Monthly Archives: May 2008

Externalities . . . Again

Mike Moffat responds to both my previous post and Peter Klein’s challenge:

Does anyone ever ask what the optimal corporate income tax rate or optimal sales tax rate is? Of course not. Why should emission taxes be held to a different level of scrutiny?

I would argue that many quibble about a variety of optimal tax rates, but I digress. In any event, I have explicitly stated (in the linked post above) that if we want to have the debate regarding what we should tax, it could certainly prove fruitful. However, that is not the ground upon which the Pigou Club is arguing. The Pigou Club largely takes for granted that taxes are warranted in order to promote an efficient outcome when externalities are present. There arguments are fundamentally based upon arguments for greater efficiency, whereas income tax rates and sales tax rates are not justified by the same presupposition. I am simply arguing that there is little reason to believe that such taxes pass the efficiency test, which is the primary justification used by Frank, Mankiw, and others.

Peter Klein says it best:

Mike’s response, based on more detailed comments here, is interesting, but to my mind misses the main point. Pigouvian taxes aren’t perfect, Mike says, but neither are income taxes or excise taxes or any other taxes. Fine, I say, but the relevant comparison isn’t between Pigouvian taxes and other taxes, but between Pigouvian taxes and alternative institutions for dealing with externalities such as cap-and-trade, common-law tort remedies, etc.

More on Externalities

David Beckworth writes:

…why not tax noisy leaf blowers (noise pollution) or billboards along the highway (sight pollution) or rancorous, smelly, ugly people (noise, sight, and smell pollution)? Conversely, should we subsidize quiet neighbors, firms that do not advertise on highway billboards, and beautiful, well-kept people?

Now I am not advocating we tax or subsidize the above items. However, this list does illustrate the fact that society does choose to correct only certain externalities. So what is the decision criteria used in this process? Presumably it involves equating some margins; I am just not sure which one they are though.

Mark Thoma also chimes in as well.

Here We Go Again…

The Pigou Club is out in full force this week in the form of Robert Frank’s Economic View column in the New York Times. He writes:

The production and consumption of many other goods, however, generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. As before, market forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.

The upshot is that gasoline consumption is inefficiently high. Suppose that pollution costs are $2 for the last gallon consumed, but that its $4 price at the pump is just enough to cover its direct production costs. Reducing production and consumption by a gallon would then cause consumers to lose fuel that they value at $4, which would be exactly offset by the $4 in reduced production costs. The $2 in reduced pollution costs would thus be a net gain for society.

The “efficiency” of the gas tax, which seems to be the highlight of Frank’s piece is a suspect concept. The idea of an efficient tax to correct for a market failure such as an externality is based on Pigouvian welfare economics, which sees the tax as Pareto-improving. Yet, even members of the Pigou Club do not argue on behalf of Pareto efficiency (whether they are aware of it or not), but rather the Hicks-Kaldor criteria under which those who benefit gain enough to fully compensate those who lose, even if the compensation never takes place.

The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.

What’s more, the idea of externalities as a market failure misunderstands the role of the market and what is meant by efficiency. Markets are not efficient in the sense that they produce the optimal outcome of some economist, environmentalist, or other casual observer who wishes for a certain outcome. Markets are efficient because they serve to allocate resources to those who value them the most.

I would welcome a debate about what we should be taxing. I do believe that it would make sense to tax the things that we want less of. However, the Pigou Club is making the argument on the grounds of efficiency, which misunderstands both the term and the process through which the tax rate would be determined.

Reflections on J.M. Keynes

The work of Keynes can be separated into two categories, the general theory and the applied theory.  Unfortunately, much of what survives as Keynesianism in today’s lexicon is the applied theory, which essentially consists of the government serving as the facilitator of increased demand during a recession or a depression.  I must confess that I myself frequently fail to distinguish between each theory when discussing what I believe to be the failures of Keynesian aggregate demand management.  Nevertheless, Keynes’ general theory was an important, but Keynes’ most profound ideas are not the ones that are emphasized in economics today.

Keynes’ applied theory has been the subject of a great deal of criticism and rightfully so.  However, his general theory has also been attacked (often by those who oppose his applied theory).  These attacks often fail to understand exactly what is important in Keynes’ general theory.  There is no doubt that reading Keynes’ General Theory is at times akin to gnawing on a two-dollar steak, but there are profound insights to be discovered.

It is clear from reading Keynes that he either misunderstood some of the classical economists or was not well read in their theory with respect to Say’s Law and monetary disturbances.  Nevertheless, this criticism is to some extent aesthetic, as Keynes was arguing as much against the classical economists as he was against the Marshallian market adjustment process. (It is in this argument against the Marshallian adjustment process that Keynes arrives at his great insight, which will be discussed later.)

First and foremost, Keynes’ theory is a monetary theory.  It begins with Keynes’ Treatise on Money and is extended through the General Theory.  This is often overlooked as Keynes’ applied theory emphasizes the impotency of monetary policy in correcting the shortfalls in aggregate demand that result in recessions.  Keynes monetary theory in the Treatise can be outlined as follows.  Each businessman has his own subjective expectations of future profitability and other business conditions.  If these expectations are pessimistic, businesses will invest less and therefore reduce the amount of securities that are issued.  This decrease in the supply of securities leads to excess demand and therefore raises the price of securities and therefore lowers the natural rate of interest.  As the market rate of interest begins to decline in accordance with the natural rate, bear speculators who were used to getting the higher rate of return begin to sell some of their ‘old’ securities and therefore the market rate is prevented from completely adjusting with the natural rate and the market ‘clears’ at a point of disequilibrium.  The result is an excess demand for money and a corresponding excess supply of commodities.

It is at this point that we must understand Keynes’ profound insight of The General Theory.  Keynes’ insight is that in the absence of perfect price flexibility, the adjustment process will come from output rather than the price level (which ran counter to the conventional wisdom of the Marshallian adjustment process).  The result is therefore a recession.

Unfortunately, the key insight of Keynes is often highlighted by modern macroeconomists as either the importance of insufficient demand or of sticky prices.  Each of these insights downplays the role of Keynes’ general theory and fails to differentiate Keynes from his classical counterparts.  The idea of sticky wages and prices is not something created or even truly advocated by Keynes (see the work of Leland Yeager or Clark Warburton for a detailed summary of the lineage of sticky prices).  Rather Keynes’ emphasis was on the fact that prices were not perfectly flexible and therefore a reduction of stickiness would not alleviate the problem.  (It is actually quite amusing that so-called “New Keynesians” adopted sticky prices in his name when in fact his theory was written in a time of rapidly falling wages and prices.)

The prevailing theory of business fluctuations (in the U.S.) was monetary disequilibrium theory, which held that when there is excess demand for money, there will be deflationary pressure which can only be eased by an increase in the money supply or a decrease in the price level.  However, the presence of sticky prices will prevent the necessary decline in the price level and output and employment will fall as a result.  In this scenario, the presence of sticky prices is to blame for the downturn.  However, in Chapter 19 of the General Theory, Keynes refutes this point, claiming that prices need not be sticky, but only lack infinite flexibility.  Further, Keynes points out that if the prices were allowed to change, it may exacerbate the problem by inducing a scenario of debt-deflation (Keynes does not use the term, but it fits his analysis).  So while the mainstream continues to adhere to this idea of sticky prices as a product of the work of Keynes, a reading of Chapter 19 suggests otherwise.

The work of Keynes is, of course, not without significant error.  His applied theory is clearly a source of frustration.  More importantly, however, is the abandonment of the Wicksell-foundation of the natural rate and market rate of interest in favor of the liquidity preference (a topic which would require another post altogether).  What’s more, it is not clear to me that Keynes’ general theory is all that general, but rather more specific to the time in which he was writing and specific periods of downturn.  Advocates of his theory may disagree with this analysis and point to the current credit crisis as an example that fits with the theory, but I am not convinced that this is the case (nor are the Austrians, of whom I am sympathetic).

This post should by no means be construed as an advocacy of Keynes’ general theory, but rather an emphasis on what he got right – something that is missing from much of the present day discussion.  Keynes’ work is best understood as a lineage of evolving ideas (an evolution, which regrettably did not remain wholly consistent with the Wicksell-foundations).  His General Theory is certainly a flawed work (this seems to fit, however, with Keynes’ famous quote, “I would rather be vaguely right than precisely wrong”), but his insights regarding output adjustments and disequilibrium should nevertheless be appreciated.

Gas Prices

Tim Haab on gas prices:

The real question CNN should ask is: What can you do about $4 gas? There is only one answer. “Drive Less”. You as a consumer have control over your own gas purchases and little over the market price. The choice to drive less may be uncomfortable, but all the whining, crying and shouting for the government to do something will only make the situation worse. Price controls, gas rationing, windfall profit taxes, gas tax holidays…are all bad policies that may make you (and politicians) happier in the short run but will make everyone miserable in the long run. Your solution to high gas prices is to adapt. Drive Less! If the market adjusts, all the better, you’re saving even more money.


Central Banking and the Credit Crisis

Axel Leijonhufvud is perhaps one of the most insightful and poignant economists of the twentieth century — not to mention the authority of John Maynard Keynes (ed. note — and what Keynes should have said?). He always seems to be a bit ahead of the curve in terms of mainstream macroeconomic thought. Thus, when he writes, I eagerly read. His latest piece over at VoxEU tackles inflation-targeting and central bank independence. Here is a sample:

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

I have come around to this view in recent months (although I favor something more like this). I cannot, however, support his view on ridding ourselves of the idea of central bank independence. The prospects for efficient policy are bleak.

Is Hayek to Blame for Liquidationism?

The Austrian business cycle theory is often derided for promoting liquidationist policies in the face of depression and recession. This view is never more prevalent than when discussing the Great Depression. This morning, I had a chance to read a forthcoming article by our friend Lawrence White from the Journal of Money, Credit, and Banking in which he tackles the question as to whether the ABCT was really to blame for the liquidationist views. His conclusion is that it was the adherence to the real bills doctrine within the Federal Reserve, not the ABCT, that were closest to these views.

The paper is excellent and supplies (at least in my mind) ample evidence to counteract the accusations that have so long hindered Hayek and the Austrian theory.