Maximizing the Human Development Index

We all recognize GDP per capita is far from a perfect measure of wellbeing in an economy, hence the Human Development Index (HDI) was developed. It aggregates indicators of health, education and income. The idea is to evaluate how well an individual can function in such an economy. But the elaboration of the HDI did not follow any formal theory in the selection of the precise indicators and their weighting. So what about doing the reverse: take the HDI seriously in theory?

Merwan Engineer and Ian King use a standard growth model, calibrated following Mankiw, Romer and Weil, and look for what it takes to maximize the HDI. And they find massive overinvestment into physical and human capital, which saving rates so much higher than what the Golden Rule would call for that consumption is almost reduced to zero. Because consumption is not part of HDI! That looks a crass oversight, as we generally assume, correctly I think, that people care about consumption for their standard of living.

Employment protection and migration

One big big aspect of resistance to immigration has to do with how immigrant might exploit social safety nets. One of them is employment protection. Thus a natural question is to ask whether emigrants choose to move to countries where jobs are better protected. Theoretically it is not that obvious, as employment protection tends to depress wages, as workers bear the cost of protection, and reduce the probability to find employment, but it could also go the other way if it leads to higher bargaining power for workers.

Rémi Bazillier and Yasser Moullan try to sort this out empirically and come to the conclusion that it is really the protection differential between sending and receiving country that matters: migrants like to enjoy the same kind of protection as at home. This is particularly the case for high-skill workers, the ones you actually want to attract. Finally, Bazillier and Moullan also find that employment protection in receiving countries matters more than in sending countries.

Why is the Chinese savings rate so high?

The current global imbalances, at least those between the US and China, are only possible because China is currently saving a historically high share of its income. Various theories have been advanced to explain this surge in the savings rate: 1) Economic reform has increased household-level uncertainty and thus precautionary savings. 2) Forces have shifted from consumption-oriented households to savings oriented businesses. 3) Demographics and the life-cycle combined with the growth in income lead currently to high savings rates because savings change through the life cycle and thus fluctuations in the dependency ratio become important.

As Carl Bonham and Calla Wiemer point out, the savings rate has not been uniformly high and is in fact consistent with the changes in the dependency ratio. The savings rate increased through the 1980s to peak at 41.9% in 1995, then "bottomed" at 37.7.% in 2000, before surging back to 51.4% in 2008. The current global imbalance occurs in part because, unlike before, investment rates are restricted by policy, and stand at 43.5%. A modest decrease in the savings rate can rebalance things.

To test the three theories against these staggering numbers, Bonham and Wiemer use a structural VAR and determine the latter one is the most important, while the others cannot be dismissed. I am not particularly fond of VARs to test theories, they should rather just describe the data, but the evidence is quite compelling in this case. Of particular interest is that one can forecast the savings rate, as the dependency ratio is quite predictable. And this forecast shows that Chinese savings rates have peaked last year and will decrase quite significantly over the next decade. If true, this should reduce considerably the pressure on China to do something about current imbalances.

The Dalai Lama effect on international trade

Since the Nobel Peace Prize was announced this year, the Chinese government has been putting heavy pressure on many foreign authorities to prevent them from showing up at the award ceremony. China has been in particular been using the threat of trade sanctions to ruin the party of Liu Xiaobo. Is this effective?

Andreas Fuchs and Nils-Hendrik Klann note that China is a regular with these tactics, but regarding contacts with the Dalai Lama. Are those threats carried out? Using a gravity model, they find exports to China have been curtailed after high-level visits only recently, and this effect vanishes after two years. This is quite interesting, as it confirms the existence of a "Dalai-Lama effect." But I wonder how this effect could appear at a time where the Chinese government has less control over imports with the liberalization of the economy. Is it that it cares that much more about the Dalai Lama?

Are military expenses good for growth?

It is obvious that federal fiscal deficits will have to be addressed sooner or later in the US, and seeing how difficult it is to raise taxes, one has to think about how to trim expenses. Of course, the biggest line item is defense, and one can ask what the consequences of cutting these military expenses could be. Critics of those cuts will point to WWII, where the military build-up has pulled the US out of the Great Depression. While I do not quite agree with this interpretation of this anecdote, it is worthwhile to study more generally the impact of military expenses.

Giorgio d’Agostino, Paul Dunne and Luca Pieroni do a literature review and note that out should not just look at the direct impact of expenses. Indeed, a military build-up is also more likely to generate conflicts, and after all a conflict is overall a waste of resources as much effort is spent blowing physical and human capital to pieces. The multiplier argument is also rather vacuous, as these funds could be used for other purposes as well with higher multipliers, in particular when you compare wars in foreign lands versus infrastructure at home. The same applies to the argument that military research has some positive impact on civilian technology (why not simply focus research on the latter?).

This clearly makes it difficult to make a case that military expenses are good for growth. Empirical work is really difficult, like so often with cross-country growth regressions, but d'Agostino, Dunne and Pieroni conclude that the evidence tends towards a negative impact. The only ones that obtain positive impacts are those that include supply-side effects, and those are of course rigged to provide a positive impact.

Money demand: financial adjustment cost, not cash-in-advance

I find monetary models very frustrating. While there is empirical evidence that money is not completely neutral over the range of a couple of years, theory has so far not come up with a believable way to understand why this would happen. The models that come closest have completely outrageous assumptions, such as the infamous Calvo pricing hypothesis I was venting about just a few days ago. This is usually accompanied by money-in-the-utility-function (sure, we all love to walk around with a lot of cash) or with the cash-in-advance constraint. Let us consider the latter a bit more closely.

Essentially, this constraint assume that households have to carry cash for some purchases. Often these models are calibrated to quarterly frequency, because this is what the data bears. This implication is that people have to carry cash for all their purchases in the next three months! How reasonable is that? Or the constraint is imposed on firms for their investment or wage payments, which about as outrageous. Yet, cash-in-advance is used all over, either blindly or because it easily generates a money demand. Of course, as people are forced to demand money.

What monetary urgently needs is a better theory of money demand. People hold money in small amounts because it facilitates transactions. They also hold some as a store of value, as any principles of economics student can recite. But this is not a good solution, as money is dominated in return by almost any asset. People hold money due to some frictions on financial markets, and these holdings are temporary. Now having both these features makes it difficult for the model builder. Which one is more relevant?

Xavier Ragot tells us financial frictions are. For one, looking at data, the distribution of money across households looks much more like the distribution of financial assets than that of consumption. He tries to match both distributions using a model with cash-in-advance for consumption (slightly modified to account for the fact that the rich can buy more on credit), a fixed cost for financial transactions, borrowing constraints and idiosyncratic shocks to household productivity. The model has two degrees of freedom to match the distributions of money, consumption and financial assets: the fixed cost for adjusting your portfolio and the transaction technology parameter from the cash-in-advance constraint. Two values are then obtained, and by turning each of them to zero, Ragot concluded that 85% of money demand comes from financial frictions, and 15% from cash-in-advance transactions. Conclusion: if you want a simple model of money demand, do not rely on cash-in-advance.

How to manage rents from non-renewable resources

Some countries are blessed with natural resources, although this turns too often into a curse as rent seeking can turn the economy into a corrupt hell-hole. To make things worse, this type of revenue is highly volatile and there is much incentive to extract rapidly with little thought for smoothing income or investing for the future. Hence, international organizations have pushed very hard for a more sensible management of resources incomes, and their advice has been to extract or invest income in a way to obtain a constant permanent income.

Anthony Venables thinks this is not appropriate for developing countries that have pressing needs right now, like poverty alleviation or a shortage of public infrastructure. In addition, one has to realize that sustained growth is not going to come from the public sector, but through private investment. And making private investment worthwhile can be helped by good, but limited government. This Venables thinks that revenue management should put more emphasis on current expenses than future ones, in order to make sure the country get out of a development trap and can continue growing on its own latter, with relying on its resource income.

PS: the paper's abstract was much more intriguing that the paper turned out to be. The reason is that the abstract make promises about the proper management of income from renewable resources, which would seem much less problematic, unless I was missing something.

On the consequences of slavery

I reported now long ago on the consequences of slavery in Africa, where it is shown that countries where more slaves were taken still have lower levels of development. It is quite amazing that this can have an impact on average income for so long. But what about the receiving end of the slave trade?

Graziella Bertocchi and Arcangelo Dimico look at county data for the US and find that current average incomes are not related to the inflow of slaves. However, income inequality is. Why would that be? It could be because slave could not own land, and this still has an impact today. Or it could be because of discrimination. Or it could be because of persistent differences in human capital.

Now using a panel data set, Bertocchi and Dimico find the last one is the most likely one. The education gap between blacks and whites has never recuperated, and segregation was certainly part of it. But this strongly persistent effect means that affirmative action still has a reason to be.

Price rigidity all wrong

Much of macroeconomics, and in particular New Keynesian Macroeconomics keeps relying on price rigidities to get anything monetary to have any relevance. That is not necessarily bad, but it becomes problematic when this is implemented with Calvo pricing which essentially states that no matter what the state of the economy or how long ago a firm has last changed its prices, firm change their prices with the same probability. This is an utterly ridiculous assumption against which I have already railed often, but people keep using it because it is analytically convenient. I am still looking for a good model of price rigidity, beyond the ones already discussed here. (Previous posts: I, II, III, IV)

The latest candidate is by Paul Middleditch. When I saw the title, A New Keynesian Model with Heterogeneous Price Setting, I was very hopeful to finally see a NK model where firms are heterogeneous and decide when and how much to change prices, leading to fluctuating proportions of price changing firms. My hopes were quickly dashed. The heterogeneity here is simply that there are three types of firms, each blindly obeying to a different Calvo probability. Nothing to see here.

Financial development and fertility

Why an economy's financial development matter for its fertility? For one, if there is little in terms of savings technology, then households need to find other ways in which they can save for old age, and children have traditionally been a good way to do this. But as long as property rights are reasonably well established, this should be that important, as there are many ways beyond financial assets to accumulate wealth, such as land, real estate, jewelry and cattle. Where a financial system can really bring change is when it gives access to credit for households.

Valerio Filoso and Erasmo Papagni study this with a life-cycle model where there is altruism from parents to offspring and vice-versa. They show that all depends on whether children are an inferior or a normal good, like in poor respectively rich countries. In addition, a relaxation of borrowing constraints allows greater investment in children. There is therefore ambiguity, which is compounded by price and second order effects. To sort it all out, Filoso and Papagni use cross-country data to estimate the sum of all these effects and find indeed that financial development decreases notably fertility in poor economies and increases it in rich ones. This may be an explanation for a fact that puzzled me for some time, why the US has a higher fertility than other rich countries.

Being rationally agnostic

What religion should people adopt if there is uncertainty about the existence of deity? If there were only one choice, to believe or not in a god, the choice would be rather simple as Pascal's wager taught us: believe in the god just in case he turns out to exist. Things become a bit more complex if one has also to choose in which god to potentially believe. First, the fact that they are multiple candidate gods means all but at most one may turn out to be frauds, and choosing the wrong one may have serious adverse consequences. What to believe then? Luckily, economists have you covered.

Tigran Melkonyan and Mark Pingle use decision theory to come to the conclusion that agnosticism, which is to not take a stand, is an optimal choice if any combination of the following hold sufficiently strongly: 1) in-life benefits of agnosticism are higher than "other" religions, 2) the after-life benefits of agnosticism are not too much lower, 3) none of the religions is very likely to be correct, 4) life is not too long or too short, or 5) transition costs from agnosticism to a religion are lower than between religions. These all make intuitive sense, except the fourth, which has to do with the fact that if life is short, you want to believe in a god right away. If life is still expected to be long, you want to believe in no god. Agnosticism is in the middle, where you postpone a choice when you can afford to do so.

It would thus seem that many more people should be agnostic then there are (1-10% in the US). Why so? I would think this has to do with the fact that we do not make such choices from a clean slate: we are conditioned by the environment we grew up in, and kids are easily impressionable. Once they have been told to believe in a particular god, switching to agnosticism is very difficult: you face the disapprobation of the immediate family and peers. But their is also the fact that in any situation, it is very difficult to change the opinion of a person, even if the person is wrong. We are all conditioned that way, and while we easily adopt a first opinion, we rarely change it. This inertia will keep agnosticism, and atheism, a minority in the US for a long time still.

A balanced budget in the US constitution, really?

Europe and the United States are a story of contrasts these days. While the Obama Administration is pushing for fiscal stimuli at the cost of large deficits, Europe is severely putting the brakes on its public expenses to bring public budget back in order. This is quite ironic, as European governments have in the past used public deficits quite liberally, while the US has always been wary of deficits, and most US states in fact have balanced budget requirements. This makes the proposal that the federal government adopt a balanced budget amendment a hot topic again.

Marina Azzimonti, Marco Battaglini and Stephen Coate use a political economy model to contrast the short time costs of the debt reduction (with lower public services and higher taxes) against the long term benefits of a lower debt burden and the long term cost of higher volatility in tax rates and public services.

In such an analysis, the first order of business is to establish why the Ricardian Equivalence would fail in a quantitatively meaningful way. If it does not, then deficits do not matter as they internalized as future taxes by all agents, and a balanced budget rule has no impact. My reading of the literature is that there certainly no agreement, but overall we are not that far away form the Ricardian Equivalence. Well, let us assume it does not hold, because labor income tax is sufficiently distorting, as Azzimonti, Battaglini and Coate implicitly assume. They also calibrate the model to the US, which is quite tricky as one needs to take a stand on the utility of public goods.

This is where the paper becomes rather strange. At least at the state level, a balanced budget rule is usually thought to be challenging because income and expenses vary with the business cycles. This is not the approach taken here, whereas the fluctuations stem from changes in the taste for public goods. The authors' argument is that one needs to distinguish normal times to unusual times where the government wants to spend massively more, like wars. I do not think this is the real issue. If wars are the problem, then an amendment to the rule can be that properly declared wars can be financed with war bonds.

Well, let us assume this is what we want to care about. The quantitative analysis indicates that a balanced budget rule would indeed be beneficial in the long run, because it imposes lower taxes, and thus less distortions, which are more valuable than the missing public services according to the calibration. But one must point out that there are serious costs in the transition, as one starts with rather high levels of debt. But these transition costs cannot be evaluated with the present model, as it does not feature growth and thus cannot take into account the debt/GDP ratio declines naturally as an economy grows. All in all, I am not sure what we learned with this paper.

How to compensate the short-lived

It is very unfortunate if you die early, and knowing this it would be optimal to compensate you for this misfortune. But this is difficult to achieve as your death is not predictable, and compensation after death is not very helpful to the deceased.

Marc Fleurbaey, Marie-Louise Leroux and Grégory Ponthière have figured out a scheme that would achieve this. First, they need to define a social welfare function that would make it desirable to compensate people for shorter lives. Second, they find a policy that would achieve such a compensation. The policy is to essentially cancel social security while putting the mandatory retirement earlier.

Basically it is all about getting people to consume early, so that the different between being dead or alive is not that large later in life. This seems very difficult to achieve given that life valuation studies indicate that people value life at a multiple of consumption. Furthermore, if we discourage people from saving that much, this must have large negative consequences for the accumulation of capital in a macroeconomic sense, something that has been neglected here, and should not.

The welfare gain from age-dependent taxation

There is now a substantial body of literature that advocates for tax rates that would depend on the age of the individual. The logic is simple: the dispersion of wages increases over age, thus the scope for redistribution increases. And if you want to encourage human capital accumulation, you want to tax high incomes more when young than when old. And the uncertainty about outcomes decreases considerably with age. Finally, the source of income varies over time, with capital income taking over labor income at retirement. And, by the way, I previously reported that age-dependent taxation could allow a transition from a pay-as-you-go social security system to a fully funded one.

Spencer Bastani, Sören Blomquist and Luca Micheletto add to this literature in two ways: first they take into account within cohort heterogeneity, second they quantitatively evaluate the welfare gain from a linear age-dependent tax on income. In their overlapping-generation economy, agents face uncertainty about future outcomes and can save. They find that one does not need to tax capital, which is very useful as one does not need to worry about incentive compatibility (it is difficult to lie about one's age) when trying to reach golden rule capital accumulation. Calibrating to Sweden and the United States, they find that a nonlinear age-dependent income tax provides a welfare gain corresponding to about 2-3% respectively 2-2.5% compared to an age-independent one. That is certainly not negligible.

And how the taxes look like? The marginal labor income tax rates are decreasing. That is consistent with this model, as one tries to increase the savings rate to the golden rule level and savings should be encouraged. And the old are systematically paying higher labor income taxes than the young at the same level of income. This is because, I think, capital income taxes are then much lower, and older workers have much more capital income. I wonder how this would look like if human capital accumulation were included as well...

Mergers and tax competition

With increased mobility of labor and capital, Europe is currently struggling with tax competition that keeps taxes lower than is deemed healthy, in particular because of some small entities trying to poach on larger ones by attracting the larger tax payers. A response to this problem would be to merge fiscal authorities so as to reduce competition and thus get higher taxes and also allow a fairer distribution of the tax burden across jurisdictions. While this is not (yet) feasible at the European level (there is no talk of a European tax), there is plenty of evidence of within country mergers. What are they expected to bring?

Marie-Laure Breuillé and Skerdilajda Zanaj note that mergers have not only an impact on regional tax rates, but on local ones as well. Mergers are expected to a) reduce tax competition, b) increase tax bases and c) take into account tax externalities of cities. The impact on tax rates differs, however, by level: regional taxes increase, while local ones decrease. That seems like a trivial results, as mergers are suppose to reduce the influence of local jurisdictions. The tax changes are direct consequences of effects a) and b), but c) counteracts it, and an ambiguity may arise. But it turns out from the Nash equilibrium of the game the regions play, c) is always smaller than a) and b). The impact on welfare, though, is difficult to establish before first saying something about public goods and tax distortions. Indeed, some level of tax competition is not always bad.