This is my last hogging post of the season. Congratulations to Bill Guerin and the rest of the Pens.
by Prof Neil Buchanan of GWU
Just read the whole thing.
The 2009 Social Security Trustees’ Report: Good News Behind the Headlines
I could not agree more with Prof. Buchanan’s conclusion.
While there is some talk of returning to address Social Security’s finances after we fix healthcare costs, it at least appears likely that we will not overreact to the annual trustees’ report by deciding to spend valuable legislative resources on a relatively (or perhaps completely) healthy program while other, more pressing problems languish.
At this point, the best that we can hope is for Congress and the President to focus on bringing healthcare costs back under control. If they can accomplish that, they will not only save Medicare but they will also find that Social Security is a program that – although it must of course be carefully monitored – need not be a legislative priority.
Neil H. Buchanan, J.D. Ph. D. (economics), is an Associate Professor at The George Washington University Law School, where he teaches tax law and policy.
Tilman Tacke and I wrote this manuscript looking at income inequality and infant mortality (I’ve discussed it here before).
I am going to indulge myself describing the paper I wanted to write but couldn’t because the data didn’t cooperate (gave essentially no empirical support for my pet theory). After the jump, my pet hypothesis:
The surprising stylized fact is that the correlation between inequality and infant mortality is very strong — too strong to be explained just by the obvious assumption that the probability of an infant death is convex in family income.
In fact, it seems that even given the incomes of the non rich, in countries where the rich are richer, more babies die.
This empirical result actually comes and goes in the data, but it was noted in the early 90s and there is a large literature on it. Also it’s back in recent data.
There are many many possible explanations. The one I like is
the life styles of the rich and famous hypothesis, or the bad role model hypothesis.
The idea is that non rich people enjoy having consumption profiles which are similar to those of the rich. This is similar as in “similar triangles” less of all goods and services but in the same proportions. That is, the idea is that non rich people consume luxuries because they enjoy pretending they are rich.
Formally this corresponds to maximizing an ordinary utility function u(c_i) plus one that penalized the difference between the proportions of different goods consumed and that of the role model — the glamorous rich and famous people v(c_i,c_rich).
Now the second part of the utility function will cause choices which don’t maximize the first (obviously if you are maximizing the sum of 2 functions you don’t max either one).
The rich and famous might like being like themselves but that doesn’t change their consumption (if you are maximizing the sum of a function and a constant you are maximizing the function).
Now consider 2 countries. The non rich have the exact same income in both but the rich have different income. If the rich are very rich, their consumption is very different from that which would maximize u(c_i) for the non rich. This means that the v term pulls choices further from u maximizing and u(c_i) is lower.
If the rich are just a little bit richer than the non rich, the choices of the rich are close to maximizing u(c_i) so the v term has little effect on choices and u(c_i) is higher. If the rich are richer, that part of welfare of the non rich which does not depend on enjoying pretending they are rich is lower. That part of welfare u() will be the one related to measurable things like health.
Well that was pointless (my hope is that it is inimitable style of doing pointless math without any mathematical notation).
The example — breast feeding. In micro data from poor countries, breast feeding has a strong negative association with the risk of infant mortality (risk of death as low as one third of that of bottle fed babies). Clearly the key issue is mixing formula with unsafe drinking water. However, another issue is that poor people can’t always afford enough formula to keep their babies healthy. So to conserve it they over dilute it and the babies are malnourished, or the fill the bottle with something cheap but not as healthy as formula. Here deaths are due to buying too little of a luxury rather than none at all.
Now imagine that the relatively rich can afford formula in 2 countries but in A they have to scrimp and save and in B the cost is no problem. In B more of the relatively rich will bottle feed. This is a reasonable choice (hey I have spent many many hours holding a bottle full of formula oh and more drinking formula from a bottle but don’t blame the formula). However it is a dangerous example for the non rich.
So the story is that the association can be explained if one includes the proportion of mothers who breast feed in the regression. The data say You Lose.
by Linda Beale
[also posted on ataxingmatter]
Both President Obama and Senator Max Baucus, key players in the health reform debate, have now indicated that one source of funding for health care reform on the table is a possible limitation in the exclusion from income of employer-provided insurance. See, e.g., Connolly, President Pivots on Taxing Benefits: Obama is Willing to Consider Move to Gain Health Reform, Washington Post, June 3, 2009.
The immediate reaction (seen in the comments section on the cited article) is rejection of this alternative. After all, many of us rely heavily on the fact that we have health insurance through work, and those of us in the lower income brackets probably would not be able to afford health insurance (at least, under the current privatized system) without that benefit.
But is the populist response the right one? We should not lose sight of the fact that the employer-provided insurance exclusion is the biggest tax expenditure in the Code that, like most tax expenditures, also tends to benefit most the highest income individuals. The Center on Budget and Policy Priorities has put out a new report titled Limiting the Tax Exclusion for Employer-Sponsored Insurance Can Help Pay for Health Reform that addresses this question directly. The Center notes that the tax expenditure is “poorly targeted” and benefits most the high income group who “least needs help paying for health insurance.” Lower-income taxpayers get less from the benefit because they may not have jobs, even if they have jobs they may choose to forego participation because of the cost of their share of the premium, and even if they participate, they get less of a benefit (in absolute dollar terms) because their tax rate is lower.
Here’s the graph showing the benefit relative to the income group.
CBPP suggests that the exclusion can be reformed without eliminating the value of employer-provided health insurance. One of the concerns is that employers will no longer provide the benefit if it becomes taxable, but a “play or pay” requirement could discourage that option and mitigate its effects. CBPP suggests that concerns about a rigid cap that would apply in all cases can be mitigated by adjusting the cap when a firm is relative small (so that more goes to administrative costs) or has more older and sicker workers (so that more health care costs must be covered) and for other, similar issues. The paper provides three specific alternatives for structuring the limitation in order to promote the goal of universal health coverage.
I think I should explain a claim I made in the post below. I assert that the efficient markets hypothesis (EMH) does not imply the rational expecations hypothesis (REH).
The EMH states that asset prices are the same as they would be if everyone had rational expectations. The strong form EMH adds the assumption that everyone has complete information. The semi-strong form, like the REH has implications only for expected values conditional on public information.
The EMH makes no statement about individual portfolios. It is absolutely not assumed or implied that each investor has an efficient portfolio.
In contrast the rational expectations hypothesis says that the expected value of expectational errors conditional on public information is zero. It is, therefore, not a statement about prices only but about behavior generally. As used it definitely amounts to much more the assumption that observable aggregates have the values they would have if everyone had rational expectations. It is common for microeconometric models to be estimated the assumption of rational expectations. Clearly a statement only about aggregates does not have implications for micro data. This use of the phrase “rational expectations” to refer to individual behavior not aggregates is common and, as far as I know, uncontroversial.
The assumption of ratinal expectations also has important theoretical implications. For example, the first welfare theorem requires the assumption of rational expectations. It is absolutely not sufficient for aggregates to be the same as they would be if people had rational expectations. I think it is safe to say that the fist welfare theorem has a well established place in economic thought. The assumption that it is a matter of no relevance is not easily reconciled with the history of the profession.
In the post below, I assumed that this point is plainly obvious. Now I think an extremely elementary proof might be useful. The proof after the jump.
update: totally wrong math corrected.
there are 2 time periods t = 1 and t = 2.
In the model there are 2 assets. 1 is a risk free asset which is the numeraire. one unit of risk free asset gives one unit of consumption good in period 2.
There is also a coin which is flipped. It comes up heads in period 2 with probability 0.5.
The economy is populated by a continuum of agents indexed by i which goes from 0 to one, who maximize the sum of the log of their consumption in period 2. They have identical preferences and endowements. Each owns one unit of the risk free asset.
It is possible for them to bet on the coin. for a price p one can get an asset which pays 1 unit of consumption good if the coin comes up heads.
Rational expectations implies that agents know that the probability the coin comes up heads is 0.5.
If everyone has rational expectations, then the market will clear with p = 0.5 for each t. Each risk averse agent will find it optimal to invest 0 in the risky asset. there is 0 net supply of the risky asset. Markets clear.
This outcome is Pareto efficient and maximizes total utility.
The EMH therefore is satisfied if the price of the risky asset is 0.5.
Now relax the assumption of rational expectations. Assume that agent i beliefs about the probability that the coin will come up heads is
i 1 if i>0.5 and 0 if i
The market clearing price is 0.5. at p = 0.5 half of the agents will buy 2 units each of the risky asset from each of the other half of the agents.
The EMH still holds. p = 0.5.
The outcome is somewhat different. In period 2 half of the agents consume 2 and half consume 0. The outcome is no longer Pareto efficient. Each agent has expected welfare equal to negative infinity.
now correct analysis of my original model.
Now assume that Assume that agent i believes that the probability that the coin will come up heads is i. The outcome is somewhere in between. The market clearing price is still 0.5 so the efficient markets hypothesis still holds. However, agent i will have consumption 2-2i if the coin comes up tails and 2i if it comes up heads. Since the agents, except for agent i = 0.5, are making mistakes, their true objective actual expected welfare is lower than it would be if they were rational. All but i=0.5 think that they think they are doing better than just playing safe but they are all doing worse. mr or ms 0.5 plays safe, invests all in the safe asset.
In the model with rational expectations, the optimal policy is laissez faire.
In the model with efficient markets but without rational expectations it would be preferable to ban gambling. Alternatively the state could impose a 100% tax in period 2 and distribute the receipts equally.
I think it is safe to say that there is a difference of interest to economists between a model in which the optimal policy is laissez faire and a model in which the optimal policy is confiscation and equal distribution of all wealth.
update 2: snark deleted.
In a strict rational expectations model, we might expect some people to overtrust others and one view of rational expectations is that investors’ errors will cancel one another out in each market period. Another view of rational expectations is that investors’ errors will cancel one another out over longer stretches of time but that the aggregate weight of the forecasts in any particular period can be quite biased owing to common entrepreneurial misunderstandings of observed recent history. In the latter case, entrepreneurial errors magnify one another rather than cancel one another out. That is one simple way to account for a widespread financial crisis without doing violence to the rational expectations assumption or denying the mathematical elegance of the law of large numbers.
After the jump an argument which might be of some interest (added as an update) and a rant.
* Update: spelling error corrected.
Update: I just noticed something odd about the paragraph by Cowen. Like many economists he has decided to call “The Efficient Markets Hypothesis”, “Rational Expectations.” So before his redefinition (which I think must be absolutely condemned as I do below) he wrote “one view of rational expectations is that investors’ errors will cancel one another out in each market period.” If by “errors” he means avoidable errors, then that would be the efficient markets hypothesis. However, it would not amount to rational expectations.
When the rational expectations assumption is used, it is used to mean “the things we care about have the same values they would have if everyone were rational.” In particular, inferences about welfare which some people actually take seriously, are derived from models including the rational expectations hypothesis.
Then somehow, when it is tested it changes to a quite different hypothesis. “aggregate variables which we can measure have the same values they would have if everyone were rational.” So, in finance, it becomes a statement about asset prices. However, for the use of the assumption in contributions to the policy debate to be defensible, one would need a model in which welfare is what it would be if everyone were rational. I am fairly confident that you can’t do this unless you assume people are risk neutral, that is make an assumption which is overwhelmingly rejected by the data.
If aggregates act as if people are rational and they make irrational mistakes which cancel out then they will bear more risk than they would if they were rational. Welfare will be lower. The amount of irrational risk bearing can be influenced by policy. The optimal policy is laissez faire *if* people are rational. If they are not rational yet aggregates behave as if they were rational, then the optimal policy will not be laissez faire.
Before moving on to discuss Cowen’s effort to dodge data by redefining terms,
I note that it does *not* become a statement about asset prices and trading volume for the simple reason that no one can write down a model with the rational expectations hypothesis which isn’t overwhelmingly rejected by the data. I believe that there are simply no models of trading volume including the rational expectations assumption in the literature. For more than 20 years agents who trade with no motive described in the model have been present in (as far as I know) all models of market microstructure. Now it may be hinted that there might be some rational reason for noise traders to trade as they do. However, no one (as far as I know and I am ignorant) has presented such a model, because the volume of trading that could be rationalized is a tiny tiny tiny fraction of observed trading volume.
My original rant is below. 5 minutes after posting, I stand by it, but I think the objection above is actually of some potential interest, while the shrillness below is, of course, something that has been said and written many many times.
Cowen has chosen to redefine the rational expectations hypothesis. He has also defined it so that it is meaningless, unfalsifiable, and not a hypothesis.
His intellectual accomplishment can be reproduced in other fields. If I redefine “The Ptolomaic model” to mean “The hypothesis that the earth orbits the sun” then I can save it from its recent difficulties.
I think he could have made his point more clearly if he decided to redefine “the rational expectations hypothesis” to be the hypothesis that 2+2=4. Oh and while he’s at it he could define “the law of large numbers” to mean large numbers are larger than small numbers.”
His use of the phrase “law of large numbers” shows that he is absolutely unwilling to consider the actual statement of any actual theorem. Oh and that he doesn’t know the difference between mathematics and science.
I think a refutation of Cowen’s argument which is just as valid as his argument is “I am Tyler Cowen and I retract abjure and reject my argument”. Technically, I am not Tyeler Cowen, but if he can redefine the rational expectations hypothesis as he pleases then why can’t I redefine “Tyler Cowen” to mean “Robert Waldmann.”
Casual discussion of macroeconomics suffers from the fact that one can get any result one wants by playing with lags. I’m not saying that I think formal econometrics adds much. However, things could be worse. Discussion of the ups and downs of the stock market is even weirder.
Courtney Schlisserman at Bloomberg seriously suggests that Paul Krugman’s guess as to when the trough will come explains a shift in stock prices larger than any that can really be justified ex post by anything ever.
“I would not be surprised if the official end of the U.S. recession ends up being, in retrospect, dated sometime this summer,” he said in a lecture today at the London School of Economics. “Things seem to be getting worse more slowly. There’s some reason to think that we’re stabilizing.”
U.S. stocks erased an earlier decline after Krugman made his comments. The Standard & Poor’s 500 Stock Index was little changed at 939.14 at 4:07 p.m. in New York after slumping as much as 1.5 percent earlier, and the Dow Jones Industrial Average gained 1.36 points to 8,764.49.
This is less ridiculous than the average explanation of stock market gyrations. In fact, it seems to me horribly possible that Schlisserman is right.
Can anyone explain why anyone ever took the efficient markets hypothesis seriously ?
Everyone is commenting on how, according to the New York Times, critics of the health care public option claim that it will provide the same health insuranceas private plans at lower cost to consumers and that this is a problem “unfair competition”. (simple rule when they say “unfair competition” they mean “competition”).
As part of the very successful, The Onion challenging, NY Times effort at humor LOUISE STORY and ERIC DASH explain what would be wrong with restricting compensation in the financial services sector.
“The industry has already adapted to the political and economic realities,” said Scott E. Talbott, the chief lobbyist for the Financial Services Roundtable, an industry group made up of the nation’s biggest banks and insurance companies. “If they are draconian, they could put the financial services industry at a distinct disadvantage in attracting and retaining top personnel.”
Wouldn’t that be a shame ? Don’t we all want our smartest fellow citizens to go into the financial services
industry frenetic clusterstock ? Why hardly a day goes by when I don’t hear someone complain about Harvard graduates deciding to become poets, because of draconian restrictions on compensation in the financial services industry.
Now Mr Talbot may imagine that I claim that the extremely smart and hard working people who go into financial services are contributing nothing of value to society. Hah. Maybe their mothers think that, but I think they’ve contributed a few trillion less than nothing.
No I want reasonably smart but not brilliant bankers who are lazy (not as lazy as I am but lazy). I want financial services sector to be like the food sector. You want bonds, go to the financial services sector, you want beets go to a supermarket. No full time salesmen trying to convince people what to buy. Trading volume like it was the day I was born (Nov 9 1960 a Wednesday).
The article contains an interesting error since the full horror of the financial services sector is, apparently, incomprehensible to Story and Dash.
“The banking industry had been lobbying the Obama administration to exclude traders and other highflying salespeople” from the restrictions.
Ooops. Traders are not “salespeople” they decide what the bank wants to own on its own account, what is underpriced so the bank wants to buy it or overpriced so the bank wants to sell it. The really key people for profits are the salespeople who convince suckers to buy the stuff banks want to sell and sell the stuff banks want to buy. This is the core competence of an investment bank. Traders can set up hedge funds, but then need investment banks to trick the rubes for them.
Note that Story and Dash really can’t believe that salespeople are among the immensley paid “When the economy was riding high, bonuses for top Wall Street executives and traders soared to tens of millions of dollars.” Hmm where are the salespeople ? Their compensation is *still* a dirty dark secret.