Credit Addiction

A Question for Jacob Hacker

Jacob Hacker is back with revised estimates on family income volatility (ht Mark Thoma). In his earlier work he found a marked increase in the volatility of family income between 1973 and 2004. These conclusions were later challenged by findings from the CBO. In turn, Hacker responded to CBO here. Now, if Hacker could be so kind as to respond to another question, one that I raised earlier:

[W]hat role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation').

Clearly, this question reflects my macro background. But it is the question that keeps coming up in my mind when I read this family income volatility debate.

Which Externalities Should Be Internalized?

Robert Frank's NY Times column on using Pigovian taxes as an "efficient" way to deal with the negative externalities of gas consumption has generated some interesting comments in the blogosphere. The article also points to an important question that has been bugging me for some time. But first, the interesting comments. First up is Gabriel Mihalache who points out an important assumption in Frank's analysis:

...A Pareto improvement [from imposing a Pigovian tax on gas consumption] means that afterwards, everyone is at least as well off (subjectively) as before and some are better off. But how can that be the case when we’re talking about taxing externalities, given that some people’s income is tightly tied with those activities?

The implicit, unstated, assumption of Frank’s article is that we could compensate the losers from the new energy policy from the gains of others. By the logic of what a Pareto improvement means, the gain to some is larger than the loss of others, so there exist potential transfers to compensate the losers and still leave the winners better off.

When supporters of free trade point out that the net losers from the full opening of borders could be compensated, with transfers from the net winners, the common criticism is that those transfers are both politically and institutionally unfeasible. There’s no mechanism we can trust that would identify the correct transfers (from whom, to whom, how much?) and make it in a way that’s politically acceptable.

I will unashamedly yield the same critique against Frank. He wants to seduce us with Pareto improvements but he only tells us half the story, less that half really… he mentions introducing the carbon tax but he remains strangely silent on the ways he’d use to compensate the losers.

Gabriel suggests we avoid resorting to the Pareto efficiency argument and say up front there may be net losers. Josh Hendrickson, meanwhile, also questions the usefulness of invoking Pareto efficiency and goes on to stress that the proper use of a Pigouvian tax requires a Herculean ability to properly assess social costs:

The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.

In short, both of these commentators suggest we should be more humble about our ability to (1) rigorously justify and (2) precisely implement a carbon tax. As noted above, Frank's column also points to another important question that I have been wrestling with for some time: exactly which externalities should be internalized? There are so many negative externalities in society so why stop at those created by gas consumption? Frank alludes to this in his article:

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. Noisy goods, like leaf blowers, for example, can jolt whole neighborhoods from calm. And goods that don’t biodegrade readily, like many plastic bags, can generate costly waste streams. The list goes on.

Okay, then, why not tax noisy leaf blowers (noise pollution) or billboards along the highway (sight pollution) or rancorous, smelly, ugly people (noise, sight, and smell pollution)? Conversely, should we subsidize quiet neighbors, firms that do not advertise on highway billboards, and beautiful, well-kept people?

Now I am not advocating we tax or subsidize the above items. However, this list does illustrate the fact that society does choose to correct only certain externalities. So what is the decision criteria used in this process? Presumably it involves equating some margins; I am just not sure which one they are though. Any thoughts?

In closing, let me refer you to Peter Klein who, in the context of applying a Pigouvian tax to negative externalities, makes the following statement:

But my main beef with today’s Pigouvians is that they cherry-pick a case here and there — taxes on gasoline, primarily — without fully pursuing the implications of the analysis. If increasing gasoline taxes is efficient, why stop there? What other market failures should the state be empowered to remedy? Here’s my question, specifically:

Please name the activities you believe deserve Pigouvian subsidies. For each activity provide the efficient subsidy amount, explain how this was calculated, and say how the revenues should be raised.

Update: Mark Thoma and others provide answers here.

Signs of the Times

Click on picture to enlarge.

The Conventinonal Wisdom on Deflation

The Conventional wisdom on deflation is that it is economically harmful and should be avoided at all costs. Consequently, no central bank explicitly targets deflation and few observers would dare say anything nice about deflation. The origins of this deflation orthodoxy can be traced to the painful deflation experience during the Great Depression of the 1930s. Japan's experience with deflation and its weak economy in the 1990s only reinforced this view. The modern economic psyche, therefore, has been programmed to go into fits at the first sign of any deflationary pressures.

This aversion to deflation can seen in the figure below that shows the number of articles on U.S. deflation in major world newspapers and the U.S. inflation rate for the years 1992-2004. During this time there were two deflation scares--one 1998 and the other in 2003--when the inflation rate dropped below 2%. As you can see the number of deflation articles spiked around these deflation scares, with most of the articles expressing anxiety over deflation. [Click on graph to enlarge.]

[The number of deflation articles comes from Lexus-Nexus search with the keywords “deflation” and "United States" or "U.S." Included in the search was a string of words and word roots associated with deflation’s potentially harmful and adverse consequences (e.g. zero nominal interest rate bound, debt burden, liquidity trap, economic weakness). I assume that any article having these key words is expressing at some level anxiety or concern over deflation.]

As some of you know, I have a problem with this deflation orthodoxy because it fails to distinguish between deflationary pressures arising from a negative aggregate demand shock versus that arising from a positive aggregate supply shock. As the above figure indicates, almost everyone assumed the deflationary pressures in 1998 and 2003 were harmful when in fact the data suggests that much of it was the result of the rapid productivity growth in those two years. This deflation orthodoxy explains why the Fed lowered its policy rate to historic lows: it, like most everyone else, thought the deflation of 2003 was of the harmful form. Because of the deflation orthodoxy, then, the Fed pushed the real federal funds rate to historic lows at the very time the rapid productivity growth was suggesting a higher natural interest rate. As I have argued elsewhere, this set off a credit and housing boom-bust cycle that we are now trying to sort out.

I hope going forward that conventional wisdom of deflation will emerge to a more nuanced view that distinguishes between the harmful aggregated demand-induced deflation and the more benign aggregate supply-induced deflation.

More on the Opportunity Cost of Religion

Mark Thoma points us to a paper by Jonathan Gruber and Daniel Hungerman titled "The Church vs. the Mall: What Happens When Religion Faces Increased Secular Competition?" The authors show that when you increase the opportunity costs of church attendance--in this case by repealing Sunday blue laws that in turn open up other opportunities on Sunday like shopping at the mall--there could be a decline in attendance. There may also be an effect on religious financial giving:

When the laws are repealed, there are two possible effects. First, time devoted to religious pursuits unambiguously falls, as individuals choose to devote more time to work and more secular consumption. Second, there is an ambiguous effect on religious contributions. On the one had incomes may rise due to new work activities, and this could increase contributions. On the other hand, new secular consumption opportunities compete with religious giving for a share of the individual’s budget, and this could decrease contributions.

What, then, do the authors find?

Thus, secular competition does matter for religious participation: increased secular opportunities for work and leisure on Sundays lead to less time at church and lower religious contributions.

The authors also find that the repeal of the blue laws lead to a significant pick up in drinking and drug use by religious people. The authors conclude by discussing two implications of their research:

First, this finding serves to validate economic models of religiosity, as discussed extensively by Iannaccone (1998). Religious participation is not independent of economic influences such as the opportunity cost of church-going.

I concur and believe it is consistent with our earlier discussions on the business cycle and religiosity. Now to the second implication:

Second, this finding can be a valuable input into the discussion of the regulation of religion and substitutable activities. Absent strong negative externalities, there seems little argument for restricting the days of the week that commerce can take place. But religious participation may be one of those activities with such externalities. As such, secular regulations such as blue laws which promote religious participation can have external effects. Whether those external effects are sufficiently large to justify restrictions on commerce is an excellent question for future research.

I believe the negative externalities they are referring to is the steep pick up in drinking and drug use by religious people after the repeal of the blue laws. However, do we really want to mix church and state because some people are now making bad choices? I certainly would not want to make the case for more state intervention in order to promote religious participation, especially one that promotes participation on a particular day of worship. What about those who worship on Saturday or who do not worship at all? There are all kinds of problems with this supposed implication.

With that said, this is an interesting paper--take a look.

It's Not Easy Being Number One

Adding to the ongoing discussion of reserve currency status, Harold James warns the Euro constituents it is not easy hosting the main reserve currency.

The Euro's Success Could Also be Its Downfall

[...]

The euro is showing all the signs of strain of being the new international key currency. Manufacturers in Europe complain that its rise is imposing new levels of pain. Politicians in many countries across Europe are pressing to have more influence on monetary policy. For many of their constituents, the euro has become one of the whipping boys of globalisation. The euro is a much younger currency than the dollar was in 1944 and it exists in a political environment in which the governance structures for the new currency are not clearly defined. That makes the internal stakes within Europe much higher.

[...]

In 1944 the dollar became the world’s key currency because the US was both the world’s leading economic and military power. In 2008, the European Union has many economic advantages but also substantial political vulnerabilities. It is not easy being the world’s main currency. It is even possible that the new strains might lead to the break-up of the monetary union.

Read the Rest.