Do not waste degrees of freedom with macro data

Dealing with microdata is relatively easy, as you have plenty of data points and can freely add explanatory variables with running the risk of running out of degrees of freedom. The story is different for macrodata, as series are much shorter, and one can quickly eat degrees of freedom by using lagged variables. The prime example here are the often abused vector autoregressions (VAR), that get larger and larger, and faster than new data points accumulate. The latest fad is to run regressions with time varying parameters, including in VARs, which is deadly for degrees of freedom as this is roughly equivalent to adding a boatload of dummy variables to the mix. Hence the need to be more parsimonious.

How parsimonious should one be? Joshua Chan, Gary Koop, Roberto Leon-Gonzalez and Rodney Strachan think the solution is in time-varying parsimony. The idea is that sometimes one needs a more complex model, and sometimes a few variables are sufficient. While this allows to spare degrees of freedom when one can do with few variables, this gain on paper is lost, and probably more than lost, by the implicit degrees of freedom used in selecting the right model. This is an old problem than is swept under the rug is many empirical applications, but in this case it becomes even more apparent because so many parameters and models are involved.

Venezuela's downfall

Venezuela was once the poster child in Latin America on how to do well (the opposite being Argentina), growing richer than European economies in the 1950's from quite modest means in less than two generations. And then all went downhill, and the country continues to slide into poverty. While many like to put blame on Chavez and his "revolution," the trend started long before he came to power.

Omar Bello, Juan Blyde and Diego Restuccia, instead of going through the usual case study that just rehashes anecdotal evidence, perform a growth accounting exercise to give the start of an answer. They find that the exceptional growth episode was due to a combination of plain old capital accumulation along with total factor productivity growth originating in the booming oil industry and its foreign direct investment transferring know-how to locals. The following collapse shows the undoing of this but with a very different origin. A severe misallocation of resources lead to a drop in total factor productivity, which then triggered capital loss. And how did the government manage ti create the mess? First, it steered the economy away from oil, which may be a good idea for diversification. But the second error was to favor heavy industries, a common development mistake. And third, general government meddling in affairs it should not be looking at. Chavez has just continued a long tradition in this regard.

Energy spending and household poverty

There is broad agreement that energy, especially polluting energy, is too cheap, calling for higher energy taxes. The problem is that such taxes are believed to be highly regressive, as poor households spend a larger share of their income on energy for transportation, heating and cooling. Of course, this could be alleviated by an appropriate redistribution of the proceeds, but to do this properly one first needs to understand well the energy spending of poor households.

Tooraj Jamasb and Helena Meier do this for the United Kingdom. There, households that spend more than 10% of their income on energy are considered "fuel poor" and deemed as having difficulties heating their home. I have always been suspicious of such definitions, as one may choose to spend more to heat at higher temperatures, for example, without being considered at risk. But this definition may indeed capture a good portion of the households of interest. While Jamasb and Meier find the usual conclusions (fuel poor households are poor, have children or are retired, spend more time at home), they also put high hope in smart meters. By showing current energy consumption, they hope that these meters will trigger behavioral changes and in particular help so far ill-informed households manage better the available energy and look for energy efficiency. As so often, good information goes a long way in managing scarcity.

Education for gifted students: all for nothing?

Not every kid progress at the same pace through school, this is why some occasionally need to repeat their grade. How to handle gifted children is more controversial. Should they be allowed to skip a grade? Should they be offered special classes? Or should they simply follow the normal stream at the risk of getting bored? A good argument for devoting additional resources to them is that they will likely be the future leaders and entrepreneurs, and those are deemed to be the engines of growth.

Sa Bui, Steven Craig and Scott Imberman study the issue in the United States. Interestingly, the US has been steering towards channeling additional funding towards lagging students through the "No child left behind" laws, ironically implemented by a Republican administration. Gifted programs suffered from this reallocation, and the question whether this had an impact on the outcomes of gifted children. Comparing fifth-graders who were the last eligible for a gifted student program to those how just missed out, Bui, Craig and Imberman hardly find a difference. The science outcomes are better when looking at a randomization experiment for eligibility to a gifted student magnet school. This may be due that in such schools, classes are at a higher level and teachers may be better (and parents may get more involved). However, students may be suffering from a lower class rank among their peers. So it may all come to a draw. There is no easy solution.

About the bastardization of news

Earlier this week, I have has the "opportunity" to spend significant time in a US hotel room. The town being of little interest, I used my time to get some work done and to watch some TV. There was the opportunity to see two interesting events, on the same day: the press conference of Ben Bernanke and the statement of Barack Obama about the war in Afghanistan. What a huge disappointment both were.

This is not Bernanke's or Obama's fault, though. The big news channel were treating this like an American Idol contest, with personalities (or journalists, what is the difference now anyways) doing instant ratings on how well they perceived the speakers. Which was then followed by an analysis of some random tweets.

The sad truth is that people will form their opinion from this circus. Never mind that Bernanke and Obama are experts in their field, have thought very hard about their issues with a lot of expert advice, these journalists know on the spot what is best and will dismiss without justification any argument by the push of a button.

This brings me back to the idea that Economics needs some way to certify people to separate those who pretend to know something about Economics and those who do. The latter are mostly unwilling to talk in sound bites and instant opinion, thus the media rushes to the pretend economists. And I wonder how many of the journalists I saw judging Bernanke have any degree in Economics, let alone a graduate degree.

Property rights and natural resources

It is a firmly established conventional wisdom that natural resources are best preserved when there are well established property rights. It is the quintessential example of the tragedy of the commons that if everyone is allowed, say, to take water, water will be over-exploited. This wisdom takes, however, a crucial assumption: that once the resources is taken, property rights are well established and uncontestable. What would happen if not?

Louis Hotte, Randy McFerrin and Douglas Wills show that reverting this assumption can have a dramatic impact. Suppose that you took a freely available resource, but that now anyone can contest your ownership of that resource. Depending on the consequences, you may not want to extract in the first place. It thus matters in which way the state is weak. If it is weak in that it gives away rights to natural resources, then there will be over-exploitation. If it is weak in that it cannot enforce property rights in general, and in particular when it comes to bring product to the market, then it is the Wild West and under-exploitation may ensue. Theft is a powerful mechanism to kill markets.

What is a sticky price?

An amazing amount of scholarly effort is devoted to figuring out optimal stabilization policies in developed economies. I am not convinced this effort is well-placed, as fluctuations in developing economies are much larger and long-term trends quickly swamp short-term fluctuations in welfare assessment for developed economies. The last recession in the US may make it worth to look at stabilization though.

Greg Mankiw and Matthew Weinzierl have a piece of rather pedagogical nature trying to convince us that stabilization policy is worthwhile. Their model is essentially the one that is taught to undergraduates: a two-period model with households maximizing intertemporal utility from consumption, a government, and firms that maximize discounted profits. Oddly, firms do not care about the resale value of capital in the second period, which makes investment largely irrelevant. Finally, prices are fixed the first period, but can be changed in the second period.

Beyond the pedagogical merit, can this model be used for serious policy prescriptions, which Mankiw and Weinzierl even quantify? For one, the last recession was sufficiently important that prices and wages actually adjusted down in the short term, which violates the critical premise of the model. Indeed, all what policy tries to do is undo the frictions stemming from price rigidity. Second, when prices do indeed not change in the short-term, it is presumably when it is not worth doing do so, thus policy intervention also does not seem worth it. Of course, it could be that there is a genuine Keynesian lack of demand, but this can be attacked best by dealing with what causes the lack of demand, not by creating artificial demand through government expenses. For the last recession, this would have been easing collateral constraints. Third, the model assumes a money quantity equation, which imposes a constant money velocity. I thought we all had agreed long ago this was a silly assumption.

I really do not understand the point of this paper. After all, as Mankiw likes to say on his blog, all this can already be found in his favorite textbook.

The marital college premium

There are a lot of good reasons to marry an educated partner. Among them is that his/her income is higher, and theory has consistently pointed to the fact that one's own returns to education should be higher. This is known as the supermodularity of the marriage return function: the second derivative of outcomes with respect to both education levels is positive. This implies that the return to education becomes even higher, as the couple's surplus increases even more due to the supermodularity. But how much?

Pierre-André Chiappori, Bernard Salanié and Yoram Weiss use an extract of the US Census to confirm that supermodularity is present is very significant manner. It varies by cohort, though, with in particular younger females seeing stronger returns than young males. This means that women have done better in three dimensions in recent decades: they closes a large part of the wage gap with men, they get a higher marital college premium and they marry better. All this compounds to remarkable progress for women, who also work more and get a larger share of the marital surplus.

Inattention and bank overdrafts

It happens to everyone: you are not careful and despite having sufficient funds, your checking account is drying up at the wrong moment and you incur an overdraft fee from the bank. Oh well, you say, the penalty is somewhat stiff, but bad planning has consequences. But for those who have genuine liquidity problems or those that are really bad at planning, those fees can add up quickly and become substantial. Even on an aggregate level, it is important. Apparently, US banks earn $35 billion a year from overdraft fees, or a staggering $100 per capita.

Victor Stango and Jonathan Zinman study what can make that people avoid those fees. A lot has of course to do with education and self-discipline, thus reminders become an important tool. Indeed, they notice that people who were exposed to information about overdraft fees in surveys are less likely to incur such fees in the next month, by 12%, and this effect builds up over multiple exposures. This works best with those who need it the most: low education and low financial literacy. And as people avoid overdrafts by making fewer transactions, not increasing balances, it indicates they lower their expenses as a reaction to realizing that they may not afford that much spending. In other words, financial and economic literacy are important and should be favored.

Mission drift in microfinance?

Microfinance is based on a very simple principle. The poorest can only improve if they invest, and very small loans may be sufficient to get them started. But conventional banks do not bother with such loans, and informal money-lenders charge horrendous rates. Microfinance step in and lend small amounts, often without collateral in a community-based scheme where one's reputation is sufficient to obtain somewhat reasonable repayment rates. I am not totally convinced this scheme would work without subsidies, but it obviously serves a useful purpose, as long as it does not crowd out the regular financial system.

Beatriz Armendáriz and Ariane Szafarz point out that the latter can become a problem because of mission drift: as microfinance institutions grow, they gradually target larger loans, neglecting their original mission and becoming more like regular banks. This is like car models that grow in size through the years to follow the life-cycle of their drivers. But Armendáriz and Szafarz think that what looks like mission drift could very well be cross-subsidization, and larger and more profitable loans are made to help continue giving small and less profitable ones. The distinction is important, as donors could be put off by mission drift.

Socialist economies smooth better the cycle

Capitalism is often presented as a wild economic system where conditions are harsh as everyone fights for his survival. The fact that economic agents are not sheltered against shocks leads them to be more efficient and possibly protect themselves better against events. Incentives are not as well aligned in a socialist economy, as free-riding is more prevalent and weaker agents may be more likely to survive in such a sheltered system. The endless discussions on which system is better ultimately boil down to preferences about risk tolerance and fairness, and on which system offers higher welfare.

Bruno Amable and Karim Azizi point out that more socialist economies appear to be better at smoothing out business cycles in the aggregate. Indeed, they tend to adopt more readily Keynesian policies, which do smooth somewhat economic fluctuations, France being the prime example. But that does not yet mean these economies are better: while fluctuations are lesser, the average level may also be lower. And fluctuations may be optimal, as we have learned from the real business cycle literature. So the jury is still out.

The daycare assignment problem

Assigning people with heterogeneous preference to medical residency, schools, job candidates or marital partners is a difficult problem, and with the help of the work of Al Roth, we have made much progress in finding optimal systems. More and more situations are uncovered that required a special analysis because some feature requires rethinking the whole process.

John Kennes, Daniel Monte and Norovsambuu Tumennasan study assignments of toddlers in daycares as applied in Denmark. It is special because if the overlapping generation nature of daycares, and the fact that some children get preferential treatment (like previous attendees and siblings). The usual Gale-Shapley algorithm appears to be Pareto-optimal, at least among stable matching algorithms, as in simpler setups, but it is unfortunately not strategy proof and does not Pareto dominate all strongly stable algorithms. For once, another assignment mechanism seems to perform better. But I wonder what would happen when there is rationing in daycares, as is typically the case.

The economic behavior of bees

I find it fascinating that there is also plenty of Economics in the animal kingdom. Two recent papers about bees just caught my attention.

Antoine Champetier studies the interaction of bees and farmers, as bees play an important role in pollination and are thought to be subject to a mysterious decline in numbers. He takes California almonds as an example and builds a model of pollination supply with hive owners and bees that forage. One aspect appears to be rather important: economies of scale in the hive, as larger hives have an easier time regulating the temperature and can devote more time to more aggressive foraging. Champetier formulates a spatial model of foraging and coordination in the bee colony, where energy used and gained by foraging is assessed, as well as time costs in each step of pollen acquisition and storage.

Noam Bar-Shai, Tamar Keasar and Avi Shmida study what makes that a bee departs early or stays longer in a flower patch. Looking at videos, they concluded that bees cannot count, but are rather governed by clues left by odor marks (to prevent revisiting the same flowers) and current foraging success.

Economic education and opinions about free markets

Public opinion about economic policy in France and the United States are very contrasted. In France, free markets are viewed very suspiciously and government intervention is required left and right. In the US, it is about the opposite, the government should stay out of any business and no tax can be justified. I find it very frustrating to talk to people (not economists) from both countries as they seem conditioned to believe steadfastly in their view. In the case of France, I was nice shocked to hear an elected politician claim that social security could easily be fixed by taking the money that "lies" in the banks.

Radu Vranceanu and Jerome Barthelemy try to relate beliefs in economic paradigms and economic education. Through a survey, they asked French Internet users about their knowledge of basic economic principles, their views on pro-market reforms, along with various demographic and education indicators. The survey was linked from a business school's website, so answers come from a population likely to be more interested than average in economic issue, and probably more likely to be open to pro-business reforms than the average French citizen. Still, it is clear that economic literacy is a god predictor of open-mindedness towards free markets. I bet it is just the opposite in the US.

The pitfalls of $1 CEO salaries

CEO how agree to be paid no salary, or a minimal one, are viewed as heroes in media and the public. But in all the cases I know off, they are of course also compensated with stock options and other deferred pay schemes. So does it really make a difference to being paid a substantial salary?

Gilberto Loureiro, Anil Makhija and Dan Zhang find that not everything is rosy abut these $1 CEOs: They tend to be overconfident and thus expect to have very high compensation in the future. As a consequence, they try to deflect future criticism about their earnings by putting on an angel face now. Also, their overconfidence implies that shareholders do not fare well with them, probably the reason institutional investors avoid them. In other words, be wart of $1 CEOs!

What is the value of research?

What is the value of the research we do? The typical way we have to evaluate the impact of research is to count citations, and possibly weigh them in some way, in Economics and any other sciences (except maybe where patents are relevant). But this only evaluates how the research output is viewed within a narrowly defined scientific community. The contribution to social welfare is an entirely different beast to evaluate.

Robert Hofmeister tries to give research some value. The approach is to consider the scientific process through cohorts, where each wave provides fundamental research as well as end-applications based on previous fundamental research. A particular research results thus can have a return over many generations. It is an interesting way to properly attribute the intellectual source of a new product or process, but the exercise is of little value if it is not possible to quantify the social value of the end-application. Indeed, Hofmeister goes back to using citations in Economics for a data application, which is equivalent to evaluate research only within the scientific community. In terms of the stated goal of the paper, we are back to square one. In terms of getting a better measure of citation impact, this is an interesting application of an old idea. And the resulting rankings of journals and articles look very much like those that are already available.

The high welfare cost of small information failures

Are stock markets efficient in the sense that stock prices reflect all available information? This question has preoccupied finance lately as many have started to doubt the efficient market hypothesis during the latest crisis. One critical aspect of this is whether current tests of the hypothesis actually give an accurate picture, and if not whether this matters in a significant way.

Tarek Hassan and Thomas Mertens
claim that it is possible for stock markets to aggregate information properly, that small errors at the household level can accumulate and amplify if these errors are correlated, and that the welfare consequences can be substantial even if the initial errors were small. This cost emerges for a portfolio misallocation due to the higher volatility of stock prices. To get to such a result, they take a standard real business cycle model, add to it that households get a noisy private signal about future total factor productivity. They then look at the stock market for additional information to form expectations. If you allow households to be on average more optimistic than rationality in some state, and more pessimistic in others, you get the above results. Interestingly, Hassan and Mertens show that households face little incentives to correct individually for these small common errors (0.01% of average consumption), but collectively the consequences are large (2.4%). Talk about an amplification.

Pollution has an impact on worker productivity

Pollution regulation is typically cast as a game between citizens and firms, the first suffering the consequences of pollution while the second are the origin of the pollution. In such a case, there is no incentive for firms to abate pollution, and the government has to mediate. But could a case be made that firms should be willing, individually or collectively, to reduce pollution. One way can be green labeling, which could increase the demand for their products. Another would be if firms realize pollution has an impact on their on productivity or on the labor supply.

Joshua Graff Zivin and Matthew Neidell take the worker productivity angle by using a dataset of dairy farm workers from a large farm in the Central Valley of California. In particular, they look how ozone levels impact the output of piece rate workers. At it is substantial. For example, a 10 ppb reduction of ozone increases productivity by 4.2%, noting that the standard deviation of ozone levels is 13 ppb. And if you object that some of the workers fall under minimum wage law and may not exert the right effort, be reassured, the authors took that into account. In addition, this impact happens even when the ozone level is well below the current national standards. Realizing this, industry should be more willing to accept the suggested tightening of pollution standards for ozone, and for nitrogen oxides and volatile organic chemicals that are the source of ground-level ozone.

Does it make sense to subsidize biofuels?

Ina relatively short time, biofuels have become remarkably popular, especially as an additive to regular petroleum based fuel. This is at least in part due to massive subsidies from the US to fuel and corn producers. As biofuels compete with food, this has lead to major price increases for corn and sugar, with adverse consequences for importing countries. This begs the question: is it actually a good idea to subsidize biofuels? I mentioned previously that it is preferable to tax other energy products rather than subsidize alternative energies (1, 2), but let us revisit this issue.

Subhayu Bandyopadhyay, Sumon Bhaumik and Howard Wall use a general equilibrium trade model and confirm that if there is a Pigovian tax on conventional fuels, subsidies are not needed. But if the Pigovian tax is not available or too low (as is the case in the US), then a subsidy for biofuels makes sense, But if the country in question is large, there are other implications through increased worldwide demand for food. In that case, a food exporter wants to subsidize biofuels and tax conventional fuels. A food importing country would only want to subsidize biofuels if the pollution reduction effect is large enough.

Hector Nuñez, Hayri Önal, Madhu Khanna, Xiaoguang Chen and Haixiao Huang look more specifically at the interaction of policies in the US and Brazil, the two largest producers of biofuels. Indeed, the US imposes a special tariff on the importation of biofuels, in particular the more advanced sugarcane based one from Brazil. Brazil is also the largest producer and exporter of beef. The paper uses a multi-country, multi-good model, unfortunately with a partial equilibrium, but it takes into account possible crop rotations and different categories of land. It concludes that eliminating the tariffs would significantly reduce biofuel production in the US, with the latter importing biofuels from Brazil and exporting corn. While this reduces producer welfare compared to the status quo, it increases consumer welfare. Given the political system in the US, guess what will happen.

Shortsightedness and tariffs

International trade theory is in large part about optimal trade theory, yet it is incapable to explain the observed level of tariffs. While under rather general circumstances theory will tell you that zero tariffs will improve general welfare, once you take into account that governments threaten and negotiate in a Nash equilibrium, tariffs should be at about 30%. They are generally far below that. It is a big challenge to explain the difference.

Mario Larch and Wolfgang Lechthaler argue that all that is needed is for trade theory to finally catch up with the rest of economics and use some dynamics. Specifically, transform the problem into a dynamic Nash equilibrium, take into account transition paths, and you get some realistic numbers if you assume that the negotiating politicians are short-sighted, which is certainly not far from the truth. This is important because the various transitional effect of a tariff change take different times. Indeed a decrease in tariffs has a faster and positive impact on consumption through an immediate increase in consumption. A counter-effect through the closing of inefficient firms takes much longer. Impatient politicians discount heavily the latter.

Should voting be compulsory?

Should one force people to vote? While there are clear incentives for people not to vote because it is very unlikely their individual vote would matter, there may be a social benefit to make sure that everyone, or at least many people, votes. Clearly, public decision-making is difficult when people do not voice an opinion. But imagine you are forced to vote, how should you vote? Selfishly, or for the public good? And how should that public good be defined? Your family, the neighborhood, your clan, your country? Indeed, if you force someone to vote, you must have an idea for what purpose you impose this.

Dan Usher tries to make sense of all this focusing on the idea of the duty to vote, the duty being an unenforceable obligation. The paper is impossible to summarize without making a massacre of it, so I will abstain. It is full of ideas on how to think about the duty to vote, abstention, and mandatory voting. Read it if you are interested.

Seat belts lead to safer driving

A classic example of the law of unintended consequences is how seat belt laws gave reasons to drive more dangerously, as car drivers feel more secure. This idea has been popularized by Sam Peltzman and several follow-up studies.

Yong-Kyun Bae puts some serious doubts in this results by pointing out that all these studies were based on aggregate data. Using individual data, which allows to exploit individual characteristics, as well as the circumstances of accidents. And once you control for these factors and exploit cross-state variations of how seat-belt laws became more or less stringent in the last decade, it appears more stringent laws make people drive more carefully. Indeed, pedestrians are getting safer. If this result stands, the challenge is to explain it: do tougher seat-belt laws signal stronger enforcement of other traffic laws? In particular, as Bae suggests, these laws may come in tandem with cell-phone and texting-while-driving laws.

Risk-free rate tax deductions

The Norwegian shareholder tax is rather peculiar in that it allows the deduction of risk-free interest income, thus only taxing the risky portion of capital income. This is rather counter-intuitive, as one usually wants to encourage risk-taking in the form of venture capital or plain entrepreneurship. But the idea in Norway was that this would make financing of firms neutral with respect to the source of funds.

Jan Södersten and Tobias Lindhe argue this line of reasoning is not appropriate for an open economy like Norway and 56% foreign ownership. Indeed, one needs to understand as well who is investing. Indeed, taxes are capitalized differently by different people. Indeed, for an economy that is so open, returns are largely determined on international markets, What is then determinant for Norway is the after-tax return, and this is where new distortion enter the picture: large firms are financed on international markets, and the after-tax rate is set abroad. Small firms that finance themselves domestically have provide similar after-tax returns, but domestic investors face different tax rules than their foreign counterparts. This is where new distortions can enter, and severe under-investment in domestic firms could be the consequence. But for a rather closed economy, this seems a good idea, especially as it is a neat way to prevent under-reporting of income.