Revisiting Greg Mankiw and the Unit Root Hypothesis

I saw the graph above at American Thinker and realized that it was time to revisit a hypothesis of my favorite Keynesian economist: Greg Mankiw. First, here's what I see in the graph above. You've got the economy, pre-2008 adding about a million jobs a year. Then the economy sheds jobs from about 2008 to 2010. Finally, it looks like 2010 saw the addition of about a million employees with a little bump tapering out that represents hiring temporary workers for the census.

On March 3rd, 2009, Greg Mankiw blogged Team Obama and the Unit Root Hypothesis. Mankiw's post was inspired by the following in the CEA's forecast analysis:

a key fact is that recessions are followed by rebounds. Indeed, if periods of lower-than-normal growth were not followed by periods of higher-than-normal growth, the unemployment rate would never return to normal.

Mankiw's summary follows:

That is, according to the CEA, because we are now experiencing below-average growth, we should raise our growth forecast in the future to put the economy back on trend in the long run. In the language of time-series econometrics, the CEA is premising its forecast on the economy being trend stationary.

In other words, the assumptions of the Obama administration as it took office were that after the economic downturn the economy would return to pre-recession levels. I should note that the original debate focused on GDP, while the graph above is one of employment. Mankiw cites a paper that he co-authored that disputes this view and introduces the unit root hypothesis:

According to the conventional view of the business cycle, fluctuations in output represent temporary deviations from trend. The purpose of this paper is to question this conventional view. If fluctuations in output are dominated by temporary deviations from the natural rate of output, then an unexpected change in output today should not substantially change one's forecast of output in, say, five or ten years. Our examination of quarterly postwar United States data leads us to be skeptical about this implication. The data suggest that an unexpected change in real GNP of 1 percent should change one's forecast by over 1 percent over a long horizon.

Wikipedia notes the debate and provides a wonderful graph to illustrate it with the following explanation:

The diagram above depicts an example of a potential unit root. The red line represents an observed drop in output. Green shows the path of recovery if the series has a unit root. Blue shows the recovery if there is no unit root and the series is trend stationary. The blue line returns to meet and follow the dashed trend line while the green line remains permanently below the trend. The unit root hypothesis also holds that a spike in output will lead to levels of output higher than the past trend.

In other words, Delong and Krugman argue for the blue line while Mankiw is suggesting the green. Another caveat: to the extent that there's any recovery, it's only a year old and everyone in the debate at the time (including Paul Krugman and Brad Delong) was looking at longer time horizons. It's too early to say whether there's been a permanent net loss of 10 million jobs—if the 2006 to 2008 trend had continued to 2010, then there would've been about 140 million workers instead of 130 million.

Greg Mankiw: The Trilemma of International Finance:

What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

• Make the country’s economy open to international flows of capital...
• Use monetary policy as a tool to help stabilize the economy...
• Maintain stability in the currency exchange rate...

Mankiw on Tax Cuts

Greg Mankiw on the crisis economic policies of the past couple years [emphasis added]:

The administration's second assumption, meanwhile, is a matter of academic theories about the sizes of the relevant economic multipliers. Textbook Keynesian economics tells us that government-purchases multipliers are larger than tax-cut multipliers. And, as we have seen, the Obama administration's economic team consulted these standard models in deciding that spending would be significantly more effective than tax cuts.

But a great deal of recent economic evidence calls that conclusion into question. In an ironic twist, one key piece comes from Christina Romer, who is now chair of Obama's Council of Economic Advisers. About six months before she took the job, Romer teamed up with her husband and fellow Berkeley economist David Romer to write a paper ("The Macroeconomic Effects of Tax Changes") that sought to measure the influence of tax policy on GDP. Crucial to the Romers' method was their effort to identify changes in tax policy made during times of relative economic stability, and driven by a desire to influence economic behavior or activity (to encourage growth, say, or reduce a deficit), rather than those changes made in response to a recession or crisis. By studying such "exogenous" tax-policy changes, the Romers could be more confident that they were in fact measuring the effects of taxes and not those of extraneous conditions.

The Romers' conclusion, which is at odds with most traditional Keynesian analysis, was that the tax multiplier was 3 — in other words, that every dollar spent on tax cuts would boost GDP by $3. This would mean that the tax multiplier is roughly three times larger than Obama's advisors assumed it was during their policy simulations.

Greg Mankiw on Tax Cuts

In the New York Times, Harvard economics professor Greg Mankiw suggests that tax cuts might accomplish what spending hasn't: "These studies point toward tax policy as the best fiscal tool to combat recession, particularly tax changes that influence incentives to invest, like an investment tax credit. Sending out lump-sum rebates, as was done in spring 2008, makes less sense, as it provides little impetus for spending or production."

Via Greg Mankiw's Blog, the WSJ has a great story about how businesses respond to perverse incentives:

The fabric is shredded, the steel parts are broken down, and everything is sent off along with the glass to be recycled.

Why all the fuss and feathers? Blame the "chicken tax."

The seats and windows are but dressing to help Ford navigate the wreckage of a 46-year-old trade spat.

Clearly, more regulation is called for: 1) a steel breaking tax, 2) a fabric shredding tax, and 3) a recycling tax might do the trick. Government meddling can always be mitigated with more government meddling—it demoralizes the whiners!

State Finances and Mankiw's Unit Root Hypothesis

Glenn Reynolds mentions an article in the WSJ by Indiana governor Mitch Daniels The Coming Reset in State Government:

During the last decade, states increased their spending by an average of 6% per year, gusting to 8% during 2007-08. Much of the government institutions built up in those years will now have to be dismantled.

...unlike the aftermath of past recessions, odds are that revenues will take a long time to catch back up to their previous trend lines—if they ever do. Tax payments have fallen so far that it would require a rousing economic rally to restore them. This at a time when the Obama administration's policies on taxes, spending and more seem designed to produce the opposite result. From 1930 to 2008, our national average annual real GDP growth rate was 3.49%. After crunching the numbers, my team has estimated that it would take GDP growth of at least twice the historical average to return state tax revenues to their previous long-term trend line by 2012.

That reminded me of Greg Mankiw's Unit Root Hypothesis. Here are a couple of key quotes from that:

...according to the [President's Council of Economic Advisors], because we are now experiencing below-average growth, we should raise our growth forecast in the future to put the economy back on trend in the long run. In the language of time-series econometrics, the CEA is premising its forecast on the economy being trend stationary.

Mankiw's research [PDF] suggests that the trend stationary premise is incorrect:

The data suggest that an unexpected change in real GNP of 1 percent should change one's forecast by over 1 percent over a long horizon.

In mid-August the professor added this:

What Olivier is saying is that the shocks to the level of GDP from banking crises are typically permanent...

By the way, the administration's midsession review, with its updated forecast, should be coming out soon. Will Team Obama continue to forecast a rebound to the previous trend path, as they did earlier in the year, or will they change their view and take to heart the kind of evidence Olivier describes above? Either way, it will be noteworthy.

Nobel laureate Robert Fogel explains why healthcare costs are rising so fast in an article titled Forecasting the Cost of U.S. Healthcare

The main factor is that the long-term income elasticity of the demand for healthcare is 1.6—for every 1 percent increase in a family’s income, the family wants to increase its expenditures on healthcare by 1.6 percent.

Hat tip Greg Mankiw who also recommends James DeLong's article Maybe We Should Spend More on Healthcare.

CNN Healthcare Poll

Greg Mankiw links to a CNN/Opinion Research Corporation Poll conducted May 14-17, 2009 of adults Americans. I'd like to see the poll re-run with the following minor rewording:

Would you prefer a health care reform plan that raises your taxes in order to provide health insurance to all Americans, or a plan that does not provide health insurance to all Americans but keeps your taxes at current levels?

Why?

Intellectual consistency is always thin on the ground, so I don't agree with Professor Mankiw's assertion: "If you are going to take that philosophy seriously, you have to take all of the implications seriously." I'm certain most Americans, perhaps even all of them, agree that Bernie Madoff's Ponzi scheme was immoral, but support for ending the Great American Ponzi Scheme of Social Security is non-existent.

Professor Mankiw continues with this simile:

It is more like your mother telling you to clean everything on your plate. If you are a Utilitarian redistributionist, the height tax is like that awful tasting vegetable your mother served up because it is good for you. No matter how hard you might wish it wasn't there sitting on your plate, it just won't go away.

Sure it will! My four year old finds all kinds of ways to make it go away. She begins by whining about it to see if her parents will capitulate. Failing that, she might chew it up a bit and gag, requiring her to spit out the offending vegetable, or she'll play a variant of "there's many a slip 'twixt the cup and the lip." Oops! It's on the floor so she can't eat it now. To put it another way, Utilitarian redistributionists can ignore the height tax because their "parents", the people that elected them, will not demand intellectual consistency. The redistributionist is excused from the table while the unwanted vegetable languishes on their abandoned plate to be discarded with scorn by those who fail to hold them to account.

Mankiw on Fiscal Multipliers

Greg Mankiw highlights the debate about whether fiscal stimulus multipliers are large or small.
He's explained elsewhere that marginal propensity to consume (MPC) increases (in contrast to average propensity to consume) during times of uncertainty. Therefore, he tends to agree with the Obama administration that fiscal multipliers will be "larger than normal as well".

I wonder if his MPC argument applies to dollars themselves. That is, during times of uncertainty, are consumers more likely to spend the spare change or drop it in a jar at home? In light of the Bloomberg report that the FDIC might run out of money this year, I wonder where consumers are putting their marginal dollars. Are they putting them in Bank of America or their mattress?

Update: Congress is considering a loan to the FDIC.

Child Labor (UPDATED)

It is worthy of particular remark that, in general, women and children are rendered more useful, and the latter more early useful, by manufacturing establishments, than they would otherwise be.—Alexander Hamilton

Gateway Pundit brings news of Obama's plans to require children in middle and high school to perform fifty hours of service annually. Savor for a moment the irony of our first African-American president re-introducing involuntary servitude then consider that he does not specify whether this child labor is going to be compelled with the minimum wage or something more forceful. And do rid your mind of any inappropriate comparisons to other national youth programs.

I suppose it's good to see The One's enlightened return to a first principal of our great country: to wit, that children should be gainfully employed. Alexander Hamilton thought that child labor would be a boon to our manufacturing industries. He was proved correct and child labor laws eventually ended the practice. Perhaps there were reasons for those child labor laws. (At that last link, please disregard the section titled "Forced or Compulsory Recruitment of Children for Use in Armed Conflict.")

I sincerely doubt that these children will be gainfully employed since, as any good Keynesian like Our Dear Leader knows, "The government should pay people to dig holes in the ground and then fill them up." Perhaps someone would be kind enough to mention Bastiat's insights about the broken window...

I would personally like to thank all of the college students that worked on Obama's campaign. Since his plan calls for a hundred hours from each of you annually, you can continue doing so!

Update: Coyote Blog observes that the way to tax people who do not make money is to take away their labor.

Update 2: Greg Mankiw sees this as a sort of new draft. I'll note that America's most decorated Marine, Smedley Butler, lied about his age to serve his country. I can only wonder who the first such patriotic fourth or fifth grader will be!

Update 3: Glenn Reynolds has noticed with an unusually verbose: "FREEDOM!" and link to a blurb at Overlawyered. What does the Instapundit think of the constitutionality of the proposal?

Update 4: While not directly related, Don Boudreaux of Cafe Hayek mentioned the passing of Marshall Fritz on election day. Fritz was the founder of the Alliance for the Separation of School & State. It's likely that his organization will be in the vanguard of this fight, so do what you can to support them. Here's information on donating and here's their How Can You Help page.

Update 5: Dr. Helen believes it will be no more successful than the government's self-esteem programs of the 70's and 80's. She (and her commenters) ask: why not make it voluntary? That would be a reasonable improvement, but why not start there? Why did they choose to start with "required" service?

Update 6: Glenn Reynolds brings news that the change.gov site has been edited and the community service has been reframed as a goal not a requirement—perhaps that's why they call it change.gov. The new text is:

Obama will call on citizens of all ages to serve America, by setting a goal that all middle school and high school students do 50 hours of community service a year and by developing a plan so that all college students who conduct 100 hours of community service receive a universal and fully refundable tax credit ensuring that the first $4,000 of their college education is completely free.

For reference, here's a copy of Gateway Pundit's screen grab. The text above is a re-write of the portion underlined in red:

He who controls the present, controls the past. He who controls the past, controls the future.—George Orwell

Update 7: Kudos to the Obama team for making this slight policy adjustment! I'd recommend that you guys port the change.gov site to a wiki. That will allow everyone to see the sausage being made—the historical edits to each page. Open government is a very good thing and it will prevent the new administration from being painted as Orwellian.

Last Update: Re-reading my initial post I have to admit that I was a bit over the top. What can I say... I was pretty fired up.

Cliff Mason over at CNBC has a post arguing that mandatory voluntary service is an oxymoron. Boston-based blogger Arkady finds irony in the pre-election fear that McCain would bring back the draft and is rightly concerned about the growth of government. I think he implicitly understand The Practical Rules of Bureaucracy. I will have a lot more to say about those someday...

Some final thoughts... Child labor law is not (and should not) be a barrier to high schoolers and college students doing volunteer work. I like the idea of encouraging children to do more work. In fact, I'm currently reading Young Bucks: How to Raise a Future Millionaire which encourages parents to train your children in entrepreneurship at an early age. (Here's the Glenn and Helen Show interview with author Troy Dunn.) My fear is that an Obama administration would structure volunteer work to preclude or restrict volunteering through religious organizations and religiously aligned colleges.

My brother was enrolled in ROTC at Grove City college his freshman year. The following year there was effectively no ROTC at Grove City. I believe that was a result of the Grove City College v. Bell decision and administrative actions at the college. I agree with the left that Federal dollars should not be spent on religiously affiliated institutions; however, I also believe that individuals should be empowered to choose such institutions and the way to empower them is to reduce their tax obligation on a dollar for dollar basis. Note that this works very well with my Pigovian Income Tax proposal... something else I'll have more to say about later.

Child labor law also needs to be re-visited. In particular, it needs to be modernized to recognize and encourage children to work in the IT sector. I have no specific recommendations because I know very little about the law, but I am sure that laws written a fifty or a hundred years ago to address problems in agrarian and industrial work can not all still be relevant.

Standing Up for Greg the Economist

Tim Wu takes a couple of shots at Greg Mankiw's work incentives under an Obama tax regime. Greg made the point that Obama's tax plans make it preferable for him to spend time with his family instead of putting out the extra effort to earn another dollar. Tim makes the following two arguments:

1. It assumes that his only incentive to do any work outside of his regular teaching and research is to make money. This seems so counter to what the idea of academia is for, and is passed over so easily.

Tenured academics like Greg M. have an incredible luxury: the time, freedom to work on what he wants, and a guaranteed paycheck (in his case, a large one). To say in that position you’ll only do “more work” if paid seems an offense to the idea of academia itself. Academics aren’t supposed to be on sale or work only on commission.

It appears to me that Tim is suggesting that tenured professors should not be paid for speaking engagements or consulting services. Since that can't be what he really means, I feel that Tim is being disingenuous. He is using the Professor's occupation to deny Mankiw the opportunity to freelance by implying that speaking and consulting are somehow part of his professorship. Neither Tim nor I know what the Professor's compensation includes, but I would not be surprised if it explicitly allowed and even encouraged Mankiw to pursue consulting and paid speaking engagements.

Greg M. himself is disproof of his own ideas. He spends alot of time blogging, and writing advice for junior professors and so on, all for free. If Obama wins, it looks like he’ll be doing more of that in the future. Obama, if his blog post is right, will alter the balance of commercial and non-commercial work he does. The irony is that that result might be better for society than Greg M. doing a bunch of consulting or paid-speaking.

The professor does not blog "for free." He blogs to receive the accolades of people like me, to improve his name recognition to advantage himself in future salary negotiations, and (perhaps most importantly) to sell his favorite text books. Similar, I blog in the hope of someday receiving a free, signed copy of the Professor's wisdom for defending him against economically illiterate attacks.

As to what is best for society, I do not think Tim is the one to judge. Surely a teenage neighbor of the Professor would benefit from a sitting job while Mankiw lectures out of town. Or perhaps one of his own children is old enough to be entrusted with the care of their siblings and the stimulation of the local economy. With a more favorable tax structure, the good Professor might hire a nanny or au pair to help raise the children, prepare meals, and clean the house. This would not only employ someone directly, but on that rare Friday night when the Professor has no speaking engagement, he and his wife could go out for a truly spectacular dinner at Aujourd'hui thus employing, in part, a few more people.

All of that is the work of the invisible hand.

Tim continues:

2. The implication, taken by other writers like “Beldar” though not by Greg himself, is that Greg working less is proof that Obama’s tax cut will hurt the country. But hold on - Greg represents 5% of the country. The rest — the 95% percent who get a tax cut, will presumably have reasons to want to work harder, because their taxes are going down.

Roughly 40% of wage earners pay no income tax. They do pay payroll taxes, but then a plan to return Social Security revenue is surely a plan to accelerate the collapse of that great ponzi scheme.

It’s a simple calculation. The tradeoff is those who make more than $250,000 doing less commercial and more non-commerical work, versus 95% percent of the population who have reasons to do more.

Its at least ambiguous. And since the money is worth more, on the margin, to people who make less than $250,000, they have more reason to want to work for it. $1000 means more to someone who makes $60,000 than to Greg M.

I agree with Tim; however, I think that the "Pigovian" income tax that I propose creates even greater incentive for lower wage earners to do additional work while also potentially increasing the Professor's incentives. It's not an either or.

The upshot: Obama’s tax plan will encourage a rich man like Greg M. to devote more time to the public and his children instead of paid speaking gigs, and gives a lot more other people more incentives to earn more money. Sounds pretty good to me.

I do not know if the Professor is rich since I only know that his income is in the upper middle class. Perhaps he is not particularly frugal, but would become so if allowed to work for and save more money. I'll agree that it "sounds pretty good" in one respect: Joe the Plumber can lowball Mankiw on a lot of those speaking gigs and probably do a reasonable job at the lectern.

Update: Welcome Instapundit readers!

Your Tax Dollars at Work

With declining circulation numbers plaguing most (all?) of America's newspapers, The Fed has developed a rescue package focussed on buying up "unneeded" paper and ink.


See also: Professor Mankiw, Money Supply

A Pigovian Income Tax

In a shameless bid to join Greg Mankiw's Pigou Club, I've devised a Pigovian income tax. I first thought about this a couple weeks ago after Professor Mankiw proposed a new metric for computing average marginal tax rate. In a follow-up post a reader suggested an improvement to the metric and dubbed this the "Mankiw effective tax rate".

At that phrase, my mind wandered. I began to think about what income tax policy Professor Mankiw would prefer. Readers of his blog would instantly know that he would prefer a Pigovian income tax, but what exactly is that. Let's start with a definition

Pigovian tax: (n.) a tax levied to correct the negative externalities of a market activity

This begs the question: what are the negative externalities of our current income tax policy? Obviously, the answers to that question are debatable. Here are the two negative externalities that I'll try to address:

1. Free riding (The poorest people pay no income tax)
2. Greed (The rich do not "pay their fair share")

Free riding and greed are related. The tax burden in modern America falls almost exclusively on the high income earners. The top 50% of earners pay 97% of income taxes. The top 5%, pay 60%. We're already soaking the rich. The bottom 40% of wage earners pay no taxes. They're free riding.

A corollary to both free riding and greed is class warfare. If the tax rates of the low and high wage earners could be linked, we could address not only greed and free riding, but also class warfare. So, my Pigovian income tax would tightly couple the interests of high and low wage earners. I would accomplish this by making the tax rate for the top wage earners a multiple of the tax rate for the bottom wage earners. For example, if we chose a multiple of two and set the bottom tax rate to 20%, then the top tax rate would be 40%. Let's apply the 20% rate to the bottom quintile and the 40% rate to the top quintile.

That leaves the middle three quintiles up for grabs. Tax brackets could be divided up differently and probably would be in the real world. Still, quintiles offer a simple way to illustrate my point. If we used a typical progressive scheme, we would wind up with progressively higher tax rates, say, 25%, 30%, and 35% for the middle quintiles.

I would prefer a tax policy that incentivizes productivity, so I will examine a policy of declining tax rates, say, 12%, 6%, and 0%. Let's consider these tax rates, but replace the quintiles with household income ranges so we can see what this might look like with real numbers.

Income Range	Tax Rate	Revenue Est.
$0 to $20,000	20%	$51,401,950,000
$20,000 to $40,000	12%	$114,728,120,000
$40,000 to $62,000	6%	$155,023,760,000
$62,000 to $100,000	0%	$171,086,480,000
$100,000 and up	40%	$776,028,380,000
Total:		$1,268,268,690,000

Note 1: I assume 22.25 million households per quintile which is slightly higher than the 2007 number implied at answers.com.
Note 2: Quintile ranges are based on data from taxpolicycenter.org. I used the mean income data there to calculate my revenue estimates.
Note 3: The taxpolicycenter.org also implies that total income tax revenue is about $1.25 trillion.

Are you shocked at that 0% rate for the upper middle class bracket? It has a couple of nice side effects. First, it clearly marks the transition to the higher "greed" tax. Second, it reduces the burden of filing tax returns for a quintile that is likely to have numerous deductions. If you're at the upper end of that quintile, there's no reason to itemize unless you can muster almost $40k in deductions. This would also apply, though to a lesser extent, with the middle class bracket of 6%. In that case, filers would have to decide if the burden of documenting a deduction was worth the 6% savings that it would net.

This incentive structure is the inverse of what currently exists. Because each tax bracket is at a higher tax rate, the incentive to itemize increases as earnings increase. I suspect that discouraging itemization (as my proposal does) will reduce fraud and raise revenues.

Who's Better for the Stock Market?

Harvard's Greg Mankiw blogged today about Republicans, Democrats, and the Stock Market. His main point is that the efficient market hypothesis implies that the incoming president moves the market prior to taking office; therefore, it is meaningless to measure market performance from their respective start and end dates in office and conclude that Democrats are better for the market.

It seems to me an analysis that omitted the first and last years of each president's term would be a much better barometer. Investors with longer time horizons for their investments might skew this measure slightly, but not too much, I would think.

There's still the correlation-does-not-prove-causality issue...