Some Perspective on the Size of the U.S. Economy

Maps like this are always fun:

This shows U.S. states relabeled with the names of countries with comparably sized economies. Do note that these “renaming maps” are not unique: a different designer could could match up each state with a handful of similarly sized countries, and make their map a little different than the last one. For example, Utah is variously matched up with not just Qater, but Algeria and Kazakhstan as well.

It’s commonplace for people to say, if California was a country it would be one of the biggest. This is true, but most U.S. states are the size of larger countries. In fact, the smallest U.S. state in terms of GSP, Vermont, is comparable in size to the economy of Latvia … which is in the top half of countries.

I copied this map from Carpe Diem, which continues with:

1. America’s largest state economy is California, which produced nearly $3 trillion of economic output in 2018, more than the United Kingdom’s GDP last year of $2.8 trillion. Consider this: California has a labor force of 19.6 million compared to the labor force in the UK of 34 million (World Bank data here). Amazingly, it required a labor force 75% larger (and 14.5 million more people) in the UK to produce the same economic output last year as California! That’s a testament to the superior, world-class productivity of the American worker. Further, California as a separate country would have been the 5th largest economy in the world last year, ahead of the UK ($2.81 trillion), Frane ($2.79 trillion) and India ($2.61 trillion).
2. America’s second largest state economy – Texas – produced nearly $1.8 trillion of economic output in 2018, which would have ranked the Lone Star State as the world’s 10th largest economy last year. GDP in Texas was slightly higher than Canada’s GDP last year of $1.73 trillion. However, to produce about the same amount of economic output as Texas required a labor force in Canada (20.1 million) that was nearly 50% larger than the labor force in the state of Texas (13.9 million). That is, it required a labor force of 6.2 million more workers in Canada to produce roughly the same output as Texas last year. Another example of the world-class productivity of the American workforce.
3. America’s third largest state economy – New York with a GDP in 2018 of $1.68 trillion – produced slightly more economic output last year than South Korea ($1.65 trillion). As a separate country, New York would have ranked as the world’s 11th largest economy last year, ahead of No. 12 South Korea, No. 13 Russia ($1.57 trillion) and No. 14 Spain ($1.43 trillion). Amazingly, it required a labor force in South Korea of 28 million that was nearly three times larger than New York’s (9.7 million) to produce roughly the same amount of economic output last year! More evidence of the world-class productivity of American workers.
4. Other comparisons: Florida (about $1 trillion) produced almost the same amount of GDP in 2018 as Mexico ($1.19  trillion), even though Florida’s labor force of 10.2 million less than 20% of the size of Mexico’s workforce of 59 million.

All the bold emphasis there is in the original. The point is general though: all U.S. states can be matched up with comparably sized countries, but in each case the U.S. state is producing a comparable amount with a smaller population.

And not by a little: the UK and Canada are regarded as rich, developed countries, yet California is matching the UK, and Texas is matching Canada with 60% of the population. A little bit of that is due to Americans working more hours, but not much (7% more than the UK, and 5% more than Canada). That means that most of the difference is due to productivity of labor, which in turn means Americans are working with more capital and better technology … and more than likely … both.

That’s actually a good example of geographic correlation. Americans are more productive than others in both California, and Texas (and other states too) presumably because our capital and our technology is geographically correlated.

Fourth Quarter Real GDP Growth Rate

The advance estimate (the first draft) of real GDP for 2018 IV usually comes out on the last Friday in January. Due to the government shutdown, that data release was delayed by a month.

It was announced this morning (the last day in shorter February) as an annualized rate of 2.6%, with a real GDP (non-annualized) growth rate for the year 2018 of 2.9%.

Over the past 60 years, this is not great. But it is very good for the last 12 where it is tied for the highest annual growth rate. (Here is a link, but it is to an interactively created table, so I’m not sure it will work).

Do note that macroeconomists are concerned about low growth rates over the last 12-18 years. A large chunk of that is demographics: labor force growth is part of real GDP growth, and labor force growth has slowed down quite a bit due to the many baby boomers exiting the labor force.

Green New Deal Cost Estimate

The “Green New Deal” (or GND) is the colloquial name of a collection of policy proposals made by Representative Alexandria Ocasio-Cortez and Senator Ed Markey on February 7, 2019. Pieces of it have been in discussion in Washington D.C. for about 15 years.

Do note that there are solid economic reasons to be opposed to most of this collection of programs, but its political support is quite good. That combination is not unusual.

This is a new cost estimate for the entire program, although I have posted this semester about other estimates in more piecemeal fashion. It comes from the American Action Forum, a Republican-oriented think tank.

Of critical note for this class, the president of this group is Douglas Holtz-Eakin. He was a professor of economics at Syracuse University, specializing in macroeconomics, with an extremely good citation record. Later he served Bush I’s Council of Economic Advisors, was director of the non-partisan Congressional Budget Office, and was chief economic advisor of John McCain’s 2008 presidential bid. So, yeah, he’s a Republican, but with a lot of D.C. experience, and definitely more macroeconomic chops than almost everyone else involved in policy-making in D.C. In short, not neutral, but way legit.

And their estimate of net costs is $52.6T to $94.5T over the 2020-2029 decade.

As ballpark figures, all levels of U.S. government combined currently outlay $7T/yr, the Federal government outlays $4T/yr, and the Federal government buys goods and services of roughly $2T/yr.

This is important: I don’t think it’s appropriate in a macroeconomics class to judge policy proposals just by their price tag. I would rather that we didn’t do this at all: either they are

• a good idea on net no matter what the cost (and should be pursued), or they are
• a bad idea on net no matter what the cost (and should be avoided).

Having said that, in this case it’s essential to run the numbers. If the U.S. Federal government

• Stopped buying everything (including salaries of employees) the GND would require spending 26-47 years worth of government in 10.
• Stopped buying everything and sending checks to people, the GND would require 13-23 years worth of spending in 10.
• Commanded all levels of all government to stop buying everything and sending checks to people, the GND would require 7-13 years of spending in 10.

Of course, do note that huge classes of things that we spend money on now would not require any spending in the future under this plan, like Medicare, Medicaid, and all welfare programs. Having said that, the GND does not propose eliminating social security or any current government employees … and those two are where most of the money goes.

Again, keep in mind, politicians are known for making policy proposals whose costs and benefits are not well-grounded

Having said that, and I do not like to have to write what follows, but the GND is a unicorn. It’s not merely unrealistic, it’s not feasible, and therefore probably not worthy of further discussion.

This is not a serious proposal from serious people. It’s bait.

A New Country/Nation/State In the Making

Our world has seen a proliferation of very small countries. It’s not clear if that’s a good or a bad thing, but it does add an element of weirdness into keeping on top of macroeconomics.

Yesterday provided an example of how this happens. The International Court of Justice made a ruling siding with Mauritius that the Chagos Archipelago should be returned to that country. In and of itself, that’s a little weird: Mauritius has equal standing with the UK in international circles, because it’s a state with a country. It also has claims to be a nation, even though no one lived there permanently until the French started building plantations in the 1700’s.

I have a suspicion that this is going to end up with the Chagos Islands declaring independence from Mauritius, because they’re a thousand miles away across the open ocean.

I don’t think an element of “who cares” would be uncalled for here. Unfortunately, there are a lot of countries around the world that no one cared about until some problem there percolated to the top of the news cycle. So here’s the backstory.

The Chagos Archipelago is a group of atolls in the middle of the Indian Ocean (similar to tourist destinations like The Maldives and The Seychelles). The French claimed them, brought in people to work coconut plantations, and ruled them from Mauritius (a more substantial island, famous as the home of the now extinct dodo). In 1810 they ceded all of that to the UK. In 1965 the UK split the Chagos from Mauritius, and then leased one of the Chagos atolls to the U.S. military.

That atoll is Diego Garcia, which does pop up in the news in the U.S. once in a while. Usually this is as a landing strip for bombers and other long-range aircraft. Do note that the original reason to militarize the island was to watch for ICBM’s from the Soviet Union going the long way around the South Pole, which was a serious concern at the time. That morphed into the island being used to monitor spacecraft of all kinds (particularly manned ones that might be in trouble and needed to phone home over that part of the world); prior to that ships had to be on station in the Indian Ocean at all times.

Two things are important going forward though. One, the UN has a rule that colonies are supposed to be fixed until granted independence, so they can’t be split into non-functional entities easily dominated from the outside. Except that’s what the UK did. And they also deported all the islanders to Mauritius.

So, here’s what I see happening. The UK has little interest in fighting this ruling. I’m sure Mauritius wants these distant atolls for potential resource extraction. But, my guess is that the former Chagos islanders have not been well assimilated into Mauritius, and will want to go back (even though as a people they only lived there for about 200 years). Then they will want independence because they’re a lot closer to The Maldives, The Seychelles, India, and Sri Lanka than they are to Mauritius.. Give it a few years.

And why will this come up in the news in your future? Climate change. It’s become a commonplace for nations of atolls to ask for special aid from richer countries in case sea levels rise substantially in the future.

So, you heard it here first: in your middle age, these islands are going to be a country that pops up in your news feed.

Wow.

By now, you are probably familiar with the news that Amazon has pulled out of its agreement to build a second corporate headquarters in New York City. The reasons for this appear pullout appear to be mostly due to political opposition that came up after the agreement was made.

If you’ve been paying attention, the very liberal/progressive governor of New York is pretty angry about the stupidity of this. Today, the state’s Budget Director released a public letter on the Governor’s website. It contains a lot of solid and practical economics. I’ve highlighted some of teh good parts.

"As just about everyone in this state, if not the country, knows by now, Amazon has terminated its plans to bring its second headquarters to New York State. It is a tremendous loss for New Yorkers and I hope that at a minimum, we understand the lessons learned.

"In my 23 years in the State Capitol, three as Budget Director, Amazon was the single greatest economic development opportunity we have had. Amazon chose New York and Virginia after a year-long national competition with 234 cities and states vying for the 25,000-40,000 jobs. For a sense of scale, the next largest economic development project the state has completed was for approximately 1,000 jobs. People have been asking me for the past week what killed the Amazon deal. There were several factors.

"First, some labor unions attempted to exploit Amazon's New York entry. The RWDSU Union was interested in organizing the Whole Foods grocery store workers, a subsidiary owned by Amazon, and they deployed several 'community based organizations' (which RWDSU funds) to oppose the Amazon transaction as negotiation leverage. It backfired. Initially, Whole Foods grocery stores had nothing to do with this transaction. It is a separate company. While Amazon is not a unionized workforce, Amazon had agreed to union construction and service worker jobs that would have provided 11,000 thousand union positions.

"New York State also has the most pro-worker legal protections of any state in the country. Organizing Amazon, or Whole Foods workers, or any company for that matter, is better pursued by allowing them to locate here and then making an effort to unionize the workers, rather than making unionization a bar to entrance. If New York only allows unionized companies to enter, our economy is unsustainable, and if one union becomes the enemy of other unions, the entire union movement - already in decline - is undermined and damaged.

"Second, some Queens politicians catered to minor, but vocal local political forces in opposition to the Amazon government incentives as 'corporate welfare.' Ironically, much of the visible 'local' opposition, which was happy to appear at press conferences and protest at City Council hearings during work hours, were actual organizers paid by one union: RWDSU. (If you are wondering if that is even legal, probably not). Even more ironic is these same elected officials all signed a letter of support for Amazon at the Long Island City location and in support of the application. They were all for it before Twitter convinced them to be against it.

"While there is always localized opposition, in this case it was taken to a new level. The State Senate transferred decision-making authority to a local Senator, who, after first supporting the Amazon project, is now vociferously opposed to it, and even recommended appointing him to a State panel charged with approving the project's financing. Amazon assumed that the hostile appointment doomed the project. Of course the Governor would never accept a Senate nomination of an opponent to the project and the Governor told that to Amazon directly.  The relevant question for Amazon then became whether the Senate would appoint an alternative who would approve the project.

"As newspapers have reported, Amazon called the Senate Leader and asked if she would appoint an alternative appointee who would support the project.  The Senate would not commit to an alternative appointee supporting Amazon.  That was the death knell.  No rational company, or person for that matter, would assume the Senate would flip flop from appointing a staunch opponent of the project to appointing a supporter of the project.  It defies logic.  However, if that was their plan, Amazon needed a direct representation to that effect from the Senate.  It never came.  Indeed, to this day, the Senate has never said they would appoint a member who would support the project.    Companies assume rational, logical behavior and cannot spend months and millions of dollars on approvals if ultimately the road is a dead end.

"Furthermore, opposing Amazon was not even good politics, as the politicians have learned since Amazon pulled out. They are like the dog that caught the car. They are now desperately and incredibly trying to explain their actions. They cannot. They are trying to justify their flip-flopping on the issue with false accusations that it was a 'backroom deal.' Let's remember that as a condition of the competition, every bid was sealed to prevent governments from altering their bids to be more competitive. Empire State Development supported the numerous local applications in the state who wanted to bid for HQ2, but on the condition that the local elected officials and community supported it, and Long Island City was no exception.

"In working with New York City, we advanced Long Island City's application with the signed support of the area's local elected officials, including State Senator Mike Gianaris and New York City Councilman Jimmy Van Bramer. Both Gianaris and Van Bramer flip-flopped on this position after Long Island City was chosen, distorting the facts of the agreement and mischaracterizing the tax subsidies as 'a cash giveaway.' Now that Amazon has pulled out, local politicians are feeling the backlash from the project's previously silent supporters and are dissembling. Local senators' claims that their phone calls were not returned are particularly offensive, given that the local senator was the first person ESD President and CEO Howard Zemsky met with when we made the HQ2 announcement. I also remained in contact with him about the project as the State Budget Director, and he refused to sit on the community engagement board or even meet with Amazon representatives. Efforts were made to address legitimate concerns, all of which were ignored.

"Third, in retrospect, the State and the City could have done more to communicate the facts of the project and more aggressively correct the distortions. We assumed the benefits to be evident: 25,000-40,000 jobs located in a part of Queens that has not seen any significant commercial development in decades and a giant step forward in the tech sector, further diversifying our economy away from Wall Street and Real Estate. The polls showing seventy percent of New Yorkers supported Amazon provided false comfort that the political process would act responsibly and on behalf of all of their constituents, not just the vocal minority. We underestimated the effect of the opposition's distortions and overestimated the intelligence and integrity of local elected officials.

"Incredibly, I have heard city and state elected officials who were opponents of the project claim that Amazon was getting $3 billion in government subsidies that could have been better spent on housing or transportation. This is either a blatant untruth or fundamental ignorance of basic math by a group of elected officials. The city and state 'gave' Amazon nothing. Amazon was to build their headquarters with union jobs and pay the city and state $27 billion in revenues. The city, through existing as-of-right tax credits, and the state through Excelsior Tax credits - a program approved by the same legislators railing against it - would provide up to $3 billion in tax relief, IF Amazon created the 25,000-40,000 jobs and thus generated $27 billion in revenue. You don't need to be the State's Budget Director to know that a nine to one return on your investment is a winner.

"The seventy percent of New Yorkers who supported Amazon and now vent their anger also bear responsibility and must learn that the silent majority should not be silent because they can lose to the vocal minority and self-interested politicians.

"It was wrong to manage this issue as if it were a single legislator's political prerogative on a local matter. This was not a traffic signal or local zoning issue. Losing the Amazon project was not just a blow to Queens County, it hurt the whole State from Long Island to the Capitol Region's nanotechnology corridor to the emerging Panasonic plant in Buffalo, and it was a bad reflection on every single local elected official. Legislators must realize there is a difference between playing politics and responsibly governing.

"Progressive politics and policies have been the signature of Governor Cuomo's administration. No state in the nation has more progressive accomplishments, and being the most progressive state in the nation means having the most stringent and aggressive protections and policies in place. We are proud that our values create a stronger, healthier, fairer work environment, but we shouldn't kid ourselves about how they impact our competitiveness when businesses consider where to locate. We are also proud of the unprecedented investments we make in education, healthcare, infrastructure and housing, but in order to fund them, we need a sustained tax base.

"As the political debate rages in this country, the Governor reminds us of the fact that 'to be a progressive, there must be progress.' The creation of opportunity and jobs is the engine that pulls the train and, as he also often says, 'the best social program is still a job.' Without a tax base we are not financially able to achieve the laudable goals we seek.

"Make no mistake, at the end of the day we lost $27 billion, 25,000-40,000 jobs and a blow to our reputation of being 'open for business.' The union that opposed the project gained nothing and cost other union members 11,000 good, high-paying jobs. The local politicians that catered to the hyper-political opposition hurt their own government colleagues and the economic interest of every constituent in their district. The true local residents who actually supported the project and its benefits for their community are badly hurt. Nothing was gained and much was lost. This should never happen again."

Honestly, I don’t think I’ve ever read a statement from a politician as scathing as this one: this is an experienced Democrat calling other Democrats morons, idiots, or whatever.

As you go forward thinking about macroeconomics and development … keep your eye on the ball. The biggest benefit to a region from any investment project is the roughly 90% of revenue that is paid out before you get to the net income line on the income statement … where 10% of revenue might end up as profits. Yet, in the non-economic thinking of many people outside our field, that 10% is more important than the 90%. This is innumeracy masquerading as sensitivity and deep thought. It isn’t either one.

The Best News of Your Lifetime

I mentioned this in class about 10 days ago, but here’s a chart from the World Bank (an anti-poverty NGO):

It is reasonable to point out that this only goes back to 1980, and that there had to be improvements before then.The $1.90/day value is the World Bank’s estimate of subsistence level consumption. This was essentially 100% in 1680. So, the improvement from 100% to 42.2% took 300 years.

It is also worthwhile to think in terms of absolute numbers (populations are in millions):

Year	Population at Subsistence	Population Above Subsistence
1680	590	10
1980	1,850	2,590
2015	736	6,622

Do note that I made up the number in the cell at the top right. The truth is the data doesn’t go back that far. But our best estimate for 1820 is 6% of the world’s population living above subsistence level, so the choice of 10 out of 600 in 1680 seems plausible.

These numbers demonstrate a phenomenon that economists understand well, but that the general public experiences as something they feel is wrong. It’s called a Kuznets Curve, and it shows up in a number of areas where environmental issues are a concern. Theoretically, it’s a very basic result that emerges in theoretical models without making unusual assumptions.

Roughly, it’s an explanation of why things sometimes get worse before they get better. In this case, it didn’t take much of an improvement in well-being for population to start rising: people lived longer, children became more likely to survive until adulthood, and so on. What doesn’t immediately change is the desire of adults to have children (who grow up to care for the adults in their senior years — that’s how human societies “did social security” on their own for millennia). Anyway, it takes a couple of generations for people to realize that isn’t necessary and to reduce the number of children they have, and invest more in each one (do note that while this is happening in many places after the advent of widely available birth control, it was observed in most of the now developed world for decades before “the pill” became available or surgical abortion was common).

In other cases, it explains why developed countries tend to be cleaner and less polluted than developing ones. The first thing people do is pollute and make money. Later on, that money is used to reduce pollution.

N.B. With science, there’s always a conflict between data and anecdotes. Scientists are able to say serious things because of their focus on data. But humans evolved in a world of anecdotes, and we still tend to prefer them. Journalists love anecdotes: they’re the basis of their stories. A problem then arises with Kuznets Curve behavior: for a while at least, the number of anecdotes increases for a while even though the overall situation is changing. So, the table above suggests that the maximum number of anecdotes about subsistence living occurs fairly recently (and actually peaked somewhere around 1970), even though the proportion of people whose lives are advancing out of subsistence has been increasing for centuries. In fact, while the number living at a subsistence level is dropping for the world as a whole, it’s still increasing in sub-Saharan Africa (even though the rate is improving there too).

In What Sense Is Last Year’s Tax Reform Paying for Itself?

The op-ed piece entitled “Tax Reform Is Covering Its Costs” by Edward Conrad is careful about its use of stock and flow variables, and comes to the conclusion that it is.

Last week the Congressional Budget Office released a 10-year forecast—the first to assess the effects of tax reform after one year of hard results. Compared with its prereform projection, the CBO now expects annual GDP growth to be almost $750 billion higher by 2027, the last year of its prior forecast. A strong case can be made that tax reform played a predominant role in accelerating GDP growth.

Do note that the CBO is supposed to be non-partisan, although most people think it leans a little towards the Democrats.

On the other side of the ledger, the CBO predicts the tax cuts will add $1.9 trillion of additional debt in the coming decade …

The first is a flow (since its GDP), while the second is a stock (since its debt). So they should not be directly compared.

However, the interest on the new debt will be a flow, and can be compared to GDP:

… and that the government will pay about $60 billion more in interest each year as a result.

How does this compare to tax revenue?

… The government is on pace to collect more than $120 billion each year from that additional $750 billion of GDP—much more than enough to cover the additional interest payments. Even if a significant portion of the projected GDP gains since 2017 are not the result of tax reform, the tax cut still pays for itself.

Do note that this is not a Laffer curve type of result (that would be that a lower tax rate brings in more tax revenue merely because the rate had been set too high). As argued in many posts on this blog last year, corporate tax rate reduction leads to increased investment because capital can be moved to where it earns the highest return, which in turn makes workers more productive.

What Has Obamacare Actually Done?

**** I have some links to add to this, but they are on my PC in the office. I’ll add those on Wednesday morning.

Ummm … I hope you get that — informed or uninformed — most people’s opinions about healthcare and healthcare finance are not very sharp.

After several years of Obamacare, there’s now serious research about its effects. The hot new one that economists are talking about is entitled “The Impact of the Affordable Care Act: Evidence from California’s Hospital Sector”.

Obamacare was sold as a lot of different things to different people (it’s a little like the musical “The Music Man”). One important aspect of this that got little attention (or understanding) on the part of the general public is that it required buy-in from the hospital industry. While healthcare is a large part of U.S. GDP, there is always a constant strain of thought that providers are not getting doing well financially, right? So they wouldn’t have signed on without some assurances that the policy was designed to ease their bottom lines.

This is related to the healthcare finance system we had before and after Obamacare. While Obamacare made many modifications, the core principle of the U.S. system remained intact: people seek to attain overpriced private insurance with very broad and deep coverage (often as a job benefit), providers overcharge those customers, and the excess is used to pay for the healthcare of people without coverage. If that excess is not enough, providers have an existential problem. That sort of care is provided for by two types of institutions: 1) county hospitals that must “take everyone”, and 2) hospitals that run on charitable donations.

Discussions of the high cost of the U.S. system tend to miss 3 salient features. First, Americans are not living a comparable lifestyle to most of the comparison countries. This is important because the income elasticity of healthcare is higher than 1 (technically, peoples’ purchases indicate it is a luxury good), so people with more money will buy proportionally more healthcare. Second, healthcare outcomes are better in the U.S. than in other countries: diseases are spotted earlier, and life expectancy after treatment is better (Americans tend to screw up their life expectancy before they get to the doctor). Third, the strong net inflows of “medical tourists” suggest many people are well aware of the second point.

Please note that none of this should indicate that I am an apologist for the U.S. system. I’m just pointing out that the evidence that we get what we pay for, and that we choose to pay for more healthcare because we can, is quite strong and needs to be acknowledged more widely.

So, what did they find?

• Medicaid enrollments are up nationwide. (Medicaid and Medicare are often confused: the former is for the poor, the latter is for the old).
• No increase (in California) in private coverage. In short, the healthcare exchanges were a waste.
• Less people are paying for healthcare out-of-pocket. Combined with the last two, this indicates that all of this change is coming through Medicaid.
• Increases in payments through Medicaid are also heavily substituting for payments that used to be made by county hospitals. Since Medicaid is funded through federal revenues, this amounts to a transfer from counties nationwide that had lower indigent costs to those that had higher indigent costs. In combination with other research, this suggests we are providing more healthcare funding to people who don’t value healthcare very highly.
• The CBO indicates that Obamacare increased federal spending by $120B/yr. That’s a 3% increase in federal outlays (that’s “the budget” that Congress passes), or a 9% increase in federal government expenditures on consumption and investment (the G in Y=C+I+G+X).
• Obamacare has increases access to hospital care, and ER utilization. And people are choosing to go to better quality facilities. However, this effect is not large: utility estimates suggest it is comparable to living 4 miles closer to the hospital.
• No net improvement on healthcare outcomes. Do note that the estimates are positive, but that the variability of healthcare outcomes swamps that and makes it statistically insignificant.
• Hospitals are bringing in more revenue.
• The gains in hospital revenue have gone mostly to those serving more indigent patients (primarily those county hospitals).
• Hospitals do not seem to be spending the increased revenue on improved quality or capital investments. This suggests it is filling holes associated with previous shortfalls.

How can all that best be summarized? How about this: we’re transferring more money from richer to poorer counties, through Medicaid, to provide better coverage to people who didn’t think it was worth the price, but they’re using it, and the hospitals are benefiting, but for the patients it’s a wash.

Trump was notably surprised when he said “Nobody knew hat healthcare could be so complicated.” It seems it may have been more complicated than the Democrats thought when they passed Obamacare too.

Economizing Is Hard (and That May be a Big Problem)

Economists are often criticized for making unrealistic assumptions about the behavior of “people” in our models: it seems implausible that real people would behave as intelligently as the “people” in the models are assumed to do.

In defense of economists, I will say that at higher levels (where you start to do a lot of theory) a lot of that implausibly smart behavior is assumed because you can’t even start to solve the problems we think about without presuming a lot of smarts: it just makes the math easier. And, then as the theory advances, we figure out ways to incorporate less smart behavior into our models.

Anyway, there’s new empirical research out about this. In “IQ, Expectations, and Choice”, researchers look at the accuracy of inflation expectations, and financial choices based on that, through the filter of IQ (their sample is men only). And what they find is not pretty.

Here’s the macro issue they’re worried about:

After the financial crisis, several governments around the world implemented unconventional policy measures to decrease household leverage and increase household spending so as to avoid a liquidity trap. Policies such as mortgage refinancing programs and unconventional monetary policy aimed to affect choice through managing households’ beliefs about future macroeconomic conditions and hence stimulating consumption over savings. Unfortunately, these policies turned out to be much less effective than expected. A candidate explanation for such ineffectiveness is that many households’ expectations might not react to policy announcement merely because households make mistakes in forming their expectations and have no understanding of economic mechanisms. [emphasis is mine, not theirs]

So, they got a long-term data set from Finland, where all men have to take an IQ test for military service at age 20. Then they match that up with consumer surveys done later in life, typically around age 33. It’s somewhat technical, so let me translate:

• Higher IQ men made smaller errors in their expectations of inflation.
• Lower IQ men did not adjust their current expectations at all when their past expectations were inaccurate.
• Lower IQ men rounded their expectations more drastically.
• Lower IQ men were more likely to report implausible or unrealistic numbers for inflationary expectations.

In one sense, none of that is very surprising, so … who cares, right?

Except that theory tells us that people behaving optimally should adjust their consumption when their expectations of inflation change.

…We find low-IQ men do not respond to changing inflation expectations … These results suggest that men with low cognitive abilities might not fully understand economic incentives, irrespective of the extent to which they are informed about current and future macroeconomic variables.

This is a doozy:

… Non-responsiveness of low-cognitive-ability individuals … might result in an implicit redistribution from low- to high-cognitive abilities men when central banks or government implement policies to stimulate demand via policies that aim to raise inflation expectations. The lack of forward-looking attitudes in low-cognitive-ability individuals might also determine a lower sensitivity to policy shocks aiming to favor
forward-looking saving and borrowing choices. Hence, cognitive abilities might contribute to changes in wealth inequality over time. Limited reaction to policy interventions by many households would also be detrimental for governments that aim to change aggregate consumption and saving patterns throughout the business cycle.

That is not pretty: expansionary monetary policy might have a reverse Robin Hood effect, and policies to discourage poor saving/borrowing decisions might not help those who have the most to lose. That’s a big problem, because 1) monetary policy is a common and basic tool of countries around the globe who are presuming that it can’t be subverted by the poor choices individuals sometimes make, and 2) it’s coverage in principles is at least somewhat indicative that this is as easy as understanding macroeconomic policy can be (and it may not be easy enough).

Further Reflection On the Quodlibet Question of Whether or Not the Housing Crisis Caused the Last Recession

For this one, the content of this post is required. The links are optional, but would make great reading for the intensely interested student.

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I forgot a sixth point in my reply to GS’s question. This is, that financial crises and recessions are two different things, and that they do not have to occur together. For example, the 1987 stock market crash was a financial crisis, but there was no recession from 1982 to 1990. Part of what made the last recession so bad was that the financial crisis overlapped it. We saw the first signs of declining home prices in southwestern Florida in early 2006, followed by the first signs of financial trouble in April 2007 with the bankruptcy filing by New Century. The recession itself began 8 months later with a December 2007 peak. The first 9 months of the recession were relatively mild, before the bankruptcy filing of the large financial firm Lehman Brothers in September 2008 sent the economy into steep decline. Arguably, the next 4 months’ decline was steep enough to be comparable to part of the Great Depression, although not nearly as sustained. In the Spring 2009 version of your class, we kept an eye on the data and started seeing brighter signs in late January. The economy troughed in July. The financial crisis went on for some time after that, but as early as March 2009, stronger banks were already trying to pay back their “bailout” because it wasn’t (and in some cases hadn’t been) needed.†

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I put the above into a post because the new issue of the Journal of Economic Perspectives  just came out. This is freely accessible. In this issue they have a symposium of 3 articles on the post-crisis financial regulation.

Former Fed Governor Tarullo writes that improved regulations have made the biggest banks stronger, but that “… the current regulatory framework does not deal effectively with threats to financial stability outside the perimeter of regulated banking organizations, notably from forms of shadow banking.” Shadow banks are financial institutions with some bank-like operations, but which are not banks at all. Examples include … hmmm … New Century (which was a REIT), and Lehman Brothers (which was an investment bank). Shadow banks get into banking-like operations in the first place because they can offer services which banking regulation prevents. There’s clearly a demand for these services, and they can clearly create crises, but we’ve done little about them.

Duffie (a big name in finance) partially uses the language I used in class the other day. He calls the housing crisis a shock rather than an impulse (shock might be more common terminology than impulse, and I use both). But he specifically argues that the financial system “became a key channel of propagation”. In parallel to Tarullo, Duffie argues that we still have a “too big to fail” mentality towards certain firms in the financial industry, but our new regulations don’t cover whole industries which are viewed this way.

Aikman, Bridge, Kashyap, and Siegert argue that better financial regulation could have prevented the financial crisis from making the recession worse (this is called macroprudential regulation). These include better monitoring of risk in real time, forcing financial firms to reduce leverage, providing liquidity for institutions to get out of funding mismatches — like borrowing short and lending long, and helping households reduce their stock of debt. They then contrast the U.S. and the U.K., and argue that the U.K.’s new institutions are well-equipped to address these problems. However, the U.S. institution, Dodd-Frank’s Financial Stability Oversight Council lacks authority to address these problems directly, and can be circumvented through regulatory capture. Ugh.

† I heard about the financial crisis vicariously, two separate times, but didn’t know what to make of it at the time.

In one case, a professor you all know brought me a consulting project to potentially work on (we were a candidate, and ultimately didn’t get the job). It was from a huge international bank. They were having problems because mortgage loans were going delinquent (by 30 days). That’s the normal part. Some of those get back on track, and some go delinquent by 60 days, and here was the new thing: the rate of ones that were getting worse was going up, and they didn’t know why. I still have that project’s files on my computer, and they’re dated December 2, 2006.

In the second case, SUU hired a new professor. I happened to run into this guy at a restaurant over the summer, and got to talking. He had left Florida Gulf Coast University, a new-ish school, south of Fort Myers, in the then booming southwestern corner of the peninsula. He got out because the housing market there had crashed, and and he didn’t want to lose a bundle on the home he owned. That was in August 2007 … 4 months before the recession started, 7 months before Bear Stearns was merged to avoid a crisis, and 13 months before Lehman Brothers went bankrupt. That’s pretty close to the top of this extensive timeline of the financial crisis.