Vernon Smith discovers the business cycle

The current recession has certainly increased the academic interest in business cycles, their origin and their cures, if any. Many prominent economists ventured outside their traditional field of research to weigh in, most prominently Paul Krugman, a trade theorist. Add now Vernon Smith, an experimentalist and also a Nobel Prize winner, to the mix.

Steven Gjerstad and Vernon Smith do an exercise that is very reminiscent of Burns and Mitchell: a graphical analysis of various recessions to determine their dynamics. They conclude that various types of investment fluctuate the most, that residential investment leads the cycle, while business investment lags it. In other words, they have discovered some of the stylized facts that have been driving business cycle research of the last decades. This is their third paper on the topic, I am sure there will be more.

Are academics still dysfunctional in Italy?

Academics, at least in Economics, have been largely dysfunctional in Italy for a long time. With faculty positions centrally administrated by the Ministry of Education, competitions rigged against people coming from abroad, and newcomers have first to pay their time in the purgatory (the South or the islands), there have been very few incentives for quality people to stay or return to the country. Hence a very large diaspora of Italian economists throughout the world who even have organized themselves into a separate society to try to shake things up. Things have moved, a little bit, as universities have now more autonomy in hiring, and one can wonder whether this has done any good.

Adriano Birolo and Annalisa Rosselli provide an assessment of the quality of new hires into entry-level positions around 1985, 1995 and 2005. While the number of hires seems to have substantially increased, their quality does not seem to have. While they may publish more, they do so with substantially more co-authors. where there seems to be some change is in the topics of research. Italy has always had a very strong tradition in the history of economic thought, indeed a sixth of all publications were devoted to this in the 1980s, and this emphasis seems to dwindle to the advantage of Microeconomics, which was virtually absent. So at least in terms of research topics, Italy is becoming less of an oddball.

What if a cohort lives too long?

Pension funds, life and health insurance companies suffer from a substantial long-term risk: What if their members live longer that expected? While they tend to work with actuarial tables to set premiums and benefits, those tables a re backward-looking, and to price things correctly, the insurers need to make accurate projections about future demographics. But if there is risk, there should be a way to insure oneself against it if a counter-party is willing to take that risk.

David Blake, Tom Boardman and Andrew Cairns make the case that insurance companies should be putting longevity bonds on the market, whose payouts are tied to the demographics of a particular cohort. Imagine an insurance company is selling annuities, but medical developments let some cohorts live unexpectedly longer. By reducing payouts on those cohorts' longevity bonds, the company can finance the shortfall. The question is then who is willing to buy those bonds. Certainly not the cohorts in question. They have annuities already, and those who do not would want a higher payout, not a lower one. Pharmaceutical companies are good candidates, as they face an inverse risk: if a cohort lives shorted than expected, the return from many drugs suffers. But is this enough?

Becker's marriage market cum sociology

Gary Becker's theory of the family has had a tremendous impact on the understanding of marriage, yet it does not explain everything. This has been attributed, for example, to the fact that there is an element of randomness (irrationality?) in marriage. But adding randomness is not sufficient. For example, one predition of the model is that as female labor participation increases, the divorce rate increases because marriage conditions have changed. But now that female labor force participation has stabilized for about a generation, i.e. it is in a steady state, the divorce rate should go back down. Yet it remained high. What about going beyond Economics and using some insights from Sociology?

Take Signe Hald Andersen and Lars Gårn Hansen, who assume that marriage does not only happen on productivity matches but also on partner specialization matches. By that they mean that like-minded people, especially with respect to female labor market participation, divorce less. But this is not sufficient: such matching is subconscious, it does not follow a rational decision, but it is consistent with it. Concretely, this means that people match on these preferences without knowing it, and when conditions change (female wages rise), divorce rates increase, but less than without partner specialization matches, and do not have to decrease. The authors then demonstrate this with an agent based model.

Make good grades costly to teachers

As a teacher, who has not faced this dilemma: you want your students to make an effort and learn, but you also want them rewarded with good grades so that they do well on the job market or with college applications. If your grading practices cannot be observed by outsiders, there is no reason for you to give bad grades, and students will not study hard.

Robertas Zubrickas rationalizes all this with a principal-agent model where the teacher cares more about the learning and the students more about the signaling. Teachers offer a contract to students, oberserving perfectly their performance and rewarding it with good grades. The problem is that issuing good grades is costless. Of course, what really matters are relative grades, but if the market cannot observe the grading rule or the grade distribution, all that matters are the "nominal" grades. The result: everyone gets the best grade, and there is complete pooling. And it is empirically observed that schools with laxer grading standards achieve lower SAT scores.

And how can one prevent this poor outcome. Either make the distribution of grades available, thus making grades "real" instead of "nominal." Or make it costly for teachers to give good grades (instead of making it costly to give bad grades by asking for extra administrative steps for those). For example by imposing a distribution or an average grade. I would certainly welcome this, as some of my colleague are clearly free-riding and giving good grades to everyone.

Even coercion is Pareto efficient

Much of Economics is based on the premise that property rights are well established, in particular that contracts are either enforced, or self-enforcing. But what if you have to deal with agents with no respect for property and armed with mallets?

Harold Houba and Hans-Peter Weikard describe what they term a "stone age equilibrium." It emerges when exchanges can be coercive, but also voluntary and is thus and intermediate between the Walrasian equilibrium (purely voluntary) and the "jungle equilibrium" of Piccione and Rubinstein (purely coercive). In a stone age equilibrium, no one prefers to take from a weaker agents, and there are no bilateral gains from trade. Interestingly, such an equilibrium can feature gifts and withholding goods. In other words, pretty much anything can happen. Required reading for all doomsday sayers and survivalists.

Multiple equilibria in environmental policy

Why do some countries, in particular developed one, engage more in environmental protection than others? The traditional answer is that higher incomes and long life expectancy allows people to value more their surroundings and the future. However, rich people or countries may engage in alleviating the consequences of a poor environment instead of contributing to a better one. For example, similarly rich countries have very different track records. Thus there must be something else that distinguishes them.

Natacha Raffin builds on the evidence that US states where higher proportion of the population holds a high school degree also are more environmentally aware, even after controlling for income. In other words education matters. But education policy is endogenous, and one needs to determine what makes a state choose to educate more its citizens on environmental issues. Say you expect poor environmental conditions, and thus shorter life expectancy. Then it is less worth investing in human capital, and the circle is complete. And the beliefs are more positive, they are also self-fulfilling. We thus have multiple equilibria. This can also explain the frustration that pro- and anti-green camps have with each other.

Richard Wagner's Lohengrin and game theory

The analysis of fiction or fictional worlds from an economic point of view is an interesting "hobby" of some economists, from the Economics of Harry Potter, World of Warcraft to CSI: Crime Scene Investigation. There appears to be also a stream of research dealing with operas, and in particular Wagner's, which are full of intrigues, hard decisions and conflicting beliefs.

Ilias Chrissochoidis and Steffen Huck look at Lohengrin. The story is about whom to believe, commitment, signaling, normal form games, Bayesian updating, and asymmetric information. I need to listen again to Lohengrin, which I have not touched in decades. Maybe I will hear it with a new ear now that I can recognize all the Economics in it. This paper is totally useless for policy, yet fascinating.

Vegetarianism and income

I am sure you wondered what makes that vegetarianism is more prevalent in some countries than others. I am glad to help you today.

Eimear Leahy, Seán Lyons and Richard Tol make a distinction between developing and developed economies. In developing ones, vegetarianism is mainly an issue of necessity, as meat is harder to come by. In developed ones, it is an increasingly popular lifestyle choice, which the authors interpret as an increasing awareness of the environmental impact of meat production. They come to this conclusion by combining household level survey data, to infer the number of vegetarians, in various countries and years with national level data. Interestingly, religion and in particular hinduism does not appear to be a factor.

Health, growth and small samples

There is currently a debate between Daron Acemoglu and Simon Johnson and David Bloom, David Canning and Güther Fink on whether health improvements lead to higher growth. Acemoglu and Johnson claim it does not, and overturn previous results on the basis that they address critical endogeneity issues. The instrument they propose is exogenous improvements in health technology and how they impact national health.

Bloom, Canning and Fink acknowledge this but think that timing is crucial. Health improvement take time to translate into higher incomes. For example, health in utero in only reflected in physical and cognitive development many years later. Concretely, this means that countries that already benefitted from good health subsequently did not enjoy improvements in health conditions, yet could show growth from previous improvements. Cross-country regressions with appropriate lags show this.

This debate makes me think again that development is in dire needs of proper modelling. All its debates are about instrumental variable choices or specifications of linear reduced form "models" with frighteningly small samples One can debate forever on such reduced forms if one does not have a strutural model to work from. Lay down a theory, derive from it testable implications, which may not be linear by the way, and then argue. This is the scientific way.

Making Sen's capacity approach functional

Amartya Sen has provided an important framework that helps define the basic needs that human should be able to get. His capabilities and functionings approach has been very helpful in establishing how to measure human rights, and especially economic and social rights can be achieved. There is a large literature that helps to channel policy given current rights achievements.

Martin Binder and Alex Coad point out that all elements in Sen's approach (the capabilities) could in fact be endogenous to each other, in other words, one component could be a precondition to the other. For example, some functioning could depend on particular resources, or the reverse, or some functionings could be resources for others. one's health may depend on income, but income may also depend on health. This is rather important when one should decide what policy one should concentrate on. But it is not obvious how to establish such a hierarchy. To do this, they apply a panel vector autoregression to the British Household Survey Panel. Thus allows to extract the relevant leads and lags.

Clearly, income is a resources for many functionings, but "being happy" is also a resource for income, especially for males, and for other functionings like "being healthy," "being nourished" and "moving about freely." Mobility is also a resource for higher material well-being. Thus, ensuring people a happy can help ensuring other dimensions of welfare are more easily achieved.

Smoking ban or cigarette taxation?

While people are now used to widespread smoking bans in the United States, European countries are right now going through the painful transitions, with the expected anxieties from restaurant and bar owners. They will do fine, but one can still ask whether simple taxation of tobacco would not be sufficient and especially more efficient in internalizing second hand smoke.

Charles de Bartolome and Ian Irvine note that taxation has a major problem here: the emergence of a thriving black market. Banning smoking in public areas also has a major disadvantage, namely that one can smoke more at home, potentially exposing more family members and especially children (see previous post in this regard). De Bartolome and Irvine give a counterargument: a ban interrupts to continues flow of nicotine, making it emotionally more expensive to the smoker, and possibly may also drive him to abandon smoking more than a tax could. We now need a paper that disentangles the quantitative effects of the polices to sort it out.

Publish school rankings, and bad schools improve

Does publishing the performance of schools work to improve them? Schools certainly resist such disclosure, as they are afraid of being exposed or misjudged, given their particular circumstances. The case of the Netherlands is interesting, as a newspaper regularly lists a ranking of secondary schools along with various scores, and has been doing so for eleven years.

Pierre Koning and Karen van der Wiel use this data and notice that schools that score badly systematically improve, once one takes into account the delays in publishing and disseminating the survey results (three years!) and in registrations in schools. This helps also in resolving issues with endogeneity. Interestingly, they find indicators that cannot be manipulated by schools (for example by preventing poor students from getting tested). Finally, one important issue here is the mean reverting bias, as schools that do badly one year may just have been hit by a bad shocks and should be doing next year anyway. Long term effects of the responses to the publication of the rankings are in the order of 10 to 30% of the standard deviation, which is substantial giving that the publisher has no way to sanction bad schools. It is all about naming and shaming.

PS: the actual text of this paper starts on page 11. What a waste!

Natural resources, rent seeking and civil war

The availability of large amounts of natural resources is sometimes a curse, sometimes a boon. There are plenty of countries where the discovery or exploitation of, say, oil or diamonds, leads to corruption or civil war, that is counterproductive attempts at grabbing the rents. But there are others where not such conflict occurs, rather various factions are appeased with the distribution of these rents, which may be a second best but is still much better than corruption and conflict. What triggers in which equilibrium a country falls in?

Kjetil Bjorvatn and Alireza Naghavi build a model where the government cannot credibly commit to transfers. When there are few rents to distribute, there is no conflict. When there are a lot of resource rents, the government has a lot to lose from conflict and is credible when it promises to redistribute, for example through patronage employment, and continue doing so. But when there is an intermediate level of resources rents, the government's future policy is not credible, as redistribution leaves it with fewer rents than if it were to try to keep them violently.

Politically feasible reform of social security

In many countries, social security systems face obvious challenges, yet little has been done about it so far. That is either because it is not possible to muster political support for it, or because politicians believe that is not possible. Let us have a look at this using some theory.

Georges Casamatta and João Gondim use a continuous time overlapping generations model to study out the parameters of a pay-as-you-go system can be modified in the face of a permanent negative fertility shock. cutting pensions benefits or delaying the retirement age find a majority of supporters, increasing the contribution rate does not. A critical aspect here is the status quo: an increase in the income tax necessary to balance the social security budget. Too often, people compare a reform to the current policy, instead of thinking what emergency reform would have to be performed once the shock has impacted.

People favor a cut in benefits even though it decreases their lifetime consumption because it gives a better stream of consumption through their life cycle, i.e., they are fine with having more now and less alter. Which also means an increase in the payroll tax is not acceptable. And an increase in the retirement age achieves the same objective, again compared to a status quo with a high tax rate, and also to the two other policy moves.

This assumed the changes in policy were applied at the moment the fertility shock happened. Delaying it changes preferences, and depending on demographics, things can go towards favoring one or the other policy change.