Monthly Archives: April 2013

While the debate about minimum wages rages on in the United States after Barack Obama’s State of the Union, it is worthwhile to think about the role wage controls have in the context of economic development rather than equity. In America, the relationship between the minimum wage and economic health is largely determined by liberal ideas of fairness. We are frequently reminded that it’s not possible for a single-mother to feed her children on a minimum wage.

While in India worker equity is a far more important issue, especially as poverty abounds, I think the real merit of such regulation derives from prospects of economic growth. When considering government intervention, it is always worthwhile to consider market failure, without which standard theory tells us regulation has no place. There is plenty of literature that talks about asymmetric information and imperfect competition as reasons for regulation.

But Indians have a much more damning irrationality: we’re not selfish. Specifically, after a given transaction not only do we expect low-quality outcomes, we want low-quality outcomes. We call this kakonomics. LiveMint tells us more:

This much-needed term, coined by Gloria Origgi, Italian philosopher of the mind, is “kakonomics” (the best translation of the Greek word “kako” is, well, “screwed up”)—the apparently strange preference for low-quality outcomes. Simply put, in a kakonomic transaction, both parties implicitly agree that both the product delivered and the pay-off will be low quality.

Rationality—and game theory—suggests that in any exchange, people want to receive high quality pay-offs. In fact, even a man offering a low-quality product would prefer a high-quality pay-off— that’s what hucksters are about. But kakonomics is the triumph of mediocrity—low-expectation exchanges about which no one complains.

Suppose a newspaper asks me to write a 1,000-word article but will pay me only Rs 1,000 for it. If I agree to this (Rs 1,000, being far less than I think I should be paid, is a low-quality pay-off), I’ll quite likely pick up chunks from articles I wrote years ago, string them together and knock the whole thing off in half an hour. So I provide a low-quality product, assuming that the newspaper would also not expect me to wrack my brains and spend six hours over the piece. In most cases, my assumption would be correct, and it would be a classic kakonomic transaction. We would have connived on a mutually advantageous low outcome.

But what if my piece goes to a conscientious editor who is unaware of the tacit agreement? She points out errors and requests a rewrite. I would see this as a breach of trust and refuse. She, being conscientious, may then offer to work on the piece herself and improve its quality. But I would still feel betrayed. For, I would now have to see the piece again in its final shape—after she has made her changes—and will possibly need to make some further changes from my side. Our well-meaning busybody is threatening the soothing mediocrity equilibrium that kakonomics provides.

For, kakonomics—cooperation for the bad—dispenses peace and stability for all concerned in the short term. It’s also equally obvious that in the long term, the outcome can only be bad. As Origgi puts it: “each low-quality exchange is a local equilibrium in which both parties are satisfied, but each of these exchanges erodes the overall system in the long run.”

In most Indian cities, even the relatively rich come to expect the plumber to be late and the maid to be shoddy. A great way to embarrass bad service person is a generous tip, because they will inevitably feel bad about the bad work. On the other hand, in America (the productivity capital of the world), the lawnmowers and maids do a spick a spick and span job. And clients tip lavishly.

That is to say the whereas bad work violates the American social contract, good work violates the Indian counterpart. I expect this tacit consent to suboptimal expectations work transcends economics. Rarely will you hear an educated Indian talk well of politicians, regardless of party or persuasion. We expect mediocrity.

Productivity in India is a joke. A few years ago we visited Goa, India’s richest state by a killing. The back yard was canopied by beautiful trees. A team of gardeners was in perpetual employment clearing fallen leaves, not because of any abundance thereof, but because workers didn’t have a rake, let alone a powered blower. Indeed they were collecting the leaves one-by-one as if in a comic play.

But if the government required we pay our plumber a minimum wage, it would no longer be acceptable for him to work slowly and carelessly. It would no longer be acceptable for the painter to leave ugly white splotches on the corner. And it sure as hell wouldn’t be acceptable for nurses at government hospitals to be incompetent, lazy, or rude.

I suspect most of the productivity gap is concentrated at the lowest sectors of urban society, for which a minimum wage is better interpreted as a required productivity. But, LiveMint gave the example of a freelance journalist who would definitely be among India’s emerging middle class. The government can solve this by levying a payroll tax on hourly wages which would be indirectly levied as a consumption tax. This would have a similar effect on expectations of quality. It might also help with India’s revenue problem.

Government has a critical role to play in the face of market failure. But this is particularly true when human interactions violate the most sacred principles of a rich society. India cannot hope to get rich if we each continue to secretly hope for bad outcomes. If I may speculate, I believe this culture of despondence-cum-kakonomics percolates into our political culture, granting politicians the freedom to abdicate their social responsibility.

Indeed, one might imagine that competing political parties play this game. Jayalalitha tells Karunanidhi, “I’ll do a sufficiently bad job so you look good – just promise me the same”. This, unfortunately, seems like a Prisoner’s Dilemma – except the convicts are coordinating.

My proposal is sufficiently modest to be tested in small-scale experiments. A firm can charge more for its services on a random subset of its employees. This extra money would be kept away from the “treated” employees, so as to eliminate the productivity effect standard economic theory predicts of higher wages. Therefore, any change in outcome can be isolated to the client expectation of higher quality. This is an important point to stress. Economists have made the argument that if increased wages bolster worker ethic, a minimum wage would increase firm profits. But this theory falls flat because firms would realize this and update wages accordingly. The complex dynamics of kakonomics and client expectations are harder to refute.

I remember Tyler Cowen commenting on Keynesians and the “self-imposed minimum wage“:

In essence you are self-imposing a minimum wage on that market, but the employer is responding by leaving you jobless.  (Analogous to “self-deportation,” a sarcastic wag might suggest.)

Is there a sense in which Kakonomics creates a self-imposed maximum wage? This would be a remarkable departure from standard economic models. Of course, in a very real sense there is is an abstract concept, but still perhaps a useful heuristic to think about development yardsticks in poor countries.

Minimum wages and payroll taxes in America are means of redistribution and fairness. In India, under the right conditions, they might become important drivers of supply-side growth. And they might help equity outcomes in the process.

Tyler Cowen (approvingly) takes us to Scott Sumner on deficits in Britain:

Step 1.  The Economist magazine reports (in the back) that Britain has the third largest budget deficit in the world, significantly bigger than the US as a share of GDP.  So fiscal policy is obviously expansionary using a simplistic metric that doesn’t adjust for the business cycle.

Step 2.  […] Just how far below potential is the UK economy?  The honest truth is that no one has a clue.  But let’s use the sorts of measures that Keynesians would rely on.  The unemployment rate is roughly the same as in the US.  So by that measure the output gap is similar, although a bit smaller in the UK because they have a slightly higher natural rate of unemployment.  But almost all economists think that no single labor market indicator is perfect.  And all the other measures show the UK doing far better than the US, especially total employment, which hits record levels in the UK month after month, while lagging 3 million below early 2008 levels in the US (a country with a faster growing population.)  Here’s the bottom line: The UK has a smaller output gap than the US using any plausible set of labor market metrics.  […]  And yet the US has not experienced the near zero growth of the UK.  Why not?

Sumner’s first assumption is that fiscal policy in Britain is far more expansionary than the United States as measured by its budget deficit. Some (incorrectly) believe that this doesn’t mean Britain’s policies are particularly expansionary, because it’s output gap is larger. I agree with Scott that this isn’t necessarily true, because Britain’s labor market seems pretty healthy.

Yet Sumner is both accepting that (a) Britain has run a more expansionary fiscal policy, and (b) It’s labor market recovery has been stronger. I don’t think labor market statistics are a good indicator of recovery – more on that later – and I think supply-side factors play a role, so I don’t want to infer any causality. But those two sure as hell seem like a strong vindication of Keynesian policy.

He goes on to say:

Step 3.  Then the Keynesians point to the low RGDP growth in Britain, and claim this somehow proves Britain has a massive output gap, and hence fiscal policy is actually quite austere.  I hope everyone can see the problem with this argument.  It makes the Keynesian theory almost impossible to refute.  

For one, we agree that low RGDP growth can’t really mean much about the magnitude of an output gap. But for different reasons: low growth just means the gap is shrinking (relative to something) slowly. However, it doesn’t make sense to reject an argument because “it’s almost impossible to refute”. Natural selection of organisms is incredibly difficult to refute and that cannot inform our belief in its veracity. The fact is, it doesn’t matter whether the cyclicly-adjusted deficit is high or low. If it’s low, we look at the record high unemployment bad growth and realize more stimulus is needed. If it’s high, we realize whatever we’ve done has worked, but we need more to decrease unemployment. 

The latter case really gets to the point of why labor market statistics are not a good measure, of anything. Unemployment rates are an arbitrary concoction. It doesn’t discriminate between a laid-off autoworker and an engineer who can’t find a job. We’re not all economically equal, so n scientists without a job is a far crappier predicament than n barbers without a job. 

We care about unemployment rates, rightly, because sound employment underpins the social contract. But, the output gap is the real measure of recession. It’s very possible, indeed likely, that the recession hurt all income groups somewhat equally at the onset. But we know recovery has been highly unequal, with most growth accruing in a small number of people. That is output gap can fall drastically without unemployment rates showing proportional decline. 

The two factors that engender this are (a) concentration of human capital and (b) falling wage share of GDP. Unemployment rates completely ignore physical capital that’s in disuse due to cyclical downturn. Of course, this is a good way to think how economically absurd the rate of unemployment is. Imagine have ten units of capital, nine screwdrivers and one factory. If the factory is shutdown, it’s inane to talk about a “10% unemployment” rate. Rather, the lost income in the form of an output gap becomes important.

My point is any conclusion about the success or failure of Keynesian policy should be careful not to use the labor market as indicator of anything. And while I don’t suggest that low RGDP growth rates implies anything about the output gap per se, the complete stagnation in Britain compared with the relative recovery in the US is important. Britain interfered to reign in deficits far more aggressively than America did. Also, in Britain government spending is a bigger component of output than in America, which further exacerbated the effects of unexpected cuts. Because total debt-GDP was expected to be higher in Britain, the deviation from the standard path is what signals austerity.

Sumner is is on the dot about supply-side policies playing an important role, but this is why I think aggregate demand is still important. Inflation is far below expectations, but Britain has not experienced deflation, yet. This chart (from Simon Wren-Lewis) clearly implies a fall in AS:



But then why hasn’t Britain experienced any real cost-push inflation? The only answer is a proportional fall in AD which hasn’t recovered in any significant level. And I’m not breaking any Keynesian assumption about sticky price levels because wages are (naturally) more rigid than prices.

All said and done, I cannot deduce that Keynesianism has failed from Sumner’s evidence, but it surely reads as an argument for a nominal income target.

We watch again as plainly avoidable disaster strikes Bangladesh. And long after this tragic event we will hear those nauseating remarks that growth isn’t “good” or “sustainable” from the educated Asian elite. We will be told that American imperialists from Walmart are hurting the poor, and that GDP isn’t important. Matt Yglesias seems to have earned the ire of some anti-market anarchists (or something) on Twitter for his response to the accident:

Bangladesh may or may not need tougher workplace safety rules, but it’s entirely appropriate for Bangladesh to have different—and, indeed, lower—workplace safety standards than the United States.

The reason is that while having a safe job is good, money is also good. Jobs that are unusually dangerous—in the contemporary United States that’s primarily fishing, logging, and trucking—pay a premium over other working-class occupations precisely because people are reluctant to risk death or maiming at work. And in a free society it’s good that different people are able to make different choices on the risk–reward spectrum. There are also some good reasons to want to avoid a world of unlimited choice and see this as a sphere in which collective action is appropriate […], but that still leaves us with the question of “which collective” should make the collective choice.

Bangladesh is a lot poorer than the United States, and there are very good reasons for Bangladeshi people to make different choices in this regard than Americans. That’s true whether you’re talking about an individual calculus or a collective calculus. Safety rules that are appropriate for the United States would be unnecessarily immiserating in much poorer Bangladesh. Rules that are appropriate in Bangladesh would be far too flimsy for the richer and more risk-averse United States. Split the difference and you’ll get rules that are appropriate for nobody. The current system of letting different countries have different rules is working fine.American jobs have gotten much safer over the past 20 years, and Bangladesh has gotten a lot richer.

My first reaction is complete, unqualified agreement. The perennial critics of American trade policy always loose sight of how much our spending benefits poorer corners of the world. There’s the occasional fire or accident, and it is sad. But for Bangladesh, a country where two kids die every hour from malnutrition, this isn’t a big deal. It’s tragic that it’s not. But this doesn’t change the fact that it’s not.

As much as the leftists who berated Yglesias want to believe money doesn’t matter, the only thing Bangladesh needs is more money, and more consumption. Only the blind rich elite could possibly claim that growth is not good, and anyone who advices you so is either deluded or misinformed (and no doubt a good concoction of both).

But Yglesias is wrong, at least in his framing. The tradeoff between safety and income is a false dichotomy.  In The Logic of Collective Action, Mancur Olson popularized the idea of “dispersed costs and concentrated benefits”. This is usually used to explain why farmers lobby for protectionist sugar policy – which costs the average American cents, but increases farmer earnings on corn by thousands: the idea that small change from many becomes a powerful force for action when directed to a few. And this is really bad, because our Coke is crappier and most people loose money. But since we’re each giving up so little, collective bargaining just isn’t worth it.

Now imagine if, instead of financing the humanitarian-industrial complex through badly designed aid schemes, America required all imports be sourced from countries with a basic level of safety: decent lighting, water, eye protection, sanitation, and maybe even short breaks. Nothing like what we enjoy in the rich world, but what might be considered “humane”. And we’d hardly have to pay for this. Because America imports so much stuff from basically everywhere, we have huge market power. As long as we make small and sensible demands, it’s highly unlikely that small and poor countries like Bangladesh will protest.

Provided the regulations are not onerous, it’s highly doubtful Bangladesh (or any given poor country) would experience any disemployment effects. We know that all firms operating outside of perfect competition earn rents, and cheap, fixed costs like safety goggles and sprinklers are unlikely to be high enough to necessitate the profit-maximizing firm to reallocate its factors of production.

Of course, as the marginal supply shifts slightly to the left, prices would rise, and export costs would increase. This is where Olson’s theory comes into place. American consumers would have to pay slightly more for their imported clothes, but the most basic regulations would be a fraction of the Bangladeshi cost of production, let alone American retail price. Millions of Americans would, on a day to day basis, be financing safer conditions in Bangladesh. And more importantly, this redistribution will be orders of magnitude more important than farm subsidies. Because a dollar to a rancher is basically the same as a dollar to a Bostonian. But a dollar to a Bangladeshi is, relatively, far more valuable to a poor laborer than it is to you and me.

And this regime could continue gradually through the process of development. Until wages converge significantly, this would be of little cost to each individual agent. This is a little bit like a carbon taxation system. A simple, dumb, tax on domestic production would simply encourage offshoring of industry to freer countries. The quick fix is a tariff that internalizes carbon output globally, thereby reducing the incentive to offshore.

In principle (though wage differences are too high in practice) this would prevent American companies for moving production overseas solely for the purpose of badly-treated labor. Whatever the case, this solution is better in a number of ways: it can replace a lot of the work done by foreign aid. It is incredibly difficult to corrupt, as the funds aren’t direct transfers. It is far cheaper, and guarantees a better standard for the worker. Best of all, it doesn’t imperil Bangladeshi growth.

I would rather we redirect USAID’s budget towards domestic problems and use our infinitely more valuable international market power to solve problems abroad. And I’d be surprised if Yglesias disagrees!

Mark Thoma takes us to David Andolfatto on why Bitcoins and gold “make lousy money”:

Imagine having gone to work for gold a few weeks ago, only to see the purchasing power of your wages drop by 10% in one day. Imagine having purchased something using Bitcoin, only to watch the purchasing power of your spent Bitcoin rise by 100% the next day. It would be frustrating.

And why stable inflation isn’t so bad after all:

Is it important for a monetary instrument to hold its value over long periods of time? I used to think so. But now I’m not so sure. While I do not necessarily like the idea of inflation eating away at the value of fiat money, I don’t think that a low and stable inflation rate is such a big deal. Money is not meant to be a long-term store of value, after all. Once you receive your wages, you are free to purchase gold, bitcoin, or any other asset you wish. (Inflation does hurt those on fixed nominal payments, but the remedy for that is simply to index those payments to inflation. No big deal.)

The point Andolfatto is making here is actually intimately connected to a piece by Tim Duy a few days back arguing that the Federal Reserve can only successfully achieve two of: low inflation, full employment, and financial stability. The import of Duy’s argument is that we would have to tolerate significant asset inflation – increasing risk of financial instability – to increase employment without increasing consumer prices.

A lot of what he talked about concerns recent financial dynamics, but it’s worthwhile studying Medieval monetary policy in both considering the veracity of this claim and applying it to Andolfatto’s dilemma. And a new paper by Anthony Hotson at Vox is the perfect place to start. Today we control consumer price inflation, or a basket of goods that the government thinks represent our living expenses. Ipso facto, assets like equity are excluded (they aren’t necessary to live, after all). Back in the good ol’ days, under the gold and silver standards, governments controlled asset inflation. But to do this they had to let consumer prices go haywire:


Or as Hotson explains this dynamic:

There was no parallel in medieval monetary policy to the modern preoccupation with the price of ordinary commodities, as measured by consumer price indices. Indeed, when faced with a change in the relative price of bullion and ordinary commodities, the authorities would resolutely keep bullion prices pegged and allow ordinary commodity prices to adjust. Relative price changes could be significant, not least as a result of new mining discoveries in the Spanish Americas.

This provides pretty solid backing to Duy’s argument that if we provide asset price stability, consumer prices will become highly volatile. And as Andolfatto argues, when the real value of money is highly uncertain on a daily basis – as the annual (light orange) data indicates – it fails to become unit of exchange. Of course there is stability vis-a-vis the money value of bullion, but this is hardly useful on a day-to-day basis.

But my conclusion is slightly different than Andolfatto’s:

If the existence of a gold reserve does not prevent a government from reneging on its promises, then why bother with a gold standard at all? The key issue for any monetary system is credibility of the agencies responsible for managing the economy’s money supply in a socially responsible manner. A popular design in many countries is a politically independent central bank, mandated to achieve some measure of price-level stability. And whatever faults one might ascribe to the U.S. Federal Reserve Bank, as the data above shows, since the early 1980s, the Fed has at least managed to keep inflation relatively low and relatively stable.

He speaks, rightly, that gold is not inherently better than fiat. Because we are using government-issued banknotes, revaluation can cause significant inflation, as did FDR. Arguably, it’s a lot easier to create inflation under a gold standard than with fiat currency. But the gold standard has an even more fundamental flaw, which is that by stabilizing bullion prices, consumer inflation can become highly volatile.

So with the gold standard, the Dollar note becomes what Bitcoin is today, if slightly less volatile. And asset inflation hawks should note that the gold standard only guaranteed the price of gold. If the Fed were to manage asset inflation altogether the consequences to consumer prices would be untold.

Indeed, consumer inflation could be solved by dropping the full employment mandate, and that is his chilling conclusion:

 If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial – and, by extension – macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability.  My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

Let’s pay heed to history. Jeremy Stein is smart, and knows that bankers are on a binge of cheap money right now. This might be a reason for expansionary fiscal policy.* But unless we renege on consumer price stability or full employment, now is not the time to cut back.  We save and invest in assets (perhaps gold and Bitcoins). It is important to maintain short term price stability of currency, but not its status as a store of value.

*An interesting question is whether this brings doubt to the “Krugman condition”. Even Krugman, the poster child of fiscal policy, believes it is justified only at the zero lower bound. If financial instability is of key concern, might there be conditions where of tight money and deficits come hand-in-hand?

Or at least not in its current incarnation. (And why market monetarists are a lot more like Milton Friedman, who actually influenced policy and intellectual development in a profound way, than Murray Rothbard who is snubbed as a neo-confederate pariah).

Because many monetarists like Scott Sumner, Lars Christensen, etc. have very pronounced market sympathies, they occasionally get defensive about their support for nominal income targeting. Most recently, Christensen went out of his way to argue that easy money is not a bailout. I’m a fan of a nominal income target, and I’m also generally a fan of “free minds and free markets“. And while market monetarism is a shining example of the latter former, I don’t think it hits the former latter. Here’s why.


If there’s one thing classical liberals and libertarians hate more than taxes, it’s regulation. But it is frankly absurd to think monetary policy should be used to smooth the business cycle without smart rules in place. Without any regulation, under such a regime, a housing bubble would force the central bank to increase rates and pummel the economy into recession. This hardly sounds fair to the job creator entrepreneur in Silicon Valley that can’t get funding for his new idea because the animal spirits on Wall Street have been on a credit binge. I’m not sure where monetarists like Sumner fall on necessity of deposit insurance, but with such deeply ingrained federal institutions, it is ridiculous to think a nominal target would be tolerated without sound regulation.

Monetary policy is a hammer, not a scalpel. That means if we’re using it aggressively, we better wear safety goggles.


…is a capital tax, and Sumner agrees:

After all, when prices rise, incomes usually rise as well. Instead, many economists would argue that high inflation is a sort of tax on capital: Our tax system punishes savers during high-inflation periods like the 1970s, as people must pay taxes on capital earnings that merely reflect price increases driven by inflation. The result is reduced saving and investment.

Anyone who reads his blog knows that Sumner is no fan of an inflation target. And reasonably so: a supply-shock under this policy would force deflation on other goods and services. Considering the nominal rigidity of wages, this would be a particularly tricky and dangerous situation. However, in periods of stagnation like today, a nominal target can be sustained only with more inflation, that is a higher effective target to close the gap from current nominal income to trend.

Using a central bank to spur consumption and devalue savings is functionally similar to a tax-and-spend fiscal policy. Now, unless money is directly deposited everyone’s checking account, rent seeking is a problem, too. The discount window gives bankers free money which are then invested in riskier assets. The inflation is socialized and the benefits are, well, privatized.

To be fair, this is actually an exception to the rule. If central banks never let nominal expenditures fall in the way they did, above-trend inflation would never be necessary (unless real, long-term growth permanently falls).

Free Banking:

Austrians are notorious for thinking a gold standard is a good idea. But perhaps their most charming idea is the idea of competitive banks each issuing notes which would be traded on the open market. Today, the government has absolute monopoly on the issue and transaction of currency.

And like any other monopolist, setting the price – the interest rate – is the sole provenance of our central bank. Again, to be fair, if NGDP was targeted via a futures market, it’s fair to say the power of each member of the FOMC is significantly reduced. (As Sumner recently put it to Noah Smith, this would be liked increasing the FOMC size to millions, where good votes are incentivized and bad ones penalized).

However, I think a NGDP target should be executed more conservatively. Market efficiency is predicated on selfish, profit-maximizing agents, that would vote/trade based on the best information available. Is it not possible that those with asymmetric information and huge market power (TBTF banks) can manipulate the interest rate, somehow? Maybe my logic here is flawed, but it leads me to my final point…

Theory of the Second Best

In 1956, Richard Lipsey and Kelvin Lancaster proved that if one of many conditions of optimality cannot be satisfied, it is possible that the next-best alternative involves changing other conditions from what was otherwise optimal. In their words:

The general theorem for the second-best optimum states that if there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable.

By having a government, and by modern extension a central bank, we violate one of the many classically liberal optimality conditions. Once we have centralized governance, it is not at all clear that, except in specific cases (such as a too-high income tax), a linear movement towards free markets is desirable. This brings me in full circle to regulation. We have a set of institutions based on our social contract to protect small savings (FDIC) and provide for the needy. As our welfare state continues to grow due to social pressures, the linear movement in certain sectors towards libertarianism seems ever more imprudent.

I say this, reading Scott Sumner’s remarks on free banking (he’s sympathetic) and Lars Christensen’s argument that a nominal target is on the way to privatizing the Fed. (Shh! Don’t tell the lefties). As our system of money, government, and social contract becomes more complicated by the day, I cannot believe that free banking is our next best alternative.

A standard, non-futures market, target broadly asserts the currency monopoly. As a supporter, I clearly believe that monetary policy is at its best when calming the nominal business cycle. But it is difficult to see how this intervention is philosophically different from fiscal policy. It might be economically more efficient, but many libertarians – including market monetarists – frame opposition to Keynesian spending on moral grounds. This is wrong.

It is important to remember that Sumner, Christensen, and MMs in general support easier money and a nominal target ipso facto. While they would prefer a futures market, it is not a precondition for the policy. Somewhat similarly, I might prefer a consumption tax to finance government expenditures, this is not a precondition for my belief. (I’m okay with deficits and/or more income taxes, at least morally if not economically).

Remember, none of this is a criticism of market monetarism in general, or nominal targeting in specific.  But I take issue that some of the more progressive monetarists believe their policy is by the fact more libertarian than fiscal policy, and I think that is indefensible on moral grounds. Atop, I mentioned something about Milton Friedman. Because, unlike Austrian neo-confederates at the Ludwig von Mises Institute, he had remarkable influence from Christensen, to Sumner, to Larry Summers. His advocacy for a negative income tax is the bedrock for one of America’s most successful welfare programs, the Earned Income Tax Credit (as progressive economist Brad DeLong forcefully argues).

The echoes of Scott Sumner’s work is heard across the world, and across the political spectrum. It has earned a New York Times op-ed from Christina Romer, discussion at the Federal Reserve, and rapid acceptance across the blogosphere.

This is because the work is fundamentally pragmatic, sensible, and forceful. There are libertarians and “true” free marketers out there. And they are irrelevant. Monetarists can defend their policy on the grounds of potential success (it has never been tried before, after all) rather than market virtues.

Market Pragmatists, perhaps?

Brad DeLong and Matt Yglesias have tried playing Bryan Caplan’s “Ideological Turing Test“:

But the ability to pass ideological Turing tests – to state opposing views as clearly and persuasively as their proponents – is a genuine symptom of objectivity and wisdom […] But the beauty of the notion of the ideological Turing Test is that it’s a test.  We don’t have to idly speculate about how well adherents of various ideologies understand each other. We can measure the performance of anyone inclined to boast about his superior insight.

I find fiscal consolidation during a time of high unemployment to be appalling, and I’m going to develop my own (plausible) argument for austerity, but first I don’t think Yglesias’ case is very “strong” at all:

But the solution to this problem can’t be to say “next time congress is going to be way better and less partisan and fiscal stimulus will work out great.” […] But I’d say the best thing to do would be to change the practice of central banks. Give the Federal Reserve an explicit mandate to level-target aggregate economy-wide spending and authorize the Fed to issue helicopter money directly to citizens when necessary to hit the targets. Then there’s no “zero bound”, there’s no question of monetary impotence, and there’s no question of discretionary fiscal stabilization […] Creating a dedicated agency charged with macroeconomic stabilization was a good idea. If it’s failed, we need to fire its leaders and replace them with people who’ll succeed. If it legally lacks the necessary tools, give it the tools. Print money and give it to people.

Or as DeLong puts the old argument:

1. The problem of legislative confusion.

2. The problem of legislative process

3. The problem of implementation.

4. The problem of rent-seeking.

5. The problem of superfluity.

Now Yglesias feels the crisis imperils (5) but validates the first 4. This is inconsistent, however, with his preference for remarkably loose monetary policy (printing cash to hit a nominal target). The Federal Reserve is similarly handcuffed by problems of implementation, legislative deliberative process, and rent-seeking. For one, it is highly idealistic to think it is a “dedicated agency charged with macroeconomic stabilization”. This might be a historically accurate statement – Volcker reigned inflation in a way the political process could not. But there is both an intellectual and political belief that the Fed’s primary purpose is stability of prices and the financial system. As Tim Duy, via Mark Thomarecently put it:

If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial – and, by extension – macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability. My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

Duy writes, convincingly, that a central bank can only give us two of: price stability, full employment, and healthy financial system. In a historically conservative institution, it is hard to believe given the choice employment would be prioritized.

This is to say that even if we’re ready to give the central bank total power, come what may, there are crucial questions of deliberation and implementation that need to be answered. More importantly, accommodative monetary policy as we know it is hardly rent-free, as John Aziz argues:

Yet data suggests that the monetary injections via asset purchases are not really trickling down, much less kickstarting strong growth. While money has flowed into stock markets and corporate debt lifting prices from the lows of 2009, real GDP growth in Britain has been deeply depressed since quantitative easing began in 2009, lending to business remains depressedunemployment remains elevated at 7.9%, and M4 growth remains severely weak, even while being boosted directly by quantitative easing. So the wealth effect so far appears to be constrained to the financial economy (to such an extent that it may be an asset bubble rather than sustainable growth).

Is it just a matter of time before the effects of quantitative easing begin to bloom in the real economy, or is the transmission mechanism fundamentally broken? And — perhaps just as importantly — is it possible to have a policy that doesn’t disproportionately benefit the richest?

When the Fed loans money at the Federal Funds Rate a low discount rate, bankers and shareholders make a killing on cheap debt and appreciated assets, without any tangible benefits to the “common man”. To be fair, Yglesias does suggest a form of “helicopter money“, but this policy is again so radical it will inevitably be delayed in policy meetings.

And just as I don’t think monetary policy is free from the more mundane “old” problems DeLong mentions, I doubt fiscal policy is as ineffectual as we perceive. There are obvious issues of rent extraction, but take the other few which can be, broadly, delineated as issues of legislation, and issues of implementation. While we have seen decapitating (?) gridlock since 2010, it is important to remember Barack Obama had a powerful governing mandate in January 2009. It is important to remember that only after Scott Sumner Brown won in the special election did Democrats loose the necessary supermajority to rule. It is also important to remember that a fair number of Republicans were on board with a good stimulus.

The implicit point he makes, of course, is that ARRA was too weak. Christina Romer, now infamously, wrote a memo arguing for a super-trillion dollar package which Larry Summers squashed fearing legislative backlash. I think he was wrong. If Obama had single-handedly focused on economic and financial stability, Ron Suskind tells us, he could have survived with a robust fiscal stimulus which might have put a serious dent in our output gap. My point is, the travails of fiscal stimulus were not as much at the political level as much as within Obama’s economic team. Or at least the argument could be made.

But, the whole point of this post is that there is an argument for austerity. Unlike other critics of Keynesian policy, like Scott Sumner or Yglesias in his above incarnation, I won’t take for granted particularly accommodative monetary policy. I will try my hand at what I think is the definitely harder argument of a truly hawkish policy: fiscal consolidation and tight money.

The most convincing economic case for deficits during a slump is the miraculous idea that it is self-financing. This is most precisely accomplished by DeLong and Summers (2012). While a few years ago I might have believed arguments that the multiplier, μ, is below 1, I think it is not too generous to assume that it is closer to 1, noting that IMF estimates have converged near or above this value. However, the pivotal nature of the multiplier to any Keynesian argument and the uncertainty in measurement thereof is by itself a red flag in the theory.

But DeLong and Summers (2012) also note the importance of “hysteresis”, or the long-term supply-side effects of unemployment and depression. This is a convincing argument, particularly in terms of forgone research and investment, but I am less swayed by long-term labor market effects of recession. While Summers has argued (even before) that employment of women during WWII had positive effects on female labor force participation, the data are less convincing in the negative direction. I.e., it is one thing to argue that temporarily employing an excluded group increases aggregate supply of labor, and another thing extrapolating that to say that temporarily disemployment an included group decreases aggregate supply of labor.

Their theory is as follows, where Y is income, η is hysteresis, r is the real interest rate, and G is government purchases:

∂Y = ημ∂G

Total revenues, then, increase as:


where τ is the tax share of GDP. We amortize this debt as:

(r-g)(1- μτ)∂G,

where g is the potential growth rate of the economy. (For reference, this is about 0.025 as measured by the CBO).

Because I’m most unconvinced about long-run supply-side effects, I like thinking about it as the minimum η for which it is worth it to borrow, rather than the maximum r, which, in a slightly different arrangement, is:

∀[η > (g-r)(tu-1)/tu]

In the US, Heritage Foundation and OECD estimates of τ are just above and below 0.25. Today, the thirty-year Treasury yield is .0288. Therefore deficits are self-financing as:

∀[η > 0.0114]

Before we even go on, I have two problems with this estimate. One is, that during just the recession, labor share of GDP fell by 2%, inevitably taxed at lower rates than most labor. DeLong estimates an η of 0.035 based on 60% labor share. I think this is an overestimate. According to FRED, it is at 44% and falling. By next recession this will be even lower, especially if the technologists betting on 3D printing get their way. Also, human capital is more concentrated than ever, to the point where discouraged workers are socially important, but economically more useless than ever before. Indeed, unless the recession has caused serious discouragement among America’s educated, I am unconvinced we ought to worry.

Additionally, this model suggests the long-run potential growth rate is at a constant 2.5%. If hysteresis is a real problem, the higher it is (and hence the more valuable deficits become), the more doubtful it is we can assume a constant g. And if g becomes progressively smaller, the requires hysteresis becomes higher. And now we have feedback.

Another issue with employing Keynesian arguments towards deficit spending is that Americans have, recently, not saved during “good times”. Deficits, in other words, are common not only in bust, but also boom. The argument that austerity sets a bad precedent for future recession is at least somewhat tempered by our inability to run a surplus during good times.

Now, people will be quick to note that our growth rate might usually be higher than the deficit, i.e. that we run a structural surplus. But this means America is becoming a bank, and why should we believe it is the most efficient? There are certain projects of such scale – massive infrastructure and education – that perhaps requires governmental coordination. But why should we let our government become a hedge fund?

Of course, confidence in the American government is so high that Bill Gross believes it is the safest asset. One might say it is foolish not to capitalize on such low rates. Again, it is hard to argue that the private forces cannot allocate capital more efficiently. If high rates are what is hurting investment, the central bank can always lend to banks for free overnight.

Indeed, if cost of capital was actually a problem, there’s a great chance the economy is booming. Rates are low because our huge trade deficit forces foreigners to buy Treasuries, banks have excess reserves, corporations are not investing, and consumers are not borrowing. The argument that government should be a leveraged broker because it can sell bonds with low yields doesn’t apply in time of prolonged stagnation.

There is also a more philosophical argument. It is imprudent to run deficits without a plan of paying them off. While a stable debt-GDP ratio is fine, one of the freedoms of low debt levels are the chance to run huge deficits when necessary. We don’t know when our next real (supply) shock will be. We don’t know the next time we will need to ramp up expenditures not for Keynesian stimulus, but for real reasons such as deteriorating infrastructure and education. These are not “shovel-ready” and a Federal Reserve of San Francisco study found that in the medium-term highway projects might actually cost us. (Positive effects are kind of evident in the first years, but only pick up six to eight years later):


We might say there is a fragility associated with debt.

Alright, arguing that austerity might actually be good is exhausting. Especially without the option of easy money policies. Maybe I should have tried before R-R blew up…

Tyler Cowen and Mark Thoma take us to Karl Smith on social risk:

Yet, lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.

Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have [sic] larger been successful. As a result our lives are getting more and more stable.

As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.

When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.

So, putting it all back together and we come up with something of a risk floor, if you will.

Smith is arguing, effectively, that any attempts to manage background risk – incessant war, say – will (after a point) be offset by an increase in personal risk which, on the aggregate, drives background risk back to the initial condition. In other words, we’re always slouching towards an inescapable equilibrium.

But the delineation between social and personal risk is not so clear. Take the example of America being a big hedge fund – lower rates have driven America to sell bonds and invest in equity, earning a pretty penny from investments abroad. By any standard model, this is risky behavior, but is it social or personal? And, if the former, unlike the social risk in Smith’s model, rents from foreign assets do have benefits. Let’s ignore modern public choice theory and assume that governmental choice to do this is the simple aggregation of risky personal preferences. Fine.

We can’t make the distinction so clearly in other examples. Let’s say a culture is particularly risk-averse. They will tolerate – given decreased background risk – increased social risk, but only up to a point. In other words, there is an absolute risk ceiling. Depending on where this ceiling falls, decreases in background risk will always result in lower long-term interest rates.

This brings up an important point that Smith ignores, that risk and associated uncertainty by itself is a cost. Classical behavioralism tells us that most people would rather be given $1,000 unconditionally than $2,500 on a coin toss. This means there is a cost associated with risk and hence even at the margin decreases in background risk do not ipso facto imply higher personal risk.

It is also important to note that, to the extent that risk creates wealth, increases in individual risk do not imply so on the aggregate. Let’s assume that education means a richer and more productive society. Perhaps decreases in background risk make a family more willing to undertake a student loan (or just save less and pay directly) to fund a college degree.

In the near-term, this would be reflected in higher rates as the supply of loanable funds shrinks on the margin. Smith would be vindicated. But not really. Eventually, the college degree would more than pay for itself, not just in immediate earning power, but also the greater likelihood descendent will attend college – a geometric scaling.

If you don’t believe in the value of college education, think about the stock market. When Americans invest, money is allocated to the worthiest initiatives allowing Apple and Google to thrive, and forcing crappy companies like Hostess to fail. Buying equity is definitely a “riskier” personal choice than is buying bonds, but in the aggregate it generates wealth and makes us all richer. And deep equity markets make it less risky to start a company. If everyone was all about debt, I’d be scared as hell to found a startup. Equity reduces the risk vis-a-vis the producer.

Of course, as we get richer (either from the stock market or education) on the margin we save more and have stabler jobs which decreases risk, both at the personal level as well as the aggregate on the loanable funds market.

Let’s say income is exogenous to a family. Standard economic theory (rightly) suggests that the marginal propensity to save scales directly with income. But background risk decreases with higher incomes. As I move into the $30-50k range I probably don’t need to worry that my kids will have food on the table. As I move into the $60-70k range (if I’m smart) I probably don’t need to worry about my retirement. As I move into the $70-90k range I probably don’t need to worry about college fees. But at $20k I’ll be really worried about the big risks.

Basically, every marginal dollar I receive is “freer”. If Smith was right, I’d just spend more. But I don’t. Of course, income isn’t a exogenous like a storm, but it really captures the idea of “background” risk. (Wars won’t matter much with enough money). If I was rich in ancient times, I didn’t need to worry about much. Today, many more people would be considered “rich”. Hence overall risk in the aggregate is lower, reflected in cheap money.

This reminds me, in some sense, of the paradox of thrift. A simplistic argument for thrift in hard times forgets that my consumption is your income and that systemic reduction of personal consumption will decrease saving in the aggregate. This, of course, is at the bedrock of the argument against austerity – fiscal or monetary – in hard times. But one form of risk doesn’t fluidly shift between the too. In fact, the argument makes a pretty strong assumption that movement in risk is precisely linear: that a unit increase in personal risk has proportional decrease in social risk. However, it is entirely possible that the risks I pursue with my increased freedom don’t have any bearing on real, social risk, or that even if it does it may never move linearly with background factors.

Now let’s take the idea of reduced background risk to its logical conclusion. If we lived in the uber-welfare state, that provided for education, retirement, unemployment, what have you. They would, basically, invest it all in stocks, right? Lets take a look at Europe which should have higher direct stock ownership rates than America. But it doesn’t, lets see ownership trends across the world:

  • 50% of Americans 
  • 20% of Swiss
  • 22% of  British
  • 16% of Germans

So clearly, decreased background risk is not the answer. Indeed, in the early 2000s, aggregate risk across Europe fell as the cost of capital of Eurozone nations converged to a historic low.

I understand there are caveats to all my points. Of course Europeans are poorer and have less disposable income than Americans which, by my own suggestion, implies a higher “risk”. But this is covered by the government, and the delta doesn’t warrant the huge differences in ownership we see.

Whatever be the case, I do think that Smith’s theory is handcuffed by reality. While the idea of a “risk equilibrium” is attractive, it just doesn’t make sense. Indeed, if the marginal decrease in background risk, at one point, equals the marginal increase in personal risk – and the relationship is continuous (economists hate broken functions, after all) the logical conclusion of a world without background risk would be rampant personal risk taking. That just doesn’t happen.

Finally, we can’t “over solve” the problem as Karl claims. I highly doubt that personal risk is linear on background risk, but even if it is, it comes with a benefit as he suggested. Background risk like wars and government default (both of which are basically solved with democratic electorates who own sufficiently distributed government debt) are never good. There is no upside.

My theory isn’t nearly as clean, and I definitely haven’t mathematized it. It’s anecdotal. And it’s not scientific. But I seriously doubt it’s as simple as he claims!

Addendum: It’s important to note that after a point, real interest rates can only be so low, somewhat like the zero lower bound. We can tolerate negative nominal rates for only ridiculously short periods of time because of obvious arbitrage. Similarly (functionally, if not structurally), lower real rates require a certain level of inflation, which society may tolerate for only so long. Indeed, as inflation is a tax on capital, there is a limit to where long-term rates can fall.

Noah Smith has a post about why macroeconomics doesn’t work (well):

1.  There are a number […] “heterodox” schools of thought, [which] claim that macro’s relative uselessness is based on an obviously faulty theoretical framework, and that all we have to do to get better macro is to use different kinds of theories – philosophical “praxeology”, or chaotic systems of nonlinear ODEs, etc. I’m not saying those theories are wrong, but you should realize that they are all just alternative theories, not alternative empirics. The weakness of macro empirics means that we’re going to be just as unable to pick between these funky alternatives as we are now unable to pick between various neoclassical DSGE models.

2. Macroeconomists should try to stop overselling their results. Just matching some of the moments of aggregate time series is way too low of a bar. [It is important] when models are rejected by statistical tests […] When models have low out-of-sample forecasting power, that is important. These things should be noted and reported. Plausibility is not good enough. We need to fight against the urge to pretend we understand things that we don’t understand.

3. To get better macro we need better micro. The fact that we haven’t fond any “laws of macroeconomics” need not deter us; as many others have noted, with good understanding of the behavior of individual agents, we can simulate hypothetical macroeconomies and try to do economic “weather forecasting”. We can also discard a whole slew of macro theories and models whose assumptions don’t fit the facts of microeconomics. This itself is a very difficult project, but there are a lot of smart decision theorists, game theorists, and experimentalists working on this, so I’m hopeful that we can make some real progress there. (But again, beware of people saying “All we need to do is agent-based modeling.” Without microfoundations we can believe in, any aggregation mechanism will just be garbage-in, garbage-out.)

This led to a very interesting Twitter discussion:

Ashok Rao ‏Personally, I’d frame it that modern theory is fundamentally deductive in nature whereas the marcoeconomy is inductive/Bayesian.

Noah Smith ‏I think that’s a wrong way of seeing things. Real science involves an iterative process of induction and deduction.

Ashok Rao ‏But your claim also assumes there’s something “fundamental” about the economy in the sense of a real science. Is there?

Noah Smith Maybe. There’s real science in earthquakes but we can’t predict them at all. 

Ashok Rao ‏Hm. So there are systemic laws. But can these not be “understood” only through induction? As in the economy as machine learning.

Noah Smith Maybe!

Ashok Rao As long as we agree that there is a lot of doubt! 🙂

This conversation is at the very heart of my discomfort with much of modern economics, and I’ve been wanting to blog about this for a while, so now is as good a time as ever to dive right into it. Before I go on, I want to clarify that it seems like Noah and I have a very different understanding of what inductive is (or at least should be):

Ashok Rao ‏Yes but the 3 ‘main’ equlibria frameworks (general, classical game theory, and rational expectations) are all deductive. Right?

Noah Smith ‏No, you can easily make a Walrasian equilibrium happen in a lab, it’s very robust under certain conditions!

Of course, to the extent that empirical creations in the lab or double auctions are inductive Noah is right. But the macroeconomics behind this is principally deductive. By this I mean mathematicians economists have employed mathematics (the major premise) to a set of assumptions (the minor premises) to infer a conclusion. Ultimately, the theory is a grand syllogism, and highly deductive in nature. Further, the comparison to earthquakes doesn’t sit well with me. Physicists have very good microfoundations about how the earth works, and they’re not in perpetual motion. Scientists might fail at the aggregation of these bits of knowledge, but economics has a much more inherent flaw.

This is precisely the reason classical game theoretic approaches work only in “small lab settings” and that the Walrasian equilibrium holds only under “certain conditions”. That they do granted the right assumptions is tautological. Indeed, mathematics is internally consistent and hence in a concocted economy (the double auction) specific deductive models have to hold.

But by induction, I don’t mean experimental confirmation tempered by statistical reasoning. W. Brian Arthur at the PARC puts it better than anyone else:

This ongoing materialization of exploratory actions causes an always-present Brownian motion within the economy. The economy is permanently in disruptive motion as agents explore, learn, and adapt. These disruptions, as we will see, can get magnified into larger phenomena. 

If economists want to import one idea from physics, it should be Brownian motion:

One way to model this is to suppose economic agents form individual beliefs (possibly several) or hypotheses—internal models—about the situation they are in and continually update these, which means they constantly adapt or discard and replace the actions or strategies based on these as they explore. They proceed in other words by induction  

The best way I can imagine this idea is a “Bayesian machine”, if you will. While classical game theory, rational expectations, and competitive (Walrasian) theory might have inductive verification, Arthur is suggesting that the economy is inherently inductive.

The catch here is that for something that is at its heart inductive, there is not deductive verification. This is why many such as myself are skeptical of the mathematical models that dominate economics as they cannot either explain or verify anything. Often criticized, is the unrealistic nature of rational expectations. But in a real economy, I not only know that I’m not rational, but I also know that fellow agents are irrational too. This means I have subjective preferences, but also have subjective preferences about other people’s subjective preferences. These two degrees of subjectivity make many economic assumptions not just wrong, but impossible. (Think the epistemological difference between is not and can not be). 

This is why I disagree with Noah. While in  specific circumstances – equilibrium is a sub-class of non-equilibrium, after all – deductive engines work, macroeconomics has failed because the economy is inductive. At every moment in time there is a constant ferment, a change in attitude and belief. Standard economics holds that we all have one, perfectly rational prior. Induction holds that we all have pretty crappy priors that are constantly updated not only by economic outcomes, but also political and institutional motion.

Talk to goldbugs (actually, avoid it if you can). They’ll tell you about how they fear a government-Jewish orchestrated New World Order meant to line the pockets of rich bankers at the cost of the worker, by debasing our currency. Every economic indicator tells you they are wrong.

In a deductive model, it is impossible to accommodate for such people. If we modify a standard DSGE to tolerate such granularity it becomes intractable. A computer scientist would think about this as a machine learning problem. While there are a handful for which analytical solutions might work, the driving theme behind modern data mining and machine learning projects, even as simple as classification problems, is the flexibility of statistical computer science.

But the problem with induction is that, well, it’s not deduction. A well-formed syllogism guarantees its inference. Very much like the sum of two and two has to be four. On the other hand, induction is fuzzy and unclear. You can’t prove any sweeping laws and ideas with inductive reasoning, as Karl Popper has brilliantly argued. Indeed, inductive thinking is fragile against “black swan” events.

These aren’t real limitations, though. In the economists’ imagination theory trumps empirics. For the same reason, running large simulations on supercomputers is hardly as appealing as theorizing Walrasian economists. Proving things is really fun (if you’re smart enough).

But just as natural evolution doesn’t lend itself to equilibrium analysis, economists cannot believe that the fundamental structure of the economy is static. It is constantly reborn in updated preferences, political upheaval, and institutional ferment. Human minds and mathematics can never model this. But a supercomputer might help.

Every now and then, economists come up with ideas that are too radical and cool not to try. Kaushik Basu asking India to legalize paying bribes is one:

The paper puts forward a small but novel idea of how we can cut down the incidence of bribery. There are different kinds of bribes and what this paper is concerned […] harassment bribes [which] is widespread in India and it plays a large role in breeding inefficiency and has a corrosive effect on civil society. The central message of this paper is that we should declare the act of giving a bribe in all such cases as legitimate activity. In other words the giver of a harassment bribe should have full immunity from any punitive action by the state.

The Theory and Experiment

In the spirit of Basu’s best writing, the idea behind this proposal is game theoretic in nature. India is famous for its corrupt political culture. Of course, foreigners sense this from the carefully coordinated heists like the 2G Scam. But most bribery isn’t that sexy, nor is it coordinated. It’s the undignified bribes a commoner must pay to the police officer, or water man. The gift to expedite regulatory approval. (In my case the bribe to bring our American-born Dachshund, Lego, into India without the murder of a quarantine India requires).  Basu’s argument is as follows:

  1. In a “harassment” situation, the bribe giver is humiliated and is eager to bring the taker to justice.
  2. Under today’s punitive laws he, too, is a criminal and hence must keep quiet. The taker knows this to be the case and hence does not fear punishment – especially as this information is restricted to the two involved parties.
  3. If the government were to a) legalize the act of giving a bribe and b) incentivize citizens to report illicit activity the dominant strategy for the citizen would be to report the bribe regardless.

Here’s what the payoff matrix might look like with symmetric liability:

Citizen/Corrupt Official Accept Don’t Accept
Give and Report (-5, -5) (0, 0)
Give and Don’t Report (5, 10) (0, 0)

In reality, (Give and Report, Don’t Accept) might be a Pareto-efficient situation, but (Give and report), in this matrix, is not subgame perfect. This means a given citizen cannot credibly threaten to report, and the official knows this. Basu’s insight was noting that it’s not difficult for the government to make (Given and Report) a credible threat. This would force officials to accept transactions without a bribe because they will be penalized if no transactions are processed. (The bribe is just a way of extracting surplus from the citizen)

Citizen/Corrupt Official Accept Don’t Accept
Give and Report (15, -5) (0, -2)
Give and Don’t Report (5, 10) (0, -2)
Don’t Give (10, 0) (0, -2)

It can be seen that (Don’t Give, Accept) becomes a subgame-perfect Nash equilibrium. (Note, I omitted the Don’t Give option in the first game because it is strictly dominated by the given matrix and hence may be iteratively removed).

The beauty of Basu’s theory is that it’s vindicated not only by matrices, but also empirics. Klaus Abbink, Lata Gangadharan, Utteeyo Dasgupta, and Tarun Jain conducted an experiment in Hyderabad that verifies this theory. The sample (students in major universities around the city) was fairly representative of India’s middle-class as a whole. 55% reported having paid a bribe, and over 60% declared some familiarity with India’s labyrinthine corruptions laws. Participants had the chance of real earnings to the tune of almost $10, ensuring that they took the experiment seriously. For the average Indian student, this is definitely not a trivial sum of money: we should be confident that they played selfishly.

The experiment played a citizen against a corrupt official, as I noted above, with the same moves. Unlike my simpler matrix, they assume a 40% chance of successful prosecution if the bribe is reported, but a 5% chance if it is not, perhaps through a third agent. Citizens and officials are made aware of the potential gains from reporting and taking bribes, but also the risk of fines from a prosecution.

Three games are played. A control where both agents are at risk of prosecution, Basu’s proposal where only the official may be punished. Abbink et al. also consider a third option where the angry official threatens to take revenge on the citizen if he reports the bribe. The results are striking:

We found strong evidence that Basu’s proposal works. Twenty five percent of citizens reported bribe demands in the symmetric case, which increased to 59% in the asymmetric case. In the case of officials, while 38% asked for bribes in the symmetric treatment, this fell to 24% with asymmetric liability as officials feared the impact of greater reporting by citizens. Interestingly, the moral “refusal to pay” did not change significantly as we switched between the two versions (17 versus 19%), suggesting that the law is not a strong guide to moral behaviour.


We find that the impact of asymmetric punishment is reduced considerably when retaliation enters the formulation. Only 42% of citizens report bribe demands and 37% of officials demand bribes, which is close to bribe demands with symmetric liability.

So Basu is correct, unless the official has the capacity to threaten citizens (perhaps with prolonged water shortage, delay, etc.)

My Thoughts

While the results of this experiment is a victory for behavioral economics and “out of the box” thinking, one sobering thought caught my eye:

Retaliation takes costly effort, but does not offer the official any explicit rewards. Thus, in our formulation, retaliation is never an optimal strategy and instead hangs as a threat that can be used by a vengeful official.

This is to say that revenge by the official is not a credible threat. Because it’s a costly process to antagonize a citizen, both parties are the worse off. In a world with symmetric information and rational actors, there should be no discernible effect in adding the option of retaliation. To the extent this sample is representative of middle-class, urban India – the game is settled outside of a subgame perfect equilibrium.

This is not to say the government shouldn’t experiment with Basu’s proposal. The idea that fairly petty officials (drunk police officers, etc.) have any long-term rationality is unlikely. Indeed, the only benefit from the non-credible threat of retaliation comes from possible deterrence and I suppose it’s unlikely many such agents have studied the Cold War.

This study decisively rebukes P. Sainath’s scathing critique  of Basu’s idea:

The Chief Economic Adviser dresses up these arguments for middle classes forced to make payoffs. For instance when a person allotted subsidised government land “goes to get her paperwork done … she is asked to pay a hefty bribe.” Yet, his law will in no way curb bribery where scarcity exists. For instance putting a child into school where seats are hard to get. Or even getting that flat or the land he speaks of, allotted. Raising the stakes Dr. Basu’s way could mean the victims face heavier demands. After all, the bribe taker needs to be compensated for the higher risk he now runs. And there is no focus at all on government failures that lead to scarcity. Nor on priorities that gift the corporate sector over $103 billion in write-offs in just this budget. Nor on spending policies that cut food subsidies and punish the poor.

If anything it suggests that behavioral game theory can soundly inform empirical study. A country like India, where the center is starved of national mandate, can only rely on the small “nudges” to fix its most damning problems. Basu offers a cheap, brilliant, and neat idea that seems to be defended by experimental study. It is time for the government to pilot similar projects at an increasing scale. Perhaps in cooperation with various municipal governments, the Centre can offer avenues for reporting petty bribes. This also gives India a great chance to work with endeavors such as Janaagraha’s I Paid a Bribe, to catalog the little bribes that dot urban India.

The marriage of technology, behavior, and design (TBD conferences anyone?) might offer India an escape from wasting institutions.

That South India is more developed than the Hindi-speaking North is a common refrain. Literacy rates and per capita income generally bear this out. Indeed, we worry of the barren villages in Bihar, not fertile landscapes across Tamil Nadu. As per the Human Development Indices across India, the South is just over 25% ahead of the All-India average.

And yet, the story is false. Or so is my conclusion after running into a few “Data Stories” of India (looks like Tyler Cowen is interested, too). While the maps give breathtaking life to the real depth of poverty across India, there are fairly rigorous analytics to vindicate my point. While the commonly-used GINI measure of inequality is very intuitive, it’s handcuffed by its inability to decompose the inequality with certain subgroups. A more appropriate measure is the Theil Index, which I talk about in a recent blog post:

The math behind the measure (between 0 and 1) requires a fair understanding of information theory but the idea is lower index implies a higher economic “entropy”.

Your physics teacher might tell you that this is a bad thing but, economically, it’s a little more complex. As Boltzmann showed, entropy increases as predictability of an event decreases. This means the entropy of a fair coin is higher than a biased one. Similarly, in a very equal economy it is very difficult to distinguish between two earners based only on their income. Indeed in a perfectly equal society this is impossible. However, as society stratifies itself, knowledge of ones income conveys far more information (redundancy), thereby decreasing entropy.

Within a system, Theil makes it easy for econometricians to understand the amount of total inequality due to within-group inequality and across-group inequality. If this is a little hard to grasp, think about it this way. If the total differences in economic output remained constant between countries (that is, India is still poor and Norway rich) but income was equally distributed within each country the residual inequality would be the “across-country” inequality. The residual from the converse, where all countries remain as unequal as they were, but world economic output is distributed equally to countries (not people), represents the “within-country” inequality.

And the same reasoning can be scaled-down to consider inequality within and across Indian states. And this is just what a few researchers from the University of Texas did. Before we discuss this, it’s worth considering what high” decomposed, across-state inequality is. A good benchmark is definitely America. While the Northeast and California are generally considered to be richer than the rest, the real turmoil of inequality – at least the public’s eye – is definitely between individuals and not states. Further, the economic relationship between various American regions has been highly volatile, with some sign that growth is picking up most rapidly (in no small part due to extractive oil and gas industries) across “middle America”. Here is a decomposed map of inequality in the United States:


A few accounting points notes here – while the overall measure can never be negative (greyish or black, in the above figure) individual agents can. A below-zero value here indicates that the given county is actually decreasing overall inequality of the country as a whole. The signal, here, is that American states are, broadly, equal. The real inequality stems from the difference between the rich and poor in Manhattan, not between the New Yorker and Iowan.

So back to Galbraith, Chowdhury, and Shrivastava at Texas, we find that across-State inequality in India is pretty low:


The dynamics of this graph are fascinating. For one, the purple line (within state inequality) is far more cyclical with overall inequality than the green line (between state inequality). While both do a fair job signalling inflections, the former represents approximately 90% of the change. Indeed, the contribution of between state inequality has been in relative decline since the 1980s.

While this chart is too fuzzy to derive any grand conclusions, it’s interesting that the correlation across between state and within state inequalities diminished significantly since the piecemeal reforms of the 1980s. While data isn’t available as far back as the ’50s, I suspect liberalization shifted the onus from the state onto the individual. Further, central bureaucrats weren’t able to throttle State growth in the same uneven manner as the years of Fabian regulation.

Of course, this is just mere conjecture. Here’s a graph from the Data Stories:


It’s surprising how relatively rich Bangalore (the blue oasis straight up from the Southern tip) is. Generally, though, almost all of India is as deprived of all the assets indicated above. Now, some might say this isn’t a good depiction of wealth inequality across India because most of the inequality doesn’t stem from the upper-middle class that owns said assets, but among the poor. However, it’s important noting that in terms of total assets, the 5% that owns these assets controls most of Indian wealth. Division of what’s leftover barely moves overall inequality.

On the other hand, in terms of overall standard of living, the South might actually be significantly better:


The big exception is that a good chunk of the North does as well if not better than the South. The cow-belt of India (it’s heartland) does remarkably badly. While this is commonly parsed as the relative wealth of the South, I think it’s the far more equitable distribution of the little that’s leftover after the 5% have taken their share. The above graph depicts what we may call the “poorest of the poor”. To that end, let’s reference this image against the Theil contributions of various states to overall inequality, again from Galbraith et al.:


It should not be hard to see that there’s a fair overlap between the states listed on here (various incarnations of Maharashtra, West Bengal, Bihar, Madhya Pradesh, and Orissa) are the darkest on the map.

This has some important implications for policy making across India. Indians all over (especially in the anxious time before an election) hear of the Gujarat or Bihar “growth models”. Panagariya and Bhagwati in India’s Tryst with Destiny (which I critically review, here) talk about the importance of pro-growth policies. They fairly argue that redistribution alone cannot better the lives of India’s poor.

And while on a national stage this is definitely true, the data above clearly show that the more habitable states (in the economic sense) are not so because of rapid growth rates, but a more equitable distribution of income between the poor and the not-so-poor-but-not-rich. There are a few future research projects, in America, India, and the world that would be very interesting. The Theil Index is, econometrically, a far more robust measure capable of fantastic insight. It would be fascinating to see a study that decomposes a country not into States, but income percentiles to gauge the extent to which each contributes to overall inequality.

I’m guessing, within the United States, there has been an overwhelming shift in the past thirty years away from general inequality to that between the top 5%. In some sense, policy should be targeted to curing not just inequality, but also inequality of inequality.