Friday, December 10, 2010

Prof Mankiw's "convenient agnosticism"!

Greg Mankiw is one of my favorite economists. His hugely popular text book is arguably the second-best window to learning the principles of Economics. His superstar blog has surely played a major role in enriching the debate on many political economy issues.

But his recent post explaining his ambivalence and agnosticism on extending unemployment insurance dismays me. In fact, it comes across as specious and positively disingenious, bordering on misleading and mis-directing the debate. Here is why

1. For a start, there is now enough literature on the pros (reduces household income uncertainty and props up aggregate demand) and cons (budgetary costs and lowers job search costs) raised by Prof Mankiw.

There is now ample evidence that extending the duration of UI does little to lower the marginal incentive to search for re-employment. Alan Krueger and Andreas Mueller have found that the time devoted to job search is fairly constant regardless of unemployment duration for those who are ineligible for UI.

Further, a recent study by the San Francisco Fed found negligible impact of UI extension on increase in unemployment rate - about 0.4 percentage point of the nearly 6 percentage point increase in the national unemployment rate since 2008.

2. The cases for and against any policy instrument varies depending on the broader macroeconomic environment. There cannot be a single applicable-for-all-conditions reasoning in favor or against a policy.

Consider this. The US economy is still recovering very slowly from a deep recession. Unemployment rates are on the rise and private sector job creation remains anemic. Inflation is low, aggregate demand is weak. Household balance sheets remain battered and will require more repairs. Monetary accommodation may have limited further traction. There is limited fiscal space available.

In the circumstances, doing nothing for lack of compelling quantitative evidence (of the success of the proposed intervention) and thereby letting the economy continue its present course has several dangers. The dismal macroeconomic conditions and prospects mean that the economy risks falling into a deep recession, from which recovery will be even more painful and long-drawn out. In fact, without recovery taking hold (and there is no evidence of this happening), the shares of debts and deficits will continue to grow.

The limited fiscal space available means that any stimulus spending should be directed at areas delivering the greatest bang for the buck. Money should be delivered to the hands of people who are likely to spend it immediately. A number of studies clearly indicate that among the various stimulus options, UI is among those with the largest multiplier.

3. The argument against any action on the grounds of conclusive enough evidence is all the more misleading since the inherent nature of an economy precludes any conclusive enough evidence on any reasonably complex economic policy intervention. Do we invoke this excuse to let a system take its own course, even when it is hurtling down into an abyss? Or do we weigh the relative probabilities of possible policy options and respond with the most cost-effective and most-likely-to-succeed option?

No one disputes that budget deficits and public debts should be lowered. The relevant question is whether this is the time to do so? What are the costs of contraction at this point in time? What is the cost of not doing anything and letting UI expire? Is there enough evidence in favor of the stimulative impact of UI?

In other words, the choice is between risking a deflationary recession with rising shares of debts and deficits and untold pain for the vast majority of people, and stimulating a recovery by running up short-term deficits. Reasonable people would choose the later as the lesser evil.

"So when I hear economists advocate the extension of UI to 99 weeks, I am tempted to ask, would you also favor a further extension to 199 weeks, or 299 weeks, or 1099 weeks? If 99 weeks is better than 26 weeks, but 199 is too much, how do you know?"

This too has echoes of the first point. Prof Mankiw surely knows that there cannot be a not-too-high, not-too-low, and just right magic figure for the duration of UI applicable for all situations. In fact, the issue to be discussed here is not whether UI duration is too-high or too-low, but the benefits of its extension as opposed to costs. At issue is not what constitutes the optimal duration of UI, but whether fiscal stimulus is required and what is the most effective form of stimulus. If we assume that the moral hazard of UI is negligible and that we need fiscal stimulus, then the case in favor of extending UI is pretty strong.

"It is also conceivable that the amount of UI offered in normal times is higher than optimal and that a further extension would move us farther from what is desirable."

On this, there is already enough evidence that US stands on the negative side of the optimum UI duration scale to Europe's positive side. So the argument on the possibility of deviating farther away from the desirable may be superfluous.

6. Prof Mankiw's argument is based on lack of "compelling quantitative" evidence on the optimum period of UI. He gives the impression that he is unable (or unwilling) to take a decision on UI till he has "compelling quantitative analysis" about "how generous the optimal system would be". Unfortunately, by setting his conditions in so comprehensive a manner, he has virtually ensured that he will never need to take a decision to support extension of UI. In any case, how much evidence is "compelling" enough?

He knows all too well that it is impossible to conclusively quantify the optimal duration of UI - not now, never in future too. In the circumtances, this logic is a convenient excuse for not doing anything. This naturally translates into letting the UI benefits expire. In other words, you vote against extension without appearing to directly oppose it!

And such reasoning has now become the convenient excuse for conservative economists to recuse themselves from supporting government interventions in many areas. The pathological opposition to tax increases too works on similar lines. Once again, it is impossible to conclusively prove whether the system falls on the upward (left) or downward (right) side of the Laffer curve.

Similarly, conservatives point to the persistent high unemployment rates and weak economic growth and argue that the fiscal stimulus measures failed. The difficulty of estimating the counterfactual condition (without stimulus) means that an argument set on such terms of reference cannot be easily refuted.

Taken to its extremes, such reasoning can be used to justify almost any position. In social sciences like economics, it is impossible to conclusively quantitatively prove that a proposed intervention or policy is required. Decisions on whether fiscal stimulus is necessary and what types of spending is required, will never be proved in a universally compelling manner.


sai prasad said...

Quantitative analysis, I feel, is at best a tool to buttress a position and I have rarely seen a public policy call being taken on the strength of Quantitative analysis alone. In fact, most calls are political and are taken taken based on the gut feeling of the chief executive and based on political feedback. Once a position is decided upon, the bureaucracy gets into the act of building the required justification and respectability.

Personally, I feel that there is nothing wrong in making political calls and in fact, they are the calls which are more often than not the most effective ones.

KP said...

Dear Gulzar,

Some blue sky theorizing ... and "theoretical" at that.

- The willingness to pay tax (or increasing tax collections on the left side of the Laffer curve) assumes a growing economy.

- The loss of tax revenue is the extent that it presupposes a growth in the economy ... and that is not a given. ( Not the arithmetic part of the tax, but the behavioral part of paying tax)

- If the economy grows then the loss of revenue is an indicator of growth - and the political economists on the right figure that it is a good situation.

-The increase in revenue through increase in taxes is then fictitious compared to the deficit through expanded or retained UI - which is real.

-The US requires a much larger expansion of demand ( outside of its own economy), and its economy cannot segue to satisfy its low value internal customer. So a growth in low level demand is insufficient for the US - but may have a larger benefit - say for China..???

-Just reverting Ian Richards argument that if the US were to impose tariff and trade restictions China cannot segue its production facilities to cater to internal (Chinese) demand. (I don't buy that logic entirely though).

- One of the dangers of the way economics overrides reason - is that it has surreptitiously moved from being descriptive - a framework of thought - to a self assumed notion of being engineering - a framework for action of an exacting (rigorous)nature and prescriptive - following from an extrapolation of its models.

The other way of looking at this could be .. that the US sits at the apex of the supply chain..holding the high value components and brands.. and distribution / retailing networks across the world.

There is higher demand for "mid to low value" - that can can be offered by anonymous manufacturing and service facilities by rebranding their offering from being anonymous players in the supply chain - where now the US skims the value.

This will force the high value operators to lower the price (notional vlue) of their offering to compete...the leveling-off of US' competitive advantage.

The political calculus - Obama is first playing to his innate decency and his quoted position that it is better to think like a one term president , and not put peoples life on the line for grandstanding on positions that will eventually be compromised by numbers(votes).

A shrewd view - is to pin the failure on republicans and ride the wave of success...and letting the rich off the hook - forgotten in a booming economy. ( However, the republicans success in pinning the problems entirely on the last 2years as opposed to all that preceded it - makes them look shrewder - the game till now..)

Simple game theory shows, the Republicans are better off if the democrats fail, and are playing to safeguard their constituency. Forcing failure(at the low end mass and pinning it on the President) and ensuring tax breaks(at the high-end elite).

The larger question - where will the economy boom for the US? Which market (countries)/ products / services?? - and where are the jobs???

"Free trade doesn't work, the global economy is a myth and the U.S. has been "duped" during trade negotiations for the past 40 years" according to economist Ian Fletcher.

"Duped" is a bit rich as the US was a sumptuous benficiary of the first wave of manufacturing outsourcing. The second waves beneficiaries sit at the creamiest layer of US's society - and that is a structural problem of how the supply chain economy has been constructed/ conceived / evolved.

On models - all successful economic models are subject to the mutations of time and location - and a way of thinking should not be elevated to a creed.


sankarshanjoshi said...

Respected Gulzar Sir,
We are students from a reputed B-school of India, and we need your help in better understanding of RBI's policies on the current scenario, specifically the steps it is taking to contain inflation and to tackle the liquidity crunch.
After having followed the news for a while now, we couldnt understand the motive behind the simulatenous Talk of Buying back of Bonds worth 12000cr, to inject liquidity in the market, and at the same time hiking the repo rate to reduce liquidity. Kindly revert back.
Waitin for your response. You can contact us at:

gulzar said...

saiprasad sir, the important thing is to make political judgement calls after having gone through all the available options, including those quantitative ones.

shankar, over the last month or so, there has been tight liquidity conditions in the market. the extent of liquidity crunch being experienced now can be understood from the large amounts being borrwed by banks from the RBI's overnight LAF auctions.

there are several reasons - the RBI's continuous tightening, the government's own massive borrowings (nearly Rs 2.6 lakh Cr borrowed till now this fiscal) sucking out liquidity, the series of over-subscribed IPOs (especially that of Coal India) limiting cash balances with investors, and the payouts by 3G purchasers. The contractionary effect of many of these will die down soon, esepcially as government starts spending the amounts borrowed (typically, govt expenditures are back-loaded into the last two quarters). the declines in inflation over the past few weeks can also be traced to this. however, this is not likely to persist and as liquidity returns the inflationary pressures could return.

gulzar said...

thanks KP for those observations. some of them are very interesting areas, and will try to blog on them in the coming days. and could you mail me your id at