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Robert_D._Tollison.jpgMy former colleague Robert Tollison has passed away.  I still remember the tour of Carow Hall he gave me when I was interviewing in 1997.  Though we only overlapped at GMU for one year, he was an unforgettable personality.  My strongest memory: At a Liberty Fund in Bozeman, Montana in the summer of 1997, someone expressed despair at economists' inability to improve the world.  Tollison responded with this aphorism, which I've repeated ever since:
"We're all part of the equilibrium."
His point: It's a huge world, so no individual can reasonably expect to make a visible difference.  But each of us pushes the world just a smidge in his desired direction - and our small efforts add up.  In the end, Tollison inspired my paper on how economists can (and do) change the world.

Farewell, Bob.  I'll miss you.

My Myth of the Rational Voter argues that elections are surveys.  The essence of a survey is that you state an opinion, secure in the knowledge that your stated opinion is non-binding.  While there remains an off-chance your vote changes political outcomes, there's also a off-chance your survey response changes political outcomes!  Indeed, a response to a nationally representative survey is probably more likely to sway policy, because a survey respondent is one voice out of thousands instead of one voice out of tens of millions. 

For a comic illustration of this insight, see this fascinating story about registration for the American Independent Party (AIP) in California.  From the LA Times:
With nearly half a million registered members, the American Independent Party is bigger than all of California's other minor parties combined. The ultraconservative party's platform opposes abortion rights and same sex marriage, and calls for building a fence along the entire United States border...

But a Times investigation has found that a majority of its members have registered with the party in error. Nearly three in four people did not realize they had joined the party...

What went wrong?  Voters treated their party registration forms about as seriously as any other survey:

Voters from all walks of life were confused by the use of the word "independent" in the party's name, according to The Times analysis.

Residents of rural and urban communities, students and business owners and top Hollywood celebrities with known Democratic leanings -- including Sugar Ray Leonard, Demi Moore and Emma Stone -- were among those who believed they were declaring that they preferred no party affiliation when they checked the box for the American Independent Party.


Of the 500 AIP voters surveyed by a bipartisan team of pollsters, fewer than 4% could correctly identify their own registration as a member of the American Independent Party.

How is this different from product confusion on, say, Amazon?  Two big ways.  First, customers have an incentive to check their work, because ordering the wrong product is selfishly costly.  Second, customers can easily check their work, because they directly experience their purchase once it arrives in the mail.  When voters face the choice to go AIP, in contrast, they have no selfish incentive to review their order.  And since each voter is just a grain of sand on the beach of politics, they can overlook their error indefinitely - or at least until the LA Times comes calling.

P.S. The AIP registration expose also neatly illustrates the principle that rare survey answers tend to be even rarer than they look.  If a survey found 2% of Americans favored abolishing the minimum wage, for example, we should suspect that many of those who said "abolish" misunderstood the question or misspoke.

Every so often I need to push back against common misconceptions regarding saving and investment. The comment section of my previous post provided a few examples, starting with "pyroseed13":

In a less risk-averse and more economically free environment, savings would be flowing into new investments. But right now all that's happening is that this savings is being used to bid up prices on existing assets, mainly housing. So this asset bubble is reducing investment in other areas of the economy.
Saving does not and indeed cannot flow into existing assets, at least in net terms. You might use $X of your income to buy a certain asset, like an existing house. But that's offset by the fact that the person you buy the house from receives $X for selling the asset. In net terms, no saving has been absorbed in this transaction. In contrast, savings get absorbed when new capital goods are constructed, as when a new home is built. Because saving equals investment, we need never worry about saving being directed into non-investment uses, at least in aggregate terms.

Regarding existing assets, it's more accurate to say that money flows through markets, not into markets.

Commenter LD said the following:

Fed policies that provide cheap credit to established (or politically favored) companies that use the money to buy back (thus raising the price of) their stock, make it more difficult for smaller, newer, or politically un-favored companies to compete in capital markets. This provides an advantage to the established companies and reduces their incentive to innovate since the more innovative companies have less access to credit.
This is a good example of Paul Krugman's point about how arguments that might sound plausible using words, break down when you are forced to defend them mathematically. Actually, this argument is exactly backwards. Small firms find it easier to invest when big companies buy back their stock.

When companies earn profit, they can either re-invest those profits in new capital goods, or return the money to shareholders through stock buybacks or dividends. If they invest in new capital goods, those savings are not available for small firms to use. But if the money is returned to shareholders, then it is available to small firms via the credit markets. Just as government investment may "crowd out" private investment, the investment of big corporations may "crowd out" the investment of small firms. Hence if big firms refrain from investing, more of the savings pie is available for small firms to use.

PS. This assumes the Fed is targeting inflation. Under a different monetary regime the analysis might get more complicated, but I doubt you'd ever find small firms being hurt by the net saving of big firms. In any case, the article I was criticizing was certainly not relying on a Keynesian argument.

CATEGORIES: Finance , Macroeconomics

David R. Henderson  

Canada Can't Dodge Two Bullets

David Henderson
At this writing, the odds that Hillary Clinton will defeat Donald Trump for the U.S. presidency are very high.

If your concern is trade between Canada and the United States, Canada dodged a bullet. Donald Trump is hostile to trade, mainly with China but also, it appears, with anyone outside U.S. borders. He has never shown an inkling of understanding about the benefits of trade and, although he's inconsistent on many things, Trump has been a steady opponent of foreign trade.

I recall a news item about a speech he gave against NAFTA in Fresno, California in 1993 or 1994. He told his audience that Mexican businessmen favoured NAFTA and, therefore, it couldn't be good for the U.S. This showed that he didn't understand the basic economics of trade. In any trade, both sides gain or, at least, expect to gain. And unless what they get in return is a big disappointment, they do gain. Otherwise, they wouldn't trade. And if they got disappointment after disappointment, they wouldn't keep trading. Trump didn't understand that.

So the good news is that Canada will likely dodge the Trump bullet. The bad news: Canada won't dodge the Hillary Clinton bullet.

This is from my "Canada can't dodge two 'trade' bullets shot from the U.S." Fraser Forum, October 24, 2016.

Read the whole thing.

I would add, by the way, that Canadians, like the rest of us, should be very worried about the military policy of both major candidates, and possibly especially of Hillary Clinton, given her pro-war views. There are many bullets.

CATEGORIES: International Trade

This article in the Wall Street Journal left me scratching my head:

The Fed, Not the Market, Is Stifling Growth
That's the title, and I eagerly looked forward to an explanation, perhaps a criticism of the Fed rate increase last December. Instead I found this comment:
Fed policies of zero interest rates and bond buying--quantitative easing--have not only failed to stimulate business investment. They have discouraged it through the misallocation of capital. This is contractionary because it starves entrepreneurship and thus productivity growth.
Well that's certainly an unconventional hypothesis. But being unconventional doesn't make it wrong--lots of my ideas are also unconventional. At this point a good newspaper would normally provide an explanation for their unconventional claims. This is what we get instead:
The North American Free Trade Agreement (Nafta) opened the Mexican economy to Canadian and U.S. imports in 1994. Many Mexicans lost jobs. Yet the country gained access to what it needed to modernize. Running water, salmon entrees, California wines and air conditioning were not standard fare here on the Mayan Riviera in 1985. They are now, and tourism has boomed.
Elite newspapers generally have editors. I wonder how the WSJ editor could have let that slip by. It does not seem to support the unconventional claim regarding monetary policy. Further along the essay does return to the Fed:
Left out of their analyses is the gargantuan role of the Federal Reserve's antigrowth monetary and regulatory policies. Mr. Trump argued in September that the Fed's eight-year policy of cheap credit is generating asset bubbles. But if he understood the problem he wouldn't rail against Nafta.
So is that the explanation--an appeal to authority? Because Mr. Trump said so? But then why follow it up by disparaging Trump's knowledge of economics, which suggests that he is in fact not an authority?

And even if Trump were right, why would an asset bubble reduce investment? The usual theory of asset bubbles (which I do not buy) says they boost investment (tech in 2000, housing in 2006, etc.) Again, no explanation.

Conventional wisdom holds that the Fed has flooded the market with credit by aggressively buying bonds and creating bank reserves on the Fed balance sheet. Yet when the Fed buys assets--such as government debt or mortgage-backed securities--it only records a short-term liability on the balance sheet. The reserves are on the books but don't create any more credit in the real economy than if the Fed never made the purchase. Meanwhile it creates shortages of medium- and long-term assets in the market.
Finally there is an acknowledgement that the conventional wisdom is different. But still no explanation of how Fed policy is discouraging investment. Plus there's a weird comment about a shortage of long-term bonds. Yet that's clearly false---I can go out and buy a Treasury bond any time I like. And even if we generously assume that the author is confusing "shortage" with "reduction in supply", there is no explanation as to why this would hurt investment. The standard textbook theory says investment is hurt when there is an increase in supply of government bonds. Indeed this theory, often called "crowding out of investment" is popular with conservative newspapers like the WSJ. So I'm still waiting for an explanation of how the Fed's policy is reducing investment.
If there were a glut of credit in the real economy it would likely show up in bank lending as expanding businesses clamored for low-cost loans. Yet credit growth "has been dismally slow," wrote David Malpass, president of the consulting firm Encima Global in a recent note to clients.
So credit growth has been slow. OK, but why link this to Fed policy? After all, haven't we just a massive banking crisis? Haven't banks just tightened their loan standards in the wake of the crisis? Haven't we had Dodd-Frank---a regulatory monstrosity? Why single out the Fed. In the very next sentence, the author seems to agree with me:
The term structure of bank assets is partly to blame, but so is regulation--by the Fed and Congress, via 2010 Dodd-Frank legislation--which has made it difficult to lend to businesses, especially small ones.
Thus it's not the low interest rate policy of the Fed, it's their "regulation". That sounds much more plausible.
The most creditworthy companies are using cheap money not in productivity-increasing ventures but to pay dividends, buy back stock or engage in other financial transactions. Fed policies, as Mr. Malpass wrote, are "reducing the credit available to smaller businesses and hurting GDP growth rather than stimulating it."
And that's it. An assertion that Fed policies are hurting business investment, but no explanation of how this is occurring. What is the mechanism? How does Fed policy discourage person A from extending credit to person B? You go all the way to the end of the article with a provocative headline, and the author doesn't even attempt to back up this unconventional claim. What a let down! I like contrarian arguments---I wish the WSJ had provided the contrarian argument that they promised in their headline. I can't criticize an argument that is not made.

This is the sort of article one gets when an ideology has reached the point of intellectual bankruptcy. The ideology is "Monetary policy is always and everywhere too expansionary." If you adhere to that ideology, eventually you'll have to tie yourself up in knots, attributing problems to "easy money" that are obviously not due to easy money. We've reached that point with the Wall Street Journal.

One can find many similar articles in conservative newspapers during the 1930s. I thought Friedman and Schwartz had put an end to that sort of conservatism. I guess I was wrong.

HT: Ken Duda

Bryan Caplan  

The Huemer Graph

Bryan Caplan
The latest reply from Mike Huemer on the ethical treatment of animals, this time with a cool graph.

Bryan Caplan posted this further comment on animal welfare arguments on his blog.

I didn't have time to address this earlier (partly because I was traveling for the talk that, coincidentally, Bryan Caplan invited me to give at GMU, on an unrelated topic). I have a few comments now.

My main reactions:

I. The argument from insects has too many controversial assumptions to be useful. We should instead look more directly at Bryan's theoretical account of how factory farming could be acceptable.
II. That theory is ad hoc and lacks intrinsic intuitive or theoretical plausibility.
III. There are much more natural theories, which don't support factory farming.


To elaborate on (I), it looks like (after the explanations in his latest post), Bryan is assuming:

a. Insects feel pain that is qualitatively like the suffering that, e.g., cows on factory farms feel.
b. If (a) is true, it is still permissible to kill bugs indiscriminately, e.g., we don't even have good reason to reduce our driving by 10%.

(a) and (b) are too controversial to be good starting points to try to figure out other controversial animal ethics issues. I and (I think) most others reject (a); I also think (b) is very non-obvious (especially to animal welfare advocates). Finally, note that most animal welfare advocates claim that factory farming is wrong because of the great suffering of animals on factory farms (not just because of the killing of the animals), which is mostly due to the conditions in which they are raised. Bugs aren't raised in such conditions, and the amount of pain a bug would endure upon being hit by a car (if it has any pain at all) might be less than the pain it would normally endure from a natural death. So I think Bryan would also have to use assumption (c):

c. If factory farming is wrong, it's wrong because it's wrong to painfully kill sentient beings, not, e.g., because it's wrong to raise them in conditions of almost constant suffering, nor because it's wrong to create beings with net negative utility, etc.

So to figure out anything about factory farming using Bryan's approach, we'd first have to settle disputes about (a), (b), and (c), none of which are obvious, and none of which is really likely to be settled. So this is not promising.


What would be more promising? Let's just look at Bryan's account of the badness of pain and suffering. (Note: I include all forms of suffering as bad, not merely sensory pain.) I think his view must be something like what the graph below depicts.


As your intelligence increases, the moral badness of your pain increases. But it's a non-linear function. In particular:

i. The graph starts out almost horizontal. But somewhere between the intelligence of a typical cow and that of a typical human, the graph takes a sharp upturn, soaring up about a million times higher than where it was for the cow IQ. This is required in order to say that the pain of billions of farm animals is unimportant, and yet also claim that similar pain for (a much smaller number of) humans is very important.

ii. But then the graph very quickly turns almost horizontal again. This is required in order to make it so that the interests of a very smart human, such as Albert Einstein, don't wind up being vastly more important than those of the rest of us. Also, so that even smarter aliens can't inflict great pain on us for the sake of minor amusements for themselves.

Sure, this is a logically possible (not contradictory) view. But it is very odd and (to me) hard to believe. It isn't obvious to begin with why IQ makes a difference to the badness of pain. But assuming it does, features (i) and (ii) above are very odd. Is there any explanation of either of these things? Can someone even think of a possible explanation? If you just think about this theory on its own (without considering, for example, how it impacts your own interests or what it implies about your own behavior), would anyone have thought this was how it worked? Would anyone find this intuitively obvious? As a famous ethical intuiter, I must say that this doesn't strike me as intuitive at all.

Now, that graph might be a fair account of most people's implicit attitudes. But what is the best explanation for that:

1) That we have directly intuited the brute, unexplained moral facts that the above graph depicts, or
2) That we are biased?

I think we can know that explanation (1) is not the case. We can know that because we can just think about the major claims in this theory, and see if they're self-evident. They aren't.

To me, explanation (2) thrusts itself forward. How convenient that this drastic upturn in moral significance occurs after the IQ level of all the animals we like the taste of, but before the IQ level of any of us. Good thing the inexplicable upturn doesn't occur between bug-IQ and cow-IQ (or even earlier). Good thing it goes up by a factor of a million before reaching human IQ, and not just a factor of a hundred or a thousand, because otherwise we'd have to modify our behavior anyway.

And how convenient again that the moral significance suddenly levels off again. Good thing it doesn't just keep going up, because then smart people or even smarter aliens would be able to discount our suffering in the same way that we discount the suffering of all the creatures whose suffering we profit from.

I have no explanation for why features (i) and (ii) would hold, but I can easily explain why a human would want to claim that they do.

Imagine a person living in the slavery era, who claims that the moral significance of a person's well-being is inversely related to their skin pigmentation (this is a brute moral fact that you just have to see intuitively), and that the graph of moral significance as a function of skin pigmentation takes a sudden, drastic drop just after the pigmentation level of a suntanned European but before that of a typical mulatto. This is a logically consistent theory. It also has the same theoretical oddness of Bryan's theory ("Why would it work like that?") and a similar air of rationalizing bias or self-interest ("How convenient that the inexplicable downturn occurs after the level of the people you like and before the level of the people you profit from enslaving.")


A more natural view would be, e.g., that the graph of "pain badness" versus IQ would just be a line. Or maybe a simple concave or convex curve. But then we wouldn't be able to just carry on doing what is most convenient and enjoyable for us.

I mentioned, also, that the moral significance of IQ was not obvious to me. But here is a much more plausible theory that is in the same neighborhood. Degree of cognitive sophistication matters to the badness of pain, because:

1. There are degrees of consciousness (or self-awareness).
2. The more conscious a pain is, the worse it is. E.g., if you can divert your attention from a pain that you're having, it becomes less bad. If there could be a completely unconscious pain, it wouldn't be bad at all.
3. The creatures we think of as less intelligent are also, in general, less conscious. That is, all their mental states have a low level of consciousness. (Perhaps bugs are completely non-conscious.)

I think this theory is much more believable and less ad hoc than Bryan's theory. Point 2 strikes me as independently intuitive (unlike the brute declaration that IQ matters to badness of pain). Points 1 and 3 strike me as reasonable, and while I wouldn't say they are obviously correct, I also don't think there is anything odd or puzzling about them. This theory does not look like it was just designed to give us the moral results that are convenient for us.

Of course, the "cost" is that this theory does not in fact give us the moral results that are most convenient for us. You can reasonably hold that the pain of a typical cow is less bad than the pain of a typical person, because maybe cow pains are less conscious than typical human pains. (Btw, the pain of an infant would also be less intrinsically bad than that of an adult. However, infants are also easier to hurt; also, excessive infant pain might cause lasting psychological damage, etc. So take that into account before slapping your baby.) But it just isn't plausible that the difference in level of consciousness is so great that the human pain is a million times worse than the (otherwise similar) cow pain.


Here's an abstract from a paper by Erich Pinzón-Fuchs:

This paper discusses a longstanding debate between two empirical approaches to macroeconomics: the econometrics program represented by Lawrence R. Klein, and the statistical economics program represented by Milton Friedman. I argue that the differences between these two approaches do not consist in the use of different statistical methods, economic theories or political ideas. Rather, these differences are deeply rooted in methodological principles and modeling strategies inspired by the works of Léon Walras and Alfred Marshall, which go further than the standard opposition of general vs. partial equilibrium. While Klein's Walrasian approach necessarily considers the economy as a whole, despite the economist's inability to observe or understand the system in all its complexity, Friedman's Marshallian approach takes into account this inability and considers that economic models should be perceived as a way to construct systems of thought based on the observation of specific and smaller parts of the economy.
Over the years, I've read lots of articles by people who think macroeconomics is making lots of progress. They are almost all macroeconomists.

I'm not sure I've ever met a non-macroeconomist with a high opinion of the field. I am also a skeptic. It's not that macroeconomists don't know a lot of useful things. I think they do. But their attempt to create general equilibrium models of the economy doesn't seem to be getting us anywhere. The abject failure of the profession to respond appropriately to 2008 (where were the calls for easier money?) and the Neo-Fisherian boomlet are recent manifestations of the problems with modern macro.

I've always liked Friedman's work because he seemed to reduce macroeconomics to smaller bite-sized chunks, which can be more easily digested. Let's use a few simple (partial equilibrium) models that we do understand, and try to see how far they can take us in explaining the economy. He relied on two key models, both based on well-established micro principles:

1. A monetary model of nominal aggregates
2. A labor market model

This is also the approach I took in my book on the Great Depression (The Midas Paradox). Only instead of looking at the monetary aggregates, I looked at the global market for gold. But the basic idea was the same. Gold was the medium of account during most of this period; hence determining the value of gold was tantamount to determining the price level. In other words, I had an essentially microeconomic model of the price level. I modeled the value of gold using simple supply and demand, and then recognized that the price level was the inverse of the value of gold.

In contrast, modern models try to directly model real GDP, and then assume that if RGDP "overheats" it will put upward pressure on prices. But that theory of inflation is not well grounded in microeconomics. In micro, rapid growth in the quantity of a product does not cause its price to rise; it entirely depends on whether the rise in quantity is due to supply or demand-side factors. Better to start with a monetary model of NGDP.

Friedman and I ground our theory of employment in basic microeconomic concepts. High unemployment can occur for one of two reasons:

1. Government policies that artificially raise the cost of labor (minimum wage laws, etc.) or discourage people from working (high implicit marginal tax rates.)
2. Unexpected declines in the price level/NGDP, due to a tight money policy, combined with sticky wages.

These are two simple tools, the S&D for money and the S&D for labor. They are pretty well grounded in basic economic theory. There is a mountain of economic evidence in favor of each view. If there is a big rise in unemployment, then one of the two factors above is almost certainly to blame.

In my work on the Great Depression, I found both of these tools to be extremely useful. Not only is the Great Depression itself not at all mysterious (how could there not have been a Depression, given the massive government hoarding of gold, combined with high wage policies?) but the various zigzags from 1929-39 are also pretty easy to explain with these basic tools.

In contrast, New Keynesian models are not very good at explaining events like the Great Depression, partly because they are not very good at identifying monetary shocks. Those parts of the model that are based on basic economic theory are buried so deep they get overwhelmed by all the questionable DSGE modeling assumptions. So the economy is hit by mysterious unexplained "shocks", which Friedman and I view as bad government policies.

That's not to say my approach has no drawbacks. Although my supply and demand for gold model can be applied to fiat money (the monetary base), it gets much more difficult at the zero bound, where other assets are close substitutes. And while we can be reasonably sure that a very higher minimum wage, or very generous social insurance system, will reduce hours worked, we don't have a very good grasp of the impact of smaller increases in the minimum wage, and/or smaller increases in implicit market tax rates. There is more work to be done.

Nonetheless, I often feel that macro would make more progress by returning to a few basic principles understood the Hawtrey, Fisher, and Cassel, and then adding on the innovations of Friedman (Natural Rate Hypothesis), Lucas (rational expectations) and Fama (efficient markets). And by dropping those strategies that have not proved very effective (real business cycle models, interest rate-oriented monetary models, IS-LM, etc.)

K.I.S.S. Work with models that we know to be true, because they are based on well-established microeconomic principles. That's how we can get macro back on track. In addition, creating new markets, such as a highly subsidized NGDP futures market, would help to clarify the nature of what we really mean by a "demand shortfall" as well as what factors cause it, and what policies can cure it. We need one model of nominal shocks, and another entirely different model explaining how nominal shocks impact real variables. Right now our models try to do both at once, and fail miserably.

Screen Shot 2016-10-23 at 10.47.15 AM.png

Paul Krugman, in a post today titled "Debt, Diversion, Distraction," argues, as his title implies, that we get diverted and distracted from more important issues if we worry about the coming high deficits and debt. His reasoning is faulty.

First, and this is not the faulty reasoning part, he uses data from something called the CBPP without ever identifying that organization. A quick Google shows that CBPP stands for the Center on Budget and Policy Priorities. Here's the study that he must be referring to. It does, as he says, show that the future outlook on federal government looks rosier than the CBPP's projection looked 6 years ago.

But why not use data from the Congressional Budget Office? All projections of the future turn out to be wrong, but the CBO probably has less of an axe to grind than the CBPP. And, while the CBPP study claims that in 2046, the ratio of debt to gross domestic product will be 113 percent, the CBO's projection, as of July, was a higher ratio: 141 percent. That's a pretty big difference.

Now to the faulty reasoning part. Krugman writes:

So proposals to "deal with" the supposed debt problem always involve long-term cuts in benefits and (reluctantly) increases in taxes. That is, they don't involve actual policy moves now, or for the next 5-10 years.

So why is it so important to take up the issue right now, with so much else on our plate?

Put it this way: yes, it's possible that we may at some point in the future have to cut benefits. But deficit scolds talk as if they offer a way to avoid this fate, when in fact their solution to the prospect of future benefit cuts is ... to cut future benefits.

But is there no difference between putting in place now policies that would cut benefits from, say, 10 years on, and Krugman's apparently preferred alternative of waiting 10 years and then cutting benefits immediately? Any person who plans his future will tell you that there's a huge benefit. If I can know that my Social Security benefits 10 years from now will be, say, 20% lower than I had thought due to means testing, I can plan my saving now. But if I simply think that the government will cut benefits 10 years from now and I don't know whether that's true and even if I think it's true, I don't know who will get cut and by how much, it's harder to plan.

Krugman seems to anticipate that objection, because here is his next paragraph:

If you try really hard, you can argue that locking in policies now for this future adjustment will make the transition smoother. But that is really a second-order issue, hardly deserving to take up a lot of our time. By putting the debt question aside, we are NOT in any material way making the future worse.

Does it look as if I tried "really hard" to do the reasoning in my paragraph immediately preceding this quote? And how he does he know that it's second-order? To a lot of people currently aged 45 to 65, it's pretty important.

David R. Henderson  

Bio of Paul Krugman

David Henderson
In 2008, U.S. economist Paul Krugman won the Nobel Prize in Economic Sciences. Krugman, one of the best-known economists in the world, is familiar to the public mainly through his regular column in the New York Times and for his New York Times blog titled "The Conscience of a Liberal." Besides being an original theorist in international trade, economic geography, and macroeconomics, Krugman has been one of his generation's best expositors of good economics. His excellent book Pop Internationalism and his popular articles of the 1990s, many of them in the web publication Slate, make a strong case for free trade.
This is from my bio of Paul Krugman in the on-line Concise Encyclopedia of Economics. Read the whole thing.

One of my projects since publication of the print version in 2007/2008 has been to catch up on bios of Nobel Prize winning economists. There will be more to come.

Because space on the web is not a constraint the same way space in a print version is, the bios that are just on the web, like Krugman's, are often longer than the bios in the print version.

Here's one of my favorite paragraphs:

One of Krugman's most powerful articles is "Ricardo's Difficult Idea." In that piece, Krugman shared his frustration, one that many economists have felt, that the vast majority of non-economist intellectuals do not understand the insight that david ricardo had about free trade almost 200 years ago. Ricardo's insight was that people specialize in producing the goods and services in which they have a comparative advantage. The result is that we never need to worry about low-wage countries competing us out of jobs because the most they can do is change the items in which we have a comparative advantage. Krugman pointed out that, although we can explain Ricardo's insight to our economics students, most non-economist intellectuals are unwilling to take even ten minutes to understand it. But that does not stop them from writing about trade as if they're informed. Krugman singled out Robert Reich's 1983 article, "Beyond Free Trade." The article, wrote Krugman, "received wide attention, even though it was fairly unclear exactly how Reich proposed to go beyond free trade."

CATEGORIES: International Trade

Long time readers know that I am a huge fan of the Efficient Markets Hypothesis, mostly for pragmatic reasons. (As with all social science theories, I do not believe it is literally true---just approximately true.) Now it appears that the EMH might be even better than anyone had imagined.

In economics, there can be an "efficiency/equity trade-off". I believe that most economists overstate how often this trade-off occurs, but it can certainly arise in some situations. The nice thing about EMH-based policies is that they improve both efficiency and equity. Patrick Sullivan sent me to this WSJ article, which provides a good example:

Steve Edmundson has no co-workers, rarely takes meetings and often eats leftovers at his desk. With that dynamic workday, the investment chief for the Nevada Public Employees' Retirement System is out-earning pension funds that have hundreds on staff.

His daily trading strategy: Do as little as possible, usually nothing.

The Nevada system's stocks and bonds are all in low-cost funds that mimic indexes. Mr. Edmundson may make one change to the portfolio a year.

So far his approach seems successful, just as predicted by the EMH:

From his one-story office building in Carson City, Mr. Edmundson commands funds whose returns over one-year, three-year, five-year and 10-year periods ending June 30 bested the nation's largest public pension, the California Public Employees' Retirement System, or Calpers, and deeply-staffed plans of many other states.

Nevada's $35 billion plan is "dramatically smaller" than California's roughly $300 billion, notes Calpers spokeswoman Megan White. "That said, Nevada demonstrates the benefits of reducing the complexity, risk, and costs in a portfolio."

His success is being copied by others:

Now many public pension funds are embracing Nevada's do-nothing approach as they wrestle with dwindling cash and low interest rates. Calpers is severing ties with roughly half the firms handling its money. New York City this year slashed its hedge-fund commitments.

And it's paying off by reducing government spending in Nevada:

When Mr. Edmundson joined the Nevada plan in 2005 as an analyst, roughly 60% of its stocks were in indexes. He turned it even more passive after becoming chief investment officer in 2012. He fired 10 external managers, and, by 2015, all of its stock and bondholdings were in passively managed funds.

Its outside-management bill is about one-seventh the average public pension's, according to Nevada plan documents and Callan Associates, which tracks retirement-plan expenses.

If Nevada consumed a typical Wall Street diet, it would pay roughly $120 million in annual fees. In 2016, Nevada paid $18 million.

When thinking about that $102,000,000 annual savings, keep in mind that Nevada has less than 1% of the US population. We are talking serious money.

So that's the efficiency part---what about equity? A number of people on the left have pointed out that the growing importance of our finance sector has contributed to increasing inequality in America. As states switch from hedge funds to index funds, the finance sector will earn less money. This will allow states to reduce taxes, and/or boost spending on more worthy projects, such as infrastructure.

The WSJ portrays Steve Edmundson as a modest fellow:

He brings lunch in Tupperware. "Great days," he says, are when his wife makes lunch--a BLT or tuna-fish sandwich. Otherwise, it is leftover fish or salads. "I don't want to spend $10 a day for lunch." . . . He generally doesn't work outside 8 a.m.-to-5 p.m. hours. He commutes in a 2005 Honda Element with over 175,000 miles on it. His 2015 salary was $127,121.75, according to a Nevada Policy Research Institute database.

With no one else on his investment staff, Mr. Edmundson rarely uses his conference table and four extra chairs. He volunteered his office to pension-fund employees who work for accounting or benefit calculations.

Last month, a wall went up dividing the room. "I'm not going to complain about my office," he says. "It was too big."

America has holidays honoring moms, dads, veterans, workers, etc. How about a national holiday honoring the key role that "beta males" like Steve Edmundson have played in "Making America Great in the First Place".

In our debate, Robin bemusedly observed that I'm one of those odd people who wouldn't step into a Star Trek transporter.  My actual view is more moderate: Before I'd use the transporter, I'd like to know how it works. Does it move my actual body?  Or just create a copy out of new materials, and destroy the original?

If you think it makes no difference, this video explains it better than I ever could.

I've been catching up on Wall Street Journal issues that piled up over the summer. One particularly good unsigned editorial (the Journal calls these "Review and Outlook") was the July 19 (July 20 print edition) editorial titled "What Has Congress Ever Done for Us?"

Here's a slice:

The talk radio crowd has so fed the narrative of GOP "betrayal" in Washington that even many Republicans believe Congress has accomplished nothing since they took the House in 2010 and the Senate in 2014. The truth is that while the GOP Congress can't match the Romans [in the Monty Python skit about what the Romans have done for us], it has achieved far more than the critics claim.

Here are some specifics:
Start with everything the GOP Congress has prevented. Universal pre-K, gun regulation, a $15 national minimum wage, an ObamaCare bailout for insurers, equal pay regulation, more disclosure of campaign donations, "free" community college, a new "infrastructure bank," closing the prison at Guantanamo Bay, among many others. President Obama proposed each of those, often more than once, but they vanished faster than Martin O'Malley's presidential campaign thanks to the GOP Congress.

Other than preventing the closing of the Gitmo prison, these were good accomplishments.

Rush Limbaugh, on his radio show, often talks about "low-information voters." He uses the term as a putdown of people who generally vote Democrat. That many of his listeners don't know about these accomplishments suggests that they also are low-information voters.

Of course, that's a problem with the political system in general. People simply have little or no incentive to get information.

Most economists view the Fed as a sort of firefighter, an institution that pushes back against "shocks" that mysteriously arise in the private sector. Bob Hetzel and Josh Hendrickson have a different view. Here's Josh:

The predominant difference between this view and the Taylor view presented above can be expressed in terms of whether the Federal Reserve can be seen as an inflation fighter or an inflation creator, as summarized by Hetzel (2008a). The inflation-fighter view suggests that ''inflation shocks are the initializing factor in inflation'' and ''explanations of inflation stress FOMC failure to respond aggressively to realized inflation'' Hetzel (2008a, 273). The inflation-creator view of monetary policy emphasizes that the central bank influences the price level through the control of a nominal variable. . . .

According to the Taylor view, the change in post-1979 policy was the more steadfast commitment to respond to inflation. The Federal Reserve became an effective inflation fighter.

The alternative view put forth in this paper suggests that the change in policy was not simply a renewed commitment to fighting inflation, but rather an acceptance of the Federal Reserve's role as inflation creator. The nominal variable that the Federal Reserve sought to control to influence the price level was expected inflation and the means of doing so was a commitment to low, stable rates of nominal income growth.

I agree with Hetzel and Hendrickson. Alex Tabarrok and Saturos directed me to a Kevin Grier post:

After the events of the great recession, it's just amazing to me that people think the economy is a steak, the Fed is a precision sous-vide machine, and all we have to decide is medium-rare or well-done.

For the millionth or so time, the models implying the Fed can do this, completely and utterly failed during the great recession. There is also evidence that a large part of the good outcomes credited to the Fed during the great moderation were actually due to exogenous forces (i.e. good luck).

Neither the Fed nor the President "runs" the economy. There is no stable, exploitable Phillips Curve / sous vide machine that lets us cook at a certain temperature.

This Fed worship is more religious than scientific. The past 10 years should be enough to convince anyone with an open mind that the Fed's power over the economy is quite limited and tenuous.

Let's start with the question of what it means to "control" an entity called "the economy". What does 'control' mean, and what is "the economy?" If the economy means real GDP (and that's usually what people mean when they say "the economy") then Kevin might be right. If 'control' means move RGDP where it wants, then he is clearly right. He's also correct that the Phillips Curve is not a useful model for controlling "the economy." That's why I oppose Yellen's suggestion that we might want to run the economy hot for a while to fix labor market problems. Please Fed, just refrain from causing more problems. You've done enough damage already

On the other hand, while the Fed cannot control RGDP in the sense of moving it where it wishes, it can destabilize RGDP through unstable monetary policy. Fed policy during the Great Moderation did not stabilize the economy by fixing problems, or pushing RGDP to the right position, rather it reduced instability by refraining from introducing as many monetary shocks.

While the Fed has only very limited ability to influence RGDP, one variable that it absolutely can control is expected growth in NGDP. Although the terms NGDP and RGDP sound similar to the uninitiated, they are actually as different from each other as a poem and a cement truck. One is a way of describing a vast real, physical economy, and the other is a way of describing the value of the medium of account.

During the Great Moderation, the Fed made the path of expected NGDP much more stable than prior to the Great Moderation. As the following graphs show, this also made the path of actual NGDP much more stable.

Screen Shot 2016-10-20 at 12.47.24 PM.png

Screen Shot 2016-10-20 at 12.47.52 PM.png

Now this greater nominal stability does not, in and of itself, make the path of RGDP more stable. Recall than in 2008 Zimbabwe's NGDP soared a zillion-fold, even as its RGDP fell into depression. They are very different variables.

And yet under some conditions NGDP can impact RGDP, at least in the short run. This is especially like to occur if nominal hourly wages are sticky. Thus one side effect of making NGDP more stable is that one also makes RGDP more stable. In 2008, the Fed took its eye off stabilizing NGDP and focused on (high) inflation. This led to a big fall in NGDP, and the Great Recession resulted. In his recent memoir, Ben Bernanke admits that Fed policy was too tight in September 2008, and indeed the same could be said for the entire second half of the year---probably the first half as well.

Some people question whether the Fed really "did anything" to create the Great Moderation. It depends what you mean by "did anything". Most economists don't know how to identify monetary policy changes, and hence in their empirical work they struggle to find evidence of the Fed having much effect on the economy. If they defined monetary policy in terms of expected changes in NGDP, then the role of the Fed would be much clearer. If at the same time the government created a deep and highly active NGDP futures market, then monetary shocks would be even easier to identify. But you go to war with the generals you have, not the generals you wished you had. And we don't have a highly active NGDP futures market.

I like to use the arsonist metaphor to force people to think about central banks in a different way. But perhaps the Fed is neither an arsonist nor a firefighter. Maybe the Fed is like a ship captain, which can do his or her job well, or poorly. If so, then the ship is not "the economy", it's the value of money.

The value of money can be defined in many different ways; I prefer 1/NGDP.

PS. The Great Moderation may be clearer if we look at the entire period of NGDP growth, on one graph:

Screen Shot 2016-10-20 at 1.06.16 PM.png

Just posted the last item in my lost works of Michael Huemer series.  In this essay, Huemer critiques the great John Searle's strange attempt to avoid both eliminative materialism and dualism.

P.S. If philosophy of mind strikes you as very far from economics, note that mental states - most notably "willingness to pay" and "willingness to accept" - are built into the very foundation of our discipline!

CATEGORIES: Economic Philosophy

Bryan Caplan  

Against Robotic Panic

Bryan Caplan
Monday I debated Robin Hanson for the Soho Forum on the following resolution:
"Robots will eventually dominate the world and eliminate human abilities to earn wages."
Video will be available eventually, but you can enjoy my slides (in pdf format) now.

The main surprise for me: To my eyes, Robin initially (and uncharacteristically) ran away from his thesis by embracing a very weak sense of the word "dominate."  Here are Merriam-Webster's definitions:
  • to have control of or power over (someone or something)

  • to be the most important part of (something)

  • to be much more powerful or successful than others in a game, competition, etc.

Robin appealed to something like definition #2.  When challenged, he bit two bullets.  First, he said that tractors already "dominate" in agriculture.  Second, he denied that Mark Zuckerberg "dominates" Facebook.  This is especially odd because, at least in his Age of Em, robots dominate by all three definitions.  Indeed, as he eventually admitted in the debate, Robin thinks there's a 30% chance the ems exterminate mankind within a year of their creation, in line with my argument here.  Now that's domination in its most horrifying form.

Despite my stark disagreement with Robin, it was a delightful debate.  One of my main debate maxims is, "Talk to your opponent like he's your best friend."  This is especially easy when my opponent is my best friend!  Right or wrong, Robin's a genius and a joy.

P.S. Don't miss the Chronicle of Higher Education's cover story on Robin!

I posted yesterday about Justin Amash's Cato University speech. Below is most of the rest of it. I'm putting his parts in block quotes. The italics are his. My comments follow where appropriate. I'll end with comments on Public Choice.

We hear so often: "I'm only one person. What can I possibly do?" Well, I'm here to tell you firsthand that one person's efforts really can make a difference. But making that difference doesn't happen overnight. You have to lay the groundwork. In this case, it wouldn't have been possible if my staff and I didn't operate the way that we do--if we didn't believe strongly in following the Constitution, in reading every bill, in consistency and the rule of law. These things have earned me trust from my colleagues--especially on due process, civil liberties, and privacy--and respect from other offices for my staff.

We do hear that. And my own view had been that while a U.S. Senator might have some power, a lone member of the House of Representatives could not. But he makes a good point: it's partly about brand name and reputation.
A few weeks earlier, in mid-June, the Orlando shooting happened. The following week, a bill called the Homeland Safety and Security Act, H.R. 5611, appeared on the legislative calendar. It was introduced by Majority Leader McCarthy as a response to Orlando, and it included one short, terrifying section that mirrored the Republican-backed Cornyn proposal the Senate had voted down the week before. It allowed the Department of Justice and a judge to deny gun purchases to anyone investigated for terrorism within the last five years (i.e., on one of those secret government lists) merely upon probable cause to believe that the person will commit an act of terrorism. Not that the person had committed an act of terrorism, or had conspired or attempted to commit terrorism, but that he or she will commit terrorism in the future.

McCarthy seemed to think that government is almost mistake-free. It's good that Justin Amash was there.
Having judges make factual, legally binding determinations of what an innocent person will do is not the practice of a free society--it's precrime; it's something out of the film Minority Report. Due process requires more.

Exactly. Minority Report was supposed to be a fictional warning, not a handbook.
We issued a statement through the House Liberty Caucus, blasting the bill and telling my colleagues we would be scoring against it. I filed an amendment to strike the gun section from the bill. That night, I went to a meeting of the House Freedom Caucus (not to be confused with the House Liberty Caucus!). At the start of the day, almost no one else opposed the bill--at best, they were neutral--but one by one, members were convinced to oppose it. And before the meeting adjourned, HFC took an official position against it. The Democrats also were expected to oppose it (because it wasn't dystopian enough), so without HFC's support, the bill didn't have enough votes to pass. Soon after, leadership quietly pulled it from the calendar. We never voted on it.

Speaker Ryan was later asked about the bill at a press conference, and he said, "We're not going to take away a citizen's constitutional rights without due process." Remember, this was the Cornyn proposal that Republicans had been lauding. This was Republican leadership's bill in the House. It was offered by the majority leader. It was supposed to pass with overwhelming Republican support. But here was Speaker Ryan on TV suggesting it violated due process! I had made the constitutional argument that convinced my colleagues, and here it was, being echoed in the speaker's remarks.

In short, one man turned Speaker Ryan around.
Now, this victory, along with the other victories over the past couple [of] months, was modest. But these are just small examples of what's possible with this approach to legislating. Abiding by the Constitution, upholding the rule of law, and applying principles consistently doesn't just allow me to take the right votes--it also makes me more effective at defending liberty in the halls of Congress.

It's this kind of story that causes me to think that Public Choice theory is fairly undeterminative. Who could have predicted that one man could turn things around like that. The bills were potentially big bills with huge consequences. Where were the interest groups? What would Public Choice theorists have predicted? Is the theory so fragile that in some cases it can be refuted by one member of a 435-member body?

CATEGORIES: Public Choice Theory

Scott Sumner  

Global warming phonies

Scott Sumner

I seem to be one of the relatively few right-of-center intellectuals that worry about global warming. In previous posts I've argued that if the GOP were smart (no jokes please) they would propose the following policy:

1. Global warming is a crisis for our planet, and it's time to stop playing politics with the issue. Therefore we suggest that Congress pass the sort of policy that experts believe is the most effective solution, without any bells and whistles that address other partisan concerns.

2. It's clear that experts view a carbon tax as the most efficient solution.

3. This tax should be completely revenue neutral, and should not be viewed as a back door way to advance other agendas, such as bigger government and more spending.

4. Therefore the carbon tax should be offset by reductions in our most distortionary taxes, especially those that bias us toward consumption. A revenue neutral carbon tax focuses like a laser on the environmental problem, and doesn't get bogged down in left-right disputes over the proper size of government.

I've suggested that this is a win-win for the GOP. First, it's possible (indeed likely) that the concerns over global warming are valid. In that case a revenue neutral carbon tax is clearly beneficial. And second, even if scientists are wrong about global warming, our current tax system is so grotesquely inefficient that it would be easy to find taxes far more distortionary than the carbon tax, which could then be reduced to offset its impact. Thus it's probably a sound public policy, even if global warming is not a problem at all.

But for GOP climate skeptics it gets even better. I've argued that the Democrats might well reject this proposal, as they actually care more about taxes than global warming, even though they pay lip service to Al Gore's claim that global warming is the great challenge of the 21st century. They would reject the GOP proposal, and this would expose their hypocrisy. Then the GOP could gain the moral high ground, by constantly reminding voters that they favored the policy that was advocated by global warming experts and the Democrats shot it down because they cared more about imposing ever-higher taxes on the public than they did about actually solving global warming. So it's a pure win for the GOP, with no downside at all. The tax never even gets implemented. Well-educated suburban women move back to the GOP.

Do I have any evidence for this outrageous charge? Are the Democrats really that cynical? I'm not certain, but consider the following:

ASK an economist how best to reduce pollution, and the chances are that they will recommend taxing carbon emissions. And with good reason: doing so should encourage markets to find the least costly way to reduce pollution, something governments will struggle to discover themselves. In November Washington state's voters will decide whether their state should mimic neighbouring British Columbia's carbon tax, after a grass-roots campaign put the proposal on the ballot. It would be the first such policy in America. You might think environmentalists would unite behind such a pathbreaking effort. Instead, many oppose it.

Initiative 732, as it is known, would tax carbon emissions at a rate reaching $25-a-ton in 2018 and then rising by 3.5% plus inflation every year, to a maximum of $100 in 2016 dollars. Today's levy in British Columbia is C$30 ($23) a ton. As in the Canadian province, the proceeds would be recycled into tax cuts elsewhere. The sales tax would fall from 6.5% to 5.5%. Low-income workers would get a tax rebate. And, to help placate affected businesses, manufacturing taxes would fall.

Yoram Bauman, who heads the Yes campaign (and who somehow makes his living by performing economics-themed stand-up comedy) proudly notes that three Republican state legislators support the initiative, and that it has not attracted the well-funded opposition from the oil lobby that a revenue-raising proposal might. Unfortunately, the price of that has been to alienate left-wing environmentalists, who are loth to give up the opportunity to use a carbon tax to fund new spending.

So it appears that I was right all along. At least if you assume that the left wing environmentalists reflect the views of the Democratic Party. Do they? I'm not sure, but Hillary Clinton opposes a carbon tax. (As does Trump.)

Screen Shot 2016-10-18 at 9.58.31 AM.png

This is from a recent speech given by Justin Amash, a member of the U.S. House of Representatives from Michigan, at Cato University.

His speech is block quoted and the italics are his. My comments follow where appropriate:

What's a libertarian in Congress to do? Today, I want to share with you a couple [of] recent stories that illustrate how my staff and I operate, how it's different from other offices, and how just one person can make a difference in the defense of liberty.

A couple [of] weeks ago, the House considered H.R. 5606, the so-called Anti-terrorism Information Sharing Is Strength Act, or the "Anti-ISIS Act." I'm sure you won't be surprised to hear that this bill has little to do with stopping terrorism. It was listed among the suspension bills for the week, meaning leadership intended to have it fast-tracked through the House, skipping committee and all the other normal procedures. In exchange for the fast-track process, suspension bills need a two-thirds majority to pass instead of just a simple majority.

"I'm sure you won't be surprised to hear that this bill has little to do with stopping terrorism." Maybe I'm naive but I would have thought it would have a lot do, even if futilely, with stopping terrorism. But read on and you'll see that he's right.
Unlike most offices, my staff and I actually read all the bills--yes, even the suspension bills. The stated reason for ha ving a process to suspend the rules and fast track a bill is that some bills are considered uncontroversial--if few members object to a bill, the idea goes, it would simply be a waste of everyone's time to have it go through the normal committee process. Most offices take leadership at their word when a bill is put on the suspension calendar--they assume that if it's up under suspension, it must be fine. Needless to say, that's not how my office works. We read and think about each and every bill, which is no small undertaking--on Friday night we were given a list of 25 bills that were to be considered the following Monday.

They actually read them. What a pleasant surprise. Good for them.
H.R. 5606 amends a section of the Patriot Act that instructs the Treasury Department to adopt regulations encouraging cooperation between banks and the government, with the "specific purpose of encouraging" the government to share information with banks about persons suspected of terrorism or money laundering. This section also includes a provision that allows banks to share information about these people with each other, without being liable to their customers for sharing their private information.

On the face of it, this law plainly encourages sharing of information from the government to financial institutions. But this is the Patriot Act. "Plain meaning" doesn't apply. Instead, Treasury has used this law to create a program whereby the government can compel financial institutions--22,000 of them--to provide law enforcement the account and transaction information of people they suspect of terrorism or money laundering.

No probable cause. No warrant. No due process.

You can learn a lot by reading carefully.
This program is bad enough as it is, but H.R. 5606 expands the program to cover dozens and dozens of additional federal crimes. Murder, drug offenses, copyright theft ... all the way down to stealing mail. I had to stop this bill, but I didn't have much time.

Now we see why Amash made his earlier claim: drug offenses and copyright theft don't sound a lot like terrorism.
We spent the weekend drafting materials to oppose the bill, and, of course, I took the fight to social media. On Monday morning, I issued a vote alert on the bill through the House Liberty Caucus, of which I'm chairman. Throughout the day, I lobbied my colleagues personally, and my staff lobbied other offices through emails and phone calls.

I love the "of course, I took the fight to social media."
On Monday afternoon, I went to the floor early to make sure there would be an actual vote on the bill. You see, House leaders often pass suspension bills with only a few members present. Votes are officially scheduled for 6:30 p.m. on the first voting day of the week, but leaders typically voice vote suspension bills in the afternoon before most members are even back in town! How do they do that without a quorum? Well, if no one is on the floor to object to the lack of quorum, they simply ignore the quorum requirement!

I had always wondered about this. I now have my real-world information about how the House works. New movie title: "Mr. Amash Goes to Washington"
So, I made sure I was there on time for the floor debate. Sure enough, both Republican and Democratic leaders had planned to pass this expansion of the Patriot Act by voice vote! Under the rules, did I have enough support to demand a roll call? No. But they didn't have enough members for a quorum. I asked for the yeas and nays to secure a roll call vote for that evening. And they granted me the roll call, knowing that I could stall the entire process simply by objecting to the lack of quorum. At 6:30 p.m., just before votes, the scheduling email came out from the whip team. They had changed the order of the votes to put the Patriot Act bill last. This is usually done to give leadership time to convince members on the floor to support the bill, so I knew leadership must have been at least a little concerned by my actions.

Republican and Democratic leaders attacking our civil liberties? This is the least surprising of all the paragraphs. I love Amash's strategic thinking.
The vote series started. I brought copies of the vote alert from the House Liberty Caucus with me to the floor and passed them out to my colleagues as we voted on the other bills. Then we got to the last vote in the series, a two-minute vote on the Patriot Act bill. And, to everyone's surprise, it failed. It had 229 yeas, 177 nays, but it needed two-thirds because it was considered under suspension.

It failed.

Wow! The power of one man out of 435.
Think about that. It's not as if bills never fail on the floor, but it is exceedingly rare--it happens only a few times a year, if at all. My office learned about the bill only three days ahead of the vote, and when Monday morning rolled around, we had less than 12 hours to put out our material and lobby other offices. No one was talking about this bill except for my staff and me--not the outside groups, not other members who care about these issues, because no one was paying any attention to it. Without our efforts, this bill would have passed 400-and-something to 2 or 3, maybe 4.

Part II will follow, along with some lessons for Public Choice, in a day or two.

CATEGORIES: Public Choice Theory

Scott Sumner  

Does AD influence AS?

Scott Sumner

TravisV directed me to a recent speech by Janet Yellen:

The Influence of Demand on Aggregate Supply The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?

Prior to the Great Recession, most economists would probably have answered this question with a qualified "no." They would have broadly agreed with Robert Solow that economic output over the longer term is primarily driven by supply--the amount of output of goods and services the economy is capable of producing, given its labor and capital resources and existing technologies. Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the mostly exogenous supply-determined longer-run trend.1 This conclusion deserves to be reconsidered in light of the failure of the level of economic activity to return to its pre-recession trend in most advanced economies. This post-crisis experience suggests that changes in aggregate demand may have an appreciable, persistent effect on aggregate supply--that is, on potential output.

It seems likely that demand shocks have at least a transitory impact on aggregate supply, if only because they impact investment. But I think Yellen is making a mistake here, which could lead monetary policy astray if we are not careful.

There are good reasons why most economists have viewed AS and AD shocks as being independent, at least as a first approximation. Deep recessions such as 1907-08, 1920-21, 1929-33, 1937-38, 1981-82, etc., are usually followed by fast recoveries. The recent 2007-09 recession is of course an exception. But should we re-evaluate the basic model based on a single exception?

Suppose the model is revised, and we now assume that deep recessions lead to a long period of sluggish growth as aggregate supply is depressed. In that case we will have not one mystery to explain (2007-09), but dozens. A more plausible explanation of the recent period is that the Great Recession just happened to coincide with a slowdown in trend growth. The unemployment rate did recover, which is exactly what you'd expect if my theory were correct. Instead, other factors not usually linked to AD seem to explain the slowdown. These include a slowdown in the growth rate of the working age population as well as a slowdown in productivity growth. Could the Great Recession have caused the sharp slowdown in productivity growth? I suppose anything is possible, but in that case why didn't previous deep recessions lead to slowdowns in productivity growth?

There's another, and in my view even more persuasive argument against Yellen's theory. The models that try to explain why AD might depress AS tend to predict lower levels of RGDP, but no permanent reduction in the growth rate of RGDP. This might reflect discouraged workers retiring or going on disability, as well as a slightly smaller capital stock. Neither factor should reduce the long run trend rate of growth in RGDP--it's one-time level reduction.

Now admittedly it's too soon to say the long run trend rate of growth has slowed. But this leads to the biggest problem with Yellen's hypothesis: long-term interest rates are extremely low, both in nominal and real terms. The overwhelmingly most likely explanation of the lower than normal long-term real interest rate is that the market expects sluggish RGDP growth to be the new normal. If that's the case, then there is really no plausible AD model to explain this slowdown. It's just barely possible that the 2008 recession depressed output by 5% today (although I doubt it) but it's completely implausible that it would depress output by 20% in the year 2030.

More likely, the US is being impacted by the same factors that have slowed growth throughout the developed world. We don't fully understand those factors, but they include a slower growth rate in the working age population, and a shift to a service-oriented economy where productivity gains are harder to achieve. Those problems cannot be fixed by "making the economy run hot" to boost aggregate supply.

Rather than trying to solve supply-side problems with monetary policy, I'd like to see central banks concentrate on refraining from causing problems by refraining from policies that generate unstable NGDP. Let other policymakers try to undo the tangle of taxes and regulations that are preventing our economy from reaching its full potential.

In 1992, I went to San Francisco's Candlestick Park to see the Giants play the Cincinnati Reds. To get into the baseball spirit, I wore my blue L.A. Dodgers helmet. (I root for both the Giants and Dodgers, but I figured why buy a Giants' helmet when I already had a Dodgers' one?) I was sitting in the stands when a young man came by selling hot dogs. Because he was about 40 feet away, rather than try to shout above the din, I put up one finger for one hot dog. The young man looked at me, noticed my helmet, pointed to his own head symbolizing my helmeted head, and shook his head as if to say, "No, I won't sell you a hot dog because you're a Dodgers fan." Then he grinned and I grinned, and he passed the hot dog down the row. We both knew that he would sell me the hot dog. There was no way he was going to refuse to make money off me even if I was a Dodgers fan.

This story of how the free market broke down discrimination may sound trivial. If it just had to do with my hot dog, it would be. But the story illustrates a much wider and crucial point: Markets are especially good at breaking down discrimination when what is exchanged is goods rather than labor. Think about how little you know about the politics, race, gender, or even nationality of the person who makes the bread you buy. You don't know because you don't care. What you care about is getting the best deal on bread, and even if this means buying it from someone whom you would hate, you'll still buy the bread. That's why, for example, even book stores whose owners and employees detest Rush Limbaugh still displayed his books prominently. By trying to hide the books, which apparently some stores did for a short time, they would pass up precious sales.

One of my favorite lines in a movie is in the scene in The Magnificent Seven where Yul Brynner tries to persuade the local hearse driver to risk getting shot while taking a dead Indian to be buried in dignity in boot hill. When the driver declines, Brynner asks, "Are you prejudiced?" The driver answers, "When it comes to saving my life, I'm downright bigoted." The market illustrates the opposite point. When it comes to saving their economic lives, even otherwise prejudiced people are downright tolerant.

The above is a slightly edited excerpt from my book The Joy of Freedom: An Economist's Odyssey.

CATEGORIES: Competition , Incentives

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