Friday, 3 June 2016

The Treasury Isn't As Wrong On Brexit Disaster As You Might Think

The Treasury's report on Brexit comes to some pretty stark conclusions.

GDP will be down by 3.6% in the short run and 6.2% in the long run, relative to remaining in the EU. There will be an immediate (though shallow) recession, with unemployment up by 1.6 percentage points, and the prices of stocks, houses and the pound will all fall through the floor.

Of course, the Treasury's analysis is a deeply political document. So what should we make of all these numbers? How sceptical should we be about their weirdly precise estimates? Here I'm going to try to ballpark their estimates, and (spoiler alert!) they're actually quite compatible with reality.

I don't think the task of trying to forecast the impact of Brexit is a totally futile one. In a world with true uncertainty, it would be impossible to judge the likelihood of Brexit causing Mervyn King to mutate into a giant velociraptor and destroying London, but the best evidence in the literature suggests that this is quite unlikely. An estimate is better than no estimate – at least we've got a model that makes some assumptions, and we can evaluate the reasonableness of those assumptions. That's quite a bit better than no model.

One thing that's interesting about the Treasury's model is it's quite ad-hoc. For the long-run model they do a few things:
  • Assume trade benefits productivity.
  • look at the trade literature to get a number for how much a given change in trade affects productivity.
  • Come up with an estimate how much leaving the EU will impact trade.
  • Therefore, work out the long-run impact on productivity of leaving the EU.

There's a similar process for the short-run model.
  • Assume that in the long run the economy will converge to your long-run forecast.
  • Plug data for 1989-2011 into a regression to try and estimate the effect of increased uncertainty on various different variables.
  • Assume leaving the EU causes uncertainty to increase by 1 standard deviation.
  • Plug that 1 SD increase into the model, and see how that affects convergence to the long-run steady-state predicted by the first model.

This sort of ad-hoc modelling is sort of inevitable. It's hard to build a model that takes into account the full complexity of the situation. But the shortcomings of this kind of approach are somewhat obvious. It's not clear that all fluctuations in trade should have the same impact on productivity, for instance – it depends on the size of the gap in relative prices and the degree to which particular industries experience economies of scale. Similarly, 'uncertainty' is quite a nebulous concept, and it's a bit of a stretch to say that the kind of uncertainty caused by bank failures around the world, as in 2008, has the same economic impacts as the kind of uncertainty caused by firms having less information about what the tariff regime they face will look like over the next decade.

One of the things these sorts of models sacrifice is internal consistency. If your model can't fully encapsulate the relationships between different variables, if you're reliant on inputting parameters for things that should really be endogenous, you run the risk that the stories your model is telling about what's happening to GDP, productivity, asset prices and so on don't quite add up.

So how well does the Treasury's model do by this score?

The Promised Recession

Let's break out the outputs of the short-run model a bit more.
  • Real GDP goes down by 3.6%
  • Of this, 2.7% is a fall in potential GDP.
  • That means the remaining 0.9% of the decline is due to a demand-side recession. In other words, the negative output gap increases by 0.9ppts.

This fall in output is supposed to lead to a 1.6pp increase in the unemployment rate. That seems like quite a big swing in unemployment compared to, for instance, the Great Recession. How much spare capacity there was in the economy before and after the financial crisis is hotly debated, but this OBR working paper estimates a 6pp swing, from 2% above potential to 4% below. And that swing resulted in a trough-to-peak rise in the unemployment rate of about 3%. That was surprisingly low, and no-one is quite sure why, but it seems like a 0.9% rise in the output gap would be unlikely to lead to a proportionally larger rise in the unemployment rate.

The Stock Market Crash

Another weird discrepancy is the huge wedge between GDP and asset prices in the short term model. Stock prices are, after all, the discounted stream of corporate future profits. Assuming that there is not a significant shift in corporate profits as a % of GDP and the risk premium remains the same, we might expect stock prices to move by the same amount as GDP in the long run. But the Treasury model's central scenario predicts a fall in GDP

It makes sense for increased uncertainty to increase the risk premium on stocks. The costs of Brexit are probably not evenly distributed across all possible Brexit-worlds. Most of the time, the status quo is likely to be approximately maintained through the EEA, and it's the unlikely event of a much larger reduction in the UK's openness to trade that is really worrying. But the sheer size of the discrepancy suggests that the rise in the risk premium predicted by the Treasury is unrealistically large.

I'm now going to do a bit of back-of-the-envelope discontinuity analysis to see how realistic the 20% drop in equities is. Shortly before 4pm on Tuesday 31st May, two Guardian/ICM polls dropped suggesting that the nation was perhaps a bit more Brexit-leaning than markets had previously been assuming. On betting markets, the subjective probability of Brexit dropped by around 3-5%.

If you squint, you might be able to make out the impact of the poll on the FTSE 100:

So let's conservatively estimate a .5% drop in the stock market caused by a 5 percentage point increase in the probability of Brexit. That suggests that a 100 percentage-point swing (ie the difference between Brexit and no Brexit) would be about 10%. Quite a bit short of the treasury's esitimate, in other words, but in the same ballpark.

There are some other interesting implications of this sort of estimate. The market capitalisation of HSBC, the second-largest firm traded on the FTSE, is about £88bn. Let's assume that HSBC is about as exposed to Brexit risk as the average FTSE 100 company (this is the reason that I didn't pick Shell, the largest company on the FTSE by market cap). A 1% swing in the probability of Brexit would then cost HSBC's shareholders about 0.1% of its value. Therefore, if spending £88m could shift the probability of Brexit by 1%, it would be a smart thing to do on the part of HSBC's management.

This is a very interesting illustration of the Tullock Paradox and makes the £5m budget of the official Remain campaign look quite low.

This has been quite a long post but here are the two main takeaways:

  •   We should be very careful to check the calibration of our models, especially ad-hoc ones. Reality, surprisingly, actually has some quite interesting theoretical implications.
  • The Treasury analysis perhaps exaggerates the short-term costs of Brexit, but it isn't wildly implausible.

Tuesday, 31 May 2016

Yes, The World Scales

I think it's a bit absurd to suggest, as Conor Sen does, that economies of scale are falling in the modern economy.

(Sidebar: this post is unashamedly a reaction to his – but it's too big and full of interesting ideas to quote properly, so you should go and read it! Let's bring back the golden age of back-and-forth econ blogging.)

On-demand startups, the Ubers and AirBnBs and Deliveroos of the world, can be viewed as a setback for scale. But the alternative view is that, as returns to scale rise, attempts to bring some of the benefits and efficiencies of scale to smaller businesses become more worthwhile.

Maybe people are driving Teslas instead of Model Ts. But that's because, in a world where scale is driving down the cost of standardised products, it's uniqueness and quality that stand out. Everyone and their mother has a cheap, high-quality Mercedes – that's why you need to spend your excess wealth on a gleaming electric status signal.

Sen cites Uber's regulatory problems as an unexpected problem caused by their scale. But it's not just Uber's core technology and business model but its legal strategy that gets advantages from scale. Part of the reason Uber has been expanding so aggressively is that, without scale, it wouldn't have the clout to fight regulators. The incentive for regulatory arbitrage in the ludicrously restrictive taxi industry has always been there. It's only with modern technology that an arbitrage operation like Uber has been able to justify the sort of scale needed to fight the regulators and win.

It's also important to distinguish actual observed scale from the costs of scale. Sure, the most-viewed TV episodes ever (at least for the US) are M*A*S*H, Cheers and The Fugitive. You have to go down the list to #11 before you get to a finale that aired this millenium - in this case, the bleeding edge of modern culture that is Frasier. But that owes less to the benefits of scale and more to the fact that they were the only game in town - M*A*S*H is on top for the same reason that there will never be another Bradman. But if you're trying to scale a TV series today, peer-to-peer networks will get it into the hands of millions of people for free - which is why content producers are now having a harder time getting people not to access their content than the reverse.

Sure, Chipotle isn't as big as McDonalds and Whole Foods will never be Walmart. But Buzzfeed is bigger than the New York Times. Facebook is busy monetising 1.6 billion pairs of eyeballs. (That's almost 3.2 billion individual eyes!)

The future may not deliver economies of scale large enough to justify 1999's stock market evaluations. But no one person has ever been able to impact the lives of so many people as the engineer who tweaks Facebook's code.

EDIT: Well, maybe this isn't such a real-time debate, since it took three weeks for Tyler Cowen to notice Conor's post, and another day for me to notice his. Costs and benefits of relying on mavens, I suppose.

Friday, 14 March 2014

Thoughts on Trichet

This afternoon I had the opportunity to see Jean-Claude Trichet, President of the European Central Bank from 2003 to 2011, give a speech about the Euro crisis at the Oxford Union. I have been known to describe him as 'the man who caused the Euro crisis,' but I was pleasantly surprised by his speech. The speech was everything you might expect – he described the 'extraordinarily accomodative' monetary policy of the ECB, and there was the usual handwringing about competitiveness and imbalances. But much of his speech was interesting nevertheless.

What struck me the most was how much the discussion focused on financial factors. He stressed the importance of the 'swift, bold' reaction of the world's central banks in preventing the collapse of the global financial system and averting a second Great Depression. He downplayed the role of interest rate policies, barely mentioning them in his main speech.

He stressed the importance of the cooperation of global central banks. I was puzzled by the importance he placed on the fact that the world's four major central banks all now agree on a definition of price stability at around 2%. I do not see why this is particularly crucial or relevant.

When asked whether he was concerned by zero interest rate policies, he argued that they were necessitated by the severity of the crisis. He sounded surprisingly market monetarist when he said this.

When asked whether the ECB should have acted more quickly and decisively to cut interest rates, he argued that interest rate policy was always focused on the medium-term inflation target and that all actions he took while president were made in light of this. He was sympathetic to the view that the ECB should at the present time be doing more to prevent inflation expectations from becoming unanchored in the downward direction. He seems to believe that the ECB's inflation target is symmetric. However, I don't know if he would recommend sticking to the status quo if Eurozone inflation were 3.2%, rather than the 0.8% figure he quoted.

His view seemed to be that the ECB had two major roles. Macro policy (interest rates) should be set to ensure price stability. Liquidity mechanisms and political oversight would then be needed as separate policies, to prevent problems in the real economy caused by financial or sovereign debt crises. My prior is that Europe's fiscal and financial problems would be far less systemic and severe if macro policy had been more aggressive. Trichet and the ECB think that, once you ensure price stability, by definition all other problems must be problems in the real economy and not caused by nominal issues.

An interesting side point he made was that, in the USA, 20% of investment is financed by banks and 80% is financed by the market, whereas this ratio is the exact reverse in Europe. This may explain his focus on the importance of financial policy and the disruption of monetary transmission mechanisms.

He mentioned the importance of greater democracy within the European project and in particular how more power should be in the hands of those members of the European Parliament who represent Eurozone countries. One of the most serious problems with the Eurozone is how it must rely on the dysfunctional institutions of the EU, where non-Eurozone countries fight increasing integration at every turn. This makes it much more difficult to respond to crises.

I was surprised that no questions were asked by the normally reliable Union audience about austerity, the flaws of neoliberalism, the evils of structural adjustment or the plight of the Greeks.

Overall I came out of the room with a higher opinion of Trichet than I had entered it with. He seemed thoughtful and less dogmatic than many European policymakers, although this is no doubt partly down to the fact than he no longer holds office.

At no point did he mention the word 'unemployment.'

Sunday, 2 June 2013

Insiders, Political Economy and The Reset

Tyler Cowen has a reminder for us:
It is a common observation that nominal wages are sticky but let’s not forget that real wages are often sticky too (and in fact nominal stickiness tends to matter much more when accompanied by real stickiness, but that is a point for another day.)  That means many labor market changes will be slow to manifest themselves in the real world.  Furthermore you often will see them first for new jobs, for the young, and for new labor market entrants (usually but not always the young)...Fear the reset.  The world will continue to produce much more value, and much more gdp, but who will capture that value is already changing dramatically and will continue to do so.
The consequence of real wage stickiness is that changes in the position of labour might be slow to manifest themselves, leading to a painful ‘reset’ where insiders lose their cushy priviliges.

Isn’t this a good thing? We don’t look at the examples of Greece and Italy, wring our hands and say, ‘Oh, if only the labour market was more heavily regulated and there were more insiders who could protect themselves from economic disruption.’* We see rather that labour markets are not flexible enough – and I think we’re right in that observation.

Similarly, the fact that insiders got health insurance and the outsiders didn’t was the exact problem that Obamacare sought to solve. Companies offering less generous plans or leaving their employees to buy coverage on exchanges was the intention of the legislation. The goal was to move healthcare away from the corporate-centric model, because that model doesn’t control costs properly and screws over anyone with a pre-existing condition.

The classical view, therefore, would be to say the reset is great! Move resources to productive activities! Cut unemployment! Increase efficiency! Bryan Caplan wants the reset and he wants it now.

But Cowen offers a reason why real wage flexibility might be a bad thing – the declining labour share of income. There’s a lot of discussion of a future in which the labour share of income is minimal, but maybe the problem of the deteriorating position of labour relative to other factors of production is worse than we think. If change is only taking place gradually, at the expense of a population of outsiders which grows only slowly while a shrinking but substantial fraction of insiders remain insulated, then the rate of change of labour share of income is sticky and there could be lots more negative distributional consequences on the way.

The argument goes thus: maybe the current system isn’t economically efficient, but it’s better at keeping what resources there are in the hands of the workers. Neoliberal wonks don’t like insider-dependent ways of helping the poor, like unions or the minimum wage, because they’re economically inefficient. They tend to argue for dismantling these kinds of protections in favour of better policies like tax credits.

The problem is that insider-centric policies have a political constituency, and the wonks’ policies don’t. Unions lobby for more union power. Big corporations which already pay above minimum wage like to make life harder for the competition. On the other hand, no-one wants to pay extra taxes in order to fund the EITC, or capital endowments. Therefore, it may be that pareto-efficient labour market flexibility is impossible, because once the protections are dismantled there’s no political constituency for helping the poor. With rising inequality, the political clout of the rich can only increase, helping them to entrench themselves as a new class of insiders, while ensuring that the poor are left out in the cold –  they lose the suboptimal redistributive policies that were helping them before, but don’t gain any optimal redistribution in return.

There’s a compelling case that this is exactly what’s been happening in recent years.
Resets show up more quickly in some sectors than others, most of all they come quickly when buyers and sellers have only sporadic and perhaps even anonymous contact with each other.  In other words, the reset comes more slowly for the mistress than for the street prostitute.  And when you see youth losing relative ground in labor markets, that is another signal that you should be worrying about resets.
Cowen’s ‘reset’ argument also casts the problem of labour market bifurcation in a wholly new light. The last few decades of economic growth have been much kinder to academics than they have to burger-flippers. But maybe what we’re really seeing is that there are more insiders at the high-skilled end of the labour market, who are better equipped to forestall their inevitable reset.

This is obviously true in some sectors. Cowen uses the great example of tenured professors, but you can look at public employees like teachers, or credentialist cartels run by doctors and lawyers. Maybe it’s not a coincidence that these have been the sectors most resistant to productivity growth. The ‘Great Stagnation’ hypothesis assumes that the reason developments in technology haven’t made much difference to retail or healthcare or transportation productivity is that we haven’t found ways to make tech work in these industries (yet). But perhaps the real reason is that there are powerful upper-middle-class insiders holding back MOOCs and Watson and Uber and tooth whitening. Part of the reason insiders are able to entrench themselves is low turnover and this is true of firms as well as individuals. A large fraction of productivity growth comes from low-productivity firms going out of business and resources being reallocated to high-productivity firms.

After all, it’s not obvious that there has been a wholesale deterioration of labour’s position in many of the ‘flexible’ sectors, and tech is a great example of this. It still provides lots of upper-middle-class jobs** and if wages aren’t soaring that’s not because the surplus is being appropriated by corporations but because it’s being taken by a) new entrants to that labour market and b) consumers.

Of course, maybe the causality goes in the other direction. Maybe tech is a ‘flexible’ sector because there’s lots of disruptive innovation going on in that industry. Maybe academics still have tenure because MOOCs haven’t really got off the ground yet, rather than the other way around. Maybe doctors can run their cartels because medical productivity growth is so slow.

If that’s the case, though, we should still celebrate the deteriorating position of insiders because it would mean productivity growth. Maybe insiders are dwindling because there is no Great Stagnation and prosperity is just around the corner.

*This might provide a useful window into the sometimes impenetrable thinking of people who use the word neoliberal a lot.

**(and might provide a lot more of them if insiders would let more people live in San Francisco)

Wednesday, 22 May 2013

Lessons from Apple's Tax Avoidance

The scandal of the day is that Apple has been using a hostof tricks and loopholes in order to avoid paying tax on its enormous global profits. Naturally, everyone’s using this as a chance to draw their own preferred policy conclusions. Matt Yglesias is hardly alone in suggesting that it’s the US corporate tax code that’s the problem. But it’s hard to see a future in which the US tax code isn’t a problem – and that’s an important fact to consider when taking a step back and looking at corporation tax more broadly.

The government needs money to pay for roads, police, schools, hospitals and pensions. That money has got to come from somewhere, and as a democratic society we have to make decisions about how much of that money should come from the rich relative to the poor. We also have to make decisions about how to actually collect that money.

Mitt Romney got a lot of stick for his infamous comment that ‘corporations are people’ and yet he and his detractors were actually making much the same point. Apple is not a person, and as such it can’t pay taxes. When the government taxes Apple it doesn’t take money away from Apple the corporation. It takes money away from Apple’s shareholders, who own those profits.*

This makes corporation tax a roundabout way of taxing rich people. Another way to tax rich people would be to take money from them directly. The appeal of corporate taxation as a way of getting at rich people’s money is that, if it’s not too distortionary, it might be easier to do and harder to avoid than if we tried to tax rich people directly. Clearly, though, the Apple fiasco suggests that, in a globalised world, it’s really really hard to squeeze money out of corporations. And Yglesias' followup echoes Derek Thompson in hitting the nail on the head – we’re never going to be able to effectively tax corporations. So what’s the point in doing it if it would be easier just to go straight after the rich people?

Sidenote: There is one side benefit of corporate over individual taxation – individual taxes apply only to people living in your country, whereas corporation tax allows the government to get revenue from rich foreigners’ investments as well. If your aim is to squeeze the most money out of foreign shareholders, though, the best strategy is to set your corporate rate low, Ireland-style, so that lots of foreigners redirect their corporate tax liabilities to your country.

*To make things simpler, I’m going to make the heroically generous assumption that the incidence of corporate taxation falls entirely on shareholders and not on workers etc.

Monday, 20 May 2013

Immigration Tariffs vs. Auctions, or Becker vs. Peri

Ashok Rao has a new post laying out a proposal for an immigration permit auction, as suggested by prominent immigration economist Geovanni Peri. This is a great idea, and it would definitely be a major improvement for public policy, especially if the number of visas auctioned was substantially higher than current immigration levels.

That said, it isn't the only way you could do market-based immigration policy. One alternative would be to have an immigration tariff, as advocated by Gary Becker. Instead of auctioning a fixed number of permits, the government would sell as many permits as demanded at a fixed price. The benefits of this kind of system are broadly the same as the benefits of an auction Ashok describes in his post. However, there are a few subtle differences that for me suggest a tariff might be a better way to go.

The first reason to prefer a tariff is that it means the market is more responsive to shifts in supply and demand. In a boom, more people want to come to the country and the economy ‘wants’ more immigrants. In a recession, the opposite is true. Using the auction system, the same number of people come – all that changes is the price. Under a tariff regime, on the other hand, the number of migrants is free to fluctuate according to the needs of the economy. This is true on a micro as well as a macro level.  If a new computing technology creates a sudden need for hordes of Indian programmers, or demand for immigrant builders goes up following a huge natural disaster, then the policy responds by allowing more immigrants. Yes, the government could adjust the number of auctioned permits according to economic circumstances, but it is better that changes in the number of migrants be market-driven, rather than decided by bureaucratic assessments of ‘need.’

Having a fixed tariff price, or at least a planned price schedule, also gives a level of certainty to the market. If I live in Mexico and my family is saving up to buy my way into the USA, I want to know how much I’m going to need to squirrel away. With an auction, the price will vary from year to year, perhaps dramatically, and there will be no guarantee that my savings will prove sufficient to get me a permit this year, or even next year. Tariffs solve this problem.

A criticism of immigration tariffs are that it is difficult to know how many people will come. If permits are auctioned, then the government knows what the level of immigration will be. There will be no concerns about a ‘flood’ of immigrants driving up house prices, overwhelming public services and so forth. Under a tariff system, things are much murkier – immigration is very difficult to forecast, as the UK government found to its embarrassment in the mid-noughties. However, that might serve as a feature and not a bug. It’s difficult for a politician to stand up and say that he wants millions upon millions of immigrants to be allowed in every year. It might be easier to sell to the public the policy of letting in anyone who coughs up £20000, even though the two policies might be equivalent. Voters are also reassured that every immigrant who arrives will ‘pay their way,’ whereas under an auction system there is the possibility (however unlikely) that the price will fall very low, creating the fear that people might get in ‘for free.’

A final, practical point is that tariffs would be far easier to administrate. It’s obviously feasible to design a working auction system, but it would be complicated. There’s a lot of room for the government to screw up, and there would almost certainly be teething problems to start with. It might also be simpler to verify the buyer’s identity and administer a background check under a tariff system.

Ultimately, I think the parallel with international trade holds – tariffs are better than quotas. An immigration tariff would be more sensitive to the needs of the market, less bureaucratic, in some ways more predictable, and maybe even more politically palatable than an auction system.

Thursday, 9 May 2013

Why not everyone should pay into the system

There’s an idea going around that it’s a bad thing when poor people don’t pay taxes. This has manifested itself in the infamous Mitt Romney ‘47%’ gaffe and also in the debate here in the UK about contributory benefits, the personal allowance and whether people should be getting benefits out of a system they haven’t paid into. The central argument is that, if you don’t pay taxes, you’re going to want to increase the provision of public services – all public services – because you get a share of whatever scant benefits there might be from the increase, and you don’t have to pay for any of it.

There are a couple of standard objections to this view. One is that poor people do pay a lot of taxes, in the form of social insurance contributions, consumption taxes and so on. Another says that, even if people don’t pay taxes one year, they might pay taxes the next; certainly, many of the 47% has paid income tax recently, and might again soon. There’s also a related life-cycle issue – many people not paying taxes are retirees or students, who have paid or will pay taxes at some other time in their life.

Then there's the argument that social insurance is just that - insurance - and just like with, say, home insurance, if some people get back much more than they paid in, it's a feature rather than a bug.

I’m going to explore a few other objections, though.

Firstly, it confuses average and marginal costs and benefits. If I’m going to vote for more spending, the cost to me of that spending isn’t the taxes I already pay – it’s the extra tax I’d pay to finance that spending. I might not pay any tax now, but if the government increases spending, it might pay for that by lowering tax thresholds so that I will pay tax in the future, or raise one of the kinds of taxes that I do pay, like VAT. Whether or not I pay taxes now has little to do with whether or not I will pay the cost of a rise in spending.

Equally, the myth of the squeezed middle (more on this later) allows many people to argue for ‘free’ benefits – not because the middle class doesn’t pay taxes, but because at the margin any tax rise is going to fall on the rich. This is obvious in the USA, where the Democrats are pushing for higher taxes on the rich and only on the rich, and consequently the alternative of spending cuts looks comparatively unpalatable.*

Secondly, the simple fact of whether or not I’ve paid into the system doesn’t really matter that much. If I paid £1 in income tax last year, it’s not going to make me dramatically more averse to increased spending than if I didn’t pay anything. As a result, even if the tax rate paid by the poor was important, the 47% statistic would still be meaningless. What’s important is the average tax rate paid by the poor. And that becomes an argument against any and all redistribution, which no-one** advocates (even flat-tax advocates think that benefits should be progressive).

Thirdly, while people are self-interested voters at the margin, on average they are actually quite civic-minded. Bryan Caplan's excellent articleThe Myth of the Rational Voter, was widely derided for calling voters idiots, but one of the interesting things it pointed out is that voters don't tend to vote for the things that will be best for them. People vote for farm subsidies not because they benefit them but because they (mistakenly) think that it will be good for society. Equally, even if poor people not paying tax had a marginal effect on how likely they were to vote for extra benefits, it wouldn't be the only or even the most important deciding factor. They might still vote against it if they thought that was what was best for society.

Summary: if anyone ever tries to argue that taxing the poor is vital for preserving democracy, tell them they're an idiot.

*This argument is starting to look a bit politically slanted. Of course, from a Rawlsian/utilitarian perspective, if you can get benefits to the poor and middle class solely by taxing the rich, maybe that’s a great thing.
**Apologies to any anarcho-capitalists I may have offended by this statement. I love you really.