Relevant and even prescient commentary on news, politics and the economy.

Bleg: James Tobin and Paying for the Viet Nam War

In Conversations with Economists (h/t Kevin Quinn at Econospeak), James Tobin refers to LBJ having made “a mistake” in “raising taxes to pay for the Viet Nam War.”

Google Desktop can’t find the line of reasoning behind that in any of Tobin’s papers that have survived my migrating possibly-non-OCR PDFs over about six computers. Anyone able to point me to Tobin’s preferred alternative?*

UPDATE: The full quote:

Klamer: We experience stagflation….How would you account for this experience within a neo-Keynesian neoclassical framework?

Tobin: That gets us into the history of the economic world in the US since 1966. Probably there were some mistakes in demand management policy. I wouldn’t deny that. In fact, it was a council of neo-Keynesian advisors that told Johnson he should raise taxes for the Vietnam War.

Is this just a reference to the mismanagement pgl has discussed here and at Econospeak so often? And is there evidence that the advisors were arguing that the war was the reason to raise taxes?

*That’s “given that the War was in progress anyway”; not funding and not fighting was not an option, no matter how preferable it might have been without the presence of Dr. Manhattan and his “glowing blue schlong.”

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How Rational Behavior Leads to Inefficiency if there are Incomplete Markets

Robert Waldmann

My effort immediately below to explain some general equilibrium theory in English didn’t work out so well. Here I will attempt to give simple examples which show how rational individual choice and/or trade between rational consenting adults can make everyone worse off.

Models will all involve strange fruit trees, that is assets which generate goods without labor. There will be only 2 periods. In the first period (period 0) agents plant trees and maybe buy and sell them. It is allowed to short an apple tree (that is to promise to deliver the apples even if you don’t own the tree).

Then in period 1 the trees produce fruit. The amount depends on the state of the world (that is say the weather). People fulfill the terms of their financial agreements. Then people trade fruit on the spot market. Then people eat the fruit giving them their only pleasure in the whole model. Then they die.

If there are so many different kinds of trees that, for each state of the world, one can construct a portfolio which pays a positive amount in that state and only in that state, then markets are complete and the free market outcome is Pareto efficient. Otherwise it is easy to come up with examples in which rational behavior in period 0 makes everyone worse off in expected value.

One Example after the jump (I will add more when my fingers stop aching).

drought resistent apple trees. Here there are only 2 states : in state 1 it rains a lot on the apple orchards, in state 2 it rains little. The only choice in period zero is that people with apple suitable land have to decide wether to grow drought resistant apple trees which get mold if it is wet or drought sensitive apple trees which do great if it is wet. People who grow apples get sick of them and don’t want to eat them. They just eat the other good (oranges). There are always the same number of oranges. Orange growers have utility which is cobb douglas in apples and oranges.

Now if all apple growers plant drought resistent apples they all face no risk. If there are half as many apples, the relative price of apples doubles. They always eat the same number of oranges (and no apples they don’t like apples). If one apple grower plants any drought sensitive apples and their is a drought, he will suffer. If apple growers are risk averse enough, all drought resistant apples will be an equilibrium.

The orange growers face risk. They always eat the same number of oranges but eat different numbers of apples depending on whether there is a drought.

A Pareto improvement is possible. If all the apple growers plant half and half drought resistent and drought sensitive apples, then they are still safe and so are the orange growers. This is a Pareto improvement.

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General Equilibrium Theory by Popular Demand

Robert Waldmann

I’m not kidding. Someone in some thread said that he or she thought it would be great if I could give a simple intuitive explanation of Geanakoplos and Polemarchakis (1985). Also I would get an interesting perspective on the crisis if I could fly to the moon.

I will try after the jump. The G&P result is that, if markets are incomplete, unless there is an amazing coincidence, there exists a regulation of financial markets which makes everyone better off than laissez faire.

This does not mean we should decide to regulate. The fact that such a regulation exists, doesn’t mean that it will be implemented if we just convince people that laissez faire is not optimal. It doesn’t even mean that economists can figure out a Pareto improving regulation and the problem is that those rotten politicians won’t implement it. Thus the result has only one practical application. If someone says that econmic theory or common sense tell us that free interactions of rational people must be in the interests of those rational people — that person has just said that he doesn’t know what he is talking about. This is not a judgment call. There is a mathematical proof.

Before the jump, I will just notice that there are many reasons why free market outcomes are presumably not Pareto efficient. The list of sufficient conditions in the most general description of economies with Pareto efficient market outcomes is very long, and for each sufficient condition for optimality it is easy to construct examples where, if the condition doesn’t hold, regulation can be good for everyone.

The requirements are rational expectations, well defined property rights, price taking behavior (which is really stronger than saying no agent has market power), no nonpecuniary externalities which implies, among other things, that people have no sense of pity and don’t mind knowing that others are starving, symmetric information and, finally, complete markets.

After the jump I will consider only the implications of incomplete markets as the assumption of complete markets — that for every distinguishable state of the world there is an asset which pays a positive return in that state and only in that state — is so absurdly false that no one claims it is a good approximation.

OK so the problem is to explain how rational choice by price taking agents with well defined property rights and symmetric information whose happiness depends only on their consumption leisure and whose actions don’t cause externalities except via prices (from now on RCBPTETC)can make all these agents worse off than they would be if the rational choices were constrained by a regulator who knows know more than they do and who can’t introduce new assets (like social insurance) which weren’t available to the private agents (from now on a RWKNETC).

The problem is that the proof really is based on an argument like “we have N inequalities and more than N variables so, generically, we can find variables such that all N inequalities are satisfied.” This is not intuitive. I was asked for examples, but I won’t get to them in this post. I will try to give examples in the next post.

I will define my terms (search for EOD to skip this part)

1. Price Taking: Agents decide what to do given prices, including prices of financial assets and their exactly accurate forecasts of future prices as a function of the state of nature. They assume that they can buy or sell any amount at current prices and ignore any effect that their buying and selling might have on prices. The bolded passage is necessary for Pareto efficiency in a one period model without uncertainty (a model without financial markets). It is also key to proving that equilibrium with financial markets is almost certainly inefficient. Oh note this is describing free markets. If goods are rationed by the regulator, agents know that they are.

2. Symmetric information: agents may not know much but they have the same information. This, along with rationality means that they have the same accurate belief about the probability that something will happen. With asymmetric information, insurance markets which are good for everyone can fail to exist due to the adverse selection death spiral. Forcing all people to participate in such markets can be good for everyone.

3. Well defined property rights: IIRC An assumption in all proofs that the market outcome is inefficient is that agents have an endowment and can choose to consume exactly that endowment neither buying nor selling. This is related to externalities. If anyone is free to pollute the air, then the good “clean air” doesn’t belong to anyone in particular. If fish in the sea belong to no one in particular, there will be overfishing — that is all people including fisherman might be helped by restrictions on catches.

4. Externalities include envy, shame at one’s unearned good fortune and pity. If people mind knowing that other people are starving, a world without starvation is a public good. I help you if I give food to the starving. Even if I care as much about you as I do about the starving person, if I care more about myself, then we can all be made happier by taxing each other to end starvation (and the formerly starving would be much happier). The sort of externality that is assumed not to exist in proofs of the Pareto efficiency of the market outcome is any interest in anything except my own consumption and leisure. Note not that people aren’t selfless but that we are completely totally absolutely selfish.

Becker showed that the results can be generalized if people are divided into non overlapping sets (called “families”) where people only care about other people in their own set and someone in each set cares enough that if you take from someone else in the set and give to them, they will choose to give it back. This is still very strong. He assumed that families don’t overlap (wonder if Becker explained that to his in-laws).

5. The regulator doesn’t know anything that the private agents don’t know. This seems clear. If the regulator knows better, then she can force people to do things which are in their interests but they don’t know it. This result will interest no one who observes the actual senate actually legislating.

6. This corresponds to the “constrained” in Geanokoplos and Polemarchakis title. The point is that, if there are incomplete markets, except for an amazing coincidence, making the markets complete *and* lump sum taxes and transfers can make everyone better off. It makes the challenge of finding a Pareto improvement harder in an important way as one way in which public intervention is widely believed to have made us better off is by introducing new kinds of insurance such as unemployment insurance. That’s too easy for G and P.

7. Pareto efficient: Look this is a very weak claim. It doesn’t mean efficient in any normal sense of the word. A Pareto improvement (making everyone better off) is interesting. The result that no Pareto improvement is possible (Pareto efficiency) isn’t interesting at all.

8: except for amazing coincidences. This is an effort at an Egnlish translation for “generically” which means “for an open and dense set of economies.” The claim is be ” if for some set of tastes technology and endowments the market outcome(s) isn’t (aren’t) constrained Pareto efficient, then there is a change in endowments so tiny that, after the change in endowments, the new economy has a market outcome which isn’t constrained Pareto efficient (or many outcomes which aren’t).” That means the set of economies with constrained Pareto inefficient outcomes is open. Also if there is an economy with a constrained Pareto efficient outcome, there is a tiny change (as tiny as you want) in endowments so that with the new endowments the outcome of the new economy is constrained Pareto inefficient (that’s the dense part).

EOD

OK the idea of the G&P result. First the model is a general equilibrium market with financial assets. The idea is that there are 2 periods, period 0 and period 1. IN period 0 agents trade financial assets which are all in zero net supply. The state the world will be in in period 1 is not known but everyone knows the probability of any possible state. Assets have payouts which depend on the state of the world. After the uncertainty is resolved (that is in period 1) agents buy and sell goods on ordinary spot markets, then they consume, then the universe ends. General equilibrium theorists claim that theis simple structure isn’t really as restrictive as it seems.

The point is that trades in the financial assets in period 0 will generally affect the prices in period 1 except in the case of amazing coincidences. One such amazing coincidence if if everyone has identical homothetic preferences so aggregate excess demand is a function of the aggregate endowment and relative prices (so demand can be represented as demand by a representative consumer). In this case only transfering wealth from one person to another (what financial assets do) can have no effect on spot prices in period 1.

So generically decisions made in period 0 will affect spot market prices in period 1. This is a pecuniary externality.

Now if we just look at one state of the world in period 1, there will be no way to make everyone better off by messing around with trade on the spot market in period 1. By then the economy has become a one period Walrasian economy with a Pareto efficient market outcome.

If the regulator messes with trade in financial assets in period 0 then some people iwll be richer and some poorer in some realizations (say one called s) of the state of the world in period 1. If these people have different tastes or if the distribution of wealth affects demand (as in some goods are luxuries) then this will affect spot prices in those states. The change in spot prices will help people who are selling goods whose relative price goes up and hurt people whose are buying those goods. That effect, the change in spot prices due to changes in trade in financial assets in period 1, will move the state s outcome from one Pareto efficient outcome to another. It will help some people and hurt others.

As always, it might increase the happiness of the people it helps by a tiny number of utils and hurt the people it hurts by a huge number of utils. That is Pareto efficient is a very weak result. To be more exact, choose one good and call it the numeraire. the market outcome in state s will maximize the weighted sum of utility of all the agents with weights equal to the inverse of that agents marginal utility of consumption of the numeraire good in state s.

This means in each state a weighted sum of utility will be maximized but the weights will, in general, be different for different states (with low weight in state s on the utility of an agent who is poor in state s)

The key point is that we know that the indirect effects on utility of messing with financial markets through spot prices will be of different signs for different agents in each state, but we don’t know anything about the effect on expected utility. Each agent knows that she will be helped some times and hurt some times, but knows nothing about the probability weighted average effect on utility.

OK so to get to the result that messing with what people buy and sell on the financial market (making them hold different amounts of financial assets than they want to) can make them all better off it is necessary to have 2 things.

1. The relative weights on different agents are different in different states. If there are complete markets, then the relative weights will always be the same (the weights are constants all multiplied by the same state specific factor for each agent). So the market outcome is Pareto efficient.

2. There have to be enough assets that the arbitrary vectors of changes in welfare do to messing around with portfolios are numerous enough that a linear combination of such changes adds up to a vector with all positive elements — that is a Pareto improvement.

The theorem requires an assumption about the number of assets compared to the number of different types of agents. Dimensions of messing with portfolios will be something like number of assets times number of agents minus 1 (because the assets are in zero net supply). There are as many inequalities to satisfy to get a Pareto improvement as there are agents.

Except for amazing coincidences, you can satisfy N inequalities if you have N unknowns so basically it is needed that the numbers of dimensions of meddling with portfolios is greater than the number of different types of agents.

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Mundell Fleming Muddle ?

Robert Waldmann

Wow an argument in favor of protection from Paul Krugman. I never expected to read that. Now he’s against protection all the same, but he does admit that there is a good argument that right now a bit of protection would be good for the world.

The argument, basically, is that governments aren’t coordinating macro policy and that, if stimuli spill out, then they won’t stimulate enough so everyone will be better off if every country keeps its stimulus to itself. He concludes however, that protection would be a bad policy, because once countries start they don’t stop so a little bit of protection right now is not an option. Anyway it’s brief so read it.

Nick Rowe has an interesting counter argument. He argues that if all countries are in a liquidity trap, then fiscal stimuli don’t spill over.

According to Krugman “His argument is based on the proposition that since interest rates are fixed under a liquidity trap, capital flows are fixed, and the exchange rate will adjust to offset any change in the trade balance.” I will comment on this alleged argument. Rowe’s post refers to a paper which I haven’t read. Actually the post seems less sophisticated than Krugman’s presentation, as Rowe seems to argue that flexible exchange rates always imply balanced trade. He can’t be arguing that, and I haven’t read the paper.

The argument that this is true specifically if we are in a liquidity trap seems to be specific to Rowe as presented by Krugman.

Rowe’s argument as presented by Krugman seems backward to me (from now on “he” means Rowe as presented by Krugman). Basically he seems to be arguing that demand for say 3 month t-bills is very elastic and so the price of 3 month t-bills won’t change and so the amount of 3 month t-bills in investors’ portfolios won’t change — that is he is going from the assumption people are willing to shift huge amounts of wealth into 3 month t-bills to the conclusion that people won’t shift any wealth into t-bills.

I repeat this argument in various ways after the jump.

The evidence that we are in a liquidity trap is simply that short safe rates are approximately zero. However, the application in macro models is the assumption that, therefore, safe short term interest rates won’t increase if more short term public bonds are issued. That seems to me to be the same as the assumption that people and firms are willing to buy much more of them.

For some reason, Rowe assumes that this applies only to domestic people and firms and that whatever makes investors so eager to buy short term public debt is confined nation by nation. Not to put to fine a point on it, this strikes me as absolutely absurd given, for example the fact that UBS is endangered by the US real estate bubble and that AIG was brought down by its London office.

The argument is interest rates are fixed because a miniscule change in interest rates would cause a huge flow therefore changes in interest rates will be miniscule therefore flows will be miniscule.

I’d say this is a case of the dear old Mundell Fleming model overcoming common sense as if it were an RBC model.

The same goes for the anchoring model.

s = sbar + (i*-i)/k

s is the exchange rate, sbar a steady state exchange rate determined long after the recession and stimulus are over, i domestic interest, i* foreign interest rate and k a constant.

Krugman assumes that k is constant which, for one thing, implies that capital flows are linear in interest rates. Does that assumption seem reasonable right now ? seems to me that an interest rate fluctuating between 0 and 10 basis points is a strong time that k is a bit low right now.

However I guess k doesn’t matter to Krugman. I guess that Krugman’s argument amounts to saying that with constant interest rates, bonds become perfect substitutes so the amounts of different bonds that people will hold (tried to avoid writing “stock of bonds” there) can change a lot and balance large trade deficits at a fixed relative price. That is Krugman is ahead of me as usual always so far.

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Global Warming Research Datapoint

I’m staring at my car, which survived the past six NJ winters without looking much the worse for wear.

At least compared to today.

Data research question of the Day: Any way to get data on the number of car washes done in the winter in, say, the latitude of the lower Rustbelt over the past thirty years?

I would give odds that the milder winters have driven the number down, even adjusted for income changes, etc.

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No laboring in economics

by: Divorced one like Bush
at the beach on vacation Ha!

Gee the economics profession is ignoring labor. I wonder why. Could it be who we follow? It’s not like we don’t quote old Adam often. Free market and ghost hand ideas are mentioned all the time as we follow Milton:

According to The Economist, Friedman “was the most influential economist of the second half of the 20th century…possibly of all of it”.[2] Former Federal Reserve Board chairman Alan Greenspan stated, “There are very few people over the generations who have ideas that are sufficiently original to materially alter the direction of civilization. Milton is one of those very few people.”[3]

I would add, a mind who focused on….wait for it…. MONEY.
“Monetarism is a school of economic thought concerning the determination of national income and monetary economics. It focuses on the supply of money in an economy as the primary means by which the rate of inflation is determined.”

In an interview at Right Wing News by John Hawkins (sorry no date)of The Man who is introduced thusly:

But I think the fact that Mr. Friedman finished in a tie for the 15 slot when RWN had conservative bloggers select, “The Greatest Figures Of The 20th Century” gives you some idea of Mr. Friedman’s stature.

we get responses to the questions by Mr Influence of the 20th century of:

From my point of view, we in the United States have gone overboard in respect to the extent of regulation and detailed control of labor standards, industry, and the like. It’s bad for us, but fortunately we had two hundred years of relatively free development to provide a strong basis to sustain the cost.

Well, they only consider half of the problem. If you move jobs overseas, it creates incomes and dollars overseas. What do they do with that dollar income? Sooner or later it will be used to purchase US goods and that produces jobs in the United States.

If the White House were under Bush, and House and Senate were under the Democrats, I do not believe there would be much spending.

How do you get them together by forming industrial cartels and keeping prices and wages up? That’s what Roosevelt’s policies in the New Deal amounted to. Essentially, increasing the role of government, enhancing the monopolistic position of labor, and creating as I said before the equivalent of price fixing cartels made things worse.

Well, who would provide the funds, the capital, and the entrepreneurship for the new industries? In a world in which there were no rich people, how would you have ever gotten the capital to produce steel mills or automobile plants? You can do it through the state, but the world tried that with the Soviet Union.

Well, Social Security is having a bad effect now through the tax system.

So we have a profession which followed a man whose focus was minimally on labor and by the above quotes maybe even condescending to labor as a factor in economics and wonder why the profession of this man has de-emphasized the subject? HELLO!!!!!!!!!!!!!!!!!!!

Maybe the profession really only needs to follow one piece of advice from Mr. Milton:

John Hawkins: Are there any political websites you’d like to recommend to our readers?

Milton Friedman: No, I don’t really follow any political websites. I think they’ll do better reading theWealth of Nations (laughs)…

Ok, lets read the words of the originator of the ghost hand theory:

“Every man is rich or poor according to the degree in which he can afford to enjoy the necessaries, conveniencies, and amusements of human life. But after the division of labour has once thoroughly taken place, it is but a very small part of these with which a man’s own labour can supply him. The far greater part of them he must derive from the labour of other people, and he must be rich or poor according to the quantity of that labour which he can command, or which he can afford to purchase. The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command. Labour, therefore, is the real measure of the exchangeable value of all commodities. The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.”[3]

If you will allow me, let’s put a picture to Mr Smith’s concept as it relates to why the economics profession needs to follow this one piece of Mr Influence’s advice.

Then there is this. And this as to why the economic profession needs to study this. Of course if the profession would just think about how the majority (like super duper majority) acquire their money, then maybe they would have not passed on this currently wide open, you can own it, make a name for your self aspect of money making.

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