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November 24, 2009

Economist's View - 6 new articles

Changes in the Composition of Consumption

I was curious how the the composition of durable and nondurable goods consumption changes during recessions. This graph shows the monthly variation in the ratio of nondurable to durable consumption since 1959 (click on figures for larger versions):

Nondurable.to.durable

And, for a better comparison over time, the log of the ratio:

Log.nondurable.to.durable

As you can see, there has been a fairly consistent decline in this ratio over time, from about 7 dollars of nondurables per dollar of durables in 1960 to close to 2 dollars in nondurables per dollar of durables today. But there is also variation around the declining trend. Most of the deviation around the trend appears to be due to recessions, but there are also time periods such as the late 70s and the late 80s where the series takes noticeable upward turn outside of recessionary conditions (and in other cases the increase in the ratio appears to lead -- as opposed to being caused by -- the recession, e.g. in the 69-70 and 73-74 downturns). In most recessions the ratio rises as consumers cut back on durables more than they cut back on nondurables, and the ratio falls once the recession ends (the 2000 recession is an obvious exception).

What has happened in this recession? In the earlier part of the downturn, the ratio rose abruptly (this is the unlogged series). It then fell sharply in August of this year, and increased again in September. The dip in the ratio this August appears to be due to the Cash for Clunkers program:

Nondurable.to.durable.2000

What will happen after the crisis? If the economy grows as before and as incomes grow along with it, there's no reason to rule out the possibility that the ratio will continue to decline. So it will be interesting to see if the economy picks up this long-run downward trend again once things return to (the new?) normal. In the meantime, though I'm not quite sure what to make of this ratio, whatever good news might have been taken from its sharp decline in August was surely tempered in September.


"The Competitive Male Warrior Stereotype"

Does competitive behavior come from nurture or nature?:

Competition and Context, by Catherine New, Columbia Business School: It's nurture, not nature. At least when it comes to competition and gender, new research suggests. In a recent column in Slate, professor Ray Fisman discussed a study (PDF) by economists that demonstrates that the competitive male warrior stereotype, prevalent in Western culture, may not be universal.

The study looked at the Khasi community of northeast India, where inheritance and social status are passed through daughters. Khasi women were more competitive than men in the same group when they competed in a ball-toss game, the research showed. Why is that? Fisman writes:

The authors suggest that it may stem from the relatively uncommon practice of female-directed household decision making and inheritance. In the Khasi society, women who learn to compete for resources get to keep the fruits of their efforts, and also pass on the wealth they generate to their daughters. Regardless of the underlying cause … [the study] proves that the Western stereotype of the male competitor isn't universal: The male "warrior instinct" is a matter of socialization rather than instinct.

Adding another dimension to the competition debate is new research from Pranjal Mehta, a postdoctoral research scholar in the Management division at Columbia Business School, Elizabeth V. Wuehrmann and Robert A. Josephs.

Their study, published in the journal Hormones and Behavior, examined the effect of testosterone on competitive performance. In the study of 30 men and 30 women, participants completed analytical reasoning tests in both individual and intergroup competition. The researchers' findings showed that the higher the participant's level of testosterone, the better the performance in individual competition; however, high testosterone had the opposite effect for intergroup competition. In other words, social context appears to moderate the relationship between testosterone and performance.

Taken together, these studies might nudge us closer to the conclusion that the debate is neither nurture nor nature, but some intricate combination therein, where socialized expectations and incentives interplay with physiology. ... Competitive success might be a matter of incentive alignment, not chromosomes.

Update: Just noticed this opinion piece at the Financial Times: Alpha males must trade on more than machismo which opens with:

"Male traders, like animals in the wild, take more risk when their testosterone levels rise. Research by myself and my colleagues found that moderately elevated levels of this hormone increased the profits of high-frequency traders – although at higher levels it can cause overconfidence and risky behavior, morphing traders into Masters of the Universe. What we could not say, however, was whether testosterone was having its beneficial effects by increasing the trader's skill or merely by increasing his appetite for risk. In a study published on Wednesday in PLoS ONE we found that testosterone had little to do with trading skill. ...


Black Friday as a Price Discrimination Scheme?

[I'm between classes, so as with the other posts today I don't have time to say much, but I suppose -- or at least hope -- that "echo mode" is better than not posting anything at all.]

I fully agree that price discrimination schemes are far more prevalent than people realize (some are disguised as two-part pricing schemes, e.g. cell phone contracts where there is a fixed amount for usage up to some point, and then high fees for anyone who goes beyond the fixed allocation is way for producers to extract surplus from consumers):

Price Discrimination Explains Everything, by Arnold Kling: In my high school economics class, my students asked me to explain why there are sales on "Black Friday." The class period was over, so I only had time to blurt out "price discrimination" without getting into an explanation of what it is and why it explains sales.
I think that price discrimination really deserves a lot more attention than it gets in the economics curriculum. A lot of "economic naturalist" sorts of questions are correctly answered by appealing to the concept of price discrimination. I think it explains airline pricing, credit card pricing, cable TV pricing, cell phone pricing, movie popcorn pricing, etc.
Suppose that a new video game console comes out. BZ likes video games, but he is only willing to pay about $200 for the console. JS lives for video games, and he would pay $400 for the console. The manufacturer would like to charge $400 to JS and $200 to BZ. However, to do so blatantly would be illegal. It might also be impractical--what is to stop BZ from buying two consoles for $200 and selling one of them to JS for much less than $400?
The console maker looks for ways to price discriminate. There might be a "standard" version of the console that sells for $200 and a "deluxe" version that sells for $400. If the features in the deluxe version appeal to JS but not to BZ, this will work. Or the maker might release the console initially at a price of $400, wait three months, and cut the price to $200. If BZ is willing to wait but JS is not, then this will work.
Back to the original question, temporary sales are often a tool for price discrimination. If you need something now, you have to buy it whether or not it is "on sale." But if the purchase is discretionary, you may only buy it "on sale." The store keeps its prices high ordinarily, in order to pick up profits from the price-insensitive shoppers. The store puts items "on sale" on rare occasions, hoping to pick up profits from price-sensitive shoppers. Unfortunately, they lose profits from price-insensitive shoppers who happen to come in the day of the sale.
The beauty of holding sales on "Black Friday" is that stores know that many price-insensitive shoppers will stay away in order to "avoid the crowds." So you can get revenue from price-sensitive shoppers without sacrificing profits from price-insensitive shoppers.

[Ten previous posts on price discrimination.]


"Escaping the Fossil Fuel Trap"

Michael Spence says developed countries should pay the cost of reducing carbon emissions, including paying for abatement measures in developing countries:

Escaping the Fossil Fuel Trap, by Michael Spence, Project Syndicate: ...[The] use of fossil fuels, and hence higher CO2 emissions, seems to go hand in hand with growth. This is the central problem confronting the world as it seeks ... to combat climate change. Compared to the advanced countries, the developing world now has both low per capita incomes and low per capita levels of carbon emissions. Imposing severe restrictions on their emissions growth would impede their GDP growth and severely curtail their ability to climb out of poverty.
The developing world also has a serious fairness objection to paying for climate-change mitigation. The advanced countries are collectively responsible for much of the ... carbon in the atmosphere... As a consequence, the developing world's representatives argue, the advanced countries should take responsibility for the problem.
But a simple shift of responsibility to the advanced countries by exempting developing countries from the mitigation process will not work. ... If developing countries are allowed to grow, and there is no corresponding mitigation of the growth in their carbon emissions, average per capita CO2 emissions around the world will nearly double in the next 50 years, to roughly four times the safe level... Advanced countries by themselves simply cannot ensure that safe global CO2 levels are reached. ...
So the world's major challenge is to devise a strategy that encourages growth in the developing world, but on a path that approaches safe global carbon-emission levels by mid-century. ...
These considerations suggest that no emission-reduction targets should be imposed on developing countries until they approach per capita GDP levels comparable to those in advanced countries. ...[A]dvanced countries ... should be allowed to fulfill their obligations, at least in part, by paying to reduce emissions in developing countries (where such efforts may yield greater benefits). ...
The best way to implement this strategy is to use a "carbon credit trading system" in the advanced countries, with each advanced country receiving a certain amount of carbon credits to determine its permissible emission levels. If a country exceeds its level of emissions, it must buy additional credits from other countries... But an advanced country could also undertake mitigation efforts in the developing world and thus earn additional credits...
Such a system would trigger entrepreneurial searches for low-cost mitigation opportunities in developing countries, because rich countries would want to pay less by lowering emissions abroad. As a result, mitigation would become more efficient...
Conflict between advanced and developing countries over responsibility for mitigating carbon emissions should not be allowed to undermine prospects for a global agreement. A fair solution is as complex as the challenge of climate change itself, but it is certainly possible.


"Bad Forecasters Can be Good Policymakers"

Marty Ellison and Thomas Sargent defend the FOMC:

Bad forecasters can be good policymakers, by Martin Ellison and Thomas J. Sargent, Vox EU: The value of the Federal Reserve's Open Market Committee (FOMC)1 has recently been questioned in a highly provocative paper by two professors at the University of California, Berkeley. The two professors are husband-and-wife team Christina and David Romer, who are amongst the most influential economists in the world today. Christina Romer is Chair of the Council of Economic Advisers in the Obama administration and a co-author of Obama's plan for recovery, and David Romer is the author of a very popular macroeconomic graduate textbook. Their paper was published in The American Economic Review, arguably the most influential journal in economics.

The Romers criticize the FOMC because of its poor performance in forecasting economic developments. Specifically, the Romers show that the FOMC is even worse at forecasting than its underlings, the staff of the Federal Reserve System. This is surprising because the FOMC should have all the advantages when forecasting. The FOMC has the staff forecast available when preparing its own forecast and the FOMC presumably knows its own policy objectives and preferences better than anyone else. Despite this, the Romers find that:

  1. It is best to ignore the FOMC forecast when predicting inflation or unemployment.
  2. The FOMC makes larger forecast errors than the staff.
  3. Monetary policy reacts when the FOMC forecast differs from the staff forecast

The Romers use these findings to paint a bleak picture of the FOMC as "not using the information in the staff forecasts effectively" and accuses that the FOMC "may indeed act on information that is of little or negative value". In their opinion, the evidence is sufficiently damning to warrant a radical restructuring of the role of the FOMC in policymaking:

"a more effective division of labor within the Federal Reserve System might be for the staff to present policymakers with policy options and related forecast outcomes, and for policymakers to take those forecasts as given. With this division, the role of the FOMC would be to choose among the suggested alternatives, not to debate the likely outcome of a given policy."

These criticisms are understandable in a world where consumers, workers, policymakers, and researchers perfectly understand the workings of the economy. In such a context, it is difficult to justify the apparently poor forecasting performance of the FOMC. Our defense of the FOMC therefore rests on asking what happens if the FOMC doubts how much the staff understands about how the economy works (Ellison and Sargent 2009). In our view of policymaking, the staff uses state-of-the-art but imperfect economic models to produce the best possible forecasts, but these forecasts are not taken at face value by the members of the FOMC. Instead, the FOMC suspects that the staff's model is imperfect and wants policies that will work well even if the staff model is misspecified.

The technicalities of how the to make decisions when the policy maker does not completely understand the economy are laid down in detail in the engineering literature on robust control. The basic idea is that the FOMC should pay special attention to events that give particularly bad outcomes. To achieve this, the FOMC needs to "exponentially twist" the forecasts of the staff by putting greater probability on bad outcomes that involve inflation and unemployment being a long way away from target levels. Twisting the staff's forecasts in this way requires the FOMC to construct worst-case scenarios, differing in their severity according to exactly how much the FOMC distrusts the model used by the staff. These worst-case scenarios are a key input to the decision-making process, because by responding to them the FOMC can design policy that works well even with imperfect understanding of how the economy operates. Our defence of the FOMC argues that the forecasts the FOMC publishes are exactly these worst-case scenarios, and they should not be interpreted as forecasts of what the FOMC thinks is going to happen. Instead, they are worst-case scenarios used to make decisions when the staff does not perfectly understand how the economy works.

Our equating of FOMC forecasts with worst-case scenarios immediately causes us to question the forecasting horse race run by the Romers. In our interpretation, the forecasts of the staff and the FOMC are incomparable, like apples and pears, because only the staff forecast can be fairly compared to actual outcomes. The FOMC forecast is a worst-case scenario that by construction is likely to be a poor predictor of future events if, as the Fed hopes, the staff's model is actually correct. In this light, it is not surprising that the Romers found that staff forecasts outperform those of the FOMC. It is what we would expect if the division of labor within the Federal Reserve System is as we have described.

Furthermore, if the FOMC does behave as we suggest, then the worst-case scenarios it publishes will definitely influence the policy actions actually taken; it is precisely when the worst-case scenario differs from the staff forecast that the FOMC needs to take pre-emptive policy steps. The finding of the Romers that the difference between forecasts predicts monetary policy actions can, therefore, be completely rationalized as due to the concerns of the FOMC that the staff's model may be misspecified.

Some policymakers have gone on the record with arguments that support our view. For example, on 4 January 2008, Forbes reported on a discussion of the Romers' paper given by former Federal Reserve Monetary Affairs Director Vincent Reinhart at the American Economic Association meetings in New Orleans:

"However, former Fed staffer Vincent Reinhart said while it may look as if 'the FOMC's contribution to the monetary policy process is to reduce forecast accuracy', they are not there primarily to be forecasters. Instead, they exist in a political system and have to be held accountable for the outcomes of their decisions. 'They can be bad forecasters and good policymakers', Reinhart said, 'if the diversity of views about the outlook informs their policy choice.'"

The arguments we make amount to a spirited defense of the FOMC. Once we identify FOMC forecasts as worst-case scenarios, there is no need to reorganize the division of labor within the Federal Reserve System. In our story, policymakers do "use the information in the staff forecasts effectively" and do not "act on information that is of little or negative value". The model where the FOMC doubts the staff model is consistent with all of the Romers' findings and explains the differences between FOMC and staff forecasts as a rational response of the FOMC to doubts about the specification of the staff model.

Footnotes

1 The FOMC sets monetary policy in the US. It is currently chaired by Ben S. Bernanke, and is comprised of members of the Federal Reserve Board and presidents of the regional Federal Reserve Banks.

References

Ellison, M. and T.J. Sargent (2009), "A Defense of the FOMC", CEPR Discussion Paper 7510, October.

Forbes (2008), "Kohn says Fed operating with diverse views, not just strong chairman", 4 January.

Romer, C.D. and D.H. Romer (2008), "The FOMC versus the Staff: Where Can Monetary Policymakers Add Value", American Economic Review 98, 230-235, May.

This article may be reproduced with appropriate attribution.


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