The Ricardian Equivalence Bubble

Suddenly it’s everywhere. Justin Yifu Lin (the chief economist at the World Bank), Tyler Cowen, Paul Krugman, Nick Rowe, our own PGL: hot debate about how Ricardian equivalence applies to the current economic situation. There’s just one minor problem: Ricardian equivalence is an absurd idea, with not a shred of evidence or logic to support it.

Behind the imposing moniker dreamed up by Robert Barro, RE simply says that government debt must eventually be paid down to zero. If the government borrows $1B this year, it must run a surplus of $1B some time in the future. If spending is constant, this means taxes have to go up.

I pointed out the vacuity of this idea in a previous post, so I won’t repeat myself. The question of the day is, why should anyone give RE more than a moment’s attention? In particular, why would smart economists with state-of-the-art training be debating the fine points of what RE would mean if it were true?

The only answer I can give is that the theory can be decked out with lots of math (overlapping generations ratex models of the behavioral response to knowledge of future taxes), enhancing the reputations of all involved. The fact that RE simply assumes a nonexistent and impossible state of affairs plays no role.

That, in a nutshell, is what’s wrong with economics.

Michael Perelman at the Left Forum

I will be on a panel: The Struggle Against Mainstream Economic Ideology

H. Panel Session 4-Saturday 5:00 p.m. - 6:50 p.m

Michael Meeropol

Doug Henwood

Howard Sherman

Michael Meeropol


Michael Perelman

37 E321

I would enjoy meeting some of you whom I know only via the Internet

Is The Arab Uprising A Revolution?

There is not a definite answer to this as it depends on how one defines a revolution. However, one distinction I keep seeing being made is between a civil war and a revolution, with numerous commentators discussing whether the situation in Libya is more a revolution or a civil war. Hard fact is that most serious revolutions involved periods that were also civil wars: France, Russia, and China for starters.

I think a useful place to start, if not necessarily to end up, is to consider the view of that old revolutionary, Karl Marx. For him it involved the uprising of an oppressed class against a ruling class, these defined in terms of control of the means of production. A full-scale revolution involved a change of the mode of production in his terminology, along with the replacement of one ruling class with another. The archetypal model for Marx was the French Revolution, in which the bourgeoisie replaced the landed aristocracy, and capitalism replaced feudalism, although there was Thermidor and reaction, and Napoleon declaring himself Emperor and naming new aristocrats, with the Bourbon Restoration following. So, maybe it was not so successful after all, even if in fact Napoleon went around Europe smashing feudal institutions all over the place and did create the modern nation state of France. As it is, we may be stuck with Chou En-Lai's reply to Henry Kissinger regarding the outcome of the French Revolution, "Too soon to tell."

What is going on in the Arab world looks to me most like what came in Europe in 1848, an international uprising with some similarities across nations as well as differences, although in the short run a failure, if not in the longer run. In some countries the ruler is a monarch, but so far none of those have been overthrown. Tunisia and Egypt were essentially military dictatorships, overthwrown by would-be democrats, although we need to wait and see what will happen, with some ugly anti-women and anti-Christian demonstrations in Egypt. As for Libya, recent developments suggest that Qaddafi may not fall after all. Too soon to tell.

Critique of Public Investment Based on Another Misapplication of Ricardian Equivalence

Antonio Fatás rightfully blasts the following from Justin Yifu Lin:

But how can the Ricardian trap be avoided, i.e. an outcome where the government stimulus fails to boost aggregate demand because economic agents expect future tax increases to pay for larger deficits and thereby increase savings? To avoid the Ricardian trap, it is important to go beyond conventional Keynesian stimulus of “digging a hole and paving a hole” by investing in projects which increase future productivity."

Antonio notes:

No one can disagree with the statement that if the government can choose between different spending projects, they should select the one with the highest return (in terms of productivity and income). But we need to understand that the advise for the government to invest in productive investment applies at all times (good and bad). What is different when there is spare capacity is that "pure demand" policies can bring the economy closer to potential in a shorter period of time. By doing so they will be increasing the overall output and income of the country. And this additional income is the source of potential increases in private spending and tax revenues. This is the intuition behind the Keynesian recipe for times of high unemployment, which is consistent with the concerns of Justin Yifu Lin.

Let me add one other important element to this critique of this supposed critique of Keynesian policies from the Chief Economist of the World Bank. Ricardian Equivalence might hold that a permanent increase in government purchases would lead to an increase in permanent taxes, which would cause private consumption to fall by an equal amount. But even if a temporary increase in government investment were squandered say on building new pyramids or another damn baseball park for a team like the Yankees (with all due apologies to my neighbors who may be Yankee fans), standard lifecycle models of consumptions (e.g., Ricardian Equivalence) do not predict a fully offsetting reduction in consumption.

Compassionate Capitalism

One must admire the extent of compassion expressed by the captains of capitalism. Some people unfairly snickered when George Bush declared himself a compassionate conservative, but he is a passionate advocate of business and his description may have been accurate.

Despite all the talk about greed being the fuel that drives capitalism, profits are virtually irrelevant. As an act of philanthropy, corporations scatter much of their profits in less developed areas, such as the Grand Cayman Islands and Bermuda.

As further evidence, I read today that the Bank of America is reluctant to lower the value of its own loans out of compassion for the people who stayed up-to-date with their payments. After all, one of the motives for subprime loans was to meet the desires for people who wanted enjoy homeownership.

Similarly, business opposes minimum wages out of compassion for workers who might lose their jobs. For the same reason, business reluctantly accepts tax breaks only because it allows them to help unfortunate workers who might find themselves without a boss. The same motives explain why business fights so heroically against regulation.

Cutting welfare or publicly provided health care does a service to the poor almost certainly as a university education. Finding themselves without a social safety net, people receive an education, allowing them to navigate the complexities of the marketplace, assuming that they survive the experience. Should such people meet their maker, their demise will represent a charitable gift to the poor-oppressed taxpayers, who already shoulder excessive burdens.

Taxpayers, in fact, are the most admired agents in capitalism. If corporate leaders were more egotistical, they would be paying more taxes. As an act of modesty, they refrain from showing off in that way, allowing others to win the glory of paying taxes.

The High-Yield Equity Risk Premium Puzzle: Yet Another Market Anomaly?

On p. 18 of the Monday, March 7 Financial Times in an article entitled, "Time to rethink as bonds' golden age comes to an end" Tony Jackson refers to a curiously obscure recent finding in the most recent Credit Suisse yearbook. I shall simply quote from the article, starting with the second sentence of paragraph 8 (I have not been able to track down this part of the Credit Suisse report):

"...there is good evidence that investors do not in fact require better odds on riskier securities, but the reverse. The source is that same Credit Suisse yearbook produced by three London Business School academics who are themselves firm believers in the ERP [Equity Risk Premium] hypothesis.

In the long run, it seems total returns from high-yielding stocks have been higher than on low-yielding or non-yielding ones. That has been true for almost all the 21 countries covered in the study. And high-yielders have also been less risky, on conventional measures such as volatility and beta. How are we to explain this?

According to other work cited in the study, it is not that investors are bad at picking high-growth stocks. In fact, they are rather good at it; but they pay far more than the growth is worth. This matches another finding, that returns from high-growth economies - such as emerging markets - are in the long run no better than the low growth ones."

Jackson goes on to note accurately that this finding violates the rational market (or efficient market) version of the ERP, an apparent anomaly like such things as the basic equity premium puzzle or the home equity premium puzzle, none of which have been satisfactorily explained by standard economic theory, although various behavioral theories appear to do so.

I do not have an explanation for this apparently newly discovered puzzle, although regular readers here will not be all that surprised that the financial markets appear to exhibit yet further failures of the standard efficiency models. In any case, I have googled it and found no label for this phenomenon. So, in parallel with the so-called equity risk premium puzzle (that people get higher returns from investing in stocks over bonds than justified by their risk), I neologistically dub this here as the "HIGH-YIELD EQUITY RISK PREMIUM PUZZLE," that stocks with high yields (dividend per price) give higher returns than explainable by their relatively low risk. Do with this information as you see fit, :-).

McConnell is Partially Right About Government Employment

David Weigel listens to Senator McConnell so we don’t have to:

"Unemployment among government workers is about 4.5 percent," said McConnell. "Most of those government workers work for state and local government. The federal government over the last two years has added 100,000 employees. The only industry in America that's not sacrificing in this current downturn is government employees. I can't tell you some federal worker won't be affected by reducing government spending, but we have largely insulated the federal government from this recession."

I looked at the government employment data provided by the Bureau of Labor Statistics and it is true that most of those working for the government work for state and local government. As our table shows, total government employment during February 2011 was 22.217 million (down from 22.582 million as of January 2009) whereas Federal employment was only 2.856 million (up from 2.792 million as of January 2009). Federal employment grew by only 64,000 which was more than offset by the fall in state government employment. Local government employment fell by 352,000 and total government employment fell by 365,000. Not exactly consistent with the message that the Senator was trying to convey.

Economic Illiteracy: The Tyler Cowen Conundrum

Tyler Cowen, from what I can gather, is everyone’s favorite George Mason libertarian. His colleagues may be considered beyond redemption, but TC himself is provocative, interesting, worth a look. He throws in references to history and culture. He has a sense of humor. No doubt he is a nice guy and uncommonly smart. In spite of all that, shouldn’t it matter that he doesn’t understand the first thing about economics?

His column in today’s New York Times is a doozy. The subject is “fiscal illusion”, and here’s his example:

Say that you have $20,000 in Treasury bills. You probably believe that you own $20,000 in wealth. This will encourage you to spend and come up with ambitious plans. Yet someone — quite possibly you — will be taxed in the future to pay off the government debt. The $20,000 may be needed in order to do that.

The illusion is this: A government bond represents both a current asset and a future liability, yet for most people, those future tax payments feel less concrete and less real than the dollars they’re holding in a money market account.

What is lacking here is not a subtle grasp of cutting edge theory, but the sort of elementary knowledge my students are asked to learn in the first few weeks of introductory macro.

Except in unusual circumstances, government debt is not paid off. To pay off such a debt would mean running fiscal surpluses equal to deficits. No government anywhere does this. Our grandchildren will not be taxed to pay off the fiscal debt we are accruing today, any more than we are taxed to pay off the debt our grandparents ran up during WWII. Every country in the world has public debt, and there will never come a “year of reckoning” when the whole world has to start running budget surpluses to pay it off.

And suppose we decided to jack up our taxes like TC says we must, and we pay down the whole thing—what then? We would have no treasury bonds out there for people to stuff into their portfolios. The only assets you could buy would be the risky stuff: you know, stocks, commercial loans, mortgage-backed securities. People would be pleading with governments to please, please run deficits again so we can have at least a few low-yielding but safe assets.

You might be tempted to say at this point, isn’t there a limit to how much public debt we can ring up? The answer is a definite yes. We need to monitor the fiscal space available to our economy and avoid getting in over our head. There is a lot of economic analysis dedicated to figuring out what these limits are and how to detect them before it’s too late. The New York Times could perform a public service by publishing thoughtful pieces by economists that discuss these questions in an informed manner.

Alas, that has nothing to do with the column at hand. TC is not making an argument about fiscal space or debt sustainability. He is saying that our treasury bonds are illusory because we will have to be taxed in the future to remove them from circulation. We are not talking about shades of opinion here, but the difference between having a basic idea of how economies work and flat-out ignorance.

Sorry: someone has to say this.

Update On Oil And The Arab Uprising

So, Qaddafi apparently has lost in his effort to retake the major oil head and refinery at Brega against the rebels against his regime, meaning that they control about 80% of Libya's oil, with the refinery particularly crucial according to the generally reliable Juan Cole at http://www.juancole.com . Needless to say, the uncertainties about oil supplies, particularly since the uprising in Libya began, have helped push up the price of oil, past $100 per barrel on both West Texas Intermediate and the roughly $13 more expensive Brent crude, which is the price most of the world outside the US pays (this gap an oddity only around since December), although the general trend with the world economy growing while world oil production has not risen at all for the last half decade is clearly going to be for prices to rise over the foreseeable future, even if there is a downward correction when these uprisings settle down.

While Libya is a major oil exporter, and fellow OPEC member Bahrain continues to have major demonstrations by the Shi'i majority against the Sunni monarchy, it continues to be the case that generally major oil exporting Arab nations are having fewer and less severe uprisings than non-oil exporters. The main latter ones without uprisings continue to be Morocco and Syria, both of which have had some minor demonstrations, but apparently remain largely calm.

However, some other major oil exporters have either experienced demonstrations or are very nervous about the possibility of there being some. Much attention has focused on the big one, Saudi Arabia, where Shi'a are about 17% of the population and concentrated in the oil producing Eastern Province and have long been oppressed by the Sunni majority. There have been calls for reforms, although no demos yet. King Abdullah has responded with a $36 billion plan to spread around a bunch more money. Key blog on the Kingdom is John Burgess's Crossroads Arabia at http://xrdarabia.org . According to his links, probably Abdullah's move will work, and the majority Sunni population remains largely loyal to the royal family.

Another less-publicized but somewhat similar situation has arisen in the United Arab Emirates. There the problems are more with expatriate workers (as in Kuwait also), who make up a substantial portion of the labor force. The UAE rulers, who also have a lot of money, at least in Abu Dhabi (Dubai is banrkupt and kept afloat by the Abu Dhabi folks), are imitating the Saudis and have announced a major money handout. One can follow events there through John Chilton's The Emirates Economist blog at http://emirateseconomist.blogspot.com .

Finally, the latest Arab oil exporter to have demonstrations, fairly serious actually, has been Oman at the southeast corner of the Arabian peninsula. Unlike the previous two cases, they do not have nearly as much oil or money, but the traditions there have also been to be much more tolerant of dissnt. Part of the issue there is regional, with most of the unhappiness in the western areas of Dhofar near Yemen (which continues to be perhaps second to Libya in terms of the seriousness of its current uprising), an area much poorer than Muscat in the east where the oil is. There is a potential for greater trouble, as Dhofar rose up in the 1980s militarily and could do so again. However, the Omanis belong to the Ibadi sect of Islam that is neither Sunni nor Shi'i. having split off even prior to the division between those two. The Ibadis seem to be more tolerant and easy-going, in contrast to their more hardline Sunni neighbors (although in Yemen part of the issue is dominant Sunnis against rebellious Zaydi Shi'is in the northern mountains), and ruling Sultan Qaboos seems to be making conciliatory moves towards the demonstraters. One can follow events in Oman at Dhofari Gucci's blog at http://dhofarigucci.blogspot.com .

David Brooks - Misinformed Cheerleading for Mitch Daniels

David Brooks hearts the governor of Indiana:

Since 2004, the 49 other states in the nation increased their debt levels by an average of 40 percent. Indiana has paid down its debt by 40 percent. Indiana received its first Triple-A bond rating in 2008, and now it is one of only nine states to have the highest rating from all three rating agencies. At the same time, the business climate has improved significantly. Infrastructure spending is at record levels. The state has added jobs at twice the national average.

I was alerted to this fluff piece by Dean Baker who had a neat chart on how this last sentence is just factually incorrect. BLS provides its own neat charts on how employment has fallen and the path of the unemployment rate in Indiana. Where David Brooks got the idea that employment in Indiana has boomed under the tenure of Mitch Daniels is not clear.

Dean also reminded us of the tenure of Mitch Daniels as OMB director. But hey – George Bush was his boss back then. As far as paying down the Indiana debt – I wonder how much of this was from the front loading of receipts from the sale of toll roads:

Leasing or selling a public asset is a classic one-shot—a short-term measure that bolsters the balance sheet today but that can't be repeated … As a result, our tax revenues wind up in Beijing—as interest payments. At the state level, Indiana is relying on foreign companies to lease public infrastructure like toll roads. And under these arrangements, tolls—taxes people pay for driving—are being paid to foreign shareholders of foreign companies.

This is not long-term deficit reduction if the sale price is less than the present value of the lost future tax revenues. But I guess teaching finance to David Brooks will have to wait until he learns to read simple graphs from the Bureau of Labor Statistics.

What Krugman Did Not Say At The Easterns

The Eastern Economic Association held its annual meeting in New York this past weekend, and on Friday Paul Krugman delivered the presidential address to an overflow crowd on "The Profession and the Crisis." Although most of it he has written or said before, it was well put and generally well received. Among his points were that economists failed to forecast the crisis and were particularly remiss in failing to note the housing bubble, that poor policy analyses were given with much bad advice as the crisis unfolded, and that that the profession exhibited massive ignorance of both economic history (particularly regarding the Great Depression) as well as of the history of economic thought (particularly that of Keynes) before and even during the crisis.

There were two main items he left out, one brought up by a questioner, one not brought up at all. The first involved the role of income distribution. Krugman sort of fumbled this, going on at some length about how Princeton will have a conference on this very soon without saying who would participate or what they might say. He went on also about how this was not like in the GD, with underconsumption not playing a role, although he did think it interesting that peaks of inequality immediately preceded this crisis and the GD. He finally admitted that inequality might have had something to do with the financial part of the housing mortgage problems.

The unmentioned issue was corruption. Now, with Elizabeth Warren being appointed over strong opposition within the administration, something on this matter might be done. However, that little has been done may reflect how many people from Goldman Sachs have been (and still are) involved in both the last and current administrations at top economic policy making levels. I note that people who have emphasized this issue have included former regulator, Bill Black (the initial whisteblower on the Keating Five S&L scandal), and Jamie Galbraith. Of course, Minsky and Kindleberger both emphasized that corruption and scams are a common side accompaniment of most speculative bubbles.

merit pay

One of the knocks on collective bargaining is that employers should be able to pay people what they are worth. An interesting example of this phenomenon came in the realm of professional football. In January 2011, Pro Bowl cornerback Nnamdi Asomugha's contract was voided because his contract included a little-known clause allowed the team to void his contract if he didn't achieve his not-likely-to-be-earned incentives in 2010 -- and he didn't. One reason for his failure to earn his incentives was that he was so effective that quarterbacks would not to pass to someone near him. Consequently, he did not have any interceptions.

Along the Libyan Coast, the World is Anything but Flat

In case you were wondering whether globalization had erased the division between the colonizer and the colonized, you can relax: the old order is still in place. Especially in moments of crisis, the platitudes about a borderless world fall away, and we can see clearly who counts and who doesn’t.

Benghazi, Libya — American and British citizens have been evacuating for days. The Chinese workers were on their way, and the Bosnians stood ready with their bags on the shore. But from the milky windows of stifling rooms in a makeshift camp, the migrant workers from other, poorer countries, stranded by war and, in some cases, forsaken by their employers, watched cruise ships — and salvation — depart.

Read on.

Are Bosses Always Right?

Disagreements over the role of unions usually come down to this: do you believe that managers normally make the right decisions over how to run organizations? If you do, then “union rules” just get in the way, and unions need to be weakened or eliminated in order to increase efficiency, as supporters of Scott Walker (and his predecessor in Indiana) argue. If you think bosses can be wrong, or capricious or self-serving, you support unions as a way to reduce power differences and compel more dialog. The debate over the Wisconsin drive to eviscerate public sector unions is really about whether you think a world in which some give orders and others simply obey is the ideal.

Where does economics come down on this? There are nice models of information flows within organizations that support dispersion of power, but they are somewhat exotic and not what gets pulled off the shelf when economists reach for a simple representation of organizational dynamics. Instead, we have crude principle-agent models of the employment relationship in which bosses always seek greater efficiency and have to fine tune the carrots and sticks of employment contracts so that workers will go along. Williamsonesque transaction cost theory is built on the same assumptions: managers must defeat workers’ opportunism, just as shareholders must subdue the opportunism of managers. Does this bias follow from the deeper assumption of individual self-interest? I think not: manager opportunism could just as readily be directed down the ladder as up. Rather, what we see is an unspoken class bias, an expression of the same instincts that lead to identifying with order-givers rather than order-takers—the belief that hierarchy is a reflection of differences in competence and social commitment and not just an organizational form.

The Two Worlds of Trade

There are two longstanding narratives in economics about trade.

1. Trade is about comparative advantage. Two people or communities that specialize in what they can do best (relative to what they would be doing otherwise) and trade with each other are better off (enjoy higher levels of consumption) than they would be without trade. The story becomes more dramatic when you bring in specializations within communities: those who specialize in goods that have a comparative disadvantage (e.g. electronics assembly in the US) lose out when trade is opened up, although their losses are not as great as the gains experienced by the rest of the community. The lesson is clear: there are special interests who will try to impede trade liberalization, but they should be resisted (or bought off) by the rest of us. Economists, who know the score, have a particular obligation to expose and combat protectionism.

2. Trade, while essential for growth and development, is a potentially destabilizing aspect of national and global macroeconomics. The gold standard was doomed to fail, for instance, because the specie flow mechanism (outflows of gold resulting in reduced money supply and lower prices) did not, in practice, cause trade deficits to diminish over time. In the absence of other adjustment mechanisms, countries with persistent deficits were forced to adopt punishing austerity measures, and this imparted a contractionary bias to the global macroeconomy. In the current period of flexible exchange rates, it is still the case that unbalanced trade is not only the norm, but has even increased in scale and destabilizing potential. Deficit countries are particularly subject to financial crises, due to the accumulation of private and public debt. (This is the message of the fundamental macroeconomic identity.) On the national level, persistent trade deficits result either in chronic employment problems or addiction to Keynesian demand stimulus that should, in principle, be only temporary medicine. In a world of sovereign states, we are still far from establishing a financial architecture that can contain the destabilizing effects of capital mobility and unbalanced trade.

What is interesting is that there is almost no communication at all between these two narratives. In particular, the second invalidates the first: if trade does not balance at the margin (changes in imports exactly offset changes in exports), the microeconomic case for trade liberalization collapses.