Isn’t it amazing how well the Consumption Euler Equation works?

While preparing graphs for my Principles of Macroeconomics class, I made this one:

fredgraph

The blue line is the growth rate of nominal consumption spending in the US, the red line is the nominal interest rate on a risk-free asset (a 10-year US government bond). See the way the red line tracks the blue line? That’s a beautiful confirmation of the Consumption Euler Equation which is the cornerstone of all modern macro models. (And no, I didn’t tweak this graph by restricting the time period or choosing different axes for the two lines or transforming the data somehow. This is a plot of the raw data without any editing. No funny stuff.)

PS: I’m actually not going to teach the Euler Equation in my Principles Class. Nobody seems to. Mankiw’s textbook doesn’t. But I’m increasingly asking myself why not?

6 1/2 Economic Principles for the Pandemic

The Coronavirus Pandemic has fundamentally changed our world. But it hasn’t changed the validity of fundamental economic principles.

I suggest six and a half economic principles which I think are important to bear in mind during these times. Most of them were touched on by Christoph Kuzmics in his excellent series of posts. But I thought it would be worthwhile to state them in a pointed, if slightly oversimplified, way:

  1. People still respond to incentives.

So, for instance, allowing small businesses to re-open earlier than large ones means there will be more small and fewer large businesses. Paying higher unemployment benefits means there will be more unemployed people. Requiring people to wear face masks when doing X, but not when doing Y, means people will do more X and less Y. 

2. World output still equals world income still equals world expenditure.

If you shut down X% of the world economy, the world will produce X% fewer goods and services, will have X% less income, and will spend X% less. The idea that we can somehow preserve everyone’s income and spending while shutting down the production of (most) goods runs into this basic adding-up constraint. The recession is the price we pay for the lockdown which at the moment is the only weapon we have to fight the pandemic (until we have a vaccine or medical treatments). Government transfers can change who gets to consume the goods, but they don’t change the amount of goods there are. (But also see principles 4 and 6 1/2!)

3. The price mechanism is still the best way of allocating scarce resources.

If the demand for toilet paper exceeds the supply at the current price, there are two options: either you let the price of toilet paper rise or you create a shortage. Allowing a higher price is by far the better option. A higher price gives producers of toilet paper an incentive to produce more of it and gives consumers an incentive to use it more carefully and economically. The same applies to face masks, ventilators, and yes, even to hospital beds.

4. Economic inequality is still best addressed by lump-sum transfers.

The pandemic will lead to more economic inequality, because the poor are hit much harder both by the disease itself (low income correlates with worse health conditions) and by the lockdown (most low-wage jobs can’t be done from home). The best way to address this is to give an unconditional transfer to all households (a.k.a. „basic income“) financed by a tax on something that is in fixed supply (at least in the short run): a once-off wealth tax for example. The second fundamental theorem of welfare economics still applies: we can achieve any desired allocation of scarce goods (including toilet paper, face masks and hospital beds) by lump-sum taxes and transfers while letting the market do its job.

5. The government budget constraint still exists.

Every euro the government spends needs to come from any of three sources: from taxes, from borrowing, or from printing money. But in the end, these are all just different forms of taxation. Government borrowing is delayed taxation: the government will need to pay back the debt with future taxes. Printing money is a tax on nominal wealth. 

6. Public goods problems still exist.

Enforcing the lockdown requires the threat (and sometimes use) of force. (That’s why it’s called enforcing). Staying at home is a prisoner-dilemma situation. If nobody is policing the lockdown, going out of the house is a dominant strategy (i.e. it is best irrespective of whether other people stay at home or go out). Social stereotyping of defectors (public shaming corona-party-goers, for instance) can go some way, but is also just another kind of force. Some civil liberties won’t be upheld during the lockdown.

6 1/2. Government spending still has a multiplier effect (but it is probably small).

If the government buys more goods, some otherwise unemployed workers will be employed making those goods. Those workers will themselves be able to buy more goods, creating further jobs for otherwise unemployed workers, and so on. However, the multiplier logic doesn’t work quite as well during the lockdown, because some workers simply cannot go to work. Government spending can help prop up demand in those sectors that aren’t shut down, but as long as many labor-intensive industries such as construction are closed, the multiplier will be only slightly higher than 1.

Intro to Econ: Eleventh Lecture Aside – Why don’t we have a global carbon tax?

If I understood it correctly, we are currently experiencing climate change, climate change is believed to be detrimental to most people, and climate change is to a large extent due to human activity, especially those activities that release CO2 and similar gases into the atmosphere. Moreover climate change is a global problem. Any CO2 released by people’s activities in Asia, this (supposedly mostly negatively) affects not only people in Asia, but also in South and North America, Africa, Australia, Europe, in fact everyone living on this planet. In other words, using the language of a previous post, climate change is a global negative externality of any economic activity that (directly or indirectly) releases CO2 (or similar gases) into the atmosphere.

In the last post I argued that such negative externality problems (that the market typically does not solve because of the logic explained in the advertising example) can often be solved by setting appropriate taxes on the offending (negative externality producing) products. I also argued that one would probably expect that a voting process will in fact lead to a country adopting such taxes. Can’t we just use a similar approach to solve the global climate crisis? I will here explain why this is not so easy.

Continue reading

Intro to Econ: Eleventh Lecture – Solutions to Negative Externalities through Taxation

In a previous post I explained why an economic activity that causes negative externalities (some form of harm for others) tend to be done “too much” in a market. With “too much” I mean that, without any other measures in place, the market will not generate a Pareto-efficient situation. Sometimes this is called a “market failure”. In this post and the next one I explain how we can deal with such situations and why this is easy in some cases and rather difficult in others.

Continue reading

Intro to Econ: Eleventh Lecture Aside – Advertising Bans on Cigarettes and Alcohol

In the previous post I explained why it may well be in some cases that companies advertise too much for their common good. I used it primarily as an example to illustrate how the presence of negative externalities can lead to too much of the activity that causes the negative externality (such as driving cars, et cetera). I here just want to point out an interesting direct implication of the advertising example I gave.

In recent years there was a fairly effective campaign in many countries in the world to reduce smoking (which by the way is almost certainly an activity with negative externalities). This was achieved by a mix of policy measures. These included education about the serious consequences about smoking (“you will die soon and horribly” written on the package together with gruesome pictures), banning smoking from many public places, significant price increases (more about this later), as well as advertising bans. Similar measures are now considered in at least the EU to reduce alcohol consumption, which is also often seen as creating negative externalities.

I certainly believe that price increases are effective to reduce the consumption of cigarettes and alcohol. I also believe that enforced bans on smoking or drinking (enforced with fines or prison time) will be effective even if the enforcement is perhaps not always necessarily proportional to the “crime”. A little bit beside the point: I have the feeling that the “education” is not very effective, but I may well be wrong about this.

But the main point I want to raise is this: I have heard the argument that advertising does not so much affect how much people smoke or drink but mostly only what they smoke or drink. If this is true then a ban on advertising will, by the logic of the previous post, only help to raise profits for the cigarette and alcohol producers, without any effect on smoking and drinking levels.

It would be interesting to assess empirically whether this is true or not. This is probably not so easy, as in many countries many policy measures were put in place at the same time, so it is hard to know which of them was effective. This does not mean that a clever empirical design could not address this, though.

Intro to Econ: Eleventh Lecture – Negative Externalities

On Austrian highways you can sometimes find a sign that says “Schnell ist laut!” or “Fast is loud!” in English. The caricature of Homo Economicus (the rational person, often interpreted as highly self-centered) upon reading this would probably react by thinking “Thank you for the warning. But it is no problem. I can just turn up the radio.”

I guess that this is not the reaction that people who placed the sign there were looking for. And I also guess that most people understand perfectly what this sign is asking them to do: Drive more slowly, so that others, i.e., those who live here, don’t have to suffer so much from the noise that you otherwise create. Whether or not this sign makes them slow down is yet another question.

In economic terms, when you drive fast you create an “externality”, in this case harm, to other people not involved in your decision or activity. In this post I want to consider what happens when economic activity imposes negative externalities on others. We will see that this creates problems to the extent that market allocations are no longer even Pareto efficient (recall this post). Continue reading

Intro to Econ: Tenth Lecture Aside – Equal Opportunities

In this post I want to use the model and insight of the previous post to talk about equal opportunities. With this I mean the idea that everyone has the same access to education. I will argue that it is not for fairness but for efficiency reasons why a social planner might prefer a world with equal opportunities. I should also add that this post is a bit fanciful and one could possibly disagree with the way the argument goes. Take it with a grain of salt.

Continue reading

Intro to Econ: Tenth Lecture – The Job Market

There are many ways we can think about the job market. I believe that I said it before that we should build a model of whatever we are studying only after we specify what exactly we are interested in. And when it comes to the job market there are many things we might be interested in. For instance, we could be especially interested in unemployment: What determines whether someone is unemployed? What consequences does unemployment have for other family members? How do unemployed people find a job again? We could also be especially interested in how many members of a household work and how much and how this is decided at the household level. Why do some people work full time and some part time? We could also be especially interested in how people prepare themselves for the job market. How do people decide which career path to choose? How do they decide what to learn? There are so many things we could be interested in and I believe that each different question will need its own model, where one focuses on the salient features of the job market for that particular question.

In this post I am perhaps being a bit eclectic but I want to think about which person gets which job. That is, I want to think about how the job market allocates people to jobs.

Continue reading

Intro to Econ: Ninth Lecture Aside – The Winner’s Curse

For one last time, I want to come back to the problem of whether you get a loan for your project under the assumption that the risk inherent in your project is stochastically independent of other investment risks. So this was our problem (see also here and here):

 \begin{tabular}{c|ccccc} Scenario & Income & Probability & you get & investor gets \\ \hline good & 200.000 & 80\% & 200.000-x & x \\ bad & -50.000 & 20\% & 0 & -50.000 \\ \end{tabular},

 

where  x is the repayment amount that you pay back to the investor in case of the project being successful. We argued (in a previous post) that the range of feasible interest rates is 12,5% to 200%. Anything outside that will certainly not be accepted by either the investor or by you.

Suppose that you and the investor are close to agreeing to an interest rate of just over 12,5%. Put yourself in the shoes of the investor for a moment. What might worry you in this case?

Continue reading

Intro to Econ: Ninth Lecture Aside – Moral Hazard

I want to briefly come back to the problem of whether you get a loan for your project under the assumption that the risk inherent in your project is stochastically independent of other investment risks. So this was our problem (see also here and here):

 \begin{tabular}{c|ccccc} Scenario & Income & Probability & you get & investor gets \\ \hline good & 200.000 & 80\% & 200.000-x & x \\ bad & -50.000 & 20\% & 0 & -50.000 \\ \end{tabular},

 

where  x is the repayment amount that you pay back to the investor in case of the project being successful. We argued (in a previous post) that the range of feasible interest rates is 12,5% to 200%. Anything outside that will certainly not be accepted by either the investor or by you.

Suppose that you and the investor are close to agreeing to an interest rate of almost 200%. Put yourself in the shoes of the investor for a moment. What might worry you in this case?

Continue reading