you.\”

On problems of transactions costs:
\”Transaction costs are large under either approach. The transaction costs are high in a technology-based

systems approach on the input side. The difficulty is no one is keeping score on the output side and we literally
have rivers that come close to dying, even though every discharger is meeting the requirements of the law. So you have a community of legal polluters killing a river. You can say we saved a lot of transaction costs. Well, I would say, “But you didn’t save the river!” Should we be concerned with transaction costs or outcomes? You do have a trade-off there.  I looked at the level of litigation under common law and statute law. We looked at the amount of litigation in the post-1970 world and the pre-1970 world and it looks like you get about the same amount of litigation with the statutes as you do at common law. It’s not an apples-to-apples comparison because all we’re looking at are counts of cases that are brought. Statute law generates a huge amount of litigation, and litigation costs are transaction costs in a way. That’s an important consideration, but I think the more important consideration is outcomes, and then to look, in some way, at the costs.\”

The start of the \”environmental saga\”:
\”From 1970 through last year, we had 2.5 million pages of the Federal Register published during that period; from 1940 to 1970, about 350,000. What I call the environmental saga begins in the United States in about
1970 and that’s when the world changes dramatically.\”

On  \”bootlegger and Baptist\” coalitions: 

\”That was the story of two groups who favor restrictions on the sale of alcoholic beverages on Sunday. The Baptists take the moral high ground; they would like to see a diminution in the consumption of alcoholic beverages. The bootlegger just wants to get rid of competition one day a week. I called it bootlegger and Baptists  for alliterative purposes. It could  have been called “bootlegger and Methodists” and you would have the same story. … I was working on the White House staff reviewing newly proposed regulations during the end of the Ford administration and the first part of the Carter administration, in a unit of the Council on Wage and Price Stability. My beat was the EPA. I reviewed the copper smelter standards. I would get their big regulatory bundles and review them, and we would make comments in an attempt to try to reduce the cost of accomplishing the goal. EPA had an excellent economic analysis. The last section said when this regulation becomes final, there will never be another copper smelter built in the United States of America. How would you feel if you had a copper smelter? You’d just been told you will never have any new competition.\”

For a short and readable recent article by Yandle, see my post of July 1 on \”The Accumulation of Regulations.\”

Noriel Roubini (aka "Dr. Doom") on Exchange Rates, China, and U.S. Investment

Nouriel Roubini, sometimes nicknamed \”Dr. Doom,\” is interviewed by Tom Keene of Bloomberg News at the Milken Institute Global Conference in May. An edited and shortened transcript of the interview is available (with free registration) in the Milken Institute Review (Third Quarter, pp. 65-74). Or you can watch the interview here. Some snippets:

On currency adjustment: 
\”Exchange rate determination is really a beauty contest about which currency is the “least ugly,” and this changes depending on relative growth concerns, fiscal policy, financial stability, sovereign debt, interest rate policies, etc. At the moment, all the major currencies have reasons to be weaker. The trouble is, not all currencies can be weak. The currencies that should be depreciating are those of the U.S., U.K. and other countries that went bust in the financial bubble, and now need export growth to make up for anemic domestic demand during the period of balance sheet retrenchment. … Countries running current account surpluses can keep on accumulating reserves, and thereby prevent the appreciation of their currencies. By contrast, countries with deficits eventually run out of foreign exchange reserves, or the bond vigilantes impose discipline. The one exception is the United States: because the dollar is the major reserve currency, we can run larger deficits for longer. If the
dollar didn’t have reserve status, it would have collapsed a long time ago.\”

On the need for rebalancing China\’s economy: 
\”In China today, half of GDP is in the form of fixed investment, while consumption is only 35 percent – and falling. That is not sustainable because no country can productively invest half its GDP for very long. Historically, every case of over-investment – the Soviet Union, East Asia in the 90s – has ended in a hard landing.\”

On the more rapid economic recovery in Asia: 
The recovery in the Asian emerging markets has been a “V” [rather than a “U”] because their financial fundamentals were much sounder and they don’t have balance sheet problems comparable to the U.S. and Europe. In some countries, though, that recovery’s now leading to overheating.
Are they in control of their own destiny? Not if China shadows the dollar and everybody else shadows China; they are effectively adopting U.S. monetary and credit policies. As a result, there’s been excessive money growth, excessive foreign exchange intervention. You’re seeing overheating in credit that is spilling out as price pressure in the equity, commodity and real estate markets. And
therefore Asia is in danger of both goods and asset inflation.\”

Why the U.S. needs a weaker dollar: 
\”Tim Geithner and others say they’re in favor of a strong dollar. But we actually need a weaker dollar, maybe 15 percent on a trade-weighted basis. Think about it rationally. Because of the asset bubble collapse, domestic demand is going to be anemic. So in order to maintain growth even close to potential, we need to reduce our trade deficit. How do you reduce this trade deficit? We have to have more private and public savings – but that’s going to slow down domestic demand even more. Therefore we need a weaker exchange rate to gradually improve the trade balance.\”

On U.S. firms sitting on their cash: 
\”While the balance sheets of government and financial institutions are damaged, the corporate sector is in excellent shape. Corporations have used the crisis to cut costs, especially labor costs. They’re highly profitable and productive: earnings are going to be surprising. They are sitting on $2 trillion in cash in the U.S. alone. But they are not spending it. And even if they start to spend, it’s not clear why they’d choose to invest in slow-growing advanced economies rather than fast-growing emerging markets. One reason they’re not spending more is excess capacity: roughly a quarter of industrial
capacity is currently not used. Why would you want to do a lot of investment where there is excess capacity?\”

An Interview with Joel Slemrod on Tax Policy

Aaron Steelman of the Richmond Federal Reserve interviews Joel Slemrod of the University of Michigan, mainly on tax policy issues. Here are some thoughts from Slemrod:

On current taxation of employer-provided health insurance: \”Well, it certainly reduces the after-tax price of health insurance for people. The problem is that it reduces the price below the true social cost, so that people acting in their own family\’s interest, are, at the margin, buying insurance where the value to them is actually less than the true cost. In a word, we are subsidizing high-deductible, low copay insurance policies and, given the upward trend we are seeing in the fraction of our gross national product that goes to health care, I think we ought to be moving toward reducing or eliminating such subsidies. Not only that, it\’s a very unattractive sort of subsidy, because the subsidy rate is dependent on the household\’s marginal tax rate, so the subsidy rate is highest for the highest-income people. And I just don\’t think that even people who would argue for a subsidy would favor such regressivity if they were designing a subsidy scheme from scratch. The reason to be wary about abandoning the subsidy is that it supports the system of employer-provided health insurance, which spreads risks across employees and offsets the problem of adverse selection that can plague health insurance markets; before we eliminate the subsidy entirely, we need to have other policies in place to prevent a collapse of efficient markets for health insurance.\”

On how high-income people react to high tax rates: \”My own view … is that certainly high-income people notice taxes, and they react to taxes in ways that lower their exposure to taxes. The evidence for taxes substantially affecting what one might call \”real\” behavior, such as labor supply or savings, is not as strong as the evidence regarding another class of behaviors we might label \”avoidance.\”\”

On how saving is affected by fear of nuclear war: \”I have three articles that try to estimate whether, when people seriously think there\’s a chance of a nuclear conflagration, this belief affects their saving behavior. In short, do people believe we ought \”to eat, drink, and be merry, for tomorrow we die?\” To test this hypothesis I looked at aggregate saving over time in the United States, across countries, and micro data within the United States, and in all three cases found that when people think, or profess to think, there\’s a chance of a nuclear war, their saving rate goes down, just as economic theory would predict.\”

On how people time their deaths to reduce estate taxes: \”We looked at estate tax return data from the history of the U.S. estate tax and found that when the estate tax was going to change — go up or down — in an anticipated way, then the distribution of deaths around that date was not symmetric. When the tax rate was going to increase, more people died before the rate rose, and when the tax rate was going to be lowered, people held on and more people died after the decrease. Since we wrote the paper, the general \”death elasticity\” finding has been replicated using data from episodes in Australia and Sweden when they ended their estate taxes. Those studies found evidence that people delayed their death to save their heirs\’ money, in some cases, millions and millions of dollars.\”

Mark Bils on price measurement

Brent Meyer of the Federal Reserve Bank of Cleveland has a nice interview with Mark Bils of the University of Rochester, focusing on the subject of price measurement. Here are some comments from Bils:

On why price measurement matters: \”My interest in price measurement really came out of discussions I had with [Stanford economist] Pete Klenow. Our interest was always less in thinking about inflation and prices. It was rather on the fact that whatever you mismeasure on prices affects how you measure real incomes and economic growth. … Because if you overestimate inflation by 1 percent, then instead of being, say, 1 percent per year real growth, it is really 2 percent per year. Well, that means the growth rate is doubled!\”

On inflation and quality change in health care prices: \”If I compare healthcare costs today versus in the year 1800, well, I could go out and buy a bunch of leeches today for almost nothing. And I could have the healthcare I had in 1800. If you had a certain condition and you had $10,000 to get treated at today’s health prices, or $10,000 to get treated at 1960s prices with 1960s technology, I don’t think it’s so obvious that people would want to go back in time to get their important health conditions dealt with. In that sense, you say, I don’t know if there’s inflation. It’s pretty hard to say that there’s been a lot of inflation over the long haul in healthcare.\”

On quality improvements and car prices: \”My first car was a 1983 Accord, which cost $9,600. It was a great car, but it didn’t have any of the safety equipment that you have today. It didn’t have power windows. It didn’t have air conditioning. It didn’t have many features. If you took that same car—it did get good gas mileage, actually—and you tried to sell it as a new car today, I don’t think you would get $9,600 for it, if you had to compete with what’s out there.\”

On why some changes in consumer prices affect macroeconomic national income more than others: \”A consumer price index isn’t an ideal measure of what’s happening to real income. That’s partly why I think that gasoline is a problem—because it’s so much an imported good. When its price goes up, that’s really a big loss in real income. Whereas when it’s a good that’s produced here, the loss in real income is that it takes more resources to produce it. If our efficiency drops in producing food, and then the food prices go up, that’s a real loss in income. If there’s an upward shock in prices, then the farmers—the people selling the food—do at least get some benefit from the price increases.\”

On the imprecision of hedonic adjustments to price measurements: \”There’s a classic example for vehicles. If you look at gas efficiency, miles per gallon, everything else equal, people would rather get better gas mileage. There’s not much question about that. But if you’re using a hedonic equation, and you say everything else that I observe, how much more are people willing to pay for better fuel efficiency? You actually get a negative number. If I take two vehicles, the characteristics I enter for them, plus miles per gallon/fuel efficiency, I’ll see the one that gets better miles per gallon tends to go for a lower price. … [T]here are very limited characteristics that we’re entering about the vehicle. So all these unmeasured characteristics that people like in their cars tend to be in a luxury car, and we’re not recording all those. They may not care so much about the fuel efficiency; they want performance of the engine. So when I, as a price measurer, look just at this, I’ll price fuel efficiency negatively. That means that if all the cars in the country got more fuel efficient, and we employed the hedonics literally, we would say inflation went up. Even with computers there are problems like this. These hedonic coefficients jump around a lot.\”