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August 31, 2008

Economist's View - 5 new articles

"The Race between Education and Technology"

There has been considerable debate in economics about the source of growing inequality. Is it from skill-based technological change, changes in union power, globalization, immigration, changes in tax rates favoring those at the top, changes in the minimum wage, or what? But no matter what the source of recent trends in inequality is, education is still important. You will do much better on average with more education than with less, education can help to offset inequality, education helps to ensure equal opportunity, and I believe that emphasis on education is required if we are going to compete successfully in the global marketplace.

Here's David Warsh:

Looking Forward, Economic Principles: Bull markets, it is said, like to climb a wall of worry. It is the same with political campaigns. In the wake of the Democratic National Convention, many stories are being written ... that Barack Obama just might lose the election. ...

Never mind what the polls and pundits are saying now. Barring something completely unexpected, Obama is going to be elected president in November. ... (I can't prove this, obviously. You'll just have to trust me for now.)

The really interesting question is what might Obama realistically hope to accomplish? He has made rising inequality the centerpiece of his campaign. But inequality cannot be redressed strictly, or even mainly, through taxation. What else is there? ...

As it happens, a provocative diagnosis ... has just appeared, offering a deep and durable metaphor with which to frame the problem, and an appealing new Rx with which to address it.

The Race between Education and Technology, by Claudia Goldin and Lawrence Katz, argues that it is American education that has fallen behind in its attempt to equip citizens to fit in smoothly with the new division of labor. ...

There's no doubt that inequality in the United States has increased dramatically since the late 1970s... Indeed, by 2005, the degree of inequality in the United States had reached levels not seen since before 1940... That was the beginning of the gradual evening-out of income between 1940 and 1980 known today among economists as The Great Compression of wages.

So what has caused the new inequality?

At first glance, the authors are concerned with knocking down an interpretation that has gained currency in recent years – that the advent of computers is sufficient to explain what happened. Clearly computerization is part of the story, the authors say. So are international trade, immigration and the decline in unionization. But dwelling on the demand for new skills is only half the equation. The other half is supply. And if the "supply of skills" increases apace, in the form of well-educated workers, there need be no increasing inequality.

Exhibit A, say Goldin and Katz, are the first few decades of the twentieth century. That's the period when electricity was widely adopted in manufacturing, when many new goods and services were introduced, when various "black-box" technologies emerged for manufacturing everything from paper to cigarettes. Technology raced ahead, requiring greater knowledge, skill and flexibility on the part of nearly all workers. Yet earnings inequality fell, for decades.

Why? Because, say the authors, a pool of skilled workers was available thanks to another new invention – the American high school.

The "high school movement," as it became known, is dated to 1910... All over America, the authors write, independent school districts raised taxes, hired teachers, built schools, designed curricula and enrolled students. "Americans were keenly aware that they were involved in a historic achievement and knew, as well, that they were setting America on a course far different from that being followed elsewhere in the world."

What happened to set those events in motion? The origins of the high school movement grew out of the experience of growing inequality of 1870s and 1880s, the authors say, in the decades after the Civil War, when new technology, big business, waves of immigration combined to conjure visions of a looming war between the rich and the poor. Bitter strikes and riots were hallmarks of the times. College was still mainly for clergy and lawyers... In 1888, Edward Bellamy published Looking Backward, a utopian vision of an egalitarian future of benevolent socialism whose power stemmed from its stinging indictment of the present day.

Parents in those days recognized the extent to which those who possessed some extra education were getting ahead. Increasing numbers sacrificed to send their children (mostly their sons) to a somewhat shadowy precursor of the high school, the academy. A few of the earliest examples of these institutions still survive as exclusive "prep" schools... Nearly all of them charged tuition.

It was the obvious success of the academies, coupled with a gradual thickening of demand for better-educated workers, that gave rise to the high school movement. Goldin and Katz take pains to enumerate and elucidate six characteristic "virtues" of the educational system that developed in the US after its revolution, as it gave rise to system of universal primary public education...

These would include:

1.) lots of decentralization and competition, thanks to a tradition of local control (districts as small as a township could go into the high school business, even if other nearby districts declined);

2.) public ownership of schools, financed mainly by property taxes;

3.) universal schooling, open to all and free (not until the 1950s would the legacy of slavery be tackled in this regard);

4.) separation of church and state;

5.) gender neutrality, with girls educated to about the same extent as boys;

6.) an open and forgiving system, far less forbidding than the systems of France and Germany, where rigorous examinations were required to advance.

The remarkable thing is that the invention of the high school required almost no top-down authority from the federal government, or even from the states... "An ameliorative policy," write Goldin and Katz, "in the form of the high school movement, was embraced by thousands of individual school districts, in one of the grandest grassroots movement in US history. ...

And then (for reasons about which the authors are not nearly so clear) the US education system somehow did it all again, extending "the right to a good education" ... to mean college, in the years after World War II. The GI Bill in 1944 ... and the National Defense Education Act in 1958 broadened considerably the opportunity to attend college. State support for education grew. And a steady stream of graduates poured forth – until about 1980.

But at that point, the growth in the educated American work forced slowed down. The high school graduation rate crested at around 78 percent in 1970 and has been flat ever since. The growth in average educational attainment, which averaged about a year of extra schooling per decade from 1930 until 1980, gained less than one year in the quarter century after 1980.

Again, why? ... [T]he authors say, that the "virtues" of the American educational system have turned against themselves in some degree. Decentralization led to much greater experimentation in the nineteenth century, but the logic of supporting schools almost solely through property taxation has led to much greater inequality in per-pupil expenditure among rich and poor districts than in the past. ... Today's proposals for reform include many that run counter to traditional ideals: vouchers, charter schools, public funding for church-based schools, and "high-stakes testing with real consequences." Yet the widespread bottom-up nature of these break-away institutes, charter and magnet schools, are reminiscent of the distant (and little remembered) outlines of the grassroots academy movement.

What now? Goldin and Katz offer three broad recommendations. Improve the operation of the schools themselves, so that students are better prepared by the time they are ready for college. Make financial aid more generous for college students once they arrive. Above all, spend more heavily on better pre-school interventions such as Head Start, since of the few things on which almost all expert economists can agree is that investments in early childhood education (and prenatal healthcare) pay off at a significantly higher rate than any other measure to reduce inequality. Couple these programs with some increased aid to workers at the bottom of the wage scale in the form of more generous Earned Income Tax Credits, payroll tax relief and better access to health insurance, and it would go a long way towards ameliorating the present situation.

So that's the task for Barack Obama, assuming he is elected — to find ways to "increase the stock of educated Americans," or, to put it slightly differently, to make sure that almost every young American goes to an appropriate school. What's wanted is not some lofty top-down No Child Left Behind rhetoric, but rather a considerable welling-up from the bottom, furthered in this day and age by federal dollars, such that schools once again become places of hope for poor people, not boredom and fear. It has happened before, say Goldin and Katz. Perhaps it can happen again.


"The Ferraro Factor"

The National Review, August 10, 1984. This all sounds very familiar:

II. The Ferraro Factor Walter Mondale had to do something to halt the hemorrhaging in the polls that had been taking place since he sewed up the nomination. Geraldine Ferraro appears to have accomplished this, at least for the time being. Walter Mondale, perhaps for the first time in his political career, has done something interesting, and everyone has paused to assess it.

Announcing a vice presidential choice prior to the convention was not an entirely new idea. Ronald Reagan made a similar dramatic move in 1976, and for roughly similar reasons. As it became clear that Reagan was narrowly failing to catch President Ford in the delegate count, erosion began to take place among Reagan's own delegates. He had to do something, and he named Richard Schweiker. This was so unexpected that it stopped the erosion and even added some suspense to the Kansas City Convention.

The preliminary assessment of Geraldine Ferraro among political professionals is that she probably represents a modest plus for the ticket, but that she is also capable of talking first and thinking about it only later, and is a potential embarrassment on that account. (See also "For the Record.") The choice of a woman in itself does add a touch of color to an otherwise drab Mondale operation, and Mrs. Ferraro at once appeases the feminists and appears to be acceptable to Hart, Jackson, and other assorted factions.

Like much else at the convention, Mrs. Ferraro, somewhat paradoxically, reflects the impact of Reagan. The week before the convention she made a speech in St. Paul, Minnesota, stressing the themes of "family, faith, neighboorhood, and hard work" that Reagan made popular in 1980 and has continued to stress as President. Like Mario Cuomo, Mrs. Ferraro is religious, even conspicuously so, and the word "God" was mentioned more often at this convention than at all the Democratic Conventions combined since 1960. Mrs. Ferraro, like Cuomo, is an ethnic American, and patriotic, and both serve up Horatio Alger with an ethnic twist. Mrs. Ferraro is an orthodox liberal, but with some differentiation: She opposes busing, favors tax credits for parents who send their children to private schools, and though she wants to cut defense spending sharply, did support the Trident submarine, the Pershing II, and draft registration. Cosmetically, at least, she represents an effort on the part of the Democrats to recapture their old middle-class and ethnic constituencies. She does not come across as a quiche-eating McGovernite or as an erstwhile admirer of Castro or Ho. That picture of her standing on a big tree stump with a plaid-shirted, outdoorsy-looking Mondale could also have been a nice middle-class couple in a Reagan TV ad.

If naming Geraldine Ferraro represents a modest psychological plus for the Mondale campaign, it has not, so far at least, produced anything dramatic in the polls. Prior to Mrs. Ferraro's emergence as the nominee, an NBC News poll found that while 11 per cent would be more likely to vote for a Democratic ticket with a woman on it, 15 per cent would be less likely to do so. Some politicians see her selection as amounting to a virtual write-off of the South, where Mondale desperately needs to carry at least some states, and the payoff to Bert Lance for resuscitating Mondale in the Georgia primary is not likely to repair his prospects there.

The Democrats will attempt to project the issue as "whether a woman can be Vice President," a point the Republicans can cheerfully concede, returning to the question of whether this woman in particular should be the Vice-President. There was no aroma of affirmative action about the elevation of either Jeane Kirkpatrick, a distinguished scholar and writer, or Sandra Day O'Connor, a distinguished lawyer and regional political figure. The performance in office of both women has abundantly validated their selection. But Mrs. Ferraro is manifestly an affirmative-action nominee. She has been in the House only since 1979 and cannot be said, on the record, to be as qualified to be President, if necessary, as, say John Glenn, Fritz Hollings, Mo Udall, or -- George Bush. Indeed, her inexperience may be the explanation for her gaffes about Reagan's Christianity and the absence of a woman at the Last Supper. Once the euphoria wears off, she will face tough scrutiny.

And Gus Hall is pretty sore about all the publicity Mondale has been getting for this "historic choice." After all, Angela Davis has been his running-mate for more than two months.


"The Death of the Credit Card Economy"

Consumer credit is drying up. If consumption begins to fall because of it, what will replace it, investment, government spending, net exports -- or nothing? With credit markets as they are, investment is unlikely to pick up the slack and may fall itself, and a sustained fiscal policy response seems unlikely (and monetary policy is already doing all it can to breathe new life into financial markets). That leaves net exports. So far, so good, but how much burden can it carry?:

The Death of the Credit Card Economy, by Daniel Gross: The most revolutionary notion in commerce today is one of the oldest. If you want to buy something, you may actually have to pay for it. We are reverting from a "borrow and buy" economy to the "cash and carry" model of our grandparents. ...

Students returning to college are finding that student loans have vanished. Retailers who freely extended credit to any customer with a pulse are deploying bean counters armed with sophisticated software to sniff out potential deadbeats. And when higher rates and fees don't deter their borrowers, credit-card companies resort to slashing credit lines. "We predicted there would be some degree of spillover from the mortgage meltdown," said Curtis Arnold, founder of CardRatings.com. "But the credit line reductions by big credit card companies in the last six months have been fairly unprecedented."

This shock to the system may further damage the already-fragile psychology of the consumer. Writing a check or deducting the price of a pair of shoes directly from your bank account packs a much more potent emotional punch than charging ... on your American Express platinum card. ...

The availability of credit also changes the calculus people use to determine what they can afford. Blowing $6,000 on a week in Tuscany might be tough to swing if you have to pay for it all next month. Convince yourself it's a once-in-a-lifetime experience that you can pay for over three years, and it becomes a bargain. With credit, Saturday night means dinner and a movie. When you pay cash and have a fixed budget, it's dinner or a movie.

The tightening of credit is forcing more people to confront these uncomfortable choices. ... In effect, the lack of credit makes things seem more expensive to consumers...


"The Perverse Effects of Term Limits"

Do executive term limits increase the likelihood of inter-state conflicts? According to this research, the answer is yes:

Democracy and accountability: The perverse effects of term limits, by Paola Conconi, Nicolas Sahuguet, and Maurizio Zanardi, Vox EU: Economists have studied in depth how alternative forms of government can lead to systematic differences in outcomes (see Persson and Tabellini, 2004). Autocracies differ from democracies in their economic and political performances. In democracies, political leaders are accountable to the electorate, since periodic elections make it possible to reward or punish them for their actions at the voting booth. In autocracies, leaders escape this general scrutiny and usually rely on a military apparatus or on the support from key groups to sustain their rule.

However, this classification is too broad and does not do justice to the complexity and diversity of political regimes. As Tim Besley and Masa Kudamatsu argued last year on Vox, autocracies in which the leaders are subject to the control of key supporting groups have better economic performances than regimes in which such discipline is missing. This observation underlines the importance of checks and balances in providing incentives to guide the behaviour of political leaders. Conversely, if the fundamental principle common to all democracies is that the power resides in the people, there are a wide variety of democratic regimes. From presidential to parliamentary systems, with all possible shades in between, each democracy has its particularities that lead to large differences in leaders' accountability.

Many democracies with presidential or semi-presidential political systems impose restrictions on the tenure of their executives. Term limits may reduce the disciplining effect of electoral accountability, as politicians who cannot be re-elected have little to lose from displeasing voters and may thus behave in a more self-interested way. Term limits come in different varieties. Many countries impose "strong" term limits, which rule out re-election after a fixed number of terms. For example, since 1917 Mexico has had one-term limits, ruling out the possibility of re-election of the President altogether, while since 1951 the United States has had two-term limits, which allow re-election only once. Other countries impose "weak" term limits, which only restrict the number of consecutive terms a person can serve. For instance, since 1994 Panama has made re-election of the President possible after skipping two terms. Figure 1 shows that a significant number of countries impose strong term limits on their leaders, making it relevant to understand how this institutional feature affects policy choices.

Figure 1. Strong term limits in 2001 Zancon1 Source: Conconi, Sahuguet and Zanardi, 2008

Democratic peace and term limits

In a recent paper (Conconi, Sahuguet and Zanardi, 2008), we examine the importance of electoral accountability for international peace and cooperation, focusing on the impact of executive term limits on inter-state conflicts. One of the few stylised facts in international relations is that democratic states are much less likely to fight one another than other pairs of states. According to an often-quoted statement by Jack Levy (1988), the democratic peace phenomenon is "as close as anything we have to an empirical law in international relations." The idea that democracies do not fight each other can be traced back to Immanuel Kant's 1795 essay "Perpetual Peace". Kant's argument was that policymakers in non-democratic states are more likely to engage in conflicts because they are not constrained by electoral accountability.

What is the link between electoral accountability and the likelihood of inter-state conflicts? And if electoral accountability is the explanation for the democratic peace, is there any effect of term limits on the likelihood of conflicts? To address these questions, we describe a simple theoretical model of self-enforcing international peace. Our analysis is based on the fundamental observation that, without a supranational authority with direct powers to punish violations, governments will only refrain from aggressive behaviour if they perceive that doing so is in their interest. The use of military force is beneficial in the short-run but has long-term detrimental consequences. Each country can gain by launching an assault on another country to obtain a portion of its wealth and resources; however, once the attacked country responds by defending itself, being in a conflict is often costly for all countries involved compared to peace.

The incentives of leaders to maintain a cooperative attitude with their foreign partners differ with the type of political regime. In democracies, leaders who want to stay in power need to behave in the interest of the voters. This observation leads to predictions about the likelihood of conflict in different dyads (between autocracies, between democracies, and between democracies and autocracies). Electoral incentives create accountability and discipline policymakers. This explains the lower probability of conflict observed between democracies: the threat of losing office reduces politicians' willingness to break peaceful relations with other countries. From this perspective, term limits, which restrict the number of mandates a politician can serve in office, should hinder cooperation, since term limits reduce and can even eliminate the incumbent's benefits from future periods in office, which reduces voters' ability to punish leaders who engage in costly conflicts.

Empirical evidence

These results are intuitive and their policy implications possibly far reaching. Is there any empirical evidence to support them? To examine the impact of re-election motives on the likelihood of conflicts, we have collected information about the different types of executive term limits adopted by countries over time. Combining this information with a large dataset of inter-state conflicts over the period 1816-2001 for a total of 177 countries, we assess the validity of our theoretical predictions by comparing the conflict patterns of democracies with no term limits to those of democracies with one-term or two-term limits.

Our analysis of the determinants of inter-state conflicts provides strong support for the accountability argument. In line with the existing empirical literature on the democratic peace, we show that democratic dyads are significantly less likely to be in conflict than mixed or autocratic dyads. Crucially, however, this result does not hold for democracies in which the executive is in the last possible mandate, which are as likely to be involved in conflicts as autocracies. Thus the presence of binding term limits invalidates the democratic peace phenomenon.

There is another implication of term limits for the accountability of political leaders. Democratic leaders are accountable as long as they face election in the future. This means that in democracies with two-term limits, there should be more accountability when leaders are in their first mandate than when they are in their second mandate. We indeed find that the likelihood of conflicts in democracies with two-term limits depends on whether the executive is in the penultimate or in the last possible mandate.

Conclusions

Our analysis of the impact of term limits on inter-state conflicts confirms that domestic political institutions can have a crucial impact on economic and political outcomes. In democracies without term limits, periodic elections provide the means to hold opportunistic political leaders accountable for their foreign policy decisions. In autocracies and democracies with term limits, in which there is no need for "contract renewal", politicians can adopt unpopular policies with no repercussion on whether or not they are able to stay in power. Some caution is clearly warranted in interpreting these results. Though our analysis shows that political systems in which the leaders are subject to re-election are good for peace, this should not be taken to imply that democratisation of dictatorships will necessarily lead to peace. The take-home message, as pointed out by Daron Acemoglu, Davide Ticchi and Andrea Vindigni recently on Vox, is that policymakers should carefully consider the complexity of the political environment when trying to shape or guide the transition to democracy.

References

Acemoglu, D., D. Ticchi, and A. Vindigni (2008): "A Theory of Military Dictatorships," VoxEU.org.

Besely, T., and M. Kudamatsu (2007): "What Can We Learn from Successful Autocracies?," VoxEU.org.

Conconi, P., N. Sahuguet, and M. Zanardi (2008): "Democratic Peace and Electoral Accountability," CEPR Discussion Paper 6908.

Levy, J. S. (1988): "Domestic Politics and War," Journal of Interdisciplinary History 18, 653-673.

Persson, T., and G. Tabellini (2004): "Constitutions and Economic Policy," Journal of Economic Perspectives 18, 75-98.


links for 2008-08-31

August 30, 2008

Economist's View - 4 new articles

The Great Partisan Growth and Inequality Divides

Alan Blinder has a question for you:

Is History Siding With Obama's Economic Plan?, by Alan S. Blinder, Economic View, NY Times: Clearly, there are major differences between the economic policies of Senators Barack Obama and John McCain. Mr. McCain wants more tax cuts for the rich; Mr. Obama wants tax cuts for the poor and middle class. The two men also disagree on health care, energy and many other topics. ...

Many Americans ... are [un]aware of two important facts about the post-World War II era, both of which are brilliantly delineated in ... "Unequal Democracy," by Larry M. Bartels.... Understanding them might help voters see what could be at stake, economically speaking, in November.

I call the first fact the Great Partisan Growth Divide. Simply put, the United States economy has grown faster, on average, under Democratic presidents than under Republicans.

The stark contrast between the whiz-bang Clinton years and the dreary Bush years is familiar because it is so recent. But while it is extreme, it is not atypical. Data for the whole period from 1948 to 2007, ... show average annual growth of real gross national product of 1.64 percent per capita under Republican presidents versus 2.78 percent under Democrats.

That 1.14-point difference, if maintained for eight years, would yield 9.33 percent more income per person, which is a lot more than almost anyone can expect from a tax cut.

Such a large historical gap in economic performance between the two parties is rather surprising, because presidents have limited leverage over the nation's economy. ... But statistical regularities, like facts, are stubborn things. You bet against them at your peril.

The second big historical fact, which might be called the Great Partisan Inequality Divide, is the focus of Professor Bartels's work.

It is well known that income inequality in the United States has been on the rise for about 30 years now... But Professor Bartels unearths a stunning statistical regularity: Over the entire 60-year period, income inequality trended substantially upward under Republican presidents but slightly downward under Democrats, thus accounting for the widening income gaps over all. ...

The accompanying table, which is adapted from the book, ... shows that when Democrats were in the White House, lower-income families experienced slightly faster income growth than higher-income families — which means that incomes were equalizing. In stark contrast, it also shows much faster income growth for the better-off when Republicans were in the White House — thus widening the gap in income.

The table also shows that families at the 95th percentile fared almost as well under Republican presidents as under Democrats (1.90 percent growth per year, versus 2.12 percent), giving them little stake, economically, in election outcomes. But the stakes were enormous for the less well-to-do. ...

The sources of such large differences make for a slightly complicated story. In the early part of the period — say, the pre-Reagan years — the Great Partisan Growth Divide accounted for most of the Great Partisan Inequality divide, because the poor do relatively better in a high-growth economy.

Beginning with the Reagan presidency, however, growth differences are smaller and tax and transfer policies have played a larger role. We know, for example, that Republicans have typically favored large tax cuts for upper-income groups while Democrats have opposed them. In addition, Democrats have been more willing to raise the minimum wage, and Republicans have been more hostile toward unions.

The two Great Partisan Divides combine to suggest that, if history is a guide, an Obama victory in November would lead to faster economic growth with less inequality, while a McCain victory would lead to slower economic growth with more inequality. Which part of the Obama menu don't you like?

Here is a summary on this topic I did for the 2006 election in a WSJ econoblog with Justin Wolfers:

Mark Thoma writes: In the last 30 years, a considerable amount of work has been devoted to an area of economics known as "political business cycles." Researchers in this area look at the relationship between electoral outcomes -- the outcome of elections and the economic policies of the party in power -- and the subsequent performance of the economy.

Broadly stated, there are two kinds of research on political business cycles. One type watches how the parties that win elections -- or are in control -- affect the performance of the economy. (For an overview of seminal work in this area see this paper by Allan Drazen. Also, see more recent papers here, here and here.)

The other class of research looks at the question from the opposite side. These researchers study how the performance of the economy helps decide which party wins an election. (For a good grounding in this type of work, see some important papers here and here.)

Here are some large research findings as summed up by Drazen:

• Inflation -- In the U.S., there is evidence of a post-electoral increase in inflation prior to 1979, but no evidence thereafter.

• Monetary Policy -- There is evidence of a pre-electoral increase in money growth rates from 1960 to 1980, but none thereafter. Money growth, or the percentage change in money supply, is an important measure of monetary policy prior to 1980, when the Fed started to focus on the federal-funds rate as the main monetary policy tool. There is no evidence for the U.S. of an electoral cycle in the federal-funds rate.

• Spending on Programs -- There is evidence of pre-electoral increases in government transfers (such as food stamps, Social Security and other cash payments) and other fiscal policy spending. This appears strongest before 1980.

• Output -- There is a clear partisan effect on economic activity, with real GDP being significantly higher under Democrats than Republicans in the first half of their terms. There is no significant pre-electoral increase in aggregate economic activity, meaning there is no evidence for pre-election manipulation of the economy.

Drazen also summarizes empirical work on the second kind of research, focusing on how the performance of the economy helps to determine who wins an election. Aggregate economic conditions before an election, specifically per capita output or income growth (and to a lesser extent inflation), have a significant effect on voting patterns.

A robust finding in the political business cycle literature is the last item on the first list, stating that output tends to be higher in the first half of Democratic administrations. If this is true, then it might be expected that the stock market performs better when Democrats are in power. Evidence in favor of this hypothesis comes from this 2003 paper by Pedro Santa-Clara and Rossen Valkanov, "The Presidential Puzzle: Political Cycles and the Stock Market." In the paper, the authors look at excess returns, i.e. returns over and above the returns on Treasury bills, using data from 1927 through 1998. Their estimates show that returns are, on average, 9% higher when Democrats are in power. (See this chart of returns by political party from University of California, Berkeley professor Hal Varian's description of the paper). They note that much of the difference in returns arises from smaller firms performing much better under Democratic administrations.

Precisely why this is the case is difficult to answer. And the paper doesn't come to any strong conclusions about the driving force behind the difference in returns. Nor does it explain why the difference persists, though it does rule out a few plausible reasons for these findings. Whatever the reason for the difference in returns, the evidence suggests that returns are distinctly higher under Democratic administrations. Therefore, if you are an investor, you may want to hope for the continued reemergence of the political left and for a Democrat to win the next presidential election. ...


"What's Wrong with This Hurricane?"

At the moment, the expected path for Hurricane Gustav threatens the Gulf Coast. Is the Bush administration ready?:

What's wrong with this Hurricane?, by Moira Whelan: I just noticed that the daily brief customarily done in advance of a hurricane is ... being given by NORTHCOM. So what does this tell us and why does it matter? It tells us that things are as broken as they were before Katrina.

The military, like EPA, Commerce, or anyone else, is only involved in emergency management to the point that they are requested to do so by the governor or the FEMA director (who acts on behalf of the President).

When it comes to disasters, the governor is always in charge. At any point, he or she can call in their state's National Guard, and/or ask other governors for their help... If a governor is worried things are getting out of control, they ask the President to provide help through FEMA... FEMA is then in charge of coordinating the resources of the federal government to support the governor and the state. In a sense, when FEMA is working properly—as it did under Clinton—when the FEMA director tells another Federal agency to do something, it's as if the President is calling. The government agency is expected to deliver and cut through red tape to make things happen and happen fast.

There is no allowance or legal authority for the Department of Defense to take any sort of control or command in this scenario. In a hurricane, DoD, like Human Services, Transportation, etc, all work for FEMA and the governor of the impacted state.

This is done for a very specific and important reason: here in America, we believe that governors should have control over their own states. The federal government needs to be there to help, but they absolutely do not move in and take over. We also do not believe that the military should ever forcibly operate inside the United States unless they are under civilian control.

With NORTHCOM taking the lead on briefing the public, it's clear the Bush Administration wants to send the message that everything is under control. Instead, to those that do this for a living, the message is clear that everything is absolutely and completely broken.

Perhaps the state governments need help. Perhaps FEMA is not up to the job. Perhaps the Bush Administration simply wants a uniform on camera, and this way of doing things is preferable to things happening the way that they should (a process, by the way, that WORKED before Bush screwed it up).

NORTHCOM taking the lead in public relations is a clear indication that nothing has been fixed in DHS and FEMA since Katrina. As a result, there is no confidence in FEMA's ability to respond to this hurricane. With NORTHCOM at the helm, the Bush Administration either doesn't care if, or doesn't want, the systems to work. ...

The bottom line is that things will not work the way they should with NORTHCOM in charge. Governors don't take orders from Generals. No one else in government takes orders from DoD. No one in emergency management even knows what NORTHCOM does, except come in and issue "orders" to a bunch of civilians who don't work for them.

I hope for the sake of the people on the Gulf Coast that the hundreds of civilians who want to do right by them prevail over the system that the Bush Administration has failed to fix. ...


"Troubling Timing" and "Uncomfortable Questions"

The 'morality tale':

Hepatitis B and missing women: The rise and decline of a finding, by Stephan Klasen, Vox EU: In late 2005, a paper by Emily Oster, published in the Journal of Political Economy (JPE), claimed that the reason that China (and to some degree South Asian countries) had large female deficits was not gender differences in mortality (pre-and post-birth) – as argued by Amartya Sen and others for years – but the fact that higher prevalence of Hepatitis B carriers there led to naturally higher sex ratios at birth. Around 45% to 70% of the alleged 100 million victims of anti-female discrimination were missing due to this biological relationship. In China it was more than 75%.

The finding made waves. It not only stirred debate in academic circles but was also promoted by Robert Barro in Business Week and Steven Levitt in Slate. The intense academic debate produced at least seven further papers on the subject published in the American Economic Review, the Population and Development Review, and several working papers still in the review process. Most of them criticised particular aspects of the arguments advanced by Oster, with her replying to some of these criticisms.

A few months ago, Emily Oster posted a new paper on her web site with the title "Hepatitis B does not explain male-biased sex ratio in China" where she reports that there is in fact no link between Hepatitis B carrier status and the sex ratio at birth in China (Chen and Oster, 2008). This amounted to a complete retraction of the earlier claim. The details and arguments are summarised in my companion column on Vox and are also available in Klasen (2008). As I just told the story, there is nothing particularly unusual about it – in fact, it could appear as a shining example that the academic community is able to weed out erroneous empirical claims through further research. Moreover, Emily Oster should be commended for not only invariably responding to the many criticisms of her work, but also for undertaking new research to examine these criticisms and then retracting her claim as soon as that research made her original claims untenable.

Troubling timing

But closer inspection of the details and timing of the events leave some open and rather uncomfortable questions.

Consider the timing of events. A first draft of the paper, dated 5 February 2005 and labelled "preliminary and incomplete", was posted on her web site in early February of 2005. Oster was a second-year Ph.D. student at Harvard at the time. The paper was also sent around to people doing research in the field (including me) and several people started providing detailed comments and pointing to some of the weaknesses in the argument.

While this work-in-progress was on-going, Robert Barro took these preliminary and incomplete findings and published a column in Business Week on 28 February 2005, summarising her paper. He claimed that "biology explains a good deal of the missing-women puzzle", while previously "the presumption was that the excess mortality came from discrimination against women by men and government". There was no mention of potential problems with the data or the analysis, mostly because at that stage there had been no opportunity to scrutinise these claims at all.

A second version of the paper was produced in March and sent off for publication soon thereafter. Later it became clear that the paper had been submitted to the Journal of Political Economy, then edited by Steven Levitt. In May 2005, while Oster was (according to a message sent to me) still waiting for a first response and referee reports from the JPE, Levitt published, together with Stephen Dubner, a column in the online magazine Slate entitled "The search for 100 million missing women." There, Levitt described Oster's arguments and the way she had arrived at them. He stated: "If you believe Oster's numbers – and as they are presented in a soon-to-be-published [!] paper, they are extremely compelling – then her detective work has established the fate of roughly 50 million of Amartya Sen's missing women." Here Levitt, who is both editor of a top economics journal (with very high ranking and associated high rejection rates) and columnist for a general-interest online magazine, clearly mixes his two roles. No wonder that after the pre-announcement in Slate, the paper was then indeed accepted at the JPE later that year and published as the lead article in the last issue of 2005.

That column generated a lot of public discussion about this argument and many of the concerns raised by critics of the claims were then made public as well. In early July 2005, I joined the public discussion and posted a detailed set of comments on the findings on my web site (still available there) which I had previously sent to Oster – they are now appearing in amended fashion as Klasen (2008). In September 2005, the Population and Development Review (PDR), arguably the top journal dealing with demographic issues in developing countries, took the unprecedented step of publishing a criticism of the Oster paper by Monica Das Gupta before Oster's paper had even been published. That paper focused on a few key weaknesses of the argument, and exchanges between Oster and Das Gupta in the PDR continued in 2005 and 2006.

Similarly, other parts of the evidence were scrutinised by Abrevaya (2008), Ebenstein (2007), and Lin and Luoh (2008). That last paper, which started as a working paper in 2006 and will now be published in the December issue of the American Economic Review, posed a particular challenge to Oster's claims as it used the data of 3 million women and their off-spring to show that there was no link between mother's Hepatitis B status and the sex ratio at birth in Taiwan. This was by far the largest data set and most compelling evidence from a country with a "missing women" problem, suggesting that the link was just not there. This paper, as well as persistent criticism of her work, led Oster to undertake further research, extending a large dataset from China to tackle the issue. That research clearly showed that in China there was no link between Hepatitis B and the sex ratio at birth and thus the missing women problem.

Lessons learned

Thus after the three years of intense research, several top-level publications, two entertaining columns, and much public and private discussion, we are just about exactly where we started. We have learned a few things on the way (also about how remarkably quickly some research results make it to the public and into top journals), but maybe a consultation of a Ph.D. thesis by the (late) Anouch Chahnazarian at Princeton, published in 1986, would have obviated the need for all of this. In his dissertation, he examined factors affecting the sex ratio at birth, including the prevalence of Hepatitis B. He concluded by saying that "the negative relationship observed here between birth order and the sex ratio at birth in children of carrier parents fails to provide an explanation of the unusually high sex ratios at birth observed at higher parities in China, a country of high hepatitis B prevalence (p.135)."

References

Abrevaya, J. 2008. Are there missing girls in the United States? American Economic Review: Applied Economics (forthcoming)

Barro, R. 2005. The case of Asia's 'Missing Women'. Business Week, February 28, 2005, p.12.

Chahnazarian, A. 1986. Determinants of the sex ratio at birth. Ph.D. dissertation, Princeton University.

Das Gupta, M. 2005. Explaining Asia's Missing Women: A new look at the data. Population and Development Review 31(3): 539-535.

Das Gupta, M. 2006. Cultural versus biological factors in explaining Asia's Missing Women: Response to Oster. Population and Development Review 32: 328-332.

Dubner, S. and S. Levitt . 2005. The search for 100 million missing women. Slate, 24 May 2005.

Ebenstein, Avraham. 2007. Fertility choices and sex selection in Asia: Analysis and Policy. Mimeograph, University of Berkeley.

Klasen, S. 2005. Comments on the Paper by Emily Oster: Hepatitis B and the Case of Missing Women.

Klasen, S. 2008. Missing Women: Some Recent Controversies on Levels and Trends in Gender Bias in Mortality. Ibero America Institute Discussion Paper No. 168. Forthcoming in Basu, K. and R. Kanbur (eds.) Arguments for a better world: Essays in honour of Amartya Sen. Oxford: Oxford University Press (forthcoming).

Lin, M-J. and M-C. Luoh. 2008. Can Hepatitis B mothers account for the number of missing women? Evidence from 3 million newborns in Taiwan. American Economic Review (forthcoming).

Oster, E. (2005). Hepatitis B and the Case of Missing Women. Journal of Political Economy 113(6) 1163-1216.

Oster, E. (2006). On Explaining Asia's Missing Women: A reply to Das Gupta. Population and Development Review

Oster, E. G. Chen, X. Yu and W. Lin. 2008. Hepatitis B does not explain male-biased sex ratio in China. Mimeographed, University of Chicago.


links for 2008-08-30

August 29, 2008

Economist's View - 7 new articles

Tax Cuts and Government Investment

Richard Serlin:

A dollar spent on tax cuts costs more than a dollar over the long run, a lot more., by Richard Serlin: With regard to ... "The Whole Analysis Sounds Pretty Fishy": So the the right wing propaganda tank, Tax Foundation, claims that tax cuts recover up to 40% of their costs through so-called dynamic effects, while Bush's own Treasury Department estimated less than 10%. Even if it actually were 40%, are tax cuts a good idea, especially tax cuts going predominantly to the rich and extremely rich? They're still costing the government 60% that can't go to many extremely high social return projects that the free market won't undertake due to market imperfections that are well established and proven in economics (real, scientific, academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts. Suppose we consider continuing Republican policies and spending another 1 trillion on tax cuts for the rich. Even if 40% were recovered (and in the long run, as opposed to just looking at short run effects, the dynamic effects go in the opposite direction -- a dollar in tax cuts ends up costing a lot more than a dollar in government revenue if that means a dollar, or even 60 cents, less in investment in high return government projects.). The vast majority of the tax cuts, it has been shown, will eventually be spent on consumption items of little long run investment value -- leaving little to show or to grow. If instead, even just 60% of that 1 trillion were spent by the government on extremely high social return investments like infrastructure, education, basic scientific and medical research, alternative energy, etc., then 10 or 20 years from now that 600 billion could result in many trillions, or even tens of trillions more in national wealth, as opposed to having the whole 1 trillion spent on rapidly depreciating Ferraris and yachts, and ultra luxury vacations and other things for the rich that have little or no productive value. In the long run, a dollar spent on tax cuts for the rich, instead of badly needed social investment puts us one more step closer to losing our status as the most wealthy and modern nation, and over the long run, like any other decision to increase frivolous consumption at the expense of high return investment, it costs us a lot more than a dollar, not less.

He has a follow-up post here.


"Big Misconceptions about Small Business and Taxes"

Would allowing the Bush tax cuts to expire harm small businesses?:

Big Misconceptions about Small Business and Taxes, by Chye-Ching Huang and James R. Horney, CBPP: Supporters of various tax benefits for high-income households often claim that failure to maintain them would have an undue effect on many small businesses. ...

This paper analyzes these claims. It likely overestimates the number of small businesses adversely affected by changes to the top two marginal tax rates, the estate tax, and loopholes available to hedge-fund managers because it: (1) adopts an extremely generous definition of "small business" ... and (2) does not consider many valuable tax breaks that small businesses and small-business owners enjoy... Yet it still finds that the claims typically made about small businesses and taxes are highly exaggerated, misleading, or false.


Paul Krugman: Feeling No Pain

The first step in fixing problems is to acknowledge they exist:

Feeling No Pain, by Paul Krugman, Commentary, NY Times: My first reaction to Bill Clinton's convention speech was sheer professional jealousy: nobody, but nobody, has his ability to translate economic wonkery into plain, forceful English. ...

My second reaction was that in Mr. Clinton's speech ... one heard the fundamental difference between the two parties. Democrats ... believe that working Americans are getting a raw deal; Republicans, despite occasional attempts to sound sympathetic, basically believe that people have nothing to complain about.

As it happens, the numbers support the Democrats. ...

[A recent] Census report gives a snapshot of the economic status of American families in 2007 — that is, before the financial crisis started dragging the economy down.... It's a given that 2008 will look much worse, so last year was as good as it will get in the Bush years. Yet working-age Americans had significantly lower median income in 2007 than they did in 2000. ... Meanwhile, poverty was up, and health insurance — especially the employment-based insurance on which most middle-class Americans depend — was down.

But Republicans, very much including John McCain and his advisers, don't believe there's a problem.

Former Senator Phil Gramm made headlines, and stepped down as co-chairman of the McCain campaign, after he described America as a "nation of whiners." ... Mr. Gramm, by all accounts, remains a key economic adviser to Mr. McCain.

Last week John Goodman, an influential figure in Republican health care circles, explained that we shouldn't worry about the growing number of Americans without health insurance, because there's no such thing as being uninsured. After all, you can always get treatment at an emergency room. And Mr. Goodman — he's ... often described as the "father of health savings accounts," a central feature of the Bush administration's health policy — wants the next president to issue an executive order prohibiting the Census Bureau from classifying anyone as uninsured. "Voilà!" he says. "Problem solved."

The truth, of course, is that visiting the emergency room ... is no substitute for regular care. Furthermore,... a hospital ... will also bill you — and the bill won't be waived unless you're destitute. As a result, uninsured working Americans avoid visiting emergency rooms ... because they're terrified by the potential cost: medical expenses are one of the prime causes of personal bankruptcy. ...

[I]t's a good bet that Mr. McCain's inner circle shares Mr. Goodman's views. You see, Mr. Goodman's assertion that lack of health insurance is no problem precisely echoed what President Bush said a year ago: "I mean, people have access to health care in America. After all, you just go to an emergency room." That's because both men — like Mr. Gramm — were just saying in public what modern Republicans say when they talk to each other. Despite attempts to feign sympathy, the leaders of today's G.O.P. fundamentally feel that Americans complaining about their economic and health care difficulties are, well, just a bunch of whiners.

And that, ultimately, even more than their policy proposals, is what defines the difference between the parties.

It's true that elected Democrats are often too cautious — and too beholden to major donors — to be as progressive as the party's activists would like. But even in the face of a Republican Congress, Mr. Clinton succeeded in pushing forward policies, like the State Children's Health Insurance Program, that did a lot to help working families.

And what one sees on the other side is a total lack of empathy for and understanding of the problems working Americans face. Mr. Clinton, famously, felt our pain. Republicans, manifestly, don't. And it's hard to fix a problem if you don't even think it exists.


"The Way We Gentrify Now"

Edward Glaeser reviews Derek Hyra's "The New Urban Renewal: The Economic Transformation of Harlem and Bronzeville":

The Way We Gentrify Now: Derek Hyra's 'New Urban Renewal', by Edward Glaeser, Book Review, NY Sun: ...For decades, Republicans and Democrats with presidential aspirations have repeatedly made commitments to bring back troubled places, such as Detroit and upstate New York. Local leaders have long justified expensive projects, such as monorails and sports stadiums, with claims that they can bring economic vitality to depressed areas.

But ... it is rarely good policy. ... If firms are more productive in New York City or Silicon Valley, then why is it sensible to bribe companies to move ... to a less economically productive region of the country?

Not only do place-based policies fail to make the economy more productive, they may also fail to improve the lives of people who actually live in the impacted area — the putative beneficiaries of the policy initiative. ... In some cases, subsidizing an area can hurt the citizens in that area, raising the cost of living and pushing up rents.

Derek Hyra's "The New Urban Renewal: The Economic Transformation of Harlem and Bronzeville" examines two neighborhoods, New York's Harlem and Chicago's Bronzeville, where increasing prosperity harmed at least some of the long-standing residents. ...

As these cities have done well, demand for space has exploded. We see rising demand in the skyrocketing price of space... Upwardly mobile urbanites, priced out of more expensive areas, have become urban pioneers "gentrifying" areas that used to be poor. But just as the real pioneers weren't always such a blessing for the American Indians on the frontier, gentrifiers aren't always a boon for the established residents of an area.

Mr. Hyra reminds us that the changes in Harlem and Bronzeville don't simply represent the free market at work. Both ... received federal subsidies as "Empowerment Zones," which were meant to encourage economic activity in small geographic areas. These zones are classic place-based policies that offer tax breaks to firms that relocate to or remain in particular places. Chicago has also torn down great swaths of public housing, displacing thousands, and turned the land over for private development. New York ... has also seen displacement as some projects have been privatized.

Mr. Hyra's main thesis is that many people in Harlem and Bronzeville have been hurt by the transformation of these neighborhoods. ...

The best statistical research on Empowerment Zones, done by Patrick Kline at Yale, delivers a ... mixed message: Employment in the affected areas increases, but wages do not, and rents rise significantly. Those renters who were already employed before the zone took effect lose out because their costs of living rise but their income does not.

Of course, the fact that some people lose from gentrification doesn't mean that ... property markets should somehow be frozen. It is unfortunate that not everyone wins from economic change, but the right way to address poverty is to bolster the social safety net everywhere, not to stop cities from becoming richer.

Mr. Hyra's chronicle of the costs of urban transformation has more policy bite when he turns to ... Chicago's destruction of public housing projects. Some Chicago projects ... had become synonymous with poverty and social distress. Tearing them down may have been the right decision, but we should weigh costs and benefits carefully. Not everyone benefits when public housing is destroyed. ...

Mr. Hyra's ... does not render a verdict on Empowerment Zones or public housing or gentrification. Instead, he ... reminds us that the growing prosperity of a place may leave many people behind. It is wise to keep this in mind when some politician starts lauding the place-making potential of a monorail.


"The Growth Future – India and China"

Arvind Subramanian says when it comes to sustaining economic growth, China is likely to do better than India:

The growth future – India and China, by Arvind Subramanian, Vox EU: Can China and India sustain their current growth rates? A traditional answer to this question is conditional: yes, provided they continue to implement policy reforms. But historical experience allows a less guarded answer. There are few examples of countries that have grown as strongly and for such long periods as India and China have – 6% and 10%, respectively, for nearly three decades – and then suffered a sharp slowdown or collapse. If history is a reliable guide, then barring major upheavals, economic growth looks likely to continue in both countries until some threshold level of prosperity is attained.

But why does growth beget more growth? One mechanism is simply that growth signals the fact of profitable economic opportunities, which encourages investors to rush in, first in response to these opportunities but then in response to each other – this is growth as a confidence trick – creating a virtuous circle. If countries are relatively poor, if their markets are large, and if their policy framework is basically sensible – all of which are true of China and India – the chances of the growth-begetting-growth dynamic taking hold are high.

But in addition to the signalling effect, growth may itself cause changes which have in turn a growth-reinforcing effect – a kind of positive feedback loop. A good example is education. For long, development economists bemoaned the poor levels of educational attainment in India, directing their critique at the government's failure to supply better education. But economic growth changed the education picture dramatically. It increased the returns to, and hence the demand for, education. And if government supply remained weak, consumers simply turned to the private sector to meet their demand for education. Improvements in educational attainment over the last 15 years are attributable in part to more rapid growth.

An important question then is whether India and China can take the positive feedback loop for granted, especially in relation to two key determinants of long-run growth: state capacity or effectiveness and the private sector's entrepreneurial capacity. In other words, is it inevitable that over time growth will itself improve the quality of private entrepreneurship and public institutions? Consider each in turn.

Policy reforms have created the conditions for the private sectors in both countries to flourish. Yasheng Huang of MIT in his new book, Capitalism with Chinese Characteristics, argues that the Indian private sector, especially the indigenous part, is more efficient and entrepreneurial than its Chinese counterpart.

One crude measure of relative sophistication or entrepreneurial capability is how much direct investment (FDI) these countries are exporting, especially to the richer countries and especially in sophisticated sectors. Based on new data on mergers and acquisitions, Aaditya Mattoo of the World Bank and I calculated that India's FDI exports to the OECD countries overall and even in the manufacturing sector were substantially greater than China's (measured as a share of GDP). China is rightly considered the world's manufacturing powerhouse and export juggernaut, and yet in the manufacturing sector, Indian entrepreneurial and managerial capital (in the form of FDI) has been more successful than China's in taking control of and managing assets in the sophisticated markets of Europe and the US. So, while both private sectors have improved, India can claim today that it is ahead of China in fostering entrepreneurial capitalism.

Turn next to institutions. In the case of China, the focus of the world, and indeed the disappointment, has been the absence of the positive political feedback loop: growth and the attendant economic freedoms have not led to greater political development and openness. Implicitly, there has been less concern about the effect of growth on the state's economic capacity. Over the last thirty years, the Chinese state has successfully created physical infrastructure and delivered essential services.

Contrast that with the Indian experience. While there are many exceptions, and at the considerable risk of over-generalising, the Indian state despite rapid economic growth has deteriorated over time. Whether it is providing basic law and order, or ensuring sanctity of contract, or delivering public services, the stench of decline is hard to ignore. For example, on a crude measure of government effectiveness on which I compiled data across time, India's performance declined sharply: in the early 1960s, India was in the top fifth percentile of countries in the sample, slipping to the middle of the pack in recent years. The education example discussed earlier is an exception to the growth-institutions dynamic, made possible only because of private alternatives to state supply. For the core public sector functions, where such an alternative does not exist, the growth-institutions dynamic has been weak or non-existent.

So, growth in India has come with a more entrepreneurial private sector but accompanied by deteriorating state capacity. China has a vastly superior state capacity but an indigenous private sector that is still finding its feet. Which combination augurs better for the future?

There is a fundamental asymmetry between state and markets. It is easier to create markets than it is to create state capacity or to prevent its deterioration. Creating markets is a lot about letting go, establishing a reasonable policy framework, and allowing the natural hustling instinct to take over. In other words, hustling is the natural state. Building state capacity, on the other hand, is quite different. It involves overcoming collective action problems, mediating conflict, creating accountability mechanisms where outputs are multiple and fuzzy and links between inputs and outputs murky, and contending with the deep imprints of history. In Weber's memorable words, building public institutions is like the "slow boring of hard boards".

In that light, China's task of improving its private sector seems easier to accomplish than India's task of arresting institutional decline. So, while China and India can probably both count on more years of high growth, the odds still favour China pulling off that feat than India. That, and not just the meagre medal tally, should be what India mulls over after the Beijing Olympics.

Editors' note: This column first appeared in the Business Standard.


The Market What?

I am apparently the victim of an insidious force and desperately in need of an exorcism.


links for 2008-08-29

August 28, 2008

Economist's View - 5 new articles

The Market What?

I am apparently the victim of an insidious force and desperately in need of an exorcism.


How Much Day-to-Day Variation Should We Expect in the Gallup Poll?

Here's something that might help you to understand what Brad DeLong is talking about when he discusses the expected variation in the daily Gallup poll results (he follows up here). I'll just do one or two of the calculations to show how it's done, it's easy to take it from there.

Let the poll result at time t be Pt. Brad has noted this has a standard deviation of 1.67 percent. Note this implies the variance of the daily poll is is var(Pt) = σ2 = (1.67%)2 = (.0167)2 = .000277.

1. First, where does the 1.67 percent figure come from?

To get this number, remember that the variance of P can be calculated as:

Var(P) = E(P2)-[E(P)]2

we know that E(P) = 1/2 from the assumption Brad made, so this is

Var(x) = E(P2)-[1/2]2 = E(P2)-1/4

What is E(P2)? It is (see, e.g. here, though you have to divide the value they give by n2 since this is the proportion, i.e. the sum divided by n, rather than the sum itself):

[E(P)]2 = (1/n)*[pr(npr - pr + 1)] where the sample size is n=900 and the probability of P occurring is pr=1/2 in this example. Then

Var(P) = E(P2)-[1/2]2 = [(1/n)*[pr(npr - pr + 1)]] -1/4

or, plugging in,

Var(x) = [(1/900)*[.5(900*.5 - .5 + 1)]] -1/4 = (225.25/900) - 1/4

Var(x) = .250277778 - .25

Var(x) = .0002777778.

Take the square root of the variance to get the standard error:

sqrt(.0002777778) = .01666667.

Thus, the standard deviation is 1.67%

2. Next, how is the variance of the daily polls calculated?

The polls are reported as three day averages, so at time t Gallup reports:

Xt = (1/3)*(Pt + Pt-1 + Pt-2)

So the reported poll result is the simple average over a three day time period.

To calculate the variance of the daily poll:

Var(Xt ) = Var[(1/3)*(Pt + Pt-1 + Pt-2)]

Var(Xt ) = (1/9)*Var[Pt + Pt-1 + Pt-2]

and with the assumption that the polls each day are independent, the cross-product terms (covariances) vanish, so this becomes (with an assumption of homoskedasticity, or equal variances at each point in time):

Var(Xt ) = (1/9)*[Var(Pt) + Var(Pt-1) + Var(Pt-2)]

Var(Xt ) = (1/9)*[σ2 + σ2 + σ2] = (1/9)*[3σ2 ] = (1/3)σ2

where var(Pt) = σ2 = (.0167)2 = .0002778.

3. How much day-to-day variation should we expect in the Gallup poll?

Now, Brad is looking at the variance in the difference in poll results day-to-day. The question is how much day-to-day variation should we expect in the Gallup poll? By calculating the variance of the difference in the averages on consecutive days, we can answer that question.

Start with the day-to-day difference in the results:

Xt - Xt-1 = [(1/3)*(Pt + Pt-1 + Pt-2)] - [(1/3)*(Pt-1 + Pt-2 + Pt-3)]

Canceling terms leaves:

Xt - Xt-1 = [(1/3)*(Pt - Pt-3)]

Now calculate the variance:

Var[Xt - Xt-1] = Var[(1/3)*(Pt - Pt-3)] = (1/9)*[Var(Pt) + Var(Pt-3)]

Therefore,

Var[Xt - Xt-1] = (1/9)*[σ2 + σ2] = (2/9)σ2.

(for a two day difference, Xt - Xt-2, something else Brad talks about, it comes out (4/92, for three days it's (6/9)σ2, and so on).

Let's apply this. Plugging in the value for the variance Brad uses:

Var[Xt - Xt-1] = (2/9)*(.000278) = .0000617.

Take the square root to get the standard deviation:

sqrt{Var[(Xt - Xt-1)]} = .007857 = .7857%.

This is the .79 percent value Brad uses when he says:

(1) The standard deviation of the difference between today's sample and the sample of three days ago should be 2.35%--meaning that the daily change in the moving average has a standard deviation of 0.79%. only a one-day change in the moving average of 2% is interesting--smaller changes are likely to be statistical noise from a hypothesis-testing point of view.


GDP Growth Revised Upward

Reactions to today's announcement that second quarter GDP growth has been revised upward from 1.9 percent to 3.3 percent:

A booming economy?, by Andrew Leonard: The Department of Commerce has revised its figures for second quarter GDP growth rate to 3.3 percent, up from the previously reported 1.9 percent, and a significant rise from the first quarter's 0.9 percent growth rate. 3.3 percent GDP growth rates are not normally associated with recessions.

One early reaction:

"Ha ha ha. And if you believe that data, I also have a bridge for sale in Brooklyn." -- The Big Picture.

The Economist's Free Exchange sheds a little more light:

It's a big flashy number, but it probably doesn't mean all that much. The first second-quarter GDP revision is in, and the 1.9 percent growth rate has been pushed up to an incomprehensible 3.3 percent. Quarterly growth was due almost entirely to exports, without which the economy would have been roughly flat. Bad news, since the dollar is rising and the rest of the world is tightening the purse strings.

As noted here when the Commerce Department released its first guess at the quarterly GDP numbers, "Trade, in other words, is the current American lifeline."

Bloomberg:

The smallest trade deficit in eight years was the biggest contributor to growth last quarter. The trade gap narrowed to a $376.6 billion annual pace and added 3.1 percentage points to growth, the most since 1980.

But free-trade fans shouldn't expect the new numbers to change any hearts and minds, in, say, Ohio. The total number of Americans receiving unemployment benefits reached a five-year high of 3.4 million. According to Calculated Risk, "By this measure, the economy is clearly in recession."

Dean Baker focuses on what it means for manufacturing:

Machinery Leads Rise in Durable Goods Orders, Beat the Press: There was a more rapid rise in durable goods orders in July than most economists had predicted. While this rise received considerable attention, and seems to have sparked a rally in financial markets, the media largely overlooked the 4.6 percent increase in orders for machinery, which was one of the largest sources of the increase.

Machinery has seen the strongest growth in orders this year, with an 11.0 percent increase year-to-date compared with 2007. (Primary metals has had a somewhat larger rise, but this is likely due in large part to higher prices.) The machinery orders are presumably associated with an increase in manufacturing capacity. Increased demand for manufacturing is in turn likely the result of the improved competitiveness of the United States due to the fall of the dollar.

...It appears that the declining dollar is having the predicted effect on manufacturing, which is the best hope for a sustained recovery from the current downturn.

Real Time Economics at the WSJ says not so fast:

Don't Turn Off Recession Siren Yet, Real Time Economics: Although revised second quarter gross domestic product figures released Thursday suggest the U.S. is nowhere near a recession and may even have grown faster than its noninflationary potential, an alternate measure the Federal Reserve looks at shows significant weakness.

GDP swelled 3.3% at an annual rate in the second quarter, ... meaning the economy grew at more than a 2% annual rate during the first half of the year — a time when many economists, including Federal Reserve staff, thought it would shrink.

But the forecasts of a shrinking economy may not be so far off the mark after all. Gross domestic income, which Fed officials have in the past highlighted as perhaps a better measure than GDP, advanced just 1.9% at an annual rate last quarter after contracting the two previous quarters. Thursday's report is the first to show first quarter GDI in the red. ...

GDP is a consumption-based measure, adding up consumer, business and other spending and investment as well as net exports. GDI is income-based, adding up things like personal income and corporate profits. ...

In theory, the two should equal each other, but they don't always. ... The difference between GDI and GDP is more than just academic.

In a Fed paper released last year, Fed economist Jeremy Nalewaik wrote that "real-time GDI has done a substantially better job recognizing the start of the last several recessions than has real-time GDP."

Fed officials have even taken notice. ...[I]t seems likely that Fed officials will ... take 3%-plus GDP growth with a big grain of salt.

And there are other signs that support this view. From yesterday's WSJ:

Worker Confidence Sinks To '01 Recession Level, WSJ/AP: American workers' confidence in the job market is as low as it was during the 2001 recession, according to a new survey.

When asked whether this is a bad time to find a quality job, 65% said it was, matching the level of the 2001 recession, according to the survey by Rutgers University ... released Thursday.

With unemployment at 5.7%, the highest level since 2004, and with weekly unemployment claims hitting a six-year high earlier this month, workers are worried about everything from their weekly hours to their total pay. ...

The survey found one-third of workers said they often don't have enough money to make ends meet.

About one-third of respondents say the amount they owe on credit cards exceeds their retirement savings; another 3% say their credit-card debt would cancel out their retirement account...

Only half of respondents said they are working the number of hours they want to work and a third say there has been a change in the number of hours they work in the past three months. Eighteen percent were working more hours, and 14% worked fewer.

I don't think the picture is completely clear yet, the signs from labor markets are much weaker than the GDP revision suggests. Even after today's revision, which won't be the last revision for this data point in the GDP series, the view is still pretty cloudy.

Update: Menzie Chinn adds "Why Does It Feel Like a Recession?":

It's clear that the amount that we're expending on (from consumers, businesses, and government) is barely growing... So the factories may be humming, but that's because exports are up, thereby illustrating how much continued growth in GDP depends upon the trends in the rest of the world.

Figure 4 illustrates why... It's because the prices for what we produce have diverged in a significant way from the prices for what we consume.

To me, this last outcome is not a surprise [3] (pdf). When a country consumes much more than it produces, then at some point, it has to repay some of the debt incurred. Repaying involves producing more than consuming. We're not even at that point yet -- we're merely moving toward producing more than we're consuming. How much longer the process will continue, and how far (i.e., will we actually run a trade surplus in the foreseeable future?) depends on a lot of things, including the desirability of American assets, and hence how much foreigners want to lend to us. ...


Why Do We Use Core Inflation?

There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment).

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined, but generally a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices).

However, in the Taylor rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here). That is, volatile prices such as food and energy are essentially tossed out of the index.

Another feature is that the indexes often include both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better.

The core inflation rate you see in the news, the one that strips out food and energy, should be though of as a short-hand, quick measure of all three of these concepts. But in each case the Fed uses measures (formally or informally) designed to best satisfy these three functions. For example, when it forecasts future inflation, it uses a different concept of core inflation than it uses in setting policy.

The Fed paper linked above is one example of how the Fed searches for the optimal way to predict future inflation. All that matters for policy is finding the most accurate way to predict inflation, and they will use whatever definition of inflation is best suite for this job. There is evidence that core inflation is best and that's why it is used, but it is a statistical question and didn't have to come out that way (and the best measure of core inflation may not be simply stripping out food and energy - also, there are different measures of prices to choose from, e.g. the CPI and the PCE).

When it comes to setting policy, the Fed doesn't formally use a Taylor rule, though they certainly have Taylor rule estimates in the information they use when considering policy moves, instead they look at a variety of measures of inflation (both core and total), and they look at the rate of change in input prices such as wages and commodities (e.g. oil) as well. They then weight each of those pieces of information in some way (and hence construct an implicit index of all of this information), and then set the federal funds rate accordingly. While I have no way of knowing if the weights they use are optimal, this is exactly what the theoretical models say they should do. But the point is that it is some implicit combination of all of this information that matters for policy, and hence this core measure is very different from the core measure that is best at predicting future inflation alone.

The core inflation rate you see in the news, the CPI less food and energy, does do a fairly good job of representing the information the Fed uses to forecast future inflation, i.e. it is a measure of the trend rate of inflation (but not the best one), and it also does well at approximating the information the Fed will use to set policy, but the actual process it uses is more complicated than this and the Fed employs measures that are specialized for the job at hand.

Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same. For a nice discussion of this topic, see this speech given yesterday by Dennis Lockhart, President of the Atlanta Fed:

Inflation Beyond the Headlines, by Dennis P. Lockhart, President, Federal Reserve Bank of Atlanta: ...Let me begin by posing the simple question: What do we mean by "inflation"? The answer to that simple question isn't as simple as it may seem.

The popular treatment of inflation in our sound bite society risks confusing inflation with relative price movements and the cost of living. By cost of living, I'm referring to the costs you and I incur to maintain our level of consumption of various goods and services including essential items such as food, gasoline, and lodging.

Relative price movements occur continuously in an economy as individual prices react to market forces affecting that good or service. Neither relative price movements nor sustained high living costs constitute inflation as economists commonly use the term....

And I think I'll end with this part of his remarks:

Attempts to measure the aggregate rate of price change—no matter how sophisticated—remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty—especially when making decisions in real time. Discerning accurately the underlying trend is difficult. It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.


links for 2008-08-28