Monthly Archives: December 2012

How Much Does Culture Matter?

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Daron Acemoglu and James Robinson write,

Were the economic prospects of North Korea, which shares the same Korean culture of course, not just as bright until the economy became enmeshed in collective ownership and central planning which destroyed incentives and opportunities? As we discuss in Why Nations Fail, this example is telling. North and South Korea had the same culture when they were divided but very different institutional structures were created in the South. It is of course not culture that explains South Korea’s success but institutions.

Do cultural habits dominate formal institutions or do formal institutions dominate cultural habits? I do not have a settled view on this issue. I agree that the Korea example argues for formal institutions. However, there are other instances that seem to go the other direction. Why is democracy apparently working out so poorly in many places, such as Iraq? Why does average national IQ serve to predict economic outcomes?

Paul Romer’s project to set up charter cities makes sense if you think that formal legal institutions are the differentiating factor. If he is right, you can set up a city in, say, Honduras, with the legal structure of Hong Kong, and over time the economy in the Honduran city will start to look like the economy in Hong Kong.

Suppose that you oversee a large organization, such as a corporation or a government department. If you want to effect change within the organization, how would you go about doing it? One approach is to change the internal rules and compensation practices–a change in institutions. Another approach is to hire people who possess certain traits and values–a change in culture. From my experience, I would say that if you are in a hurry you need to bring in new people and change the culture.

In the long run, institutions may be what matter, but that does not necessarily provide you with a guide to social change. Institutional change tends to affect people gradually, and you may never get to the long run. Most urban school reform efforts fail, because the entrenched teachers and bureaucrats outlast the reformers.

John Cochrane on Health Care

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A reader asked me to comment on Cochrane’s essay from October 18. The title of the essay was “After the ACA,” which might indicate that Cochrane mis-forecast the election. To make a long story short, I agree with his economic prescription but disagree with his political diagnosis for why we have what I call insulation instead of real health insurance. Cochrane’s explanation for the absence of the latter is:

Because law and regulation prevent it from emerging. Before ACA, the elephant in the room was the tax deduction and regulatory pressure for employer‐based group plans. This distortion killed the long‐term individual market and thus directly caused the pre‐existing conditions mess. Anyone who might get a job in the future will not buy long‐term insurance. Mandated coverage, tax deductibility of regular expenses if cloaked as “insurance,” prohibition of full rating, barriers to insurance across state lines – why buy long term insurance if you might move? – and a string of other regulations did the rest. Now, the ACA is the whale in the room: The kind of private health insurance I described is simply and explicitly illegal.

My thoughts:

1. Nowhere do we observe the Cochrane (or Kling) health insurance system, or anything close to it. This suggests that something other than anomalous U.S. regulations are at work.

2. Health care is something that people love to have others pay for. Insert obligatory Robin Hanson reference.

3. Very few people understand insurance in general. Most people seem to be more loss averse than risk averse. They will buy extended warranties on cheap goods but ignore risks of catastrophic events, such as floods.

4. All around the developed world, third-party payment dominates direct consumer payment for health care. Perhaps consumers feel that if they are spared the need to take out their credit cards then it is easier sustain the belief (illusion?) that their doctors really care about them.

5. All else equal, doctors prefer being paid by someone other than the patient. They prefer to be thought of as offering the “gift of healing.” Of course they do want to get paid.

It turns out, much to doctors’ dismay, that all else is not equal. Third party payers impose all sorts of unpleasant paperwork and regulation. But you won’t see many doctors lobby for consumer-paid health care as the solution. They seem to view paperwork and regulation as an evil plot foisted on them for no apparent reason, without recognizing that it as an intrinsic result of introducing a third party into the payment process.

Cochrane goes on to discuss health care supply. Again, I agree with his prescription, which is to allow for vigorous competition. But he seems to regard health care regulation as an evil plot foisted on society, without recognizing that it may emerge naturally.

Competition is a trial-and-error process. In health care, we equate consumer protection with prevention of error, creating a trade-off between consumer protection and competition. Our choice along this trade-off is affected by the problem of “the seen and the unseen.” Health care errors have concentrated, direct impact on identifiable patients. Competition has diffuse benefits that show up indirectly in an ill-defined broader population. I think it is very difficult to convince people to trade off consumer protection for competition. And, of course, incumbents in the health care industry will do their best to persuade people not to make that trade-off.

While I think Cochrane’s essay will appeal to those who are already inclined to agree with him, others are unlikely to be persuaded. Incidentally, I had the same reaction to John Goodman’s book, Priceless.

Neither Cochrane nor Goodman addresses the arguments for intervention that derive from Arrow and Stiglitz. Arrow focuses on asymmetric information between consumers and doctors, which appears to justify consumer protection. Stiglitz focuses on asymmetric information between consumers and insurance companies, which appears to justify mandated health insurance.

Both the Arrow argument and the Stiglitz argument have merit in theory. My own view is that other forms of “market failure” are more important in practice. The “seen and the unseen” problem that I alluded to earlier means that, contra Arrow, we have too much consumer protection in medicine, not too little.

As I suggested earlier, the health insurance market suffers from the fact that consumers choose on the basis of loss aversion rather than risk aversion. Moreover, contra Stiglitz, there is that evidence relatively healthy people, rather than opting out of health insurance, are more likely to pay for it. This reflects the fact that the personality characteristic of conscientiousness drives both health and the propensity to obtain insurance. As a result, health insurance companies are treated to favorable selection, not adverse selection.

Having said that, I do not think it is Arrow and Stiglitz that libertarians need to overcome. I think we need to understand the deep-seated cultural beliefs that pertain to health care and either adapt our recommendations to those beliefs or try to change them.

Mobility

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Timothy Taylor writes,

geographic mobility in 2011…all-time low since the start of the data in 1948

Read Taylor’s whole post, and you may also wish to click through to some of the links he provides. My thoughts:

1. After the Second World War, the U.S. population shifted for a variety of reasons. Blacks moved north, to escape segregation. Otherwise, because of air conditioning, the south became more attractive than it had previously. Factories left cities and were replaced by office buildings, eventually leading to an urban population that was more white-collar than blue-collar. The automobile gave rise to suburbia.

All of these shifts are now complete, more or less. There will always be new factors that provide an impetus to mobility, but they may not be as strong as the ones that operated in the 1950s and 1960s.

2. I think that it is often the case that in order to raise your income you have to be willing to move. Over time, people may have become less motivated (certainly less desperate) to increase their incomes.

3. Read (or re-read) Enrico Moretti’s The New Geography of Jobs. I am not saying that he directly explains the decline in mobility, but his data and analysis are relevant.

4. I believe that exit, not voice, is the best check on government. A reduction in mobility is likely to cause state and local government to get worse.

Chris Anderson on 3D Printing

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He talks with Russ Roberts. He views it as a general-purpose technology, like the personal computer. I have some doubts about the analogy. It might be more analogous to digital technology in music production. In theory, digital music studios empower anyone to become a recording artist. In practice, only a limited number of people have the time, inclination, and aptitude to create music.

Still, it is a fascinating discussion. The ability to prototype and test-market products cheaply should lead to faster evolution in product development, even if the number of people who join the “maker movement” is smaller than Anderson anticipates.

Evidence for Cronyism

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Jordi Blanes i Vidal, Mirko Draca, and Christian Fons-Rosen write,

Lobbyists with experience in the office of a US Senator suff er a 24% drop in generated revenue when that Senator leaves office. The eff ect is immediate, discontinuous around the exit period, and long-lasting. Consistent with the notion that lobbyists sell access to powerful politicians, the drop in revenue is increasing in the committee assignments power held by the exiting politician.

The published version is available to subscribers. The link is to an draft.

What should be done about the revolving door? My instinct is that the door does not revolve rapidly enough. But I need to articulate that.

Mortgage Brokers and the Three Axes

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Susan E. Woodward and Robert E. Hall write,

Untrained, inexperienced borrowers interact with specialist mortgage brokers in the mortgage origination market. Brokers earn two kinds of compensation, explicit charges the borrower pays in cash and a commission the lender pays based on the spread between the coupon rate the borrower agrees to and the par mortgage interest rate. Both types of broker compensation seem to confuse borrowers. The wholesale lender’s commission is determined by financial dynamics understood by a tiny group of professionals, and the rate sheet that summarizes the possible payments is never shown to borrowers.

…With respect to policy changes that might help achieve a more efficient equilibrium, we believe in evidence-based design. Disclosure law has historically been in the hands of lawyers, who designed dense forms that may help absolve their clients of blame for consumer error, but which did little to help consumers find better deals. A new movement to design disclosures that are proven to be helpful, through field experiments, may result in some progress. Whether these forms can overwhelm the persuasion of skilled expert salesmen remains to be seen. We are inclined to believe that simple admonitions, such as “mortgage brokers are salesmen and the only way to get a good deal is to shop and bargain” and “you are more likely to get a good deal if you shop for no-cost loans” are more likely to yield improvements than, for example, trying to teach borrowers enough financial economics to understand the tradeoff between cash and the interest rate.

(Note that the quote is from the published version, which is subscriber-only. The link goes to an earlier version.)

This can be viewed through the oppressor-oppressed narrative. Mortgage brokers can earn more money by luring borrowers into more expensive mortgages (usually, “more expensive” means a present-value cost to the borrower of $1000 or so, but it can be higher than that). Note, however, that as Woodward and Hall point out, this does not make mortgage brokers rich. The brokers operate in a highly competitive environment, and while they over-charge as many borrowers as they can, profits are competed away in marketing expenses used to try to lure those borrowers.

This also can be viewed through the civilization-barbarism narrative. This sort of business does not exactly attract and reward caring, conscientious sorts of people. I think of mortgage brokers as slick and deceptive salesmen, prone to sports cars, bling, and other signs of conspicuous consumption.

Of course, from the standpoint of the freedom-coercion narrative, nobody forces you to take a loan from a mortgage broker, and it is a highly competitive industry. However, I think you have to be at least in the 99th percentile for sophistication in legal and financial calculations in order to be able, as a consumer, to use the competition to your advantage and to get the best possible deal.

I am pessimistic that consumer education or rules-based regulation can prevent consumers from being exploited in these situations. I think that the best chance is with principles-based regulation. That is, rather than designing the disclosure form, introduce the principle that disclosure should enable the consumer to understand and compare fees from different lenders.

The Political Economy of Health Care

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Yuval Levin writes,

the health care debate forces us to weigh health against other national priorities — and, as we have seen, this is something our political system and our kind of regime are exceedingly ill-suited to do. Attempts to confront this problem always seem to turn into efforts to spend yet more on health. The Patient Protection and Affordable Care Act enacted in 2010, colloquially known as Obamacare, was first sold (and perhaps genuinely intended) as a way of “bending the cost curve down,” as President Obama liked to say back then. Even as originally intended, it would have tried to do so in a way that was very unlikely to work, as it would have relied on federal regulation to induce greater efficiency in the health sector. But as it made its way through the political system, the bill became simply a means of expanding public entitlements to health coverage, and so of increasing costs rather than lowering them.

When it comes to dealing with trade-offs, markets work relentlessly and governments fail relentlessly. It is reasonable to suggest that you do not like the way that markets resolve trade-offs. It is less reasonable to suggest that government therefore is the solution.

Pay in the Public Sector

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Andrew G. Biggs and Jason Richwine write,

the average federal worker shifting to a private job actually accepts a small salary reduction of around 3 percent. Similarly, private sector workers who move to federal jobs don’t take a pay cut. They get a first-year raise averaging 9 percent, well above the raise other workers get when they switch jobs within the private sector.

The authors suggest that this is evidence that public sector workers are not underpaid. Can we interpret it any other way? Perhaps public sector work has an unobserved “pain factor” that requires a compensating differential?

Other data that would be interesting would be data on job applications. Is there a flood of applications for private sector jobs coming from the public sector? How does it compare with the amount of applications going the other way?

Saving, Taxation and the Three Axes

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Suppose that Lois Lender and Sammy Spender work at identical jobs, earning identical incomes. However, Sammy spends all his earnings, while Lois saves 20 percent of hers. Do you think that Lois should pay more in taxes than Sammy, as happens when we treat interest, dividends, and capital gains as income?

Along the conservative civilization-barbarism axis, the answer is clearly “no.” Lois is deferring gratification and is entitled to consume more as a result. Sammy is enjoying instant gratification and should not be given favored treatment for doing so.

Along the libertarian freedom-coercion axis, it is hard to say. From this perspective, all taxation is theft. One libertarian argument might be that you want to permit the government to tax as few activities as possible in order to hold down theft. But does that argument provide a rationale for making capital income, rather than labor income, excluded from taxation? Ultimately, I think that a lot of libertarians would fall back on the conservative rationale against taxing capital.

From the progressive’s oppressor-oppressed axis, Lois becomes an oppressor. I realized this when this Douglas Hopkins essay was emailed to me by the author. Hopkins argues for taxing capital income at the same rate as labor income, rather than at a lower rate (remember that the conservative position would be that capital income should not be taxed at all).

Who would have believed that a society governed by majority vote would over-burden its working middle class in order to provide tax preferences to its privileged elite? But that is exactly what we do when we offer preferential tax treatment to investment income. …Reducing the marginal tax rate on earned income and putting more discretionary income in the hands of laborers would be a far more effective method of stimulating savings where we most need it – than continuing to siphon money from the middle class into the hands of current wealth-holders.

Since Hopkins emailed the essay to me, I tried to open his mind to other narratives about capital taxation. Not surprisingly, in his email responses he would not budge. I thought that his responses just recycled the same rhetoric, in which those who accumulate capital are oppressors and those who only have labor income are oppressed.

The essay complains about economists failing to get the oppressor-oppressed narrative. I only wish that were the case. In fact, there is a whole army of economists ready to talk about income and wealth inequality in oppressor-oppressed terms. When the U.S. experiences a sovereign debt crisis, I predict that wealth confiscation will be put on the table as a solution. Why cut spending on the oppressed when there is so much wealth concentrated among the oppressors that could be used to pay down the debt?

I expect that the demonization of “the rich” and “the one percent” will gain more and more traction as the level of government spending ratchets ever upward. And, yes, I am mostly on the libertarian axis on this issue.

EMH and Macroeconomics

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A reader asks,

if an economist comes up with a novel and correct theory that makes predictions about macroeconomic variables, shouldn’t this theory enable him to beat the markets using these predictions?…

Therefore, it seems that if we accept both the EMH and the basic validity of macroeconomics, the latter must be about predictions that are somehow novel, correct, and non-trivial, but at the same time provide no new information about future market prices, even in terms of crude probabilities. But what would be some examples of these predictions, and what principle ensures their separation from market-relevant information?

Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. Here are various alternative ways of doing so:

1. Policy has no effect. Markets do what they will do, regardless. The market uses the best prediction model, so economists’ macro models can, at best, replicate the market’s implicit model.

2. Policy has an effect, but markets try to anticipate policy. The expected component of policy has no effect. Only policy surprises have an effect.

It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

A challenge with this “multiple information sets” view of the world is that we all trade in the same market. I think that people who own long-term Treasuries and people who own gold have different expectations for inflation. Why does someone not combine short positions in bonds and gold in order to arbitrage against these different expectations? I am afraid that one has to make risk aversion and leverage constraints do a lot of work.

From this perspective, the response to policy changes is hard to predict. For both economic modelers and policy makers, a difficulty is that you do not know which models the market participants are using. Thus, you cannot know how markets will react to policy moves.

I think that such humility is appropriate. Arguments of the form “on x date the Fed did y and subsequently z happened, just as my theory would have predicted” are not persuasive to me. One can usually find other instances of the Fed doing something like y with different results.

Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance. Continue reading →