Innovation, bubbles, and welfare: erratum

Here is the correct link to Calvo's paper: Read this .

Innovation, bubbles, and welfare: A Calvo model

Here is the view I find most congenial with my own, about our « financial-schumpeterian » crisis. The financial bubble followed and amplified real returns in a phase of intense innovation, which did boost welfare too. And the crisis was a correction marking the end of the innovation phase.

Read this .

Keynes and efficient markets

Greg Mankiw (“Was Keynes really a savvy investor?” in Greg Mankiw’s Blog, June 26) quotes a great post by Scott Sumner : “Don’t trust historians”, The Money Illusion , June 2009.

While Keynes is usually presented as the man who single-handedly created the new field of macroeconomics, but also, besides being a first class statesman, as a shrewd portfolio investor and financier, Sumner sets the record straight an describes how he near bankrupted a syndicate he set up with his brother, some of the Bloomsbury circle, and a financier friend from the City of London in May 1920. He had to be bailed out by his tolerant father and, propped by a loan from the coolly acute financier Sir Ernest Cassel. He could then persever in his speculation, gaining some and losing some other bets.

Adds Sumner: “Translation, without help from his rich daddy and rich friends, this cocky, arrogant, smart-aleck would have fallen on his face, ended up digging ditches somewhere and we would never have heard of him.”

Maybe. Anyway, his later gains indeed were not a proof of his superior ability as Sumner explains, giving a beautiful example of how, with a large enough capital to start with – i.e. a low or negligible risk of ruin -, earning money by speculation is not that difficult.

Conclusion: “From now on I will never believe anyone who tells me that Keynes was a great investor.” And without such a reputation “nobody would take seriously his Chapter 12 in the General Theory where he tries to shoot down the efficient market hypothesis” with “a lot of nonsense about musical chairs, beauty contests, and the seasonality of ice prices”.

A must read.

A Delicious Visit of Monticello

In today’s New York Times artist Maira Kalman tells everything about the pursuit of happiness, here .

The Future of "Francophonie" (in English)

An eye-opening paper posted on A Fistful of Euros. The center of gravity of Francophonie is moving south and is now, most probably, somewhere around Bamako, Mali. A must read, here .

Via Tyler Cowen (Marginal Revolution).

Large size banking is a social bad

Willem Buiter follows on Mervyn King’s path and suggest here some solutions (in the Financial Times).
Via Mark Thoma’s blog, Economist’s View.

Regulation versus classical banking

Jo Johnson, Head of Lex, the sophisticated team of commentators writing a column on business and financial topics in the Financial Times, wonders if more regulation is really the solution to current ills (June 19). “Many are skeptical” he writes, one central banker even telling the London newspaper that “macro-prudential supervision gives rubbish a bad name.” Can central bankers really spot bubbles better than the market?

“In the UK, Mervyn King, Bank of England governor, used his Mansion House speech (last Wednesday) to push for “smaller banks” and the separation of high street/commercial banks from their investment banking arms” he adds.

Readers of this blog will recognize the “classical” or “narrow” banking proposal that many economists and decision makers deem necessary to prevent future crisis. Welcome to the classical banking club Dr. King.

The risks of a double-dip recession may be growing

Many risks of a downward market correction remain writes Nouriel Roubini, the economist that rightly predicted the current great recession. In the June 20 Taipei Times issue. Via Mark Thoma (Economist’s View).

U.S. Beware : Don’t Go European on Health Care Costs.

“Democrats Scramble to Cut Costs From Health Plan” titles the New York Times (June 18). The American policy debate over universal health insurance coverage is indeed replicating years of hand wringing by policymakers in Europe in general, and France in particular, about the ever rising “costs” of health care. But what do they mean by that? Does anyone deplore the rising costs of restaurants or of any other type of services, or are these costs considered a government “problem” that should be met by bureaucratic rationing? Of course not.

What creates a “cost problem” is broad or universal health insurance coverage that is financed by taxes, and taxes that all fall in fine on labor. Economists everywhere know that it is irrelevant that the tax is paid formally by employers or by employees as long as it is based in both cases on labor earnings.

Then, in such a bismarckian system, increasing health care spending becomes a “bad” since it forces increases in the tax on labor and thus reduces labor participation and GDP growth (see Edward Prescott’s work on this effect). Accordingly governments try to cut the health “costs” (health care spending), even against the demanders’ and suppliers’ will, because they somehow realize that further increases in labor tax will bring economic slowdown and stagnation.

This is the bismarckian trap in which continental Europeans fell a long time ago and vainly try to escape today, from one “rationing plan” and administrative “cost control” to another, with no avail. Governmental health insurance financing labor tax goes up steadily and GDP growth rates trend down basically because older and richer consumers want more health care, not less. This experience should help the U.S. avoid a major mistake.

How then properly insure low income families against health care risks? Instead of universal provision of government supplied health insurance (paid with taxes) make universal private buying of some health insurance compulsory, and thus reduce the total amount that has to be financed by a tax to what is necessary to subsidize the lower income families with a “health care voucher” in order to enable them to buy the same insurance coverage that is compulsory, and that richer families can easily afford.

In such a scheme there is no “socialized medicine” bias since the compulsory health insurance is bought in a competitive market from the insurer of your choice and health care can be bought from any private supplier that is recognized by the insurer. There is also a clear macroeonomic benefit to that since compulsory buying does not generate a deadweight loss comparable to that of a tax, and since the tax on labor can thus be minimized that way. In the example of France that I develop in my Commentaire paper of this spring (“Comment gagner plus”, available here ), I show that such a plan would reduce the necessary amount of the tax on labor by 2/3 (two third).

You can get then an effective social policy without the growth hindering effects of government supply of health care and its growth destructing tax finance.

A French Advice to President Obama.

Do not finance universal health insurance coverage by increasing taxes on labor. Make private buying of insurance compulsory instead - if necessary - for the current fraction of the uninsured that has not deliberatly and voluntarily chosen not to insure, and subsidize low income families - whenever necessary - with a health care complementary voucher.

In that way you can limit the job destruction effect of higher labor taxes. If you imitate the European pattern of universal tax-financed and publicly provided health insurance, you’ll obtain the same low and falling level of labor participation, and the reduced GDP per capita that comes with it: about minus 30% relative to U.S. level for France for instance.

Still the age of democratic revolutions...

The return of the state and of authoritarianism? Forget it, freedom is still in demand, and the great recession may help topple authoritarian - not democratic - regimes, as Iran may show, says Ross Douthat in The New York Times (June 15).

For an argument along the same line, but with regard to more developed countries, see my article “La crise des capitalismes hiérarchiques“ published in Commentaire (December 2006)and available here.

A word from David Friedman.

Commenting on the reference to his article “A Theory of the Size and Shape of Nations” in my post “Why Europe Then?”, David writes:

“That was my first journal article in economics--nice to see that someone still finds it useful.”

As all readers of that paper know, it is a seminal contribution to the economic theory of politics, and it is here to stay. I personally feel that it has been seriously underused in the literature until now, and I would be glad to know what the author thinks of Europe as a "t-nation".

Why Europe then?

An English version of "Mais pourquoi l'Europe?", by popular demand...

“Europe” here refers to the political superstructure that the nation-states of the continent have been building over the past half century. The purpose of the venture is not completely clear to say the least. Doubts about it abound, and the more so after repeated rebuffs by several national electorates during the past few years, especially regarding the proposed “constitutional law” that would represent a further step towards a federal continental integration. On June 8th, only 43% of European voters did participate (a steady downward trend in election after election), and only a little more than 40% of French voters went to the booths. Hence the “why”.

Obviously the building of a political Europe is not intended to foster any more a large internal market where corporations could take advantage of economies of scale, because the common market has been completed a long time ago, because national markets have been opened everywhere to globalization and free trade, and because the current corporate management trend favors downsizing over large scale.

Political Europe is not intended as a means for social policy either, since it remains the exclusive preserve of national authorities, and since there are apparently no economies of scale to be gained there, while a common social policy would lose much of its selectivity and capacity to target specific clienteles.

The aim could not be defense or security since the implosion of the Soviet union removed the threat of an international nuclear conflict, although nuclear terrorism cannot be dismissed so easily.

It is not (any more) to build a super-state or world power in an era of fragmentation of large states, and considering the very limited military budgets and efforts of all the continent’s states.

Why then are practically all political leaders (and business elites) tirelessly advocating further integration in defiance of the growing disinterest in Europe that voters express (the “no” of French and Irish referendums, the majority of French people who do not trust the euro according to the polls, the 59.4% of abstentions in France in the recent vote), in the absence of immediate external danger and given the constant protection of U.S. military power since 1945 while no European nation consent indeed a major defense effort?

Why this obstinate research of political scale, while all over the world large nations are fragmenting and independence is the key word? Why did European leaders chose to expand from 12 to 15 and then to 27, a move which can only increase the difficulties of common governance?

Why a political union at all when the key element of this centralization, the single currency, has an economic cost which clearly exceeds its benefits (see Martin Feldstein, “Reflections on Americans’ Views of the Euro Ex Ante” NBER Working Paper No. 14696, January 2009)?


There are, ultimately, only two answers, which are also complementary: one which concerns the States interests, and the other concerning the big business interests, while the voters, on the contrary, express disinterest in or opposition to the venture.

For the States: the goal is of course to maximize revenues. Their agents pursue a resource maximization strategy, just like private agents in the economy. But in an era of globalization, and thus of increased mobility of men and capital resulting from trade liberalization, and the abrupt fall of transaction costs, increased tax competition undermines the states’ collection of resources.

How to deal with that? An answer is to be found in a profound analysis of David Friedman: “A Theory of the Size and Shape of Nations”, (Journal of Political Economy, February 1977). It starts from the simple fact that while the burden of a tax falls, in fine, on individuals, capitalists or wage earners (employees), it can be levied on different factors of production or on products. The comparative costs of using these different tax bases determine the specific tax structure and the “optimal tax dimension” of a nation (a “t-nation” as defined by Friedman).

A tax on trade, for example, collected by several tax authorities along a trade route, encourages each of them either to tax too much the product transported by the addition of several local taxes, if the route is unique, or to lower too much their tax rates if the trade can take other routes, for fear of diverting the trade flows away from each local jurisdiction. In both cases the chosen tax rates diverge from the “optimal” rate of a monopoly authority covering the whole trade route, optimal rate that would maximize tax revenues. Political integration then maximizes fiscal resources when the tax is levied on trade.

On the contrary there is no incentive for increasing the size of the nation in the case of a land tax.

A tax on labor is rather similar to a tax on trade to the extent that labor is mobile. A way for the tax authority to overcome this difficulty is to reduce the mobility of its workforce through the development of a national culture (e.g. a national language) that makes adaptation abroad more difficult, or through sheer regulations hindering emigration. Another approach is to broaden the territory under a same tax authority, or to organize a tax cartel of several neighboring countries in order to suppress tax competition, which obviously reduces the value of emigration to these countries, and allows an increase of the tax on labor.
The question then is: why would business people support a project that aims at raising taxes?

For corporations, the political unification presents two advantages.
The first is that taxes are levied essentially on the less mobile bases, those that cannot escape taxation. Today, capital is more mobile than labor, so that it is mainly the latter which is imposed. In the case of integration the owners of capital are thus relatively certain to be better treated than wage earners.

But secondly, and more importantly, corporations derive a direct benefit from integration. European countries emerged from World War II with basically unchanged prewar industrial structures, corporatist, cartel-ridden regimes, in which collusion was organized between big business, the governments and large, officially recognized, unions. The postwar institutional construction of the common market started with the cartels of coal and steel, a Franco-German enterprise at first, progressively extended to other countries and other sectors.
Trade was managed as a matter of fact by intra-industry agreements that allowed large companies to fix prices in order to generate rents and limit competition (see the analysis of the initial step by Françoise Berger: “France,Germany and steel (1932-1952). From the strategynof cartels to the creation of CECA”, Université de Paris 1, a doctoral thesis in history, defended in 2000).

But the globalization of trade that occurred later, in the 70s and 80s, threatened this system by opening the door to a much more active competition. At the same time, the fluctuation of exchange rates that became the rule after the collapse of the Bretton Woods system in 1971, made international price agreements much more difficult to manage. The return to fixed exchange rates, which could only be secured by a single currency, is thus a way to restore a cartel management of industries across the whole continent. And here again, the larger the union, the more efficient the cartel rule.

This is why the business establishment – and especially that of the financial sector - has pushed so hard for the creation and defense of the euro, even though its political “raison d’être” is fast disappearing and its adverse economic effects are becoming more evident every day.


These two kinds of collusion, the cartel of States and the European wide cartels of corporations, define together the nature of the European centralization venture and process.


The conclusion is unavoidable: smaller size, independent States, are subject to both a more intense competition between companies for the benefit of the consumer, on the one hand, and to a weakening of their tax extraction power, on the other hand, because they are smaller and thus more open to foreign trade. And a lower tax burden, in a globalized world, mainly benefits employees because they are less mobile and therefore more taxed than capital.

The employees would thus be the first beneficiaries of the competitive independence of smaller nations, while state bureaucracies and large business firms prefer the collusion of a politically unified continent. Apparently abstention in the recent poll came mainly from the less affluent parts of the electorate.

Questioning euro membership.

« One size fits none » is the title of an article on the euro area in the June 11th issue of The Economist, here .

The journalist quotes at length Jordi Gali, a professor at University Pompeu Fabra who expresses fears about the capacity of Spain to recover while handicapped by an overvalued, because nominally fixed, exchange rate. Well, at least a few European academics hard pressed by the facts begin to recognize - at last though willy-nilly - the validity of basic economic reasoning. That was long overdue.

But Gali then asserts “No one sold the euro as a solution to high unemployment”. Sorry but this, again, is totally contrary to the facts. The official slogan of the campaign for the creation of the euro that Mr. Delors, Mr. Trichet and national politicians repeated over and over was that the euro would boost growth through price stability and shield the European economies from recessions and financial shocks. Sadly most European economists helped obligingly to spread such nonsense, that they concealed in a mass of irrelevant technicalities and byzantine discussions destined to divert the public’s attention.

Some of them went so far as pretending that imposing a single currency on a non optimal monetary zone would make it optimal ex post! In other terms a currency could force, by its very existence, heterogeneous economies to converge. Others demonstrated that a single currency would boost trade between economies by multiples of 100% (!), way beyond what free trade would achieve. And the creator of the optimal currency area concept, Nobel prize winner Robert Mundell, developed and ad hoc argument in favor of the euro exactly at odds with his own theory thus ridiculing the Nobel Jury.

This was not an episode for economists to be proud of. Only two top economists kept consistently critical of this irrational euro exuberance: Paul Krugman who showed that a common market was more likely to increase structural divergence between member economies rather than foster convergence of specialization, and Martin Feldstein who from the start diagnosed the euro as an economic liability in search of a political rationale. Milton Friedman, an early defender of flexible exchange rates, also criticized the euro, but occasionally only.

Readers of this blog can check in L’Erreur européenne (Grasset, 1998) what could easily be diagnosed in advance, before the fact, on the basis of straightforward economic theory.

The next question, however unorthodox, now is: who should exit, and how. Again, almost all European economists pretend that the cost would be huge. But again they are wrong.

Have you read that?

Well you should! Here is the Glaeser column in Economix.

Barack Obama’s Greatest Accomplishment (so far). … Bis.

Here is the post again, the address was incomplete.
A fair comparison of George Bush’s and Barack Obama’s policy regarding the closing of Guantanamo, by professor Engram (no first name supplied) on his blog Back Talk, here .

Barack Obama’s Greatest Accomplishment (so far).

A fair comparison of George Bush’s and Barack Obama’s policy regarding the closing of Guantanamo, by professor Engram (no first name supplied) on his blog Back Talk, here .

Le vote écologique aux européennes.

En France, 40 ans après avoir rejeté les communistes, en mai 1968, les bourgeois socio-libertaires se décident à lâcher les socialistes étatistes, en espérant les remplacer.

Record abstention in Euro-elections.

An honest assessment on Charlemagne’s notebook (a blog of Economist.com) here .

Mais pourquoi l’Europe ?

Ce n’est pas pour les économies d’échelle dont pourraient bénéficier les firmes sur un grand marché intérieur, à l’ère de la plus petite dimension des entreprises et de l’ouverture de tous les marchés nationaux en un vaste marché global.

Ce n’est pas pour le développement des échanges internationaux, déjà réalisé sur une plus vaste échelle à l’ère de la globalisation.

Ce n’est pas pour une politique sociale de redistribution qui reste du domaine réservé des autorités nationales et d’ailleurs ne bénéficierait d’aucune économie de dimension et perdrait en ciblage différencié si elle devait être unifiée sur l’ensemble du continent.

Ce n’est pas pour assurer un objectif de défense ou de sécurité, à l’ère de la disparition de la menace soviétique et de l’éloignement du danger d’un conflit nucléaire international (mais pas nécessairement de celui d’un terrorisme nucléaire non directement étatique).

Ce n’est pas pour construire une superpuissance étatique, à l’ère de la fragmentation générale des Etats, et alors que l’on s’en tient sur le continent à des budgets militaires nationaux des plus limités.

Pourquoi alors la presque totalité des responsables politiques prône-t-elle inlassablement le dogme de l’Europe unie au mépris des réticences de plus en plus affirmées des électorats (Le « non» des Français et des Irlandais aux référendums sur Lisbonne, une majorité de Français qui ne font pas confiance à l’euro, près de 60 % d’abstentions (59,4%) aux élections d’aujourd’hui), en l’absence de danger extérieur immédiat et sous la protection de la puissance militaire américaine, tandis qu’aucun de ces pays ne consent véritablement d’effort de défense autonome?

Pourquoi cette recherche obstinée de la dimension alors que partout dans le monde la tendance est plutôt au « downsizing » ? Et pourquoi les dirigeants politiques ont-ils absolument tenu à l’élargir de 12 à 15 puis à 27, alors que cela accroît évidemment les difficultés d’une gouvernance commune ?

Pourquoi enfin l’Europe politique alors que la première pièce de cette unification centralisatrice, la monnaie unique, comporte un coût économique qui dépasse clairement ses avantages (voir Martin Feldstein : « Reflections on Americans’ Views of the Euro Ex Ante », NBER Working Paper No. 14696, January 2009)?


Il n’y a, in fine, que deux réponses, qui sont aussi complémentaires : l’une concernant les Etats, et l’autre concernant les entreprises, les peuples, eux, étant contre.

Pour les Etats : l’objectif essentiel est bien entendu de s’assurer des ressources aussi abondantes que possible. Ses agents maximisent le flux de revenus dont ils peuvent disposer, comme d’ailleurs tous les autres agents de l’économie.
Mais dans une période de globalisation, et donc de mobilité accrue des hommes et des capitaux résultant de la libération des échanges et de la chute verticale des coûts de transaction, la compétition fiscale accrue qui en résulte compromet la collecte de ces ressources.

Comment y parer? Il faut se référer à l’analyse profonde de David Friedman (« A Theory of the Size and Shape of Nations », Journal of Political Economy, février 1977 ) sur la dimension optimale des Etats.
Il part du constat simple de ce que l’impôt, qui pèse toujours in fine sur des personnes, salariés ou capitalistes, managers ou propriétaires, peut être assis différemment sur les facteurs de production, ou sur les produits. Ce sont alors les coûts économiques comparés d’utilisation de ces assiettes qui en déterminent le choix, et par suite définissent la dimension « fiscalement optimale » de la nation.

En effet, un impôt sur les échanges par exemple, prélevé par plusieurs autorités fiscales sur une même route commerciale, incite chacune d’entre elles à réduire son prélèvement si le commerce peut emprunter d’autres routes, de peur de détourner les flux commerciaux de son espace national, ou au contraire à augmenter son prélèvement si son pays constitue un point de passage obligé. Dans les deux cas les taux d’imposition ne correspondront pas à celui d’un seul Etat agissant comme un monopoleur et choisissant le taux (de monopole) qui maximise les recettes fiscales de l’ensemble. L’intégration politique maximise alors les ressources fiscales. Au contraire un impôt foncier n’implique aucun gain pour l’autorité fiscale qui soit lié à la dimension de la nation.

Le cas de l’impôt sur le travail est similaire à celui de l’impôt sur les échanges dans la mesure où les salariés sont mobiles: chaque nation est alors amenée à réduire ses taux d’imposition. Elle peut pallier cette difficulté en essayant de réduire la mobilité de sa main d’œuvre par le développement d’une culture spécifiquement nationale qui rend l’adaptation à l’étranger plus difficile (langue nationale par exemple), ou en freinant réglementairement l’émigration. Mais une autre façon de faire consiste à élargir l’autorité fiscale à plusieurs pays voisins de façon à unifier l’imposition du travail, ce qui réduit évidemment l’intérêt de l’émigration vers ces pays et permet, par une collusion fiscale entre Etats, d’augmenter l’imposition du travail.

Mais pourquoi le grand patronat soutiendrait-il un projet destiné à alourdir les impôts ?

Pour les entreprises l’unification politique présente deux avantages. Le premier vient de ce que les impôts portent essentiellement sur les assiettes les moins mobiles, celles qui ne peuvent lui échapper. Or aujourd’hui le capital est bien plus mobile que le travail, ce qui fait que c’est principalement ce dernier qui est imposé. Les propriétaires de capitaux sont ainsi relativement mieux traités que les salariés lors de l’intégration.

Mais surtout, deuxièmement, les entreprises tirent un avantage direct de l’intégration: les différents pays européens ont émergé de la deuxième guerre mondiale avec des économies à structures corporatistes, c’est-à-dire régies par des cartels du coté patronal, en collusion avec les Etats dirigistes et les grands syndicats officiellement reconnus. La construction européenne, à partir des « pools » et notamment du pool charbon-acier, n’a fait que conforter ce système en l’étendant à un espace plus vaste, franco-allemand dans un premier temps, puis continental avec le marché commun.

Le libre-échange qui a été instauré à l’époque a ainsi été géré par des ententes industrielles intra-européennes (voir la thèse d’histoire de Françoise Berger : « La France, l’Allemagne et l’acier (1932-1952). De la stratégie des cartels à l’élaboration de la CECA. » Université de Paris 1, soutenue en 2000) qui ont permis aux grandes entreprises de s’entendre et de dégager des rentes en limitant entre elles la compétition par des accords de prix.

Mais la globalisation des échanges qui est intervenue ultérieurement, à partir des années 70-80, a menacé ce système en ouvrant la porte à une compétition beaucoup plus active. En même temps, la fluctuation des changes qui est devenue la règle après l’effondrement du système de Bretton Woods, en 1971, a rendu très complexe l’établissement et plus encore la gestion des accords de prix entre entreprises situées dans des nations différentes. Le retour a des changes fixes, qui ne pouvaient être mieux garanti que par une monnaie unique, est dans ce contexte la seule façon de pérenniser la gestion cartellisée d’une industrie au niveau de l’ensemble du continent.

C’est la raison de l’acharnement qu’a mis l’establishment industriel et plus encore financier, à créer, et qu’il met encore aujourd’hui à défendre, l’euro, alors même que sa raison d’être politique est en passe de disparaître et que ses effets économiques néfastes deviennent chaque jour plus évidents.

Ce sont ces deux ordres de collusion, celui du cartel des Etats et celui des cartels européens d’entreprises, qui définissent la nature profonde de l’entreprise centralisatrice européenne.


La conclusion est alors inévitable : des Etats indépendants de plus petite dimension sont soumis à la fois à une concurrence plus intense entre les entreprises, au bénéfice du consommateur, d’une part, et à un affaiblissement de leur pouvoir d’extraction fiscale, parce qu'ils sont d'autant plus soumis à la concurrence fiscale qu’ils sont plus petits, et donc plus ouverts au commerce extérieur. Et la moindre pression fiscale, dans un monde globalisé, profite essentiellement aux offreurs de travail (les salariés) parce qu’ils sont moins mobiles et donc plus imposés que le capital.

Ce sont ainsi les salariés qui seraient les premiers et principaux bénéficiaires de l’indépendance compétitive de plus petites nations, en lieu et place de l’intégration collusive des Etats et des grandes entreprises cartellisées. Et l’on croit comprendre que ce sont les catégories les moins aisées de l’électorat qui se sont le plus abstenues.

Is the innovation wave « passé »?

The cover story of Business Week (“The Failed Promise of Innovation in the U.S.” , June 3, 2009), by Michael Mandel, BW’s chief economist, is a thoughtful piece. It is well worth reading, here .

Thanks to Tyler Cowen for signaling it on Marginal Revolution.

Health Insurance Options.

Greg Mankiw makes a good point regarding the Obama plan for health care on his blog today. While Paul Krugman argues that a “public option plan” will give Americans a “better range of choice, make the health care market more competitive, and keep the insurance companies honest”, Greg asks “Would the public plan have access to taxpayer funds unavailable to private plan?” Here is the debate. Readers of my proposal for France and Europe know that already: I suggest that the government should provide low income families with a “health care insurance voucher” and then let them choose, with the same buying power than richer families, the provider, whether private insurers or public insurer, in a fair competitive market. Assuming that the public insurer won’t get subsidies on the side …

Deep misunderstanding about efficient markets.

Is efficient market theory « passé »? That’s a very popular argument at the moment. The financial and housing markets boom and bust supposedly “prove” that these markets are inefficient and that the “Chicago School” of economics, where one finds many prominent advocates of free markets, has been proved wrong.

Here is the demonstration, according to a New York Times journalist (“Poking Holes in a Theory on Markets”, June 5):

“First came the rise of behavioral economists, … who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices – meaning that the market isn’t so efficient after all.”
Wrong: it just shows that individuals do not use perfect or complete information in all their decisions (limited rationality). This behavior in itself can be rational: it does not pay to spend much time, and the same amount of time, for all decisions, because the time spent at gathering information is costly and anyway most relevant information is not available for free. If these costs exceed possible benefits, then it is rational to decide under limited information. But individuals could adopt limited information behavior and nevertheless markets could be efficient, because the definition of an efficient market is a market that incorporates into prices all the available information. If individuals and firms decide that it is not worth producing more information, then the total amount of information incorporated into market prices will be limited to that amount.

But the article goes on:

“Then came a bit of more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.”
Wrong again: bubbles could be rational if investors produce for themselves different amounts of information, accumulate it progressively rather than all at once, and even, in the case where information production is very costly for them, decide to imitate other investors’ behavior, because they think that those other investors are better informed (the firm’s insiders for instance).

What efficient market theory concludes is that there is no “easy money”, i.e. it is difficult for an investor to beat consistently the market, and there is no obvious way to forecast market prices. Interviewed by the journalist, that’s exactly what Burton Malkiel said: “The problem with bubbles is that you cannot recognize them in advance.” In other words an efficient market is a market the evolution of which is very difficult, or impossible, to predict.

But the popular demand addressed to economists is precisely the impossible: tell me what will happen tomorrow, without any “if” or “conditional upon”. What serious economist can do, on the other hand, is precisely to predict what will happen if ….

As Burton Malkiel said in the same article:

“If you are leveraged 33-1 and you’re holding long term securities and using short-term indebtedness, and then there’s a run on the bank …. How can you blame that on efficient market theory?”

A last word regarding the Chicago School. First it is an exaggeration to pretend that all economists there consider that all markets are perfect. Imperfect markets are currently analyzed at Chicago as they are elsewhere, and it is widely recognized that the study of imperfect information is necessary. Second, one could both recognize that imperfect markets are a reality, depending on the part of the economy under review, and still conclude that an imperfect market is preferable to no market at all or even to a market that is imperfect but heavily administered by a very imperfect political process.

To conclude, it is obvious that information is imperfect, especially that of journalists and other economic commentators.

Good News from Casey Mulligan.

In his post of yesterday on Supply and Demand (in that order) here , Casey Mulligan compares the current recession track to that of 1980-1982. Each point represents GDP as a percent of its level three years before the end of the recession, which for the current one is assumed - provisionally - to take place in the third quarter of this year. Between 1979 and the end of 1982 two recessions in fact hit the U.S. economy. The current recession is not over yet but the red series give some senses of optimism, even though the fall has been more concentrated in time than the 1981 one. Mulligan cautiously adds:

“We do not know for sure when this recession will end, let alone whether it will be followed by a second recession. … but that does not change the fact that real GDP growth in much of the late 2000s was better than it was in the early 1980s.”

U.S. Health Care Reform and the French Experience

The Council of Economic Advisers (CEA) published yesterday a report on The Economic Case for Health Care Reform . Excerpt:

“We estimate that slowing the annual growth rate of health care costs by 1.5 percentage points would increase real gross domestic product (GDP), relative to the no-reform baseline, by over 2 percent in 2020 and nearly 8 percent in 2030.”(page 2).

This assertion seems a bit surprising at first: why should a decrease of the growth rate of any economic activity boost GDP growth? The explanation is to be found on page 4:

“It would prevent disastrous budgetary consequences and raise national saving. Because the Federal government pays for a large fraction of health care, lowering the growth rate of health care costs causes the budget deficit to be much lower than it otherwise would have been (assuming that the savings are dedicated to deficit reduction). The resulting rise in national saving increases capital formation.”

Obviously, where health care spending is financed by taxes, more taxes mean less growth. Indeed, European countries which adopted such a Bismarckian model after WWII are now burdened by very high and increasing tax levels, and slow growth. They have been trying for decades to bureaucratically ration health care spending, to no avail. It is now clear that tax financed health insurance has eroded, not stimulated growth, because of the disincentive effects of higher taxes on labor.

Maybe the CEA members should have a look at my recent report, published in the French review Commentaire (“Comment gagner plus?”, Printemps 2009, available on my homepage, here ), in which I suggest that while the government should subsidize the personal buying of health care insurance for lower income families it should avoid the trap of providing directly tax financed public health insurance in the Bismarckian welfare tradition. The difference of tax levels between Europe (and especially France) and the U.S. is due mainly to the tax on labor that funds universal public health care, and this difference goes a long way to explain the quite different growth rates of GDP on both sides of the Atlantic.

The CEA should look closely at the European experience for fear of repeating the same mistakes.

Exuberance again?

Money & Co, one of the many Los Angeles Times blogs, has published on May 28 a post with the title “After a big rally, stocks aren’t looking so cheap”. Even though your equity portfolio may be down more than 40% in the last year and a half, the major indexes have been up more than 30% since early March. Note that it doesn’t bring you back to your starting point, before the crash, but about 20% or 25% lower.

The median price/earnings ratio of stocks in the Standard & Poor’s 500 has averaged about 18 since 1988, based on operating earnings over the preceding 12 months, according to S&P.

That ratio is now 22, a warning sign that there may not be much room left for additional short-term gains.

The Oil Price Puzzle

James Hamilton (”Supply, demand, and the price of oil”, Econbrowser, May 31) wonders if the recently rising oil prices signal a resurgence of economic growth. In the U.S., Europe, and Japan, however, the consumption of oil has been reduced even while the price of oil was booming, from 2005 to 2007. Moreover the U.S. consumption in the first three months of 2009 has been well below that of 2007:Q1. Japan’s real GDP fell at a 15 % annual rate in the first quarter of this year, and declines in Europe also exceed those in the United States.

Meanwhile, there is no indication of rising inflation anticipations as measured by the implied expected inflation rates in U.S. nominal yields compared to inflation indexed yields. And it is not a question of anticipated dollar depreciation since oil’s price is rising in every currency.

Add to that oil inventories that are well above average and you are confronted, as Hamilton is, to a major puzzle.

His tentative conclusion: the long term prospect for rising oil prices is much better than the short term one, given the growth trend in China especially, and speculators have in mind the long term. As he notes “oil stores for quite a while, particularly if you just leave it in the ground. …Perhaps those crazy speculators are doing just that.”

Read the complete post here .