Moving back home- Determining the household size!

I am great fan of Greg Kaplan’s paper `Moving Back home’ in which he motivates moving back with parents as an insurance mechanism against labor market risks. I think, apart from explaining consumption and savings responses of low income households, it highlights one of the most important economic determinants of household size for not only the US but also for other countries. When no other insurance mechanisms are available, people tend to huddle up economizing on costs of living and minimizing labor market risk through skill set diversification (much like portfolio diversification!). This explains, for example, why traditional societies like India had joint family systems for a very long period of time to the extent of becoming a defining feature of Indian society. The important thing to realize is that this system may not be here for long. The  general increase in incomes, economic opportunities, and capacity to shield oneself from economic risks will reduce the need for a joint family.  This is already evident in the increasing nuclearization of families across urban India. Moreover, the size of the households also might change over the business cycle!

A recent paper with José-Víctor Ríos-Rull and Sebastin Dryda,  extends the idea of moving back home with parents to build a model of household size determination that is amenable to equilibrium business cycle analysis with aggregate technology shocks. The authors then use this model to explain the discrepancy between the micro evidence on the Frisch elasticities and the ones implied by the macro models. Interesting stuff!

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Must be right- Krugman says it!

A couple of students from UMass Amherst find a fault in the results by Ken Rogoff and Carmen Reinhart weakening their claim about the proportion of debt to GDP and its deleterious effects. It seems, now that this link appears to be tenuous, the case for austerity in case of many debt ridden EU countries is significantly weakened and finally the Keynesians of the world win the intellectual battle. Certainly, Paul Krugman seems to think that in successive blogposts on the Rogoff affair!

So is the case for austerity for these debt ridden EU countries really that tenuous? Should they be allowed to continue to inflate their way out? I do not think so. A clear picture of what plagues EU can be found here. The theoretical and empirical evidence against government spending as a way out of economic problems is overwhelmingly in support of austerity. Empirical work by Barro clearly shows that even with huge government spending shocks, the expenditure multiplier tends to just a little over or equal to 1. Moreover, theory tells us that polices that alter the incentives people face will tend to work far better in stimulating the economy in the desired direction. Even if there is deficient private demand, just filling in the gap will just do that- plug the hole. It does not affect the behavior of private sector in the long run. For example we know that the 2008 tax rebate did not move current consumption at all. Savings went up and people paid down the debt that was accumulated in the past. Sometimes even seemingly well intentioned policies can have opposite effects. Casey Mulligan makes an interesting case for this in his latest book, “The Redistribution Recession”.

There might be some case for government spending or inflation tax in developing countries. The presence of a substantial informal sector and significant positive returns on investment in public infrastructure are the cases in point. But you cannot have the same prescription for every country, and hence the Keynesians or Left thinkers especially in developing countries should not take shortcomings in Rogoff and Reinhart’s work as their victory.  Increased government expenditure on employee salaries is still unproductive and deficient private demand (if present at all) may still not be corrected with it. And that replication of results should be still taken seriously before we base policy prescriptions on them.

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On Powerful Macroeconomic Concepts: Consumption Smoothing

The idea of consumption smoothing is a very powerful one and seem to underlie a variety of economic as well as social phenomenon. In what follows I discuss a few examples to illustrate this. Consumption smoothing implies that the people prefer a smoother consumption path over a relatively choppy or fluctuating one. The ability to smooth consumption differs across countries and within countries across income classes. For example it has been documented that private consumption expenditure in developed countries is less variable than the real GDP at the business cycle frequencies, while in the developing countries it is more variable than the real GDP. This difference can be explained by differing access to credit markets as well support from governments in terms of welfare spending. You can read more about this here and here.

A couple of research papers on India also highlight how consumption smoothing can help explain patterns of migration and marriage as well as the probability of survival of a girl child in rural India. For example, Rosenweig and Stark (1989) find evidence among rural households in India that marriages are arranged between families that come from areas with different income risks. This allows for inter-household transfers of good and services and helps households to tide through rainfall shocks. Such arrangements are important in the absence of formal agricultural insurance products and difficulties in credit provision. Rainfall shocks are not uniformly distributed over the region and hence such flow of goods and services associated with such marital arrangements helps families smooth consumption in difficult time periods.

In another study on India, Elaina Rose shows that one can explain excess female mortality in rural India with the help of consumption smoothing. Using data from almost 4000 rural households, Rose finds that the ratio of probability that a girl survives until school age  to the probability that a boy survives to this age is related to rainfall shocks in childhood. This ratio shows improvement for a cohort that experiences a positive rainfall shock in the first two years of life.   This means that when there is an increase in income or purchasing power of a household because of good rainfall, the probability of a girl child surviving improves as households can afford to allocate more resources to the girl child. The opposite happens when there is a negative rainfall shock. The general  importance of rainfall shocks in fluctuations in Indian GDP is discussed here.

However dismal these findings, they have important implications for government policy. As Rose argues, becuase excess female mortality in rural India is associated with inability to smooth consumption  through other means, promoting institutions that provide alternative mechanisms to smooth consumption might do far good in improving survival of the girl child than any other policy. In case you doubted the importance of insurance and other financial products that provide a hedge against income fluctuations, you will find som solid argument here!

 

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To deregulate or not?

An article published at Macroscan on the dilemma of the Indian government about whether to deregulate the price of oil or not, the author argues for not to do so. However, I think he needs more than the analysis he is basing his argument on. The simulation is based on Tinbergen style simultaneous equations model of the Indian economy. So my 5 cents to the debate are as follows:

There are several general equilibrium effects of an oil price shock that have to considered. How are people going to react to the change in price of oil? In the first place, shielding the consumers from oil price shocks has distorted consumer decisions. Combined with shoddy public transportation system, it has lead to a higher demand for private transportation vehicles. If government passes on the oil price changes to the consumer, the consumers might respond to the relative price changes. Over the period of time there will be further demand for efficient public transportation and the reliance on oil for private transportation might actually go down leaving the net effect on GDP close to zero. Also, reduction the oil subsidy will reduce the over fiscal deficit and lower the inflation tax. The government might decide to channel that expenditure somewhere else like better schools or highways! But to account for such kind of changes you will have to simulate a micro-founded general equilibrium model and not a Tinbergen style simultaneous equations one (NIPFP working paper No. 2012-99) which does not allow for equilibrium responses from economic agents (the famous Lucas critique!). I think right assessment of what should be the appropriate policy in the case of oil price deregulation cannot be made till such analysis is undertaken. You still might have a case for not deregulating the price of oil but it would be based on a more robust analysis.

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Payment Systems in India

Recently, the Governor of the Reserve Bank of India (RBI), Dr. Subbarao emphasized the need to move to electronic payments system in India from its current primarily cash based one. It seems to be a reasonable proposition coming from a central banker especially such transition might mean a better control over an economy with a large informal sector. However, is it economically feasible to have such a transition in India right now? Dr. Subbaroa’s answer is yes and he cites other emerging economies like Brazil that use way less cash than a typical Indian does. But I believe that the nature of payment systems practiced only partly depends on deliberate policies and a whole lot on the economics involved. This is especially true for the retail transactions which was the focus of Subbarao’s statement.

Cash is preferred in many transactions in India as a significant number of people lack access to banking facilities. The RBI has time again pursued various initiatives to spread the banking access, but such efforts have not meant much in terms of transforming retail payments. The way commerce is organized in India (a large number of small sellers- large scale retailing is a new and urban phenomenon) make electronic payment systems prohibitively expensive. Further, use of electronic platforms like Visa or Mastercard for payments subjects the economy to economics of two sided markets. There are many issues involved, and most resolutions suggest a preferred cash used in equilibrium for a country like India (For a review of economics of two sided markets see Rysman 2009. For a non-technical discussion of payment systems in India see Waknis (2010)).

A large informal as well as black economy adds to the necessity of cash use in transactions. Lastly but not the least, the level of economic growth itself is a good determinant of the payment system used. While one could argue that Brazil uses less cash than India and hence the later should follow suit, these countries are not exactly in the same league. To further shed light on such cross country comparisons, one probably needs a careful analysis controlling for country specific characteristics to understand the factors that determine the use of electronic payment systems. In addition, questions like do the existing payments systems evolve to address the frictions in payment system and how do they affect economic efficiency also need to be given thought (See Kahn and Rehbords 2009 for a survey of empirical and theoretical literature on payment economics.).

Cash allows anonymity in transactions and in itself can be looked upon as a solution to anonymity of buyers and sellers. This implies that there will be always some transactions that will use cash. The money search literature pioneered by Lagos and Wright (2005) makes this point very well where money as a store of value gets valued in the centralized Walrasian market because the participants are anonymous. This literature is rich and has handled many issues related to payment systems. For an introduction see Williamson and Wright (2010).

So what could Dr. Subbarao do to make it economically attractive for market participants to use electronic payment systems instead of a cash one? Now that is a question worthwhile some thought!

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Game Thoery and Macroeconomics

The increasing emphasis on micro-foundations in macroeconomics seems to have lead to modeling efforts incorporating strategic decision making at the individual level in a general equilibrium setting yielding interesting insights on important questions.  A couple of days at a workshop organized by the Center for Game Theory at the scenic Stony Brook university on the use of game theory in macroeconomics was indeed an enjoyable experience in this regard. Here is a peek at a few interesting papers from the workshop.

1. B Ravikumar et al, Unemployment Insurance Fraud and Optimal Monitoring:

How do you address the problem that the unemployment benefits overpaid because of fraud are more than ten times the overpayments due to insufficient search?  Ravikumar and his coauthors  study optimal monitoring of fraudulent behavior in a model of unemployment insurance and suggest an interesting optimal monitoring mechanism to avoid the overpayment .

2. Harold Cole et.al, Why does technology not flow to developing countries?

A very interesting approach to answering the question asked originally by Robert Lucas in his 1990 AER paper.  Cole and his coauthors concentrate on efficiency of financial system of a country as the factor determining technology adoption. They conduct a comparative analysis of technology adoption in the US, Mexico and India to help shed light on the question. They propose that “the ability of an intermediary to monitor and control the cash ‡flows of a fi…rm plays an important role in a fi…rm’s decision to adopt a technology“. This is where the efficiency of the financial system comes into play.  Based on this hypothesis, they develop a costly state verification model of venture capital where the position of a firm wishing to adopt a particular technology on the technology ladder is private information. An intermediary financing the adoption of technology for  such a firm has to incur positive costs for monitoring and where it cannot monitor, it has to develop incentive schemes to ensure successful running of the venture.  The model is then embedded in a general equilibrium framework and calibrated to the US, Mexico and Indian data for applied analysis.

3. Perri Fabrizio and Vincenzo Quadrini, International Recessions.

The recession following the recent financial crisis in the US is different than the ones before in many respects. One of them is that this recession seems to be internationally synchronized at least for the developed countries. How do we explain this synchronization? Perri develops a two-country model with financial market frictions where a credit tightening can emerge as a self-fulling equilibrium caused by pessimistic but fully rational expectations. As a result of the credit tightening, countries experience large and endogenously synchronized declines in asset prices and economic activity (international recessions). The model suggests that these recessions are more severe if they happen after a prolonged period of credit expansion.

4. Xavier Mateos-Planas and Victor Rios Rull, Credit Lines.

An interesting analysis of unsecured credit arising out of use of credit cards:

This paper develops a new quantitative theory of long-term unsecured credit contracts. Households can default and can switch credit lines. Banks can change the credit limit at any time, but must commit to the interest rate or not depending on the regulatory setting. Without commitment, the distribution of households over interest rates, credit limits and wealth matches observed patterns. We study the new regulatory rules in the U.S.credit card market which require a stronger commitment from banks not to raise interest rates discretionally. This results in tighter limits but lower interest rates, reduced indebtedness and lower default.

Overall it was a good food for thought and a much needed intellectual refreshment!

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Krugman and Layard’s Economic Nonsense

What would Keynes say about the way his ideas are being used and abused to figure out what should policy makers do in the wake of recent financial crisis? I would like to believe he would not repeat his general theory. But leaving the speculation on this question for some other time, I would like to focus on Krugman and Layard’s manifesto for economic sense in today’s Financial Times. Interestingly, while arguing for differences in the European and US financial crisis, Krugman and Layard seem to have a single policy response as a panacea. This according to me actually seems to be a first step towards economic nonsense.

My reasoning is as follows: Among many other things related to how the ECB should function and whether Greece should stay or go, the European crisis is indeed a crisis of excessive public borrowing in countries like Greece, Ireland, Portugal, Italy and Spain. Contrary to this, K and L suggest that excessive public borrowing is a problem only in the case of Greece. To refresh on the EU situation, both of them might do good by reading or watching the work by Fernando Martin and Chris Waller of the St. Louis Fed. Fortunately, K and L get at least part of the US crisis right.  They say it was caused by “excessive private borrowing” but leave out the counterpart that this appetite was whetted by the financial system’s need for collateral to settle debts between themselves. While K and L somewhat agree with these differences, their blanket prescription for government spending in both the cases makes little sense. Looking at the level of public debt that the above mentioned countries have,  austerity does seem like the only way to go! On the other hand, considering the ‘paucity of good collateral argument’, at least in the long run US government  should borrow and spend more.

Now as K and L suggest, is there no evidence for deleterious effects of government deficits and the resulting borrowing on interest rates? The  rising yield curves on government debt for countries in EU,  (See this interesting  chart on Andolfatto’s blog), seem to suggest otherwise. It is probably only US that can still borrow at a lower interest rate without risking an immediate rise in the future interest rate. This is primarily because the US dollar still remains a strong international currency and the ability of the US government to honor its debt is not yet in doubt.  So as much one could argue for government spending in the US, especially on retraining programs or on Universities where the unemployed tend to flock, not all countries have the capacity to roll over their debt indefinitely and sustain such expenditure.

So what should be the manifesto for economic sense? Thinking carefully about the nature of the two crises and suggesting policy prescriptions based on such analysis or lumping both these crises together and somehow arguing that government spending is a panacea in both the cases? I pick the former while practical men seem to gobbling down the later keeping with the Keynesian adage of falling for a defunct economist!

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Public Debt in United States

While looking for some current material on public debt for my intermediate macro students, I came across this article from the Economist. It highlights the important role that US government debt plays in the financial markets. As you might know, the short term debt securities act as a good collateral in financial transactions, safe haven for foreign countries US dollar reserves and hence are always in demand. A steady supply of such securities crowds out the need for other asset backed securities to act as collateral and hence may reduce systemic risk and other harmful effects of private money creation. This reminds me of this blog post by David Andolfatto a while ago. It comments on Ricardo Caballero’s paper on Macroeconomics of Asset Shortages where Ricardo proposes that the root cause for mortgage based currencies gaining demand was shortage of good assets to facilitate financial transactions.

The point I want to make here is this: usually, a rise in government spending is associated with the rise in public debt. However, while thinking about efficacy of public spending in the context of current stimulus debate, I haven’t seen this beneficial role of the public debt taken into account. If we do so, then the estimated government spending multipliers that are rarely greater than one, can be argued to be actually underestimating the total beneficial effect of government spending. The important question however is how to estimate these benefits. Looks like a good food for thought over the summer break!

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Factor shares in India’s National Income

The business cycle properties of data in the US says that consumption is much less volatile than the GDP. This suggests that households do engage into consumption smoothing and hence looking at consumption distribution is not a good gauge for what is happening to income distribution. A similar argument can also be made for India and hence the debate on effects of liberalization policies would do better if based on income distribution than just on consumption distribution. C.P. Chandrashekhar and Jayati Ghosh make this point quite well in their recent column in The Hindu Business Line.

According to their analysis the share of wages and salaries in the national income of India has shown a decline since 1991. This decline is evident both as a share of total NDP as well as of Organized sector NDP. It was roughly around 70% for a decade preceding the economic reforms and has declined since to 50% in the year 2009. This might seem surprising given that in the US (and probably most of the developed world ) the share of compensation of employees in national income has remained between 60-70% for last 50 years or so.

The authors suggest this as an evidence for rising income inequality after the economic reforms and I don’t necessarily disagree with that interpretation.This issue is certainly important to look into and might suggests a role for policy intervention.

However, the contrast with the US suggests that there might be some other factors at play causing the shares to settle at different values in both these countries. One reason for this contrast is that the factor shares could reflect the relative factor scarcity. Capital being relatively scarce in developing countries compared to the developed ones, higher overall returns for it might be expected. The other reason might be the declining importance and presence of unions in the Indian organized sector after reforms than before. If one admits that most of the growth of the organized sector has been because of the rising service sector, then this does makes sense. In addition, the continuing rigidity of labor laws might also mean a lower opportunity cost for ones time further reducing the bargaining power of the workers.

Overall, these empirical regularities and differences in factor shares across countries are definitely worth investigating more.

Update- January 24, 2014: The recent issue of QJE has a paper on this issue. Looks like declining labor share is not just an Indian phenomenon. The authors surmise that the relative decline in price of investment goods explains this trend. You can read it here.

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Economic Oportunities and Fertility Behavior

While Indian policy makers attack the population growth problem using variety of incentives, it looks like the economic incentive trumps all others. In a recently published paper in the Quarterly Journal of Economics, Robert Jensen finds that increased awareness of prospects of gainful employment made the women in the treatment village to be less likely to marry and have kids than those who were not aware of such opportunities (control village). Those married were also more likely to limit the number of kids in order to pursue a steady career.

The economic reasoning behind the behavior displayed by these women is simple. An increase in the economic opportunities increased the opportunity cost of getting married and having kids leading to a substitution away from them. A good example of rational behavior from rural India. You can find the paper here.

Reference:

Robert Jensen, Do Labor Market Opportunities Affect Young Women’s Work and Family Decisions? Experimental Evidence from India The Quarterly Journal of Economics (2012) 127(2): 753-792

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