Search Theory Gets a “Nobel”

The “Nobel” economics prize has just been awarded to the trio of Diamond-Mortensen-Pissarides (DMP) for their work on search theory, the most influential theoretical trend in labor economics. (The quotes around “Nobel” signify the non-Nobelian history of this prize.)

Others are far more qualified than I am to discuss the larger significance of their work. I’ve been interested in one aspect: its implications for the concept of full employment. In the days before search theory, one standard story went like this:

The labor market is like other markets in the sense that market-clearing occurs when there is neither excess supply nor excess demand. The difference is that there is great heterogeneity of jobs and workers, and information is often murky. The result is that, at any moment, there are many jobs looking for appropriate workers and many workers looking for appropriate jobs. Taken together, these reflect structural and frictional unemployment.

It can all be viewed in terms of a Beveridge Curve, with the number of unfilled jobs (vacancies) on the vertical axis and the number of unemployed workers on the horizontal axis:

The 45º line represents equal numbers of vacancies and unemployed workers, therefore no excess demand or supply in the aggregate. Its intersection with the B-Curve determines the level of unemployment that should be viewed as “full employment” for any particular economy. This full employment level can be lowered by making the labor market more efficient, through job training programs (to reduce structural unemployment) and information and referral systems (to reduce frictional unemployment).

A very different story, about inflation and the “natural rate” of unemployment, largely displaced this one, but I won’t go there now.

So back to the B-Curve. Along came D-M-P, and especially M-P, and we got a new definition of full employment. The 45º line, we were told, is arbitrary. Why should equal levels of vacancies and unemployed workers signify labor market equilibrium? On the contrary, we should pay more attention to the microstructure of labor markets. Two factors in particular intrude, the relative flows of workers and jobs into the market and the relative ability of workers and employers to locate a suitable match. Equilibrium occurs, it was asserted, at the ratio of vacancies to unemployed workers which, given these factors, will be stationary over time, ceteris paribus.

Consider a different B-Curve:

Unlike the other, this one isn’t symmetrical. Its shape suggests that the economy is “biased” toward higher unemployment; this can be because the “steady-state” flow of workers exceeds the corresponding flow of job openings, or because workers are less efficient at finding jobs than employers are at finding workers. A flatter line, at an angle significantly less than 45º, represents a ratio of vacancies to unemployed workers less than one-to-one; this ratio will remain constant given the underlying determinants of the B-Curve. Its intersection with the curve gives us the true level of full employment.

I never got it. (a) Why should a steady-state criterion represent either equilibrium or a normative goal for labor market performance? This would make sense if we lived in a steady-state world, but we don’t. The analysis is simply a snapshot, and what would be impossible if we had to sustain it for all eternity can be entirely possible if it occurs for only a few quarters. In particular, I would want to see worker and employer behavioral response functions that could be estimated with real-world data before I would draw any conclusions about what point on the B-Curve should be viewed as an equilibrium. (This goes for the “naive” 45º line story too.) Here, for instance, is where efficiency wage theory would come in. (b) The flows highlighted by search theory are themselves sensitive to cyclical influences. Workers are responding to today’s dismal labor market, for instance, by withdrawing from search and, in some cases, by choosing non-work alternatives, like more education (good) or giving up on personal ambition (bad). Over time, there is hysteresis. Job flows are influenced not only by immediate demand considerations, but also by delayed or discarded investment plans, another form of hysteresis. This may not affect the positive side of the story (equilibrium), but it should definitely change the normative spin we give to it.

As for myself, I remain agnostic. I accept the critique of the 45º line, and I don’t assume that the goal of macropolicy should be to equalize labor and job offers. I don’t think search theory has given us an adequate replacement, either. Maybe the best we can do at the moment is to benchmark our current performance against recent time periods when labor markets were in more acceptable shape—for instance, the late 1990s. By any reasonable standard, a greater than five-to-one ratio of unemployed workers to job vacancies is simply abysmal and refutes the claim that it is the position of the B-Curve (structural unemployment) that ails us rather than our position out at the far southeastern tail (deficient demand).

Michael Perelman's Analytical Biography Updated

Many of you told me that I should reedit this. See if you like this better.
http://michaelperelman.wordpress.com/an-ideological-biography/

Economics, Ethics, and the Good Life

I just gave this lecture regarding the decoding of economics. The subject matter was different from any other I have given. I describe how the subject mutated with the changing needs of the ruling classes. The audience included the public at large, students of economics, philosophy, and other subject. The first couple sentences were directed at the way that I was introduced.

http://www.archive.org/details/EconomicsEthicsAndTheGoodLife_690

Climate Science: Prepare for Increasing Uncertainty

Environment 360, a very useful online magazine, has a new article by Fred Pearce that explains why the next IPCC assessment (AR5) will tell us that the consequences of living with climate change will be even more uncertain than they predicted back in ‘07. Part of this is due to external pressure on IPCC to express uncertainty more honestly than they have in the past, and part is the result of including more feedback processes whose magnitude, and even direction, is not well understood.

Pearce worries about the political fallout from this trend: how will the public respond to the argument that, the more science advances in this field, the less confidence there can be in any particular prediction? I agree, and I think economists are going to have to rethink how they represent the economics of climate change. Point estimates of damages (expected benefits of mitigation) become less relevant to policy as error bars widen; rather quickly, as Weitzman and others have argued, the uncertainty itself becomes the story. Mitigation needs to be seen not as an investment, justified on cost-benefit grounds, but as insurance. What price are we willing to pay to reduce the extreme risks that the next report will include as within the realm of possibility?

Cuccinelli's Baaaack!: Witch Hunt, Part Two

"Witch Hunt, Part Two" is the title of the lead editorial in today's Washington Post, regarding the report that Virginia Attorney General, Ken Cuccinelli is not taking "no" for an answer in his effort to hound climate science researcher, Michael Mann, for his 1998 "hockey stick" paper, along with the University of Virginia. Following up on the narrow window of opportunity left by the court, he is investigating Mann again for the one grant he got from the Commonwealth of Virginia, supposedly to detect fraud, which Mann got for a study on "the interaction of the land, atmosphere, and vegetation in the African savannah," which has nothing to do with his hockey stick paper (which was cited in the grant application, giving Cuccinelli his thin shred of opportunity).

Beyond the earlier subpoenas to U.Va. (which is resisting all this), Cuccinelli now wants in addition all emails between Mann and 39 other scientists. The sign of what he is really after is that none of these include the two co-applicants on the grant in question. This is even a worse fishing expedition than the previous one, given that both the National Academy of Sciences and Penn State (Mann's current location) have absolved him of any wrongdoing, even though there are debates over how good his statistical methodology in the original 1998 paper was (which he has changed in subsequent research anyway). I also note that so far, U.Va. has spent $214,700 defending itself from Cuccinelli's earlier investigation, while Cuccinelli has himself spent $350,000 so far on this, with more to come during a period of supposed budget austerity. Of course, supposedly Cuccinelli is the legal defender of the University of Virginia, hack, cough.

There is a lot more I could say here, but I suspect my position on all this is obvious and well known, given that I have blogged on this matter previously. However, I fully agree with all the broader arguments the WaPo editorial brings up regarding this totally appalling matter.

Feldstein and the President Publicly Clash Over Ending Tax Breaks for the Wealthy

John McKinnon reports on a public debate between the President and two of his outside advisors – Martin Feldstein and William Donaldson – over the President’s proposal to let the Bush tax cuts for the wealthy expire:

When Harvard professor Martin Feldstein’s turn came to talk, he suggested continuing the current tax rates for two years for everybody, then ending them. He said that course would bolster demand at a time when the economy is weak, and also would reduce the long-term federal debt that Obama projects. When Harvard professor Martin Feldstein’s turn came to talk, he suggested continuing the current tax rates for two years for everybody, then ending them. He said that course would bolster demand at a time when the economy is weak, and also would reduce the long-term federal debt that Obama projects. William Donaldson, a former chairman of the Securities and Exchange Commission, then offered similar suggestions, saying that confusion over future tax policy is adding to business uncertainty.

The President needs better advisors than this. Donaldson’s argument that business uncertainty is retarding economic recovery strikes me as Tea Party propaganda but then Donaldson is not an economist. Feldstein is. The difference between the President’s and Feldstein’s policy positions centers on whether we should extend the tax cut for the wealthy for another two years. Does Dr. Feldstein really believe that a temporary tax cut for the wealthy significantly increases consumption demand? I’m sure most of his students at Harvard have heard of the life-cycle model of consumption and the Barro-Ricardian equivalence proposition!

Finance Capital vs. a Productive Economy

To celebrate the closure of TARP, I just posted a video on finance capital versus a productive economy. Any comments will be appreciated. I apologize that did not feel very spontaneous in my presentation.

http://www.youtube.com/watch?v=3w6hRP6oiYE

The Wonders of Private Equity

No comment needed

Creswell, Julie and Peter Lattman. 2010. “Private Equity Thrives Again, but Dark Shadows Loom.” New York Times (29 September) Dealbook Special Section: p. 1.

http://dealbook.blogs.nytimes.com/2010/09/29/private-equity-thrives-again-but-dark-shadows-loom/?ref=business

“This summer, executives from the New York-based private equity firm SK Capital traveled to Houston to celebrate the first anniversary of their acquisition of a nylon manufacturing business. Soon they will have a bigger reason to uncork the Champagne. The nylon manufacturer has announced plans to issue about $1 billion in debt, of which $922 million will be used to pay a dividend to SK. For SK, which paid $50 million in cash for the business, that is an astonishing almost 18-fold return in a little more than a year.”

Michael Perelman's Analytical Biography

It probably needs some polishing.  Suggestions welcome.

http://michaelperelman.wordpress.com/an-ideological-biography/

The Home in the Valley

A personal story published this week. How Americanised Australians are. We were all the way with LBJ during the Vietnam War. Conscription, street protests and all.

Pledge to America: Short-term Fiscal Restraint and Long-term Fiscal Folly

Michael Ettlinger and Michael Linden focus on the fiscal folly part of the Pledge:

The “Pledge to America” budget would mean $11.1 trillion in deficits over the next 10 years. By 2020, the federal budget deficit would be 6.3 percent of gross domestic product, the federal debt would exceed 93 percent of GDP, and interest payments on the debt would be more than $1 trillion a year. The budget deficit would be about $200 billion larger in 2020 under the “Pledge to America” plan than it would be under President Barack Obama’s budget, and over the next 10 years deficits would be $1.5 trillion higher than under the president’s budget. The substantial increase in deficits under the “Pledge to America” budget are due to the significant tax cuts that come from extending all expiring tax provisions and the implementation of several new tax cuts. Altogether, tax revenues under the “Pledge to America” plan would average 16.7 percent of GDP. During the last period the federal government ran balanced budgets revenues averaged 20 percent of GDP. The document claims that these cuts will be offset by spending reductions, but their proposals for these reductions add up to significantly less than their revenue cuts. The vast bulk of these spending cuts are achieved through what are described as “hard caps,” but they provide little detail as to what programs would be cut. The “Pledge to America” also includes a repeal of the Affordable Care Act. But since the ACA reduces deficits over the next 10 years, repealing it increases the deficit as well.

Also take a look at their chart which shows how the deficit would be larger under the Pledge after 2012 but smaller over the next couple of years. In other words, the Pledge has fiscal policy all backwards. We need more short-term fiscal stimulus in the short-run with fiscal restraint after we get back to full employment. Which is why the Pledge’s promise to create new jobs is just stupid from an economic perspective!

Summers Over

It’s Sept. 22, and I’m looking at the news about the departure of Larry Summers from the White House. I agree with most commentators on the left that Summers was a disaster for the country and the Democratic Party. He used his aggressiveness and the confidence Obama placed in him to narrow the range of options given consideration—already well reported in the case of the undersized stimulus, and to be reported in the future on financial reform. (I’m guessing at this, but only a little.) He contributed mightily to the miasma of disappointment that surrounds Obama and encourages the paleolithic right.

I wish I could say that policy post-Larry looks to improve, but it doesn’t. By all indications, Summers faithfully reflected Obama’s own economic predilections, and the next economic team will probably follow down the same path. From a PR point of view, it may matter who the public faces are, but I see no reason to expect a significant mid-course correction. I really, truly hope I’m wrong.

Incidentally, I never got the bit about Summers’ “brilliance”. (Try googling “Larry Summers” and “brilliant”.) I saw him in action only once, on an AEA panel, and, while he was very quick and sure of himself, his comments were not particularly insightful. I’ve read a number of his papers, and I think he’s competent, but his work generally lacks the element of aha-ness I associate with brilliance, as opposed to just getting the job done. Economists often seem smarter than they really are to the general public, because they are so well-schooled in a narrow, formulaic intellectual framework. They have fast answers that are clever, often technically sophisticated, and seem to tie up all the loose ends. In the lingo of an older style of scholarship, mainstream economics offers a “premature totalization”, and the appearance of brilliance without the substance.

Nightmare On Elm Street Ticket: Palin And O'Donnell

It just occurred to me, two peas in a pod, and with the witchcraft and all too.

Climbing Out of a Very Deep Hole

As AP reports the National Bureau of Economic Research has deemed that the Great Recession ended in June 2009. While it is true that real GDP has inched upwards over the past 4 quarters, real GDP as of 2010QII was only $13,191.5 billion per year as compared to $13,363.5 billion as of 2007QIV. With 2007 witnessing a growth rate that was less than 2 percent and with negative cumulative growth since then – we are far below full employment today. AP also reports that the President isn’t exactly celebrating this NBER announcement:

President Barack Obama saw little reason to celebrate the group's finding that the recession had ended. Appearing at a town-hall meeting sponsored by CNBC, Obama said times are still very hard for people "who are struggling," including those who are out of work and many others who are having difficulty paying their bills. "The hole was so deep that a lot of people out there are still hurting," the president said. It's going "to take more time to solve" an economic problem that was years in the making, he added.

The problem, however, is that we still don’t see any bold and significant policy measures that would get us out of this deep hole.

Crass

This morning’s New York Times has an article about historic preservation in Italy: because of a shortage of funding, municipalities are renting out public buildings as billboards. Advertising revenue finances restoration, but at the cost of destroying the character of the country’s piazzas and palaces.

Here’s what I saw a couple of weeks ago in Turin. The photo was taken on the main square in the center of town; the building is the Palazzo Madama, an architectural gem. Its facade is draped by fabric to cover up the restoration work being performed on it. But note the ad—not only its size, but who it’s for: Mediaset, the TV empire owned by Silvio Berlusconi.