Sunday, March 30, 2014

It's Tax Time!

I prepared my income taxes this weekend. Every year I think: "Taxes should not be this confusing -- and why do we tax income rather than consumption, anyway?"* 

At least this year I join the ranks of millions who will be getting a refund check from the government rather than writing a check to the government. That should make me happy, right? 

WRONG! Getting a refund check when you've had wages withheld is a BAD THING. It means the government held more of your money as collateral for your taxes than you even owed! And held it without interest. Granted, interest is at historic lows, so it doesn't really matter that much this year, but still; it's the principle of the thing!

* If you are looking for a great read about taxes, I recommend Taxing Ourselves: A Citizen's Guide to the Debate over Taxes by Slemrod and Bakija. Actually, this one is just a great read, period.

Monday, March 10, 2014

Macroeconomic Fables

I finished reading The Undercover Economist Strikes Back: How to Run -- or Ruin -- an Economy by Tim Harford. His first book in the series, The Undercover Economist, is amazing. If you read one pop econ book, that's the one to read. Let's just say that Strikes Back felt a little rushed and a little thin in comparison. The question and answer format did not sit well with me, either. However, there were a couple of great macroeconomic fables included.

The Island of Yap

If you think you know what money is ("whatever is used as a medium of exchange, unit of account, and store of value"), think again after reading about the "money" used on the Island of Yap (an actual island -- not the fake ones that economists usually make up).

Sadly, there is one description of how modern money and banking came to be that is still vastly under-appreciated and did not make the cut into Harford's book: Adam Smith's digression concerning banks of deposit, particularly concerning that of Amsterdam, The Wealth of Nations, Book IV, Chapter 3, Sections 12-29. The gist of that excerpt is this: Because people "clipped" metallic coins, merchants did not always know what the coins were actually worth. Banks backed by cities sprung up to vouch for the coin, storing it in a vault, issuing "bank money" guaranteeing it's worth, and charging depositors interest and a warehouse fee. Banks took away the uncertainty in the value of the payment and provided easier methods of payment (bank money is easier to transport than sacks of gold); that was the value they added to society. What's interesting about the bank of Amsterdam is that it did not lend out money; it kept 100% reserves. That's why depositors had to pay a fee. It's negative interest on those saving accounts! The upside? No bank runs.

It's just a small step from the process described by Smith to a central bank with an empty vault. As the Island of Yap and our modern economy based on fiat currency shows, it's not necessarily important for money to have "intrinsic" worth in order to be valued as a medium of exchange, unit of account, or store of value. Everyone just has to believe it.

The Phillips Curve and the Lucas Critique

Outside of economics, and unfortunately, sometimes inside economics, as well, it's under-appreciated how important it is to understand what is generating the data. You can't just look at correlations and draw broad policy conclusions because the actors that are part of the system (you and me) are making choices in response to policy and those choices often depend heavily upon beliefs. That's what makes economics (especially macro) hard.

The Phillips Curve and the Lucas critique is covered in this one hour talk on the book. If you want to skip the introductory material, the talk starts at minute 7:00. In the response to Harford's talk, Alex Tabarrok pushes Harford about exactly the right things.

Honestly, in this case, the "movie" is better than the book.

Monday, March 3, 2014

Failing Well

Last week I read The Up Side of Down: Why Failing Well is the Key to Success, by Megan McArdle. It asks the question: How do we build a society that gives people the right incentives to keep failing and learning? It never struck me as overly rosy picture of failure, and it's a nice mix of summaries of academic work and McArdle's personal story.

There were four sections that really stood out for me.

Forager versus Farmer

I was totally unaware of this research, and it is pretty neat. How much people share with others is a function of the risk environment. If there is higher variance to the rewards for effort ("foraging"), then people are more likely to share with each other. If there is low variance to the rewards for effort ("farming"), people are much less likely to share with each other. One study McArdle highlights is this recent experiment by Kaplan, Schnieter, Smith, and Wilson. Here's a portion of the abstract:
‘Lucky’ individuals share food with ‘unlucky’ individuals with the expectation of reciprocity when roles are reversed. Cross-cultural data provide prima facie evidence of pair-wise reciprocity and an almost universal association of high-variance (HV) resources with greater exchange. However, such evidence is not definitive; an alternative hypothesis is that food sharing is really ‘tolerated theft’, in which individuals possessing more food allow others to steal from them, owing to the threat of violence from hungry individuals. Pair-wise correlations may reflect proximity providing greater opportunities for mutual theft of food. We report a laboratory experiment of foraging and food consumption in a virtual world, designed to test the risk-reduction hypothesis by determining whether people form reciprocal relationships in response to variance of resource acquisition, even when there is no external enforcement of any transfer agreements that might emerge. Individuals can forage in a high-mean, HV patch or a low-mean, low-variance (LV) patch. The key feature of the experimental design is that individuals can transfer resources to others. We find that sharing hardly occurs after LV foraging, but among HV foragers sharing increases dramatically over time. The results provide strong support for the hypothesis that people are pre-disposed to evaluate gains from exchange and respond to unsynchronized variance in resource availability through endogenous reciprocal trading relationships.
I really like how McArdle interprets this in a political context, too. In a modern society it is very hard to understand what other people do because of the amount of specialization ("Is he lucky or good?"). In the past, it was easy to determine the risk environment; today, it is hard. She writes:
When you see a liberal and a conservative hotly debating welfare policy, isn't this what they are arguing about? The liberal says "It's not their fault that they were born poor" and the conservative says "They could stop being poor if they waited to have kinds until they got married, worked full-time, and finished high school." Both statements are true. And so how you feel about poverty and social policy depends on whether you think that living in the American economy is mostly like being a big-game hunter, where rewards are largely dependent on luck, or whether it's like being a farmer, where rewards are mostly a function of effort.
The Dangers of Unemployment

It was nice to be reminded in this part of the book that in addition to the monetary and skill depreciation consequences of unemployment, unemployment is one of the few events in life were people underestimate its negative emotional consequences. Life satisfaction plummets and stays lower even 5 years later (on par with widows/widowers who never got over their grief), people withdraw from relationships, and they worry about their future.

The solution? Look for a job (more effort really does translate into more offers). In addition, have a system that emphasizes effort: set input (NOT output) goals, record your efforts, use a script, and surround yourself with people who are going through the same thing as you. If all else fails, revise downward your reservation wage and be willing to move.

Consistent Enforcement Matters

In an economic model of crime, the supply of crime decreases when you increase the expected punishment.  You can do this by increasing the probability that a crime is discovered (so it's punished more often) or by increasing the penalty that is applied when caught.

Expected Punishment = (Penalty) x (Probability of Discovery)

If you can't increase the probability of discovery, you can still decrease crime by increasing the expected punishment by increasing the penalty (increased jail time for drug abusers, etc.). So when Megan begins talking about reforming the criminal justice system in a way that reduced the jail time of offenders, I roll my eyes and prepare to skim the rest of the chapter. She talks about how great HOPE is (a program in Hawaii) and how criminals love it, but then reveals what the program does:
It sends people to jail. Every single time they are caught violating a term of their probation, Judge Alm gives them at least a few days in the pokey.... Judge Alm's true innovation [is] catching as many probation violations as possible and punishing every one of them. 
I don't understand. How could punishing every violation be a radical new program that reforms the parole system? Am I missing something? Evidently, yes. The system in most places is not consistent punishment, but randomized draconianism. What's really going on is this:

Expected Punishment = (Penalty) x (Probability of Discovery) x (Probability of Enforcement)

where the probability of enforcement is low even conditional on being caught. So the "revolution" is lowering the penalty and increasing the probability of enforcement to 1 by eliminating discretion. Instead of 10 probation violations before getting any punishment then getting a multi-year jail term for being late to a hearing when your car battery dies, every violation comes with a sure, but smaller punishment.

Watch a PBS segment on the program here.

This seems so obvious, I can't believe it's not done everywhere!

Putting the "Moral" in Moral Hazard

The last chapter is on ease of bankruptcy and how letting people let go of their debt can be a good thing. What really stood out was the last section where McArdle focuses on culture.
[H]owever much abuse is in the system, the surprising thing is that there isn't more. At the height of the financial crisis a number of commentators actually cheered the possibility that millions of Americans would mail in their house keys to the banks holding their mortgages, forcing bankers to suffer the losses. In many instances they would be better off -- so why don't they do it? The answer is surprisingly simple: shame. They are too embarrassed. They don't want to be thought of as deadbeats.
Aside from the fact that some people who could pay did mail in their keys, the point stands. If people self-regulate their behavior and hold themselves to a higher personal standard, then bankruptcy can be more lenient for those who really need it without as much worry about inducing people to go bankrupt who don't really need it.

Resources devoted to fraud prevention, crime prevention, and related government services could be much lower if people just didn't commit as much fraud or crime. Culture really does matter.

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