A Debate for the Pigou Club

Brookings economist Ted Gayer opines.

Brad DeLong and Paul Krugman attack.

Ted responds.

Why health consumers aren't cost conscious

Source.

The Temporarily Disappearing Estate Tax

In an odd twist of legislative history, the U.S. estate tax is scheduled to expire on January 1, but for one year only. This article describes people responding those peculiar incentives.

Rich Cling to Life to Beat Tax Man

Nothing's certain except death and taxes -- but a temporary lapse in the estate tax is causing a few wealthy Americans to try to bend those rules.

Starting Jan. 1, the estate tax -- which can erase nearly half of a wealthy person's estate -- goes away for a year. For families facing end-of-life decisions in the immediate future, the change is making one of life's most trying episodes only more complex.

"I have two clients on life support, and the families are struggling with whether to continue heroic measures for a few more days," says Joshua Rubenstein, a lawyer with Katten Muchin Rosenman LLP in New York. "Do they want to live for the rest of their lives having made serious medical decisions based on estate-tax law?"

Currently, the tax applies to about 5,500 taxpayers a year. So, on average, at least 15 people die every day whose estates would benefit from the tax's lapse.

The macabre situation stems from 2001, when Congress raised estate-tax exemptions, culminating with the tax's disappearance next year. However, due to budget constraints, lawmakers didn't make the change permanent. So the estate tax is due to come back to life in 2011 -- at a higher rate and lower exemption.

To make it easier on their heirs, some clients are putting provisions into their health-care proxies allowing whoever makes end-of-life medical decisions to consider changes in estate-tax law. "We have done this at least a dozen times, and have gotten more calls recently," says Andrew Katzenstein, a lawyer with Proskauer Rose LLP in Los Angeles.

Of course, plenty of taxpayers themselves are eager to live to see the new year. One wealthy, terminally ill real-estate entrepreneur has told his doctors he is determined to live until the law changes.

"Whenever he wakes up," says his lawyer, "He says: 'What day is it? Is it Jan. 1 yet?'"...

The situation is causing at least one person to add the prospect of euthanasia to his estate-planning mix, according to Mr. Katzenstein of Proskauer Rose. An elderly, infirm client of his recently asked whether undergoing euthanasia next year in Holland, where it's legal, might allow his estate to dodge the tax.

His answer: Yes.

AEA Humor Session

For those of you attending the meeting of the American Economic Association next week, here is a session you might want to attend:

AEA Economics Humor Session in Honor of Caroline Postelle Clotfelter

• Sunday Jan 3 at 8 pm at the Atlanta Marriott Marquis [www.marriott.com] room A704. Free and open to the public!
• Merle Hazard [www.merlehazard.com] ("Busted Dreams and Cheatin' Hearts: The Credit Crisis, Nashville-Style")
• Hugo Mialon of Emory University ("The Economics of Faking Ecstasy")
• Jodi N. Beggs [www.economistsdoitwithmodels.com] of Harvard University ("Economists Do It with Models")
• Stand-up economist Yoram Bauman [www.standupeconomist.com] ("What to Expect When You're Expecting the Nobel Prize").
• Kenneth West of the University of Wisconsin will be presiding.

The Monetary Base is exploding. So what?

Click on graphic to enlarge.

An article in Saturday's Wall Street Journal says that some big-league investors are betting that inflation will rise significantly.  The reason?  "The nation's exploding monetary base is a harbinger of inflation."  Is this right?  Probably not.

It is true that the monetary base is exploding.  See the above graph.  Normally, such surge in the monetary base would be inflationary.  The textbook story is that an increase in the monetary base will increase bank lending, which will increase the broad monetary aggregates such as M2, which in the long run leads to inflation.

That is not happening right now, however.  The broader monetary aggregates are not surging.  Much of the base is instead being held as excess reserves.

But, you might ask, won't the inflationary logic eventually take hold as the economy recovers and banks start lending more freely?  Not necessarily.  Recall that the Fed now pays interest on reserves.  As long as the interest rate on reserves is high enough, banks should be happy to hold onto those excess reserves.  That should prevent a surge in the monetary base from being inflationary.

Here is one way to think about it.  The standard way of reducing the monetary base is open market operations.  The Fed sells Treasury bills, say, and drains reserves from the banking system, reducing the monetary base.  But consider what this means in the monetary current regime.  An open market operation merely removes interest-paying reserves from a bank's balance sheet and replaces them with interest-paying T-bills.  What difference does it make?  None at all.

Both reserves and T-bills are interest-paying obligations of the Federal government (including the Federal Reserve).  They are essentially perfect substitutes.  The monetary base, however, includes one of them but not the other, largely for historical reasons.

The bottom line is that when reserves pay interest, the monetary base is a pretty uninteresting economic statistic.

Does this mean that investors should stop worrying about inflation?  No.  Yet the worry should stem not from the monetary base but from the political economy and difficult tradeoffs facing monetary policymakers.  As the economy recovers, interest rates will likely need to rise.  Will the Bernanke Fed, feeling the political heat, get behind the curve and allow inflation to take off?  Will it decide that a little bit of inflation is not so bad compared with the alternative of risking an anemic recovery, a double dip recession, or (gasp!) congressional action to reduce Fed independence?   Maybe.  This is, I think, the right way to argue that higher future inflation is a plausible outcome.

I don't know whether such inflation worries are justified.  But I am pretty sure that the exploding monetary base is not, by itself, a reason to fear a coming surge in inflation.

Gruber on the Cadillac Tax

The MIT economist is in favor of it.

Can you name this economist?

Click here to identify this future economic superstar.

P/E Ratio

This chart, from Jim Hamilton, shows the ratio of a stock market price index to the average of the previous ten years of real earnings.  The red line is the historical average.

By this metric, popularized by Bob Shiller, the market is now slightly above its historical average valuation.

Smoot-Hawley Revisited

According to a view common among macroeconomists, the Smoot-Hawley tariffs of the 1930s were a poor policy choice, but they were not a main reason for the severity of the Great Depression.  In an interesting blog post, economic historian Scott Sumner calls the second half of this conclusion into question:

In the period around March and April 1930, there were a few “green shoots” in the economy. The stock market recovered a significant chunk of the huge losses in 1929. (I recall the Dow fell well below 200 during the famous crash, and got back up over 260 in April. The 1929 peak had been 381.) Then in May and June everything seemed to fall apart, and stocks crashed again. So what happened in May and June?

The headline news stories during those months were the progress of Smoot-Hawley through Congress. Each time it cleared a major legislative hurdle, the Dow fell sharply. This pattern was obvious to those following the markets, and was frequently commented upon. After it cleared Congress it went to Hoover. The President received a petition from over 1000 economists pleading with him to veto the bill. (A veto would not have been overridden.) Over the weekend Hoover decided to sign the bill, and on Monday the Dow suffered its biggest single day drop of the entire year.

Scott then goes on to propose an explanation of these events that can be viewed as consistent with the textbook Keynesian model. In particular, I interpret Scott as saying that the retreat from free trade reduced business confidence, shifted the investment function I(r) to the left, and thereby reduced aggregate demand.

One general lesson from his discussion is that it is often hard to distinguish shocks to aggregate supply and shocks to aggregate demand.  Policies and events that adversely affect aggregate supply (e.g., trade restrictions) will often reduce the marginal productivity of capital, decrease investment spending for given interest rates, and depress aggregate demand as well.  In the short run, the indirect demand-side effects of "supply shocks" could potentially be larger than the direct supply-side effects.

This is something to keep in mind as our economy enjoys the beginnings of a recovery.

The Ten Principles Down Under

The economics editor for the Sydney Morning Herald summarizes the Ten Principles of Economics from Chapter 1 of my favorite textbook.

A Reading for the Pigou Club

From the ever sensible David Wessel.

The Case Against the Millionaire Surtax

The latest from my friend and former student Alan Viard.

The Price of Christmas

Up 1.8 percent this year.

Sachs on the Copenhagen Summit

Jeff is not happy.

Rolling the Dice on Medicare

The latest from the Congressional Budget Office:

CBO expects that Medicare spending under the legislation would increase at an average annual rate of roughly 6 percent during the next two decades—well below the roughly 8 percent annual growth rate of the past two decades (excluding the effect of establishing the Medicare prescription drug benefit). Adjusting for inflation, Medicare spending per beneficiary under the legislation would increase at an average annual rate of roughly 2 percent during the next two decades—well below the roughly 4 percent annual growth rate of the past two decades. It is unclear whether such a reduction in the growth rate could be achieved, and if so, whether it would be accomplished through greater efficiencies in the delivery of health care or would reduce access to care or diminish the quality of care.

Epstein on the Reid Bill

Legal scholar Richard Epstein opines on the current version of health insurance reform.  An excerpt:

At this point, there is a near mathematical certainty that the scheme of health insurance market regulation contemplated by the Reid bill will reduce the risk-adjusted rate of return below the level needed to keep these firms in the individual and small-group health-insurance markets. I am not aware of a single provision in the Reid Bill that looks to ensuring a minimum rate of return. And there are countless provisions in the bill that impose new obligations to cover services while eliminating the revenue sources to deal with them. It is just this combination of regulatory programs that leads the CBO to treat private health insurance issuers as part of a federal program—as though they have been subject to de facto nationalization.

Readings on Financial Regulatory Reform

1. Squam Lake Working Group
2. NYU Stern
3. Hart and Zingales

The Big Questions

Looking for a Christmas gift for that special econonerd in your life?  Try Steven Landsburg's new book, The Big Questions. 

I recently finished it, and it is much fun. Reading it is like having dinner and sharing a bottle of claret with a smart, creative, iconoclastic friend.  The conversation jumps from topic to topic in math, physics, philosophy, economics, public policy, etc., in a seemingly random fashion, and your friend does not always convince you of his point of view.  But throughout you are entertained, and in the end you are even edified.

Reinhardt on Drug Reimportation

The policy debate about drug reimportation brings up a lot of interesting questions, touching on the topics of free trade, price discrimination, and protection of intellectual property rights.  Princeton economist Uwe Reinhardt has a good discussion of some of the issues.  For an old post of mine, click here.

Mankiw vs Pinker

We reached different conclusions about a new educational technology.  I am not at all confident that I am right about this one.

Nine Observations about Investment

1. Above is a chart of the growth rate, from four quarters earlier, of real investment in equipment and software.  Notice the left scale.  Investment spending is very volatile.  This is one of the standard stylized facts about the business cycle.

2. Investment has been particularly weak during this economic downturn.  Weak residential investment is not a surprise, as the downturn was started by events in the housing market.  But as this graph shows, business investment has also been very weak.  Indeed, by the metric used in this graph, it is far weaker than in previous deep recessions, such as 1982.

3. Why is business investment so weak?  Part of the reason is that the downturn is severe and investment responds to the overall economy.  Part of the reason is that the credit crunch makes financing more difficult.  Part of the reason is that the policy environment seems adverse to business.  I am referring here to a group of policies that include higher minimum wages, the seeming retreat from free trade, proposed mandates to provide employees health insurance, higher prospective energy costs from climate change regulation, and the likelihood of higher future tax rates resulting from the huge fiscal imbalance we are now experiencing.  All of these factors have worked in concert to depress business investment.

4. The recent weakness of business investment was one of unstated reasons why, in my recent NY Times column, I suggested that an investment tax credit (ITC) might have been a better form of fiscal stimulus than what we in fact are getting.  Given the amount of money being spent on stimulus, the ITC could have been sizable.  The measure of investment used in the chart above is about $1 trillion per year.  So, to give a very rough example, if Congress had passed a 20 percent ITC in 2009, 10 percent in 2010, it would have cost the Treasury about $300 billion.  Essentially, the Treasury would have picked up 20 percent of the cost of all of these investments if done this past year, and half that amount next year.

5. Some readers might wonder if this policy would work in the presence of the zero lower bound on interest rates (aka the "liquidity trap").  The truth is that we don't fully understand the role of the zero lower bound, and most of what we do know is based on stylized theoretical models with scant evidence to back them up.  But those models suggest that an ITC would work just fine.  The zero-lower-bound whiz kid Gauti Eggertsson in fact endorses the ITC as a plausible policy in that environment.

6. In my most controversial NY Times column, I said that what the economy needed was negative real interest rates, which could be accomplished via inflation.  A temporary ITC does something similar.  By temporarily reducing the effective price of capital goods, it creates expected inflation in this particular price.  Under the numerical example above, the effective price of new capital would immediately fall by 20 percent, and expected inflation would rise by 10 percent.  If nominal rates stay at zero, the real interest rate measured in units of new capital goods would become negative 10 percent.  That is one way to view the way in which a temporary ITC stimulates investment spending.

7. So much for theory, but would it work?  The cash-for-clunkers program is thought by many to have promoted, or at least accelerated, car purchases.  An ITC would be similar, but it would apply to business investment rather than personal cars.  Instead of targeting a very narrow, politically favored industry, it encourages investment broadly.  It should have positive effects on aggregate demand in the short run and positive effects on aggregate supply in the medium and longer run.

8. Recall that an investment tax credit was part of the Kennedy plan to get the economy going again back in the early 1960s.  According to historical reports, Kennedy came to this idea of tax cuts with the advice of economist Paul Samuelson, who just passed away.  In memory of Professor Samuelson, if the Obama administration wants to switch gears and try a sizable investment tax credit, I propose that we call it the Paul Samuelson Memorial ITC.

9. Update: Intrigued by this idea? Try these further readings on the subject by Bruce Bartlett and Hal Varian.

Memories of Paul

Like many students of my generation, I started my studies of economics with Paul Samuelson.  When I took econ 101 as a freshman at Princeton, Paul's textbook, then in its 9th or 10th edition, was the assigned reading.  I recall the book well, and I give it a lot of credit for fostering my interest in economics.

A few years later, as a grad student at MIT, I sat in some of Paul's lectures.  They were mainly about "reswitching" and the Cambridge-Cambridge capital controversy.  A few years after that, when I was an assistant professor, Paul was part of the effort that tried to recruit me to join the MIT faculty.  (In the end, I decided to stay at Harvard--persuaded in large measure by Paul's nephew, Larry Summers).  Over the past decade or so, I saw Paul off and on, mainly at the Federal Reserve Bank of Boston, where we both served on an academic advisory panel.  He remained engaged and insightful well into his years of retirement.  He will be missed, in that meeting and many other places as well.

A few years ago, I had the good fortune of running across a first edition of Paul's textbook (not the recent reprint of the original text, but an actual 1948 edition).  It was a real find.  I bought the volume in an online auction for, if my recollection is correct, $35.  Talk about consumer surplus!  I would have gladly paid many times that.

At the next Boston Fed meeting, I took the book along to get Paul to sign it.  Below is the book's title page, along with Paul's gracious inscription.

Click on images to enlarge.

Why Keynesians drive Scott Sumner nuts

Scott explains in a thought-provoking post.

Paul Samuelson has died

Sad news.

Fiscal Stimulus Revisited

Click here to read my column in tomorrow's NY Times.

Joe Stiglitz

Prakash Loungani profiles the Nobelist.  Click here to watch Joe's recent congressional testimony.

Chip Case retires

The noted housing economist and textbook author is stepping down.

Colbert on the Fed

The Colbert Report	Mon - Thurs 11:30pm / 10:30c
Fed's Dead
www.colbertnation.com
Colbert Report Full Episodes Political Humor U.S. Speedskating

The Colbert Report	Mon - Thurs 11:30pm / 10:30c
Fed's Dead - Bernie Sanders
www.colbertnation.com
Colbert Report Full Episodes Political Humor U.S. Speedskating

Thanks to the RTE blog for the pointer.

Tiger Woods as a Natural Experiment

Chapter 21 of my favorite textbook discusses the role of income and substitution effects in determining labor supply, including a case study about lottery winners. UCLA economist Matthew Kahn applies this kind of thinking to the Tiger Woods saga.

Before reading Matthew's analysis, ask yourself this question: Does economic theory predict that Woods will play more or fewer tournaments next year?

The Transactions Tax

Burt Malkiel (the Princeton prof from whom I took econ 101) and the George Sauter (of Vanguard) say a tax on financial transactions would hurt all investors.

My Freshman Seminar

Sadly, my freshman seminar is now over. Above is a group shot from our last meeting, held over dinner at my house. (Note the shirts, which the seminar participants arranged.)

I took a poll of the students' favorite readings. The winners were

1. Capitalism and Freedom by Milton Friedman
2. Nudge by Richard Thaler and Cass Sunstein
3. The Worldly Philosophers by Robert Heilbroner

Click here for the full reading list.

I also asked the students how their views had changed over the course of the semester. Those who started out liberal said they came to appreciate market mechanisms more. Those who started out conservative said they came to appreciate the market's limitations. In other words, after a few months of reading and discussing economics and public policy, most of them moved toward the political center and closer to agreement.

The Pigou Club talks to the Senate

Club Member Ted Gayer makes five points:

1. Either a carbon tax or a cap-and-trade program will result in substantially lower economic costs than command-and-control regulations that mandate technologies, fuels, or energy efficiency standards.

2. Given the uncertainty of the future costs of climate policy, a carbon tax is more economically efficient than cap-and-trade.

3. Carbon allowances in a cap-and-trade program would be susceptible to price volatility. Price volatility causes economic disruptions and complicates investment decisions. It also could lead to political pressure on Congress to repeal or substantially loosen the cap.

4. A carbon tax, in which the revenues are used to offset economically harmful taxes or to pay down our deficit, would substantially lower the cost of climate policy compared to a cap-and-trade program that gives away allowances for free.

5. The currently proposed climate bills rely heavily on offsets to reduce the overall costs of cap-and-trade. Given the substantial potential value of offsets, there is a very real concern that offset integrity will not be maintained. This would result in a weakening of the cap, undermining its environmental benefits.

Continue reading here.

What I've been listening to

I am bit embarrassed to admit this, but the answer is Lady Gaga. Her music reminds me Blondie, which I enjoyed back in my student days. I particularly like the Lady Gaga song Bad Romance.

Update: If you wonder about my comparison, listen to Gaga's Summerboy and Blondie's Heart of Glass.

What responsibilities should the Fed have?

Vincent Reinhart opines:

As a result of legislative convenience, bureaucratic imperative and historical happenstance, a variety of responsibilities have accreted to the Fed over the years. In addition to conducting monetary policy, the Fed also distributes currency, runs the system through which banks transfer funds, supervises financial holding companies and some banks, and writes rules to protect consumers in financial transactions. Mr. Bernanke argues that preserving this mélange is not only efficient but crucial to protecting the Fed's independence.

Apparently, the argument runs, there are hidden synergies that make expertise in examining banks and writing consumer protection regulations useful in setting monetary policy. In fact, collecting diverse responsibilities in one institution fundamentally violates the principle of comparative advantage, akin to asking a plumber to check the wiring in your basement.

There is an easily verifiable test. The arm of the Fed that sets monetary policy, the Federal Open Market Committee (FOMC), has scrupulously kept transcripts of its meetings over the decades. (I should know, as I was the FOMC secretary for a time.) After a lag of five years, this record is released to the public. If the FOMC made materially better decisions because of the Fed's role in supervision, there should be instances of informed discussion of the linkages. Anyone making the case for beneficial spillovers should be asked to produce numerous relevant excerpts from that historical resource. I don't think they will be able to do so.

The biggest threat to the Fed's independence is doubt about its competence. The more the Congress expects the Fed to do, the more likely will such doubts blemish its reputation.

Glaeser on Financial Regulation

My Harvard colleague Ed Glaeser looks at the way forward.

Take Out Your Pencils 4

This week's problem:

A friend of yours is considering two providers of cell phone services. Provider A charges $120 per month for the service regardless of the number of phone calls made. Provider B does not have a fixed service fee but instead charges $1 per minute for calls. Your friend’s monthly demand for minutes of calling is given by the equation Qd= 150 – 50 P, where P is the price of a minute.

a. With each provider, what is the cost to your friend of an extra minute on the phone?

b. In light of your answer to (a), how many minutes would your friend spend on the phone with each provider?

c. How much would he end up paying each provider every month?

d. How much consumer surplus would he obtain with each provider? (Hint: Graph the demand curve and recall the formula for the area of a triangle.)

e. Which provider would you recommend that your friend choose? Why?

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If you enjoy this kind of thing, click here for the previous installment in this series. As always, I will not post the answer, so instructors can use the problem as homework.

Predicting Honors

In a new NBER working paper, Daniel Hamermesh and Gerard Pfann estimate the probability that an economist will be honored by his peers (by receiving a Nobel Prize, being elected President of the American Economic Association, being named a Distinguished Fellow of the AEA, or winning the AEA's Clark Medal).

The bottom line: An economist's citation ranking is a strong predictor. Given citations, an economist's number of publications has no additional predictive value for whether he will obtain such an honor.

FYI, here is an up-to-date citation ranking of more than 20,000 economists.

How to Create Jobs

Nobelist Paul Krugman vs Nobelist Gary Becker.

Harvard's Finances

The Boston Globe takes a look at what went wrong.

P < AVC

Economics textbooks, including Chapter 14 of my favorite one, explain how firms shut down production when the price of output falls below average variable cost. Here is an example:

NY apple growers leaving more fruit on trees

New York's apple orchards are being carpeted with red as unpicked apples drop to the ground.

With the best of the crop off to market, growers say this year it's cheaper to leave leftovers on the trees than to pick and sell them for juice....

One reason is an abundant crop, not only in New York but in neighboring Pennsylvania and nearby Michigan, which has produced more second-tier fruit than juice and applesauce makers need and driven down market prices.

When labor and transportation costs are factored in, selling anything but the cream of the crop for the supermarket can become a losing proposition.

"In some cases it's not worth the bother of picking them off the tree," said Peter Gregg, spokesman for the New York Apple Association.

The difference in prices is the biggest one-year swing some have ever seen. Last year, growers hurt by severe hailstorms were getting an above-average 12-18 cents per pound for processing apples, those sold for sauce and slices. The price is about 5-8 cents this year.

Thanks to econ prof Linda Ghent for sending this along.

My Crib

The Harvard Crimson visits the Mankiw family abode.

A Reading for the Pigou Club

A profile of the club's namesake.

Is a Tobin Tax feasible?

The Tobin tax--a tax on financial transactions--is very much in the news. Before one gets to the issue of the desirability of such a tax, one has to address the question of whether the policy is even feasible. I am skeptical. Financial transactions are easy to move: If two parties to a financial contract can just as easily sign and enforce the contract in the Cayman Islands as in New York or London, there is little point in US or UK policymakers imposing a Tobin tax. Unless, of course, moving the finance industry offshore is the policy goal.



In his column today, Paul Krugman raises and then dismisses this issue as follows:

On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair. Take, for example, Tobin’s original proposal to tax foreign exchange trades. How can you do this, when currency traders are located all over the world? The answer is, while traders are all over the place, a majority of their transactions are settled — i.e., payment is made — at a single London-based institution. This centralization keeps the cost of transactions low, which is what makes the huge volume of wheeling and dealing possible. It also, however, makes these transactions relatively easy to identify and tax.

This passage left me scratching my head. Even if most transactions are now settled in one place, that need not be the case in the future after a significant change in the policy environment. It is not as if London has some large, natural comparative advantage in financial settlement that would persist despite a tax on transactions there. The finance industry is set up to take advantage of very small price differences. If London became ever so slightly more expensive, wouldn't contracting and settlement quickly migrate elsewhere?



Update: NYU finance prof Aswath Damodaran reaches similar conclusions.

Please Resend

A student (from abroad, I believe) sent me an email query this morning, which I inadvertently deleted before replying. If you are that student, please resend. Everyone else: Never mind.

How Little We Know

Economist Russ Roberts opines on financial reform.

Take Out Your Pencils 3

In my most recent Ec 10 lecture, I discussed Arrow's Impossibility Theorem. Here, from my favorite textbook, is a fun problem based on it:

A group of athletes are competing in a multi-day triathlon. They have a running race on day one, a swimming race on day two, and a biking race on day three. You know the order in which the eligible contestants finish each of the three components. From this information, you are asked to rank them in the overall competition. You are given the following conditions:

• The ordering of athletes should be transitive: If athlete A is ranked above athlete B, and athlete B is ranked above athlete C, then athlete A must rank above athlete C.
• If athlete A beats athlete B in all three races, athlete A should rank higher than athlete B.
• The rank ordering of any two athletes should not depend on whether a third athlete drops out of the competition just before the final ranking.

According to Arrow’s theorem, there are only three ways to rank the athletes that satisfy these properties. What are they? Are these desirable? Why or why not? Can you think of a better ranking scheme? Which of the three properties above does your scheme not satisfy?

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If you enjoy this kind of thing, click here for the previous installment in this series. And let me note, before anyone asks, that I will not post the answer, so instructors can use the problem as homework.

Now it all makes sense

Click on the graphic to enlarge. Source.

Healthcare Reform and the Big Tradeoff

David Brooks gets it right today about the debate over healthcare reform. The fundamental question is, Should Americans embrace a more robust social safety net at the cost of much higher marginal tax rates, reduced work incentives, and a smaller economic pie?

From a strictly economic perspective, there is no right answer to this question. Arthur Okun said long ago that the big tradeoff in economic policy is between equality and efficiency. The pending healthcare reform bill moves us along that tradeoff. Let's just not pretend, as some healthcare reformers would have us do, that we can easily get more equality without paying the price in efficiency.

Put simply, the healthcare reform bill would make the United States more like western Europe. That may mean more security about healthcare, but it also means that future generations of Americans will likely spend more time enjoying leisure.

The Changing Face of the World Economy

Source: Mark Perry. Click on graphic to enlarge.

New Research on Fiscal Policy

From Harvard's Alberto Alesina and Silvia Ardagna:

Large changes in fiscal policy: taxes versus spending

We examine the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007. Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.

Steering into an Iceberg

Former CBO director Douglas Holtz-Eakin opines on fiscal policy.

What makes a nation rich?

The answer from MIT economist Daron Acemoglu.

Laibson in Ec 10

Every year, one of the most popular guest speakers in ec 10 is David Laibson, who gives students a clear and compelling introduction to behavioral economics. David is giving that lecture today at noon in Sanders Theater. If any other Harvard students want to attend, feel free. (If any other local blog readers want to join us, email me; we can accommodate a few others.)

Take Out Your Pencils 2

Readers seemed to enjoy my recent post of an introductory economics problem. Here is a new one for you. (I won't post the answer, so instructors can assign the problem as homework.) This one is in honor of Professor Pigou.

The town of Wiknam has 5 residents whose only activity is producing and consuming fish. They produce fish in two ways. Each person who works on a fish farm raises 2 fish per day. Each person who goes fishing in the town lake catches X fish per day. X depends on N, the number of residents fishing in the lake. In particular,

X = 6 – N.

Each resident is attracted to the job that pays more fish.

a. Why do you suppose that X, the productivity of each fisherman, falls as N, the number of fishermen, rises? What economic term would you use to describe the fish in the town lake? Would the same description apply to the fish from the farms? Explain.

b. The town’s Freedom Party thinks every individual should have the right to choose between fishing in the lake and farming without government interference. Under its policy, how many of the residents would fish in the lake and how many would work on fish farms? How many fish are produced?

c. The town’s Efficiency Party thinks Wiknam should produce as many fish as it can. To achieve this goal, how many of the residents should fish in the lake and how many should work on the farms? (Hint: Create a table that shows the number of fish produced—on farms, from the lake, and in total—for each N from 0 to 5.)

d. The Efficiency Party proposes achieving its goal by taxing each person fishing in the lake by an amount equal to T fish per day and distributing the proceeds equally among all Wiknam residents. Calculate the value of T that would yield the outcome you derived in part (c).

e. Compared with the Freedom Party’s hands-off policy, who benefits and who loses from the imposition of the Efficiency Party’s fishing tax?

Happy Birthday, Professor Pigou

Arthur Cecil Pigou was born 132 years ago today.

Flier on Healthcare Reform

Jeffrey Flier, the Dean of Harvard Medical School, opines on pending healthcare reforms.

A Rational Loss for Bill Belichick

Chapter 2 of my favorite textbook has a box on David Romer's work on 4th down strategies in football. One fan of this work is Patriots' coach Bill Belichick, who recently applied Romer's analysis. Click here to learn more.

It did not work out well in this particular case, and Belichick is coming under some heat for his call. This does not mean Romer and Belichick are wrong. Some strategies that fail ex post might be optimal ex ante. Randomness is a fact of life, even if Patriots' fans do not fully appreciate it.

The Actuary on the House Bill

Click on the graphic to enlarge.

Keith Hennessey summarizes the actuary's report on the House healthcare reform bill:

• The bill would mean almost 30 M new people in government-run insurance, more than four times as many as would be newly insured through private coverage.

• By far the largest effect of the bill would be to enroll more than 23 M new people in two existing government programs, Medicaid and S-CHIP. Medicaid is today widely regarded as fiscally unsustainable before adding more people.

• Foster estimates that 18 M people would remain uninsured and have to pay the penalty tax. These people are clearly worse off than they would be under current law.

News for New Econ PhDs

If you are an economics graduate student on the job market this year, click here. Everyone else: Never mind.

Supply, Demand, and Healthcare Reform

Let's review some basic principles of supply and demand: If a government policy increases the demand for a service, the price of that service tends to rise. If the government prevents prices from rising, shortages develop. The quantity provided is then determined by supply and not demand. In the presence of such excess demand, the result could be a two-tier market structure. Consumers who can somehow pay more than the government-mandated price will be able to purchase the service, while those paying the controlled price may be unable to find a willing supplier.

Those principles lie behind this story from the Washington Post:

A plan to slash more than $500 billion from future Medicare spending -- one of the biggest sources of funding for President Obama's proposed overhaul of the nation's health-care system -- would sharply reduce benefits for some senior citizens and could jeopardize access to care for millions of others, according to a government evaluation released Saturday.

The report, requested by House Republicans, found that Medicare cuts contained in the health package approved by the House on Nov. 7 are likely to prove so costly to hospitals and nursing homes that they could stop taking Medicare altogether.

Congress could intervene to avoid such an outcome, but "so doing would likely result in significantly smaller actual savings" than is currently projected, according to the analysis by the chief actuary for the agency that administers Medicare and Medicaid. That would wipe out a big chunk of the financing for the health-care reform package, which is projected to cost $1.05 trillion over the next decade.

More generally, the report questions whether the country's network of doctors and hospitals would be able to cope with the effects of a reform package expected to add more than 30 million people to the ranks of the insured, many of them through Medicaid, the public health program for the poor.

In the face of greatly increased demand for services, providers are likely to charge higher fees or take patients with better-paying private insurance over Medicaid recipients, "exacerbating existing access problems" in that program, according to the report from Richard S. Foster of the Centers for Medicare and Medicaid Services.

Though the report does not attempt to quantify that impact, Foster writes: "It is reasonable to expect that a significant portion of the increased demand for Medicaid would not be realized."

Netherlands joins the Pigou Club

A student alerts me to this story about the new Dutch policy to internalize externalities:

The Dutch government said Friday it wants to introduce a "green" road tax by the kilometre from 2012 aimed at cutting carbon dioxide emissions by 10 percent and halving congestion.

"Each vehicle will be equipped with a GPS device that tracks how many kilometres are driven and when and where. This data will be then be sent to a collection agency that will send out the bill," the transport ministry said in a statement.

Ownership and sales taxes, about a quarter of the cost of a new car, will be scrapped and replaced by the "price per kilometre" system aimed at cutting the Netherlands' carbon dioxide emissions by 10 percent.

"Traffic jams will be halved and it helps the environment," the ministry said.

Dutch motorists driving a standard family saloon will be charged 3 euro cents per kilometre (seven US cents per mile) in 2012. That would increase to 6.7 cents (16 US cents per mile) in 2018, according to the proposed law.

Bending the Curve: How's it going?

Jim Capretta has the answer.

Steuerle on Healthcare Reform

Gene Steuerle of the Urban Institute describes the maze of incentives embedded in the pending healthcare reform bill.

The Poverty Trap

Chapter 20 of my favorite textbook has a section on antipoverty programs and work incentives. One basic point is that when multiple income-based programs are piled on top on one another, the implicit marginal tax rate can reach or even exceed 100 percent.

The chart above (source, via Kling) illustrates this phenomenon. It shows income after taxes and transfers as a function of earned income. Notice that as earned income rises from about $15,000 to $30,000, income after taxes and transfers is roughly flat. Indeed, it could even fall. The bottom line: If you are poor, the government is inadvertently ensuring that you have little incentive to try to improve your condition.

Request to CBO: Can you please make and disseminate charts like the one above? Producing this kind of chart correctly is not easy (and I cannot fully vouch for the accuracy of this one) because a variety of different government programs are involved, and their rules are often complex. CBO has the staff to do it right. Moreover, if such a chart came from a high profile, widely respected, and nonpartisan source such as CBO, the problem would get more attention. It certainly deserves it.

I bet there are people in the Obama administration who are quietly worrying about this problem. Why do I say this? Read this old post. The story there is told by Jeff Liebman, a very smart Kennedy School professor now working for President Obama.

Update: Here is some related work by Larry Kotlikoff and David Rapson.

For Extra Practice

A student emailed me today looking for additional practice problems to help him prepare for tests in his introductory economics course. Where did I send him? To the Study Guide prepared by David Hakes to accompany my favorite textbook.

Old Time Recession

More on LHS

Vanity Fair profiles Larry Summers.

Dick Armey on Harvard Economics

Okay, this has got to be one of the goofiest comments from a major political figure in recent weeks:

"I don’t consider Larry Summers a serious economist," [Dick] Armey said. “You can get a Ph.D. from Harvard without ever having seriously considered the subject.” (Source).

If Dick Armey wants to criticize Larry Summers or the economic policy of the Obama administration, there is no shortage of ammunition and easy targets. But saying that Larry is not a serious economist, or that a PhD from one of world's preeminent economics departments doesn't mean much, makes Mr Armey look more than a tad ridiculous.

Unintended Consequences

A surprising effect of the minimum wage:

Growing consumption of increasingly less expensive food, and especially “fast food”, has been cited as a potential cause of increasing rate of obesity in the United States over the past several decades. Because the real minimum wage in the United States has declined by as much as half over 1968-2007 and because minimum wage labor is a major contributor to the cost of food away from home we hypothesized that changes in the minimum wage would be associated with changes in bodyweight over this period. To examine this, we use data from the Behavioral Risk Factor Surveillance System from 1984-2006 to test whether variation in the real minimum wage was associated with changes in body mass index (BMI).... We find that a $1 decrease in the real minimum wage was associated with a 0.06 increase in BMI.... Real minimum wage decreases can explain 10% of the change in BMI since 1970. We conclude that the declining real minimum wage rates has contributed to the increasing rate of overweight and obesity in the United States.

From David Meltzer and Zhuo Chen.

Feldstein on Obamacare

Marty's latest salvo.

Take Out Your Pencils

For those blog readers who fondly recall exams in introductory economics (I am sure there are many), here is a fun problem based on a question from a recent ec 10 test. Enjoy!

Only one firm produces and sells soccer balls in the country of Wiknam, and as the story begins, international trade in soccer balls is prohibited. The following equations describe the monopolist’s demand, marginal revenue, total cost, and marginal cost:

Demand: P = 10 – Q
Marginal Revenue: MR = 10 – 2Q
Total Cost: TC = 3 + Q + 0.5 Q^2
Marginal Cost: MC = 1 + Q

where Q is quantity and P is the price measured in Wiknamian dollars.

a. How many soccer balls does the monopolist produce? At what price are they sold? What is the monopolist’s profit?

b. One day, the King of Wiknam decrees that henceforth there will be free trade—either imports or exports— of soccer balls at the world price of $6. The firm is now a price taker. What happens to domestic production of soccer balls? To domestic consumption? Does Wiknam export or import soccer balls?

c. In our analysis of international trade in Chapter 9, a country becomes an exporter when the price without trade is below the world price and an importer when the price without trade is above the world price. Does that conclusion hold in your answers to parts (a) and (b)? Explain.

d. Suppose that the world price was not $6 but, instead, happened to be exactly the same as the domestic price without trade as determined in part (a). Would anything have changed when trade was permitted? Explain.

Unemployment Update

Click on the graph to enlarge. Click here for my interpretation.

Spreading the Word

My favorite introductory economics textbook comes in many variants. For American students, there are five versions, each with a different subset of chapters, so every instructor can find one that best suits his or her course. Students abroad can use one of these or choose among various editions that have been tailored to particular regional institutions and languages. Yesterday, I learned about two new members of the line-up: the French Canadian editions, available for both micro and macro.

Environmentalism vs Homeownership

My Harvard colleague Ed Glaeser looks at the negative externalities from suburban sprawl.

Assuming a Can Opener

I have previously expressed skepticism about projected Medicare spending assumed in the health reform effort making its way through Congress. If reductions in spending don't materialize as Congress now posits, health reform will not turn out to be deficit neutral but will, instead, add to the large fiscal gap we are bequeathing to future generations. In a recent letter, CBO gives some numbers about projected Medicare spending that shows how wildly unrealistic it is:

The bill would put into effect (or leave in effect) a number of procedures that might be difficult to maintain over a long period of time. It would leave in place the 21 percent reduction in the payment rates for physicians currently scheduled for 2010. At the same time, the bill includes a number of provisions that would constrain payment rates for other providers of Medicare services. In particular, increases in payment rates for many providers would be held below the rate of inflation (in expectation of ongoing productivity improvements in the delivery of health care). Based on the extrapolation described above, CBO expects that Medicare spending under the bill would increase at an average annual rate of roughly 6 percent during the next two decades—well below the roughly 8 percent annual growth rate of the past two decades, despite a growing number of Medicare beneficiaries as the baby-boom generation retires.

Thanks to the blog reader who drew this passage to my attention.

Counting Jobs

How to create or save 9 jobs for $889,

An amusing story about how government statistics are not always completely reliable.

Taking out the Trash

I don't usually respond to illogical cheap shots from around the blogosphere (life is too short). But when the cheap shot comes from a Nobel prize winner in economics, I will make an exception.

Paul Krugman says I should be ashamed of myself for calling into question Obama administration estimates of how many jobs have been "created or saved." Here is what Paul writes on his blog:

The Obama administration’s “jobs created or saved” is just a way of saying “other things equal” in non-economese. Of course it makes sense to ask how many more people are working than would have been the case without a given policy — and every administration makes assertions along those lines. During the 2001 recession and its aftermath, how many times did the Bush administration claim that the recession would have been worse without its tax cuts? And while many of us quarreled with that claim, I don’t think I ever argued that other-things-equal arguments are nonsense on their face.

Yet Paul is rebutting claims I did not make, and he is giving Team Obama more credit on this question than it is due. Here is what I wrote on the topic last February:

The 4 million job number is a counterfactual policy simulation of what the stimulus will do based on a particular model of the economy. As such, I have no objection to someone citing it in a policy discussion. In fact, macroeconomists use models to generate figures like this all the time. I have even done it myself.

But as an answer to the question "how can the American people gauge whether or not your programs are working?... What metric should they use?", citing the 4 million job figure is a non sequitur, or more likely a diversion. A metric has to be measurable, and the actual number of jobs "created or saved" by the policy will never be measurable from any data source.

That is, I do not object to claims such as,

A: "Based on our models of the economy, we believe there would be X million fewer jobs today without the stimulus."

But it is absurd to suggest that you can say,

B: "We have measured how many jobs the stimulus has saved or created, and the number is X."

Economists are capable of making statements such as A, but it is beyond our ken to make statements such as B. Statement B is,of course, much stronger than statement A, as it purports to be based on data rather than on models. Unfortunately, we are hearing statements like B much too often from administration officials. A good example is here, where can you "learn" that 110,185.36 jobs have been created or saved in California alone.

Disincentives from Reform: House Edition

In my Sunday Times column, I discussed the marginal tax rates implicit in the Senate Finance Committee version of the health reform bill. CBO has just released some numbers on the version of health reform being considered in the House of Representatives.

The bottom line: The implicit marginal tax rates are even higher in the House bill.

If you are interested in a more specific comparison, here is what I wrote about the Senate Finance bill on Sunday, with the new numbers for the House bill added in brackets:

A family of four with an income, say, of $54,000 would pay $9,900 [$6,200] for healthcare. That covers only about half [a third] the actual cost. Uncle Sam would pick up the rest.

Now suppose that the same family earns an additional $12,000 by, for example, having the primary earner work overtime or sending a secondary worker into the labor force. In that case, the federal subsidy shrinks, so the family’s cost of health care rises to $12,700 [$10,000].

In other words, $2,800 [$3,800] of the $12,000 of extra income, or 23 [32] percent, would be effectively taxed away by the government’s new health care system.

And remember: This implicit marginal tax hike of 32 percent is added on top of the explicit marginal tax rate the family already faces from income and payroll taxes.

Government Motors: Update

President Obama's plan:

What we are not doing -- what I have no interest in doing -- is running GM. GM will be run by a private board of directors and management team with a track record in American manufacturing that reflects a commitment to innovation and quality. They -- and not the government -- will call the shots and make the decisions about how to turn this company around.

So how is that working out for you, Mr President?

In May, even before the government's ownership became official, lawmakers erupted when GM disclosed it planned to produce a new subcompact car at its factories in China. Under congressional pressure, GM dropped those plans and promised instead to retool an existing U.S. facility in Michigan, Wisconsin or Tennessee for the new model.

Lawmakers from those states demanded and received high-level meetings in Washington to quiz GM on the criteria for site selection and to tout their states. GM in the end picked a site in Michigan.

That same month, GM dealer Pete Lopez in Spencer, W.Va., received notice that GM was giving him just over a year to shut down his Chevy, Pontiac and Buick dealership, which he'd acquired two years earlier. GM's move to shutter more than 1,300 dealerships -- about one-quarter of its network -- was central to its restructuring because it cleared out underperforming showrooms and brought the network more in line with its shrunken sales.

With an assist from his mayor, Mr. Lopez took his complaint straight to one of his state's senators, Jay Rockefeller, the Democratic chairman of the powerful Commerce
Committee.

Sen. Rockefeller sent a letter to GM headquarters on Mr. Lopez's behalf, according to a staff aide. He arranged for Mr. Lopez to come testify before a Senate panel in early June, alongside GM Chief Executive Frederick "Fritz" Henderson. The senator introduced the two men, giving Mr. Lopez a chance to make a personal pitch.

"He couldn't have been nicer," Mr. Lopez said of the GM CEO. "He said to me, 'We've made some quick decisions and now we're going to look it all over again.' "

The GM chief executive put Mr. Lopez in touch with Mark LaNeve, then the company's top official for North American sales. The dealer received a response on the last Saturday in June while fishing on a lake near his house.

"Mr. LaNeve called and said, 'I've got some good news for you. We're going to save your dealership,' " Mr. Lopez recalls. He says he owes it all to Sen. Rockefeller.

Disincentives from Health Reform

Here is my column in tomorrow's NY Times about the marginal tax rates implicit in the health reform bill making its ways through Congress. Let me add a few additional observations on the topic.

1. Here are the CBO numbers on which the article is based. Unfortunately, the Times did not run the table of implicit marginal tax rates that I gave them based on the CBO numbers. But the example I used in the piece (an implicit tax rate of 23 percent) is representative. For lower income levels, the implicit marginal tax rate is even higher. Between $42,000 and $54,000, the implicit marginal tax rate from health reform is 34 percent.

2. When CBO estimates the budgetary cost of such bills, it holds GDP constant. If you think (as I do) that large increases in marginal tax rates tend to depress labor effort and thus GDP, then you should be wary of claims based on CBO scores that the health reform bill is deficit neutral. Lower GDP will mean lower tax revenue and thus a larger budget deficit.

3. How much do people respond to tax rates? Economists differ in their answer to this question. The latest thinking on this topic, by my Harvard colleague Raj Chetty, indicates that the elasticity of taxable income with respect to (1-tax rate) is about one half. So, for example, if a person starts with a marginal tax rate t of 0.3 and health reform raises it to 0.5, the percentage change in 1-t, using the midpoint method, is .2/.6, or 33 percent. With an elasticity of one half, his taxable income will fall by 17 percent. Thus, the economic impacts from these implicit tax hikes are sizable.

4. In my Times piece, I wrote, "None of this necessarily means that health reform is not worth doing. President Obama’s push for reform is premised on the belief that access to good health care should be a right of all Americans — a proposition better judged by political philosophers than economists. But we should not forget the cost of translating that noble aspiration into practical policy."

This passage may seem a bit passive-aggressive, as I appear to be criticizing the bill without really taking a stand. My aim, however, is to emphasize that economics alone cannot settle the debate.

Behind the healthcare debate is the classic tradeoff between equality and efficiency. Consider the following question, which is not about healthcare per se: Would you favor a substantial increase in marginal tax rates for millions of middle and upper income Americans to provide more resources for those toward the bottom of the economic ladder?

Your answer to this question cannot be determined by positive economics without adding in some normative judgments. But your answer should strongly influence your view of the health reform bill. The bill moves us closer to much of Western Europe by favoring equality and paying the price of reduced efficiency from much higher marginal tax rates.

That may be a policy choice Americans want to make. But before buying the merchandise being offered by Congress, I hope we all take a close look at the price tag.

How well known are economists?

Thanks to Tyler Cowen for the pointer.

Average Marginal Tax Rate

From Barro and Redlick.

Is Amazon predatory?

Chapter 17 of my favorite textbook has a section on controversies over antitrust policy, including a discussion of predatory pricing. This topic is in the news again: The American Booksellers Association says Amazon, Wal-Mart, and Target "are using these predatory pricing practices to attempt to win control of the market for hardcover bestsellers" and that this behavior "is damaging to the book industry and harmful to consumers."

Read more about the case here and here.

The so-called predatory price cuts have not spilled over to the sale of textbooks. Is that good news for students (as the Booksellers' argument suggests) or bad news?

More Competition

Steve Landsburg is blogging.

The Value of Human (?) Capital

A fun story from NPR about how monkeys value skills, as long as those skills are in scarce supply.

Is the efficient markets hypothesis kaput?

No, says Wharton economist Jeremy Siegel.

Economics Rap

I have previously alerted readers to the rap version of Ten Principles of Economics. If you liked that, you might enjoy this as well.

A Tribute to John Meyer

From Ed Glaeser.

From the CEA Chair

Health Care Reform and the Budget Deficit.

The Public Plan, Again

The possibility of including a public plan in the health reform bill is on the table again. Here are a few viewpoints on the topic: Robert Samuelson, Paul Krugman, Richard Thaler, and me.

The Big Tradeoff

A Question for Class Discussion

Here is a question I will be asking my freshman seminar this week:

You are a utilitarian social planner. You have a limited number of H1N1 vaccines. How do you allocate them? Do you (A) give them to specific groups, such as high-risk populations, or (B) sell them to the highest bidder and rebate the revenue lump-sum to everyone? If you choose (A), do you allow those individuals allocated the vaccine to sell their dose to someone else? Be sure to specify the economic environment as carefully as possible. And remember: Your goal is to maximize total utility.