What drives the size of the shadow economy?

Why is the size of the informal sector larger in some countries than others? While it is easy to think what can drive off formal activities is easy, quantifying the contribution of each is difficult, foremost because we do not have much information about the informal sector, it is escaping the vigilance of the government, after all.

Friedrich Schneider and Andreas Buehn have a go at it. Schneider has made a living in computing and improving proxies for the size of the informal sector. They use his latest estimates for 39 OECD countries and regresses them on various indicators. While one may have doubts about the power of such estimates given the small sample lengths and the obvious uncertainty about the validity of the data, especially in a time series, one can still learn a few things, hopefully. In order of importance, these are the major factors for informality: indirect taxes, self-employment, unemployment, income tax and tax morale. But beyond doubts about sample size and degrees of freedom (what fixed factors are used in the panel regressions?), I am mostly concerned that the informality proxy used here (MIMIC) is constructed with some of the very variables (or close correlates) that are used in the regressions of the paper, namely the tax burden. I would have expected that you would use a different measure in this context, like a survey-based one or currency demand. Or used a different method than plain old OLS.

Financial reform need not increase capital flows to emerging markets

Firms in emerging markets have a hard time getting foreign capital to expand and improve, and this includes the best ones. The issue is that debt enforcement in those countries is generally weak, and few investors are willing to take such risks. But once legal and financial institutions are reformed toward better enforcement, the general understanding is that we should see foreign direct investment shooting up.

Wrong, say Alberto Martin and Jaume Ventura. Indeed, you need to think in terms of general equilibrium. Once you have put through your reform, the least efficient firms should disappear and all the funding they were attracting should become available to the most efficient ones. With this "new" internal funding source, foreign direct investment becomes less necessary, and FDI may actually decrease. And one should not be disappointed if a reform does not translate into a surge of FDI, quite to the contrary.

How much do spouses suffer from unemployment?

Unemployment spells not only reduce income, they can have lasting consequences. The next job has a lower wage than the preceding one. Unemployed workers lose human capital. They are less healthy, in particular in terms of mental health.

Jan Marcus shows that an unemployment spell also has lasting consequences on others: the spouses. Using data from the apparently inexhaustible German Socio-Economic Panel, he finds that spouses of workers who have bee laid off suffer from worse mental health outcomes. Specifically, he looks at plant closures, where the layoff should not correlate with previous private conditions of the worker or spouse (although I can imagine a plant closure is not a complete surprise and may influence their mental state). While it is understandable that the unemployed worker may suffer, for example, from depression, it is interesting to see that spouses suffer almost as much from adverse mental health. This means not only that the cost of unemployment is higher than we think, but also that spouses should also have access to the mental health benefits the unemployed get.

Should the government help in case of natural catastrophes

With the recent calamity that descended on the Northeast coast of the United States, an old claim of presidential candidate Mitt Romney resurfaced: emergency operations in such cases should be left to the private sector. Now that it has happened, this statement is viewed as embarrassing. Is it really?

It is clear that there is a case of intertemporal inconsistency here. Imagine that as a government you assert you will not help people in a flood plain, but once there is a flood, you are compelled to help. The same holds for Romney, he now stands there as a politician without compassion. But he still has a point: why should the public sector take over something that the private sector could do as well?

Well, does it? A very significant part of the rescue and clean-up operations are already being performed by the private sector. Reconstruction of homes and rebuilding the electrical grid are tasks for private contractors. The public part in this is mostly the financing of it all, through grants, subsidies and preferred loans, which are of course financed from taxes. This looks very much like an insurance scheme, thus the question boils down to whether there would be a market for private insurance against natural events, and whether this market would do better than the current situation.

Most insurance policies actually have exclusions for natural events, and for a good reason. It becomes very difficult for an insurance company to credibly cover such costs, especially if it were to include transportation infrastructure. As, say, an earthquake causes widespread destruction, the insurance company cannot spread the risk. It is an aggregate risk, and there are very few counter-parties to absorb this type of risk. Especially now that natural events are becoming more frequent and more costly, re-insurance companies have themselves a hard time providing credible guarantees.

A government is in a better position here: it can leverage its power to tax in the future to obtain lots of resources. It can confiscate goods and time (through an army) to mobilize cheaply resources towards immediate relief that is of higher social than private value. It can change the rues of the game to provide help to everyone. All this the private sector cannot do.

And, finally, if private insurance were so much better, why is there no such insurance in place, especially for governments?

The Taylor Rule does not always work

The Taylor Rule is held in exceedingly high esteem in policy circles for two decades now. Initially meant to describe the actions of the Federal Reserve after it tamed the post oil-shock inflation, it has become a policy prescription that even members of the FOMC refer to when setting policy interest rates. And this almost blind following of the Taylor Rule is not limited to the United States.

Yet, it does not seem to work that well in other countries. Rodrigo De-Losso looks at Brazil and finds that while the country was experiencing hyper-inflation, the central bank was actually following a Taylor Rule. To stabilize prices, it decided to deviate significantly from it by actually reverting the Taylor principle: to maintain inflation in check, the reaction of the policy rate to inflation became smaller, In retrospect, that was a gutsy move of the central bank, but then, there was not much to lose.

The vanishing independence of central banks

As I have claimed recently, central banks have lost considerable independence in the current crisis. Indeed, both the US Federal Reserve and the European Central Bank engage in quasi-fiscal policy because the corresponding governments do not or cannot apply proper fiscal policy. This means that what the politicians do not do, the central bank has to. This is almost as if the politicians would tell the central bank what to do.

But is central bank independence really what we need? As Marvin Goodfriend highlights, a central bank that is completely independent can leads to stop-and-go monetary policy and inflation bursts, as past history has shown. This has been fixed by imposing on central banks a price stability mandate. But central banks have no bounds on their credit policy. Look at the Fed now: it increased its balance sheet to proportions never seen before. That may be OK under some very special circumstances, but the current ones violate the principles that Walter Bagehot set for the Bank of England: the central bank should stand ready to stabilize the financial markets by lending any required amount at an interest rate above market rates. And now they are certainly below market, and for a long time. The solution is to get back to Bagehot's principle and imposing that the central bank cannot lend below market. And this will force the politicians to conduct proper fiscal policy, because the central bank will not.

How to measure the monetary stance when the interest rate is zero

The United States have interest rates close to zero, and it will stay like this of a few more years according to the Federal Reserve. This has also been the case in Japan for more than a decade. When the interest rate is not informative, it because very difficult to establish when the central bank policy is tight or loose. A Taylor rule may tell you that it should have negative interest rates, but because they cannot be negative, we cannot measure the impact of the unconventional tools the central bank may have used.

Leo Krippner finds a way to tease the monetary stance out of the yield curve. The issue is that the interest rates cannot go negative no matter what the central bank does because there is always the option to hold cash instead of bonds. This gives Krippner two ideas. First, one can then decompose a bond into an option to hold cash and another security, which may have a negative return (a shadow interest rate). The return of this security measures the monetary stance. The second is that the yield curve can help in pricing the option. For example, if long yields are very low the option has a lot more value than if the yield curve is steep.

This decomposition is then executed for the United States. The results are quite fascinating. For example, over the past five years, the shadow interest rate is at -5%, meaning that the Fed is doing a lot to help the economy. Whether this is enough is another question, but it does not look like it is just doing nothing effective. Also, one can easily match movements of the shadow interest rate with actions of the Fed. Sadly, these actions seems to have rather short-lived impacts, beyond keeping the shadow interest rate at roughly -5%.

Economic growth with egoistic dictators

Western nations, and especially the United States, put a lot of effort into nation-building and democratization in developing economies. The premise is that democratic countries are more peaceful, and they grow richer thus opening new markets. The problem is that if there is a correlation between democracy and the wealth of nations, the causation actually goes the other way: wealth brings democracy. Then if we could pick dictators to promote growth, which should they be? The benevolent dictator may be an elegant theoretical construct, he is difficult to find in reality.

Giacomo de Luca, Anastasia Litina and Petros Sekeris look at high unequal societies and find that in some circumstances autocratic dictators actually generate more growth than democracy (where the median voter is the dictator). The key is that dictator needs to be very rich, so much so that his interests overlap significantly with those of the country, and thus also the interests of other capital owners, as long as capital-ownership is highly concentrated. A wealthy median voter, though, prefers democracy. The logic is that redistribution lowers growth, thus rich capital owners always prefer dictators. With a lot of inequality, the median voter is poor and wants redistribution, this yields low growth. But if the median voter is relatively rich, she wants little redistribution and we have more growth, even more than with the dictator (who still has kleptomaniac tendencies, after all).

How to infer the value of time from gasoline prices

How much do people value time? One way to look a this is to consider how much they need to be compensated to work. But this masks the disutility of effort, boredom, future payoffs, etc. And the value of time changes through the day (do not tell me lawyers reason all day in billable minutes). In other words, the value of time varies through time and from person to person. Hence it is important to get many estimates.

Hendrik Wolff finds a subtle way to estimate it. Looking at fluctuations in gasoline prices and the speeding behavior of car drivers, using speed data from an uncongested flat portions of highway in rural Washington State. The elasticity of -0.01 is very low, but from calculating the time gained through speeding, one can value time at about half gross wage. That is lower than previous estimates that were using congested highways, and frustration may have been priced in those. The Wolff estimates are cleaner, and they provide a logical negative relation between gas prices and speeds, a relation that was positive in studies tainted by congestion or other external factors.

How important is Delaware as a tax haven?

The larger OECD countries have increasingly complained that some of the smaller member countries are hurting them because of their tax havens. While I have argued before that these tax havens have some benefits, foremost to provide tax competition to keep the others with reasonable bounds, there is no doubt that they hurt various efforts in collective action. But there are tax havens also within the borders of the complainants, and the prime example is Delaware, a small state that tries to attract corporations and financial companies through low taxes and little regulation.

Scott Dyreng, Bradley Lindsey and Jacob Thornock show that if regulatory concerns have been shown in previous literature to be an important determinant in the Delaware location choice of companies or their subsidiaries, the tax haven status of the state is even more relevant. If a firm adopts a so-called Delaware tax strategy, it can save 15 to 24% in state taxes, which amounts to increasing after tax income on average by 1 to 1.5%. Given profit margins, this is huge. It is then no wonder that Delaware is often mentioned in the same breath as other world-renowned secretive tax havens. Domestically, the paper shows that the tax savings have decreased, because the other states have either tried to close loopholes or have lowered their tax rates. But there is surprisingly little international policy reaction to this, and I wonder why.

And for Europeans, a significant lesson to be learned from Delaware is that if you want to adopt a formula apportionment system, make sure that its formulas and rates do not differ across countries, or you will have some Delaware that exploits some loophole.

Why is research about Bulgarians' sadness so sad?

We know the saying that money does not buy happiness. But even if there is a significant correlation between income and measures of satisfaction, it is far from one, with some pretty significant outliers. One of them is Bulgaria, whose inhabitants
are among the saddest in the world despite being "middle income."

Hernando Zuleta and Maria Draganova claim this can be explained by a set of factors: it is too cold in the winter, but I would counterargue that this is also valid for Bulgaria's neighbors. Health matters, too, but Bulgaria fares better than its neighbors, in particular Russia (where it is even colder). Maybe the sadness can be explained by the low proportion of young people, or the lack of upward mobility of family income, or the increased inequality, or the collapse of incomes in the 1990's. But again, this all applies to the neighboring countries as well. This sounds all very speculative, but this is really what the paper writes about. One can put all this is a regression and see whether it actually matters. And if Bulgaria is still an outlier, blame culture. Which the authors actually do.

Resit exams are a bad idea

What should be the best design for important exams? One attempt and you are out? Resit allowed once? Twice? Maximum number of attempts over all exams? If you ever have to go through a meeting about this type of rules, you will be surprised how opinionated people are about this. I do not think it is because they can base their views on hard evidence, but rather that they like the system they (successfully) went through themselves in their studies.

Peter Kooreman asks whether allowing students to resit on failed exams within the same academic year makes them learn more, the ultimate objective of an exam. His exercise is theoretical and looks at a student who does not like working but wants to pass. The probability of passing an exam depends on the effort. If there is only one exam, the student provides more effort than for the first exam in a set of two chances. For the second exam, the effort should be equivalent to the lone exam. Thus with two exams, the probability of passing is higher. Effort is lower, and likely much lower. After all, some students get through the first exam with luck and little study while the others get seriously about it only one the second exam.

This short study misses a couple of important ingredients, though. The first is that it assumes that students are risk neutral. My casual empiricism tells me that students are quite nervous about exams, indicating quite a bit of curvature. Also, students have a clear preference for passing exams earlier than later. Risk aversion increases the distance between the two exam schemes. Impatience reduces it and could change the ordering. Finally, it would be great to see some empirical evidence. But the latter is likely asking for a bit too much here.

Better educated twins live longer

What is the secret to a long life? A healthy life style, good nutrition, few worries, few risks, little stress. That is all obvious. When you look at data, life-span has a very high correlation with income, education, and other measures of standard of living. Of course, none of this implies causation, if fact one may think that an expected longer lifespan leads people to get more education. Enter the twin studies.

Petter Lundborg, Carl Hampus Lyttkens and Paul Nystedt use twins, who have the same genes and where subject to the same starting conditions, to disentangle what leads to longer lives. Education comes here as a clear winner. Even differences between twins like birth weight cannot make this disappear. Having more than 12 years of education gives you a bonus of 2-3 years, whether male or female.

To log-linearize or not to log-linearize?

Some recent research has shown that there is a free lunch lying there for fiscal policy when interest rates are constrained by the zero lower bound, in particular Eggertsson-Krugman and Christiano-Eichenbaum-Rebelo: the fiscal multiplier is larger than one and a tax rate cut leads to an increase in employment. But there is also a fundamental principle in Economics: always be suspicious of free lunches.

Anton Braun, Lena Mareen Körber and Yuichiro Waki show that the research above is all humbug. The way these new-Keynesian models are built is by log-linearizing around a steady-state with stable prices. There are two problems with that: 1) the fact that prices do change implies that there is a resource cost in these models due to either price dispersion or menu costs, depending on how you model the source of price rigidity; 2) log-linearization by definition implies a unique equilibrium. The sum of the two means that the extent literature has been approximating around the wrong steady-state and possibly looking at the wrong equilibrium.

Why? The cost of price change alters the slope of the aggregate supply, and this depends on the size of the shocks hitting the economy, once you looks at a non-linear solution of the model. Policy outcomes then look much more like those from an environment where there is no zero lower bound for the interest rate. That is, a tax increase reduces employment and the fiscal multiplier is close to one. To possibly get the other, more published result, one needs to have a price markup in the order of 50%, which is wildly unrealistic.

What this shows is that linearization is a nasty assumption, especially when a non-linearity is central to your case. Also, this highlights that the models punt too much on why prices are rigid. Simple rules are not sufficient. But regular readers of this blog already knew that.

Temp work does not lead to full-time work

Companies that refer temporary workers ("temps") like to advertise that temporary work with few benefits is a stepping stone to full-time work with full benefits. Whether they can back this up beyond anecdotal evidence is another question, and it may depend very significantly on the labor market in question. Sectoral practices differ widely, and regulation about temp work in some countries makes it actually difficult to convert temp work to full-time work. In fact, some agencies even try to prevent this, as they would lose their commissions.

Joakim Hveem looks at Sweden and finds that work intermediated through temp agencies actually decreases the probability of subsequent full-time work, as if a stigma were attached. While this negative effect seems to be caused by immigrants, this results is still disturbing, in particular for women who often rely on temp work as a stepping stone to regular work (they could instead try with volunteering). The only good thing that comes out of this study is that temp work at least keeps people out of unemployment. Note, however, that the study is only about temp work intermediated through an agency. As mentioned above, these agencies may have perverse incentives. Self-intermediated temp work may fare better for later outcomes.