If wages fell during a recession

A paper I wrote with Dan Houser is forthcoming in the Journal of Economics Behavior and Organization. “If wages fell during a recession”

https://www.sciencedirect.com/science/article/abs/pii/S0167268120303577

The title comes from Bewley’s famous book “Why Don’t Wages Fall During a Recession?” In that book, Truman Bewley asks managers why they do not cut wages in a recession when equilibrium analysis tells us that the price of labor should fall.

We run an experiment in which employers and workers encounter a recession. The employers could cut wages, or they could keep them rigid as we normally observe during recession. The concept of a “cut” assumes a reference point from which to go down from. We establish that reference point by letting the employer set a wage before the recession and repeating that payment to workers for 3 rounds.

We use a Gift Exchange (GE) Game to model the relationship between employers and workers. Employers offer a wage that is guaranteed to the worker. Employers have to trust that workers will not shirk. We do observe a few subjects shirking, and those people are not very interesting to us. We are interested in the workers who respond with positive reciprocity because that means there is “good morale” in the “workplace”. The employers interviewed by Bewley were afraid that wage cuts would damage the good morale that is necessary for a business to run.

After three rounds, there was a recession. The total surplus available in the GE game shrank by 10%.  In the Inflation treatment, the exchange rate of tokens to dollars increased, such that if firms kept nominal wages rigid there would in fact be a 10% real wage cut.

If workers resent nominal wage cuts, then firms should keep wages rigid in a recession. If worker morale falls and workers decrease effort, then firms will be hurt more by the fall in productivity than by a large real wage cost.

In fact, about half of the firms did cut wages. So, we did not observe wage rigidity and we’d like to do follow-up research on that point. It did mean that we had variation and could observe the counterfactual that we were interested in.

Workers don’t like wage cuts. Workers who had been selecting an effort level near the middle of the feasible range dropped their effort significantly if they experienced a wage cut. The real wage cuts under Inflation did not have as sharp of an effect on effort, which suggests some nominal illusion.

Here’s a cumulative distribution of effort choices among workers (Recession treatment had no inflation). After half of the workers experienced a wage cut, the effort distribution moves toward 0.05, the minimum effort level.

We measured loss aversion at the end. We can’t say that loss averse workers resent wage cuts, because everyone resents wage cuts. There’s maybe some evidence that loss averse employers are less likely to cut wages. Thanks for reading! Please reach out through my Samford email if you’d like to know more.

The relationship between loss aversion and wage rigidity deserves more attention from behavioral economics.

Special thanks to Misha Freer, Cesar Martinelli, and Ryan Oprea for conversations that helped us. Also, we are indebted to everyone that we cited, of course, and to all the people we failed to cite.

2020 Nobel Prize to Milgrom and Wilson

The big news in our world is that the Nobel Prize was announced today for economists. (We call it “the Nobel Prize”.)

Paul Milgrom and Robert Wilson win for 2020. They are known for auction theory and design. Here is a popular introduction from the Nobel Committee.

This prize is special to me because auction design was one of the very first practical problems that presented me with a chance to put economic ideas into practice. As an undergraduate at Chapman University, I had the privilege to spend time talking with people like Vernon Smith and Dave Porter. Some people think of Vernon Smith as being someone who “does things in the lab”. The thing that he actually did was often auctions.

My master’s thesis at Chapman University was a project on auctions. A practical problem to motived our inquiry. Students at Chapman were upset about the way that the most convenient parking spots were allocated. Concerns about parking showed up in quantitative student satisfaction surveys.

We designed an auction to price and allocate the most coveted parking spots. In this scenario, multiple items are being sold because the parking lot has many spots. Hence the “multi-unit” in the title of our paper Information Effects in Uniform Price Multi‐Unit Dutch Auctions.

We had an important question, since we were actually going to run an auction that would affect people’s lives. How to we choose from among the different possible auction formats?

Paul Milgrom (with Robert J. Weber) provided guidance to us in their 1982 paper in Econometrica.

Among other things, in that paper, they compare the revenue properties of English auctions and Dutch auctions. In an English auction, the price starts low and bidders compete to out-bid each other until the price is so high that only one bidder remains. That is the popular conception of an auction. There is another mechanism class (Dutch) in which the price starts higher than anyone wants to pay and drops until a buyer jumps in. Once you start thinking about how many ways one could run an auction, then you need some way to decide between all the mechanisms.

Theory can help you predict who will be better off under different formats. And, in my case, needing to figure out the revenue properties of different auction formats can help you learn economic theory!

Economists and Cocktail Parties

Sometimes I remark to my students, “This is why economists don’t get invited to cocktail parties.” This post is about that.

From 2008 – 2011 I taught a course at Florida State called “Economics of Compassion”. It is a course co-designed with my mentor Mark Isaac. The class discusses historical and contemporary problems related to poverty, both at the domestic and international levels. Having heard about the course, the Social Justice Living Learning Community at Florida State wanted me to teach the course to their incoming freshman. 

It was quite different from other courses they were taking that seemed to talk in terms of solutions without regard for scarcity. My role was to put parameters on their utopia and get the students to think carefully about a couple questions related to issues they care about:

  • Compared to what?
  • What happens next?

The students seemed to like the class, but, for a committed group of people who want to change the world it was also quite a downer. It was a downer for them the same way economics is a downer for people at cocktail parties.

We start with scarcity. Scarcity is a fact of life. There are never enough resources to satisfy everyone and there will always be unmet desires. For the economist, the notion of trade-offs — you must give up one thing to get another — flow from this scarcity. It means that anytime a solution to a problem is attempted you are always giving something up.

For example, the death of George Floyd this summer sparked conversation about how to reduce police violence. One approaching to curbing this important social problem is to eliminate or reform qualified immunity (QI). This is a legal doctrine intended to protect police and others from frivolous lawsuits. The problem is that QI has made accountability extremely difficult. The logic of reforming QI is that doing so will increase accountability, raise the cost of police violence, and therefore lead to less police violence. That’s good economics.

But, remember there are trade-offs. In a new world where police are opened up to lawsuits, local government might need to increase police compensation to retain or attract qualified men and women. Where does the money come from? Can you reduce the number of police and/or will you have to raise taxes? There are other trade-offs too. Will police become more reluctant to enter dangerous neighborhoods? After all, there is a greater chance that inserting themselves into a risky situation will lead to financial ruin.

Moving from heavy to light. If you haven’t seen Yoram Bauman’s comedic schtick on Principles of Economics Translated, take five minutes and check it out here. As he illustrates, “economic profit” depends on alternatives: A Snickers bar valued at one dollar with no alternative implies an economic profit of $1. However, if the alternative was M&Ms that you value at 70 cents then your economic profit is 30 cents … Your profit from pursuing one course action declines as the value of the alternative increases.

By accounting for trade-offs the net benefit of a course of action goes down. When we bring up trade-offs in conversation, economists effectively eat into people’s mental profits for some course of action.

Another thing to consider, when you’re intervening, that intervention can sometimes have dramatic side effects that you didn’t even think about. You cannot merely move people around as if they’re pieces on a chessboard (head nod to Adam Smith).

For example, it is possible that eliminating qualified immunity leads to less police violence but more neighborhood violence overall if police decide not to insert themselves into situations that could be more costly. Beyond this hypothetical example I have been using, there are loads of other unintended consequences economists talk about.

Thinking in this way is the bread and butter of economists. This is how we see the world. But, don’t try this in social settings. As EconTalk host Russ Roberts once commented (this podcast), a pleasant picnic veered into chilly company when he pointed out someone’s proposed minimum wage could have negative employment effects. The others at the picnic started to inch away from him on the picnic blanket. At parties, I’ve had people talk about the idea that a tax won’t effect them because it is only on sellers, homeowners, etc. I’ve had to ask myself, “Is it worth it to bring up that the tax is likely to be passed through?”

So while my last couple posts sing the praises of economics, I should let you know, at cocktail parties people don’t like to think about scarcity, tradeoffs, and unintended consequences. Economists like to think about the seen and unseen. Many others, especially in social settings, would rather the unseen remain unseen.

Spontaneous Emergence of Property Rights in the Classroom

Last week I posted about Bart Wilson’s talk on his new book “The Property Species” and promised to share a class demonstration about the emergence of property rights in the classroom. But first let me tell you why I did this demonstration.

When I was a student I hated assignments that go through the motions of learning, but provide no learing. Building a paper maché volcano, while fun for some, teaches little about volcanic eruptions. Shaking and opening a soda bottle (pop?) is more instructive: it’s the fall in pressure as the bottle is opened that leads to the rapid release of the gas disolved in the liquid, the same thing happens to magma. And while being able to algebraically solve for the equilibrium price given supply and demand functions is a very necessary evil (to a point), it teaches little about the process of competition and price formation.

This is why I was reluctant to having my first Intro to Economics class write their own version of “I pencil”, quite a few years ago. Driving the point of how largely anonymous exchange and specialization, coordinated peacefully through property, prices, and profits and loss makes the modern world possible is very important. But how much can you really learn about this by watching and transcribing an episode of “How It’s Made”? For most students, not much at all. Partly in dread of reading and grading 80 versions of “I whiteboard marker”, or “I toothbrush”, and partly following my conscience I decided to throw in a twist.

The twist may seem evil and arbitrary at first. Students still had to choose a good and write their own version of “I _____” , but if two students wrote about the same good I would divide their grade by 2. If three students wrote about the same good I would divide their grade by 3 and so on. I did not give any additional prompts about how they should sort out potential conflicts or coordinate amongst themselves. These were just the rules of the assignment.

Without this seemingly arbitrary grading rule, goods to write about were not scarce. By changing the grading rules, goods to write about became scarce. While there are many more goods to write about than students, certain goods stand out in the mind, and extra effort must be devoted in thinking up a new good, and finding out if someone had already looked around their room and chosen the same good. Now students also had to coordinate amongst themselves or run the risk of a fairly severe penalty to their grade.

As expected, I have never had to enforce the the harsh grading penalties (anecdotal, I know). Students always find a way to coordinate and establish property rights over suddenly scarce goods. The point of the assignment was no longer about I pencil, but about the emergence of property rights and social coordination (and hopefully a little bit about I pencil as well). I didn’t act as a central authority that imposed and enforced property rights. I merely changed the incentives and constraints, hoping that the costs of coordinating and setting up agreements was smaller than the costs of not doing this.

When they turned in their assignment, we discussed how they had actually coordinated. Over the years I have seen multiple ingenious mechanisms. From class forums using the university platform, to a simple spreadsheet circulated amongst the students via email or WhatsApp. In the good old times before the pandemic they would sometimes meet after class and sort it out in person. Sometimes they created a common pool of goods and one of their classmates is chosen to distribute them among their peers. Leaders emerge to fill various roles from dispute resolution to registering claims. How this person is chosen also varies from class to class. Some students volunteer, others have it thrust upon themselves. The use of a homesteading rule is fairly common, first to choose gets the good in cases where there are multiple claims. In class we discuss why they use this rule, rather than last to choose gets the good, and the problems this alternative would entail.

I have only had one instance of a strong and contested dispute among “property owners”. That semester students had to not only write but present their work. Two groups (that semester “I _____” was a group assignment) wanted to do a good they thought would be amusing to present in class. I’ll leave it up to your imagination what good students in their late teens and early twenties might find to be amusing to present in class. The two groups of students underwent a rather complicated dispute resolution system with the rest of the class playing the role of arbiters of the multiple claims to the same good. Neither group wanted to budge, but one group ended up ceding the rights in the end.

What I like about this little classroom demonstration is that it makes it easier to teach the emergence of institutions as the products of human action but not human design. Order without design is a difficult concept to grasp, but maybe even more importantly it is a concept that is difficult to accept. But after this demonstration, not anymore, students experience the emergence of property rights. An added bonus is that in this case scarcity is clearly a product of the relation between their minds and how they relate to the world, not about objective quantities of goods.

Property rights emerge through their coordination but are not centrally imposed. They coordinate because a change in the environment turned a previously free good, the subject of their short “I ____” essay, into a scarce (economic) good. As you can probably tell Harold Demsetz is one of my favorite economists of all time. After the barrier of disbelief is breached, we can easily talk about the spontaneous emergence of money, cover a little about how property rights emerged in whaling on the high seas, and the spontaneous origin of law (very useful for future law students usually educated in the positivist tradition, as is the norm in Ecuador).

I later learned of the fish game (I am not an experimentalist). But, no disrespect intended, it seems a little contrived. I still like my assignment better. While the goldfish game teaches the tragedy of the commons, the “I _____” assignment teaches how the tragedy can be solved without a centralized authority by having students solve if for themselves and come to grips with the real limitations and problems they faced, albeit on a much smaller scale. I am still hoping for an experimentalist that thinks something serious can be made out of my little classroom demonstration.

Timeline of the Global Financial Crisis, Part 1: January-September, 2008

The sudden shutdown of much of the economy of the U.S. and of the world starting in February and March of 2020 led to deep concern, if not panic, in world financial markets. Millions of people were suddenly unemployed or furloughed, millions of small businesses faced bankruptcy, and stocks plunged some 30% in the fastest fall of global markets in history. Demand collapsed, and prices for nearly all financial assets fell. Trillions of dollars of financial transactions were in danger of unravelling.

The Federal Reserve immediately rode to the rescue, slashing interest rates and buying up all kinds of financial assets. These purchases of bonds and similar products injected cash into the markets to provide much-needed liquidity, and kept the system on track. In late March, the U.S. federal government authorized trillions of dollars of payments to individuals and businesses to stave off bankruptcy, and forbade foreclosures on mortgages, to keep people from losing their homes (at least in the near term). Banks and governments in other nations took similar measures. By May, it was clear that the worst scenarios had been averted, even though there will be significant lingering consequences of the Covid shutdowns.

The speed and scale of the Fed and government responses in March, 2020, may be attributed in part to learnings from the 2008-2009 Global Financial Crisis (GFC). In that crisis, the severity of the problem was not understood at first. There was naturally reluctance to take unprecedented actions to do what was perceived as bailing out of irresponsible banks and other companies. Over a period of many months, various measures were implemented to address some immediate needs, but then more and more problems kept cropping up. It was a macroeconomic game of whack-a-mole.

As a bit of a history lesson, here is a timeline of the main financial events of January-September, 2008. These descriptions are taken, with only minor editing, from an article by Kimberly Amadeo in The Balance.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

January 2008: Fed Tries to Stop Housing Bust

Easy credit and expectations of always-increasing home prices led to a speculative run-up in housing in 2002-2006. Mortgages were given to people who really could not afford them, and billions of dollars of those unsound sub-prime mortgages were repackaged and sold into the broad financial system. That all began to unravel in 2006-2007. In response to a struggling housing market, the Federal Market Open Committee began lowering the fed funds rate. It dropped the rate to 3.5% on January 22, 2008, then to 3.0% a week later. Economic analysts thought lower rates would be enough to restore demand for homes.

It didn’t help the millions of homeowners who had adjustable-rate mortgages.

February 2008: Bush Signs Tax Rebate as Home Sales Continue to Plummet

President Bush signed a tax rebate bill to help the struggling housing market. The bill increased limits for Federal Housing Administration loans and allowed Freddie Mac to repurchase jumbo loans.

February’s homes sales fell 24% year-over-year. It reached 5.03 million according to the National Association of Realtors. The median resale home price was $195,900, down 8.2% year-over-year.  Foreclosures were up.

March 2008: Fed Begins Bailouts

The Fed Chair realized the Fed needed to take aggressive action. It had to prevent a more serious recession. Falling oil prices meant the Fed was not concerned about inflation. When inflation isn’t a concern, the Fed can use expansionary monetary policy. The Fed’s goal was to lower the LIBOR benchmark interest rate, and keep adjustable-rate mortgages affordable. In its role of “bank of last resort,” it became the only bank willing to lend.

It increased its Term Auction Facility program to $50 billion. It also initiated a series of term repurchase transactions. These were 28-day term repurchase agreements with primary dealers. The Fed’s goal was to pump $100 billion into the economy.

March 11: The Fed announced it would lend $200 billion in Treasury notes to bail out bond dealers. They were stuck with mortgage-backed securities and other collateralized debt obligations. They couldn’t resell them on the secondary market. The subprime mortgage crisis dried up the secondary market for these debt products.

No one knew who had the bad debt or how much was out there. All buyers of debt instruments became afraid to buy and sell from each other. No one wanted to get caught with bad debt on their books. The Fed was trying to keep liquidity in the financial markets.

But the problem was not just one of liquidity, but also of solvency. Banks were playing a huge game of musical chairs, hoping that no one would get caught with more bad debt. The Fed tried to buy time by temporarily taking on the bad debt itself. It protected itself by only holding the debt for 28 days and only accepting AAA-rated debt.

March 14: The Federal Reserve held its first emergency weekend meeting in 30 years. On March 17, it announced it would guarantee Bear Stearns‘ bad loans. It wanted JP Morgan to purchase Bear and prevent bankruptcy. Bear Stearns’ had about $10 trillion in securities on its books. If it had gone under, these securities would have become worthless. That would have jeopardized the global financial system.

March 18: The Federal Open Market Committee (FOMC) lowered the fed funds rate by 0.75% to 2.25%. It had halved the interest rate in six months. That put downward pressure on the dollar, which increased oil prices.

That same day, federal regulators agreed to let Fannie Mae and Freddie Mac take on another $200 billion in subprime mortgage debt. The two government-sponsored enterprises would buy mortgages from banks. This process is known as buying on the secondary market. They then package these into mortgage-backed securities and resell them on Wall Street. All goes well if the mortgages are good, but if they turn south, then the two GSEs would be liable for the debt.

The Federal Housing Finance Board also took action. It authorized the regional Federal Home Loan Banks to take an extra $100 billion in subprime mortgage debt. The loans had to be guaranteed by Fannie and Freddie Mac

Fed Chair Ben Bernanke and U.S. Treasury Secretary Hank Paulson thought this would take care of the problem. They underestimated how extensive the crisis had become. These bailouts only further destabilized the two mortgage giants.

April – June: Fed Lowers Rate and Buys More Toxic Bank Debt

April 30: The FOMC lowered the fed funds rate to 2%.

April 7 and April 21: The Fed added another $50 billion each through its Term Auction Facility.

May 20: The Fed auctioned another $150 billion through the Term Auction Facility.

By June 2, the Fed auctions totaled $1.2 trillion. In June, the Federal Reserve lent $225 billion through its Term Auction Facility. This temporary stop-gap measure of adding liquidity had become a permanent fixture.

July 11, 2008: IndyMac Bank Fails

July 11: The Office of Thrift Supervision closed IndyMac Bank. Los Angeles police warned angry IndyMac depositors to remain calm while they waited in line to withdraw funds from the failed bank. About 100 people worried they would lose their deposit. The Federal Deposit Insurance Corporation (FDIC) only insured amounts up to $100,000. This was later raised to $250,000.

July 23: Treasury Secretary Paulson made the Sunday talk show rounds. He explained the need for a bailout of Fannie Mae and Freddie Mac. The two agencies themselves held or guaranteed almost half of the $12 trillion of the nation’s mortgages.

Wall Street’s fears that these loans would default caused Fannie’s and Freddie’s shares to tumble. This made it more difficult for private companies to raise capital themselves. Paulson reassured talk show listeners that the banking system was solid, even though other banks might fail like IndyMac.

July 30: Congress passed the Housing and Economic Recovery Act. It gave the Treasury Department authority to guarantee as much as $25 billion in loans held by Fannie Mae and Freddie Mac.

September 7: Treasury Nationalizes Fannie and Freddie

The FHFA placed Fannie and Freddie under conservatorship. It allowed the government to run the two until they were strong enough to return to independent management. 

The FHFA allowed Treasury to purchase preferred stock of the two to keep them afloat. They could also borrow from the Treasury. Last but not least, Treasury was allowed to purchase their mortgage-backed securities. 

The Fannie and Freddie bailout initially cost taxpayers $187 billion. But over time, they two paid back all costs plus added $58 billion in profit to the general fund. 

September 15, 2008: Lehman Brothers Bankruptcy Triggered Global Panic

Paulson urged Lehman Brothers to find a buyer. Only two banks were interested: Bank of America and British Barclays.

Bank of America didn’t want a loan. It wanted the government to cover $65 billion to $70 billion in anticipated losses. Paulson said no. The U.S. Treasury had no legal authority to invest capital in Lehman Brothers, as Congress hadn’t yet authorized the Troubled Asset Relief Program. Barclays announced its British regulators would not approve a Lehman Brothers deal.

Since Lehman Brothers was an investment bank, the government could not nationalize it like it did government enterprises Fannie Mae and Freddie Mac. For that same reason, no federal regulator, like the FDIC, could take it over.  Moreover, the Fed couldn’t guarantee a loan as it did with Bear Stearns. Lehman Brothers didn’t have enough assets to secure one. 

When Lehman’s declared bankruptcy, financial markets reeled. The Dow fell 504 points, its worst decline in seven years. U.S. Treasury bond prices rose as investors fled to their relative safety. Oil prices tanked.

Later that day, Bank of America announced it would purchase struggling Merrill Lynch for $50 billion. 

September 16, 2008: Fed Buys AIG for $85 Billion

The American International Group Inc. turned to the Federal Reserve for emergency funding. The company had insured trillions of dollars of mortgages throughout the world. If it had fallen, so would the global banking system. Bernanke said that this bailout made him angrier than anything else. AIG took risks with cash from supposedly ultra-safe insurance policies. It used it to boost profits by offering unregulated credit default swaps.

October 8, 2008: The Federal lent another $37.8 billion to AIG subsidiaries in exchange for fixed-income securities.

November 10, 2008: The Fed restructured its aid package. It reduced its $85 billion loan to $60 billion. The $37.8 billion loan was repaid and terminated.The Treasury Department purchased $40 billion in AIG preferred shares. The funds allowed AIG to retire its credit default swaps rationally, stave off bankruptcy, and protect the government’s original investment. 

September 17, 2008: Economy Almost Collapsed

Due to losses from Lehman’s bankruptcy, investors fled money market mutual funds. That’s where companies obtain their short-term cash.

September 16: The Reserve Primary Fund “broke the buck.” It didn’t have enough cash on hand to pay out all the redemptions that were occurring.

September 17: The attack spread. Investors withdrew a record $172 billion from their money market accounts. During a typical week, only about $7 billion is withdrawn. If it had continued, companies couldn’t get money to fund their day-to-day operations. In just a few weeks, shippers wouldn’t have had the cash to deliver food to grocery stores. We were that close to a complete collapse. 

September 19, 2008: Paulson and Bernanke Meet with Congress

U.S. Treasury Secretary Henry Paulson (L) speaks as Federal Reserve Board Chairman Ben Bernanke (R) listens during a hearing before the House Financial Services Committee on Capitol Hill September 24, 2008 in Washington, DC. Photo: Alex Wong/Getty Images

September 19: Paulson and Bernanke met with Congressional leaders to explain the crisis. Republicans and Democrats alike were stunned by the somber warnings. They realized that credit markets were only a few days away from a meltdown. 

The leaders were prepared to work together in a bipartisan fashion to craft a solution. But many rank-and-file members of Congress were not on board. 

Bernanke announced the Fed would lend the money needed by banks and businesses to operate so they wouldn’t have to pull out the cash in money market funds. This, along with the announcement of the bailout package, calmed the markets enough keep the economy functioning.

September 20, 2008: Treasury Submits Legislation to Congress

On September 20, Paulson submitted a three-page document that asked Congress to approve a $700 billion bailout. Treasury would use the funds to buy up mortgage-backed securities that were in danger of defaulting. By doing so, Paulson wanted to take these debts off the books of banks, hedge funds, and pension funds that held them.

When asked what would happen if Congress didn’t approve the bailout, Paulson replied, “If it doesn’t pass, then heaven help us all.”

September 21, 2008: The End of the “Greed Is Good” Era

Goldman Sachs and Morgan Stanley, two of the most successful investment banks on Wall Street, applied to become regular commercial banks. They wanted the Fed’s protection.

September 26, 2008: WaMu Goes Bankrupt

Washington Mutual Bank went bankrupt when its panicked depositors withdrew $16.7 billion in 10 days. It had insufficient capital to run its business. The FDIC then took over. The bank was sold to J.P. Morgan for $1.9 billion.

September 29, 2008: Stock Market Crashes as Bailout Rejected

A trader gestures as he works on the floor of the New York Stock Exchange September 29, 2008 in New York City. U.S. stocks took a nosedive in reaction to the global credit crisis and as the U.S. House of Representatives rejected the $700 billion rescue package, 228-205. Photo by Spencer Platt/Getty Images

The stock market collapsed when the U.S. House of Representatives rejected the bailout bill. Opponents were rightly concerned that their constituents saw the bill as bailing out Wall Street at the expense of taxpayers. But they didn’t realize that the future of the global economy was at stake.

Stock investors did, sending the ​Dow Jones Industrial Average down 770 points. It was the most in any single day in history. It didn’t stop there. Global markets panicked: The Morgan Stanley Capital International World Index dropped 6% in one day, the most since its creation in 1970.

To restore financial stability, the Federal Reserve doubled its currency swaps with foreign central banks in Europe, England, and Japan to $620 billion. The governments of the world were forced to provide all the liquidity for frozen credit markets.

[Again, these descriptions are taken nearly verbatim from 2008 Financial Crisis Timeline, by Kimberly Amadeo. See her article for coverage of the rest of 2008, and the ending of the recession in 2009.]

Why Eliminate Water Subsidies when we could Reform Our Entire Society?

I love the Gastropod podcast. The hosts do a great job of trying to explain the historical debates concerning food in a charitable and careful manner. Their guests also tend to be very careful.

But the guest from the September 15th, 2020 episode about beef in the US was not nearly so careful. It’s a curse, really, to listen to a great podcast, only to have a portion of an episode ruined because a guest was allowed to spout on a topic outside of their expertise.

John Specht, a history professor at Notre Dame, committed such an offense that irked the heck out of me:

“Any reform is likely to make beef more expensive. So what that means is, I think, to avoid a charge of elitism, we have to recognize that changing how we produce our food has to happen in concert with building a more just society. We need to think of ways to make people better able to afford better-produced food. And we can’t just focus on one facet of that story. We have to think holistically about that. And what that means is that this is an even bigger challenge of what already was a big challenge. But it’s also perhaps even more powerful and even more important.”

Let me first say that I have no doubts concerning Dr. Specht’s knowledge concerning the history of beef in the US. If it’s like the rest of his Gastropod interview, I look forward to reading his book and I suspect that it is stellar. But the above quote has nothing to do with history and everything to do economics, public choice, and political economy. The above quote is why I can’t take seriously many people’s claims about what the ‘good’ is and how to achieve it.

  1. Any regulation or legislation that introduces additional requirements for beef producers will, almost certainly, increase production costs. I’m not sure what a ‘just society’ means to Dr. Specht, but I’m sure that it’s not an objective thing (knowable or not) that aids in analysis.
  2. We need to think of ways to make people better able to afford better-produced food.” Luckily *we* don’t need to think of that. We don’t have the local knowledge of the beef market, nor the potential markets that beef-processing laborers face as alternatives (it’s different for everyone). The age-old, classical econ answer for improving people’s real incomes is to increase their productivity. Even if the labor supply for beef processing is perfectly elastic, and all increases in productivity accrue to the firm, the result of constant wages is a *partial* equilibrium conclusion. In general equilibrium, beef processing skills are probably partial substitutes for some other labor activity. This means that skilled employees can move to other sectors, employers, and industries. *We* don’t have much say aside from policy that makes productive innovation and skill accumulation easier.

Dr. Specht makes the problem out to be worse than it is and the solution to be more difficult than it is. We don’t need to reform an entire social and economic system. We don’t need a new political system that somehow, against all incentives, reflects compassion for beef processing laborers. That’s more than government can achieve.

Government *can* get out of the way. It can ease pathways to working legally in the US, which would reduce the labor abuses in which beef firms can indulge. Legal employment alternatives increases the opportunity cost of laborers. Government can stop subsidizing cattle hydration through water subsidies to ranchers. Reducing the number of cattle, and demand for meat processing laborers would cause fewer of these workers to be employed in what many consider an unpleasant job. With perfectly elastic labor supply, there is no decrease in wages. In general equilibrium, the decline in wages is small if there are many other firms that would demand the unemployed manual labor.  Further, the decline in the quantity of beef produced would make the marginal carcasses more valuable. Employers will likely desire more skilled and better-compensated labor to carve the more valuable inputs. Importantly, the better compensation comes, not from a re-orientation of societal values, rather, from the higher opportunity cost enjoyed by labor that is more skilled.

But removing subsidies and permitting more foreign-born workers aren’t the reforms that are proposed by the likes of do-gooders. Do-gooders want to feel responsible for their good. It’s not enough for them to get out of the way – no one receives praise for permitting others to engage in hard work. Typically, it’s the hard-workers who get that credit. Do-gooders mistake proactivity with good intentions. The result is a desire to employ government in activities that are doomed to failure due to imperfect design and adverse incentives. The incentives provided by markets are inadequate – not for firms, but for the people who desire a prominent role as caring managers.

Affording a second child

I have been reading Matt Yglesias’s book. I’m going to quote his podcast with Tyler here:

I also think that a lot of the way society is structured disincentivizes educated professional people from having a second or third child, even though it’s not that the objective financial cost of doing it is so high.
But you think about Democratic Party micro-targeting of everything. They’ll say, “Well, okay. If this little extra boost will help lift some people over the poverty line, we should do that. But if you’re making $140,000 a year, you don’t ‘need’ help with your childcare costs.” That’s how the people in the think tanks think.

Matt Y

On the margin, people who don’t live in poverty still feel financial pressure. They still worry about whether they can “afford” more children.

The following Facebook post stood out to me yesterday. I went to high school with this woman (call her Rachel). She teaches at a public elementary school in New Jersey. She is married with one daughter.

It sounds like Rachel wants another child, a sibling for her daughter. As a working mom, I can sympathize with her desire to not quit her job.

More answers from her peers include “I’ve been also looking for this answer. Anyone I know who has had more than one, one usually stays home and the partner works. I don’t know how people do it!” and “I have to say this month has been TERRIBLE! Paying $250 a month for my baby at daycare and then having my oldest there a few days a week bc my in-laws can’t handle zoom 😳 I’m literally working for health benefits.”

This response is probably from someone who is one stage of life ahead of Rachel, “It was hard but we lived off one salary till the kids were 5 years old. We didn’t go out or do much at all. Cost of daycare for twins was insane. Once they were in school most of the day I got my job…”

Matt Yglesias wants Rachel to have another child, and a third if she wants a “big family”. That’s not how we get to one billion Americans, it’s simply how we avoid population shrinkage.

I’ll probably deal with more of Matt’s ideas in future posts. Even if you disagree with all his policy recommendations, it’s a great book to get you thinking.

I did some quick Googling and it seems like Rachel’s job pays over $40,000 per year. It wouldn’t be crazy to assume that Rachel’s household income is “6 figures”. If their daughter is currently in daycare and they have a second child who needs daycare, then they could be looking at a daycare bill over $20,000 per year during the crunch time. That crunch time wouldn’t last very long, BUT that is a daunting bill to pay when you are also paying for rent and diapers and don’t want to eat beans every day. New Jersey has relatively high property taxes, rents, and daycare costs.

Abraham and Kearney on the Decline in Employment

Katherine Abraham and Melissa Kearney just published
“Explaining the Decline in the US Employment-to-Population Ratio: A Review of the Evidence” in the Journal of Economic Literature.

The unemployment rate measures people who are actively looking for work and can’t find a job. The authors are not examining short term fluctuations in unemployment (which shot up in pandemic times). They are looking at at long term decline in employment rates of working-age adults in the US. The trend began in 1999. Employment of adults in the US dipped after the Great Recession and still has not recovered a decade later. Less-educated males have experienced the largest drop in employment.

I’m reviewing the entire paper with my Labor Economics class. Most of what the authors talk about can be found throughout our Labor Econ. textbook, but I like using the paper to organize and motivate the collection of facts and theories.

Here’s a summary of their thorough examination of possible causes of the decline in working.

They estimate, drawing on other empirical work, that two factors have a considerable and measurable impact on the decline in formal employment. Import competition from China (the US changed their position on trade with China in 2000) and automation (industrial robots) both result in lower demand for US workers.

There are three contributing forces that the authors declare them to be minor casual factors. Increased receipt of disability benefits disincentivizes working, higher minimum wages results in less jobs, and the increased incarceration rate in the past few decades takes adults out of the labor force.

The paper is called “A Review of the Evidence”. The following is a list of factors that could in theory be responsible for the decline for working but for which data is scarce:
Lack of child care
Changes in leisure options (i.e. young men play video games)
Changes in social norms (i.e. young people can stay “in the basement”)
Increased use of opioids (could be a result of diminished job opportunities)
Rise in occupational licensing
Frictions or matching issues

All of those indeterminate items represent research opportunities.

Can I Borrow Your Reference Point?

That is the title of a blog I wrote for a new publication Works in Progress.

I summarize an article I published in 2020 and relate it to the current polarized political environment, which is not an extension I made as explicitly in the article.

We often talk of a moral obligation to sympathize with others and “walk a mile in his/her shoes”. We do not often “walk a mile” in the shoes of our neighbors just to be nice, and we can’t even do it for money. In a lab experiment, I put people in an environment where they could earn money for accurately guessing what others did. I found that people tend to transfer their own reference point on to other people, which causes them to make bad predictions.

There is more at the blog. I end with a conclusion that some might say is too optimistic or too generous to the opposing side:

If people of opposing political persuasions spent more time learning each other’s life stories, then we would end up with a less toxic climate.

How Much Money Is There?

It is not straightforward to define what “money” is in a modern national economy. Simply tallying the amount of coins and paper currency is inadequate. Most buying and selling is now done by shifting numbers between abstract bank accounts, not by pushing a bundle of bills across a table.  Thus, these bank accounts serve the functions of money (medium of exchange and store of value). The question then arises as to which of these financial accounts to regard as money.

Among financial assets, there is a broad spectrum of liquidity. Typically you can write a check on your checking account which, when it clears, provides immediate and final settlement for a purchase.  On the other hand, if you want to tap your brokerage account with its holdings of Apple stock to buy a television, you would typically have to sell (liquidate) your stock. A third party would have to be willing to give you something more money-like (e.g. credit your money market fund at your brokerage) in exchange for the stock at some negotiated price. Then you might have to transfer the funds from your brokerage fund into your bank checking account before you can actually buy that TV.  Because of all these intermediate steps, and the fluctuating value of the stock before you complete the sale, the stock holding would not be counted as “money”, even though its value enabled you to ultimately make your purchase.

There are a number of measures of money in modern economies. In the U.S. some of these are:

M0: The total of all physical currency (coins and paper bills).

MB (“Monetary Base”): The total of all physical currency (coins and bill) plus Federal Reserve  Deposits (special deposits that only banks can have at the Fed). This is money essentially created by the government plus the Federal Reserve, which does not necessarily enter the private economy to be spent.

M1: Physical currency circulating outside of the Fed and private banking system, plus the amount of demand deposits, travelers’ checks and other checkable deposits. This is highly “liquid” money, i.e. accepted and used for transactions in the private economy.

M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000). The funds in these additional savings and money market accounts can in general be easily transferred to checkable accounts, and thus could go towards making purchases if desired.

MZM: “Money Zero Maturity” is one of the most popular aggregates in use by the Fed because its velocity has historically been the most accurate predictor of inflation. It is M2 – time deposits + institutional money market funds.

Below is a chart showing the growth in the U.S. in the past fifteen years of M0 (total currency, labeled “currency in circulation), MB, M1, and M2. The grayed areas are recessions, i.e. 2008-2009 and the present.  [1]

Various Measures of “Money” in the U.S.

The M1 money supply (green line) was about $1.4 trillion ( $1,400 billion on the chart) in 2005, was fairly steady for several years, then started a steady ramp up to $4 trillion by January, 2020. Due to the extraordinary events associated with the Covid-19 shutdown (government stimulus package plus Fed purchases of securities), M1 jumped up to $ 5.4 trillion by August of this year. M2 followed similar trends, though on a much larger scale, rising to$18.3 trillion this year. This compares to a current U. S. total GDP of about $21 trillion.

The lowest line on the chart is the physical currency (blue line), which has grown slowly but steadily. The “Total MB” (red) line, was essentially on top of the blue line up until the 2008-2009 recession. Since MB = physical currency plus reserves, this meant that the amount of money in the reserve balances at the Fed of the private banks was nearly zero before 2008. The reserves jumped up (difference between the red and blue lines) in 2009, with the onset of massive purchases of securities by the Fed (“quantitative easing”). The Fed buys these securities from the banks, and credits their reserve accounts. The Fed has tried to taper down its holdings in recent years (red line declining 2015-2019), but suddenly purchased trillions more this spring (red line jumping up in 2020).  Most pundits hold that all this Fed money injected into the financial system has been the major cause of the enormous rise in stock prices in the past decade, especially in the past six months.

[1] Chart produced on the St. Louis Fed “FRED” site, https://fred.stlouisfed.org/categories/24 . This site has a wealth of economic data. Unfortunately, it is not easy to change units, so I was stuck with “billions” instead of “trillions” for the axis labels. Also, the M0 and MB numbers were only available in “millions”, so I had to divide those numbers by 1000 to get them to fit on the plot with M1 and M2. The grayed out spots on the graph labels is where I blotted out the “ /1000 ” which the plotting software put in. It would have been cleaner, in retrospect, to have exported the data to Excel and replotted it there.