How to keep the American Dream intact?

The Equality of Opportunity Project is an impressive research venture using big data to explore new pathways to upward mobility in the American society. One of the pictures that came out of this project and that has made quite a few rounds of tweets is the following one: project_abs_lato

It shows the percentage of children earning more than parents over the years according to when a child was born. So if you were born in 1940 there was higher likelihood for you to earn more than your parents than if you are child born in 80’s. It is a very interesting data in itself and the paper itself makes an interesting read. (alternative link here)

I think this measure of the fading American dream provides an incomplete narrative of what might be happening in the US today. Given, that per capita incomes were much lower in 1940s compared to today and that economic growth rate measured by growth in per capita real GDP has stayed constant over this period at 2 percent per year (see graph below), it seems obvious that children born later would face a lower probability of doing better than their parents than children who were born in earlier decades.

fredgraph

I think the story of decline in absolute mobility is invariably linked with the nature of growth process in the US. Today there is an unprecedented increase in the skill requirement on an average to produce 1 unit of real GDP than in 1940s. Also, aging population means that there are less people who can acquire those skills. If this is coupled with a simultaneous rise in required time for skill accumulation, then at any given point in time we might see an increase in the proportion of people working part time reducing the probability of earning more than your parents. See Acemoglu and Autor’s Handbook chapter for skill biased technological change and its impact on the US labor market.

When looked at in conjunction with these changes in the American economy, we get some interesting policy implications.

  1. One, there should be more spending on education- given the importance of ideas for economic growth in future, the case for education having diminishing returns is already weak.
  2. Second, have more skilled people come in through immigration-directly as workers or indirectly as students- which can help increase the size of economic pie while people born in the US get the required time and money for education.
  3. Third, there should be a change in the way we approach education in order to foster life long learning capabilities in those being educated.
  4. Fourth,  Redistribution-More public spending on education also means more redistribution, something that the paper finds reverses the decline in probability of earning more that your parents.

Leave a comment

Filed under current economic issues, economic growth

On Black Money, Corruption, and Demonetization

Money facilitates more trades and improves welfare than what is possible without it. Monetary theorists would call this as money being ‘essential’ because the total volume and value of transactions achievable with money is much bigger than the one achievable without money (see pp. 47, Nosal and Rocheteau, 2011). From this perspective, demonetization of November 8, 2016 definitely reduced economic well-being of Indian people at large overnight. However, the effect may not be just this as temporary one-time reduction in the achievable set of transactions but also the ones in immediate future. While current markets in goods and services facilitate current consumption and investment, credit markets allow economic agents to smooth production and consumption over time. A pervasive reduction in liquidity therefore, however short term, is bound to adversely affect both current and future consumption and investment decisions. This effect could be pronounced in case of the Indian economy where a huge proportion of transactions are in cash including cash used for lending through informal channels like money lenders as well as microfinance. Accordingly, it should not be a surprise if there is a significant reduction in real GDP over at least 3-4 quarters if not more.

So what was the objective behind the policy? Initially, we were told that the main objective was to curb corruption, terrorism, and black money. However, the narrative slowly changed as days passed and the outcome discussed now is making India a cashless economy. Accordingly, there are two separate sets of questions that need to be asked. They are as follows:

  1. Is demonetization the best way to deal with corruption and black economy?
  2. Is there something inherently good about a cashless economy over a cash based economy that makes it a desirable goal?

Let us look at these one at a time.

Dealing with corruption and black money:

In order to figure out how to curb corruption and black money, we first need to know what gives rise to these phenomena. If we do not know that then treating these problems by demonetization would be akin to treating a person with high blood sugar by replacing all the sugar laden blood with fresh healthy one without any thought to what lowered sugar absorption in the first place!

It turns out that almost all the countries have some degree of black economy (also called shadow or informal economy) and hence there has been significant amount of research on its causes and determinants. According to a survey of such literature by Schneider and Enste (2000) , the most important and often cited causes are:

  1. the rise of the burden of taxes and social security contributions;
  2. increased regulation in the official economy, especially of labor markets;
  3. forced reduction of weekly working time;
  4. earlier retirement;
  5. unemployment; and
  6. the decline of civic virtue and loyalty towards public institutions combined with a declining tax morale.

Clearly, all of the above reasons seem to be relevant for India with varying degree of intensity giving rise to the black economy. Even if demonetization reduced the existing stock of black money, a different set of policies would be required to reduce its growth in the future.  Research substantiates these claims. For example, studying the old and new EU member states, Fialova and Scneider (2014)  indicate that one institution that unambiguously increased shadow economy is the strictness of employment protection legislation. Besley 2004 shows that the states in India that implemented pro-worker laws experienced lowered output, employment, investment, and productivity in registered or formal manufacturing and an increase in output in unregistered or informal manufacturing. Pro worker laws were also associated with increase in urban poverty. So in order to reduce black economy one of things that the government could do is reform the labor laws that currently make hiring labor through formal channels costly. Now that is a tough decision with significant political cost makes it a less attractive option for any political party in power.

Other regulations that introduce opaqueness in implementation of and compliance with them also increase the size of black economy. The policy of GST is right step in this regard and so would be streamlining of other direct and indirect tax laws and regulations. India has consistently fared worse on the ‘ease of doing business‘ index and one of the main reason is the lack of transparency in rules and regulations governing business transactions. Reforms in these laws would certainly reduce the growth of informal or black economy.

I think India suffers from a low tax morale because people do not trust the government to deliver on public goods and hence avoid paying taxes. In response to poor quality of public goods, it is natural that people would hoard cash to solve the lack of public goods problem for themselves. For example, some people may evade taxes because of high cost of private education for their kids, the necessity of which arises because of serious shortage of affordable public education. If people cannot meet the needs that should be satisfied by public goods, then they are more likely to engage in corruption in addition to tax evasion making corruption and black economy complementary goods. This is not mere speculation but something that research substantiates. For example, analyzing a sample of 51 countries around the world over the period 2000 to 2005, Buehn and Schneider (2011) present empirical evidence for a complementary (positive) relationship of corruption and the shadow economy.

In short, the set of policies that could influence the size and growth of black economy as well as corruption have to do with transparency of policies governing different economic transactions in the economy. Unfortunately, demonetization is not one of them.

Desirability of Cashless Economy:

Let us go back to the way monetary theorists think about use of money in its various forms in the economy. As mentioned above use of money expands the size of economic pie. What if we still use money but now only in its electronic form- that is we go totally cashless? Is that desirable from a theoretical point of view? We will use the same logic as before: look at the set of transactions that use of cash makes possible and compare that to the one made possible with use of electronic money. Clearly everything that can be done through use of actual cash can be done by use of electronic money. There will be some kinks to smooth out- for example the infrastructure required to go totally cashless should be present and all that- but let us for a moment assume that all the preconditions to go cashless have been met. Would it lead us to a better size of the economic pie or bigger set of allocations compared to what is possible with just cash? From a pure theoretical point of view, the answer is no because actual cash has an important advantage over its electronic form- possibility of anonymity!

For transactions that could be completely legal, but out of privacy concerns I may not want them recorded. Secondly, may be the value of the transaction may not be high enough to justify the cost of using the electronic payments infrastructure. If we move from predominantly cash based economy to the one just based on cash in electronic form, all such transactions would be difficult and that will reduce the size of economic pie or even worse push such transactions to the underground or black economy. Therefore, the policy of going cashless will most likely give rise to a different kind of black economy or alternative hard to trace forms of payments like crypto-currencies.

To make use of electronic payment systems economical, commerce would have to organized in a different way. The smaller neighborhood grocery shops may have to give way to larger ones to benefit from economies of scale. This might be easier said than done because these small neighborhood grocery stores also provide credit to their customers. Because each of these stores deal with a smaller set of consumers, it is easier for them to monitor repayment. This ability of smaller grocery stores to provide and monitor credit allows credit constrained consumers to manage the mismatch between expenditure and income flows. If we want people to shop in bigger stores instead, then we will have to provide people access to formal credit markets. The presence of informal economy makes verifying income flows difficult and therefore access to formal credit markets limited. Hence, reduction in the black economy would make it easier to increase the use of electronic payments rather than the other way round.

Policies to reduce corruption and black economy:

We are back to the question again-what are the policies that would reduce the extent of black economy? A preliminary look at the data tells that tax evasion, corruption, and black economy are problems more acutely present in developing countries than in developed ones. This suggests there is something more fundamental than availability of high denomination currency notes that is causing this. Besley and Perrsson (2014) provide some answers and they are closely related to the importance of institutions argued very convincingly in Acemoglu and Robinson’s Why Nations Fail. Economic institutions are the set of rules that govern our economic transactions and outcomes. Most developing or poor countries have extractive institutions that allow access to resources and economic opportunities to only few and often at the cost of the majority. They do not provide clear property rights making it difficult to claim returns to investment in physical and human capital. We can see clearly from the analysis above, corruption and black economy are a result of extractive institutions. For example, poor property rights also make it easy to hide unaccounted cash in real estate. So to reduce black economy, we need to replace the extractive institutions with ones that broaden access to resources and opportunities and help build capabilities. Such institutions are called inclusive institutions examples of which would be impartial rule of law, clearly defined property rights, access to public education and health care, and well-functioning markets. Unfortunately, there are no shortcuts- and demonetization is not even that- it is actually stripping people of their rights over their income making it an extractive institution.

1 Comment

Filed under current economic issues, demonetisation, indian economy, macroeconomics, Monetary Policy, money search

Demonetization: analysis updates

It has been more than 30 days since Prime Minister of India Narendra Modi cancelled the Rs. 500 and 1000 notes that constitute almost 85% of currency in circulation.

A good analysis of how the policy narrative has changed over these days is by Praveen Chakravarty in Business Standard.

A better economic analysis can be found on Ajay Shah’s blog in  post written by Suyash Rai.

On the other side of the camp, there is Professors Bhagwati, Krishna, and Sunderasen in a blog post on the Times of India who can be seen literally scrambling to justify the policy of demonetisation without much success. I am pretty sure that most economists working for Niti Ayog(for e.g. Arvind Panagariya) had to do the same thing- somehow come up with some arguments to justify the policy as a good move. One wonders if they were consulted at all!

 

 

Leave a comment

Filed under current economic issues, demonetisation, Monetary Policy

What can scrapping larger currency notes do?

Today Narendra Modi, the Prime Minister of India made a surprise announcement to scrap Rs. 500 and 1000 notes- by Nov 8 midnight these notes will cease to be a legal tender. Indian citizens will get couple of months to exchange these notes for the denominations that are still legal tender. The government will introduce new Rs. 500 and Rs. 2000 notes later. According to media reports, the aim of this move is to reduce black money in the economy, tackle potential fake currency allegedly being circulated by Pakistan and curb corruption. The question of course is would such a move be helpful in achieving these objectives.

Would such scrapping reduce the total currency in circulation? It most likely will as people find it hard to convert all their currency hoards in time for denominations that are legal tenders. This one time reduction in money in circulation could help control for inflation and possibly redistribute resources away from the commodities and services bought by such cash. However, this effect might only be temporary. The new Rs. 500 and Rs. 2000 notes will become the new store of value for people who have a need to hoard and transport large amount of cash. The time period between abolition of current high denomination notes and introduction of new ones will be the time when hoarding black money would be difficult. But ultimately, if the government thinks that black money is a function of availability of high denomination currency notes then not much will change in the long run. To make sure hoarding and transportation of cash is difficult on a more long term basis, it might be advisable to reduce high denomination notes permanently and possibly have it done simultaneously by other countries as argued in this recent article from the Economist.

To address the problems of black money and corruption on a more permanent basis, we will have to look at root causes of these phenomenon. Not all black money is illegal- the monthly cash transaction between you and your maid is also a part of the black economy. Every time you decide not to insist on a receipt for your transaction, you are participating in the black economy. Hundreds and thousands of Indians participate in these transactions on a daily basis contributing to the black economy. So behavior of common people is a part of the problem and solution. There is also an element of redistribution in corruption. If there is lack of equal opportunity and/or presence of persistent inequality, corruption might serve as a way of redistributing money from the haves to the have nots. Sometimes black economy might be a reaction to excessive state regulation and corruption. There is a rich literature that looks at the causes and consequences of shadow or informal or black economies. See Schneider and Enste (2000),  a comprehensive survey published in the Journal of Economic Literature.

Therefore to seek a long term solution to problems of black money and corruption we might have to dig deeper than just surprise scrapping of higher denomination notes.

Update: Read my critique of the Arthakranti proposals here. Looks like some of the ‘wisdom’ behind Modi’s move came from that!

Leave a comment

Filed under current economic issues, indian economy, Monetary Policy

Economics of Brexit

After slowly recovering from the shocking news of Brexit in the morning, I decided to browse the internet to see what the experts are saying. Two interesting articles stood out. Lawrence Summers writes in the Washington Post about implications of Brexit for the US and the global economy. The main concerns are summed up nicely in the following paragraph:

The effects on the rest of the world will depend heavily on psychology. I continue to be alarmed, as I wrote in this space a few days ago, that this unexpected outcome in the U.K. will raise the specter of “Trump risk.” If the U.K. can vote for Brexit perhaps the United States can vote for Donald Trump. I fear this possibility will lead to a freezing up of spending decisions particularly on the part of internationally oriented businesses.  The odds of U.S. recession beginning within the next 12 months are now in the 30 percent range. Also noteworthy is that an environment of increased risk aversion and flight to quality will complicate Japan’s problem of generating inflation and China’s challenge of attaining currency stability.

The rising xenophobia and racism on both sides of the Atlantic are primarily to be blamed on mismanagement of risks of globalization-the main point made by Maitreesh Ghatak of the LSE and summarized below in one of the paragraphs from the article:

Why then is immigration such a hot-button issue, shaping the discussion around the Brexit debate as well as the Trump campaign? The reason is that economic dislocation caused by impersonal market forces inevitably results in a search for visible scapegoats. No doubt xenophobia and racism is at work among some of Trump and Brexit supporters. But these are symptoms of a deeper problem. The economic reason behind the wave of xenophobia, whether it is the anti-immigrant rants of Donald Trump or UKIP (UK Independence Party) leader Nigel Farage, is really a misdirected rage at visible scapegoats of globalisation.

The next thing to see is what is going to happen to EU and the UK itself given that Scotland predominantly voted “remain” in the referendum. Fingers Crossed!

Leave a comment

Filed under current economic issues, European crisis, globalization, immigration

Economics of Immigration

However strong the moral and humanitarian case for immigration is, people across the western world seem to be deeply divided on the issue primarily because of the perceived negative impact of immigration on their current living standards. In the US this is evident from the political rhetoric surrounding current Presidential race and in the UK in relation to the question of staying or exiting from the EU (Brexit). I think a couple of recent papers on these issues could throw some more meat at the debate and strengthen the public discourse.

Linsensova and Sancez-Martinez (2016) talk about the long term impacts of lower migration to UK. Here is a summary of their findings.

This paper looks at the possible scenarios of migration policy should the UK leave the EU. The paper uses an OLG model which brings together labour market, fiscal and other macroeconomic effects in one framework. It also adds a dynamic perspective, differentiates between natives and different categories of immigrants and captures age and qualification compositional effects. The paper compares the two migration scenarios: Leave and Remain. By 2065, in the Leave scenario, aggregate GDP and GDP per person are 9% and 1% respectively lower compared to Remain scenario. Reduced migration after leaving the EU has a negative impact on the public finances, because of higher dependency ratio. This requires an increase in taxation of about £400 per person (2014 pounds) in 2065. The results are sensitive to the assumptions that change productivity of the labour force and dependency ratio.

A paper presented at the 2016 ASSA meetings by Jeffrey Sachs talks about the need for an international migration regime. It has some interesting suggestions for research that would help develop a clearer perspective on what such regime should look like.  Reading this paper also reminded me of an interesting paper by Jess Benhabib titled, “Optimal Migration: A World Perspective“. Here is what the paper has to say about the level of migration that would maximize world welfare.

We ask what level of migration would maximize world welfare. Welfare is assumed to be a weighted average of the utilities of the world’s various citizens, but the weights are also country specific. Using a calibrated one-sector model, we find that unless the weights are heavily biased toward the natives of rich countries, the extent of migration that would be optimal far exceeds the levels observed today. The claim remains true in a two-sector extension of the model. All versions of the model assume that migration is the only redistributive tool.

In general, it looks like if we just think narrowly about the impact of immigration on a particular country or a geographical area, the answer may or may not be convincing. But if we think about the issue in terms of the welfare of the world economy, there seems to be a sufficiently strong argument for moving people from the developing countries to the developed ones. The main problem is that the costs and benefits of migration are not only economic in nature. There are significant non-economic adjustment costs as people belonging to different cultural and social backgrounds come together. Also, there is a significant time dimension to all the costs and benefits with costs somehow perceived to be more pronounced in the short run and benefits spread over the long run. Unfortunately, the political debate on both sides of the Atlantic has been feeding off the fear that is primarily based on short term costs like rising unemployment which is often more localized and sector specific than being pervasive. The rising religious fundamentalism across the globe has only fueled this fear suggesting that the case for making academic discourse more accessible to general public has never been stronger!

Leave a comment

Filed under current economic issues, economics research, immigration

Gender equality and economic growth

Despite the past and current social reform movements across the globe for gender equality, there still seems to be significant resistance to it as suggested by differences in male and female labor force participation rates. So in case you are still a closeted feminist, here is an economic argument to help you come out:

For a sample of Asian countries, Kim, Lee and Shin (2016) find that if gender inequality is completely removed, aggregate income will be about 6.6% and 14.5% higher than the benchmark economy after one and two generations respectively, while corresponding per capita income will be higher by 30.6% and 71.1% in the hypothetical gender-equality economy. This is because fertility and population decrease as women participate more in the labor market.

In addition to the calibration and simulation exercises to estimate the macroeconomic impact of removing gender inequality, the data in the paper highlights some other aspects of the gender inequality puzzle. For example, in almost all the Asian countries studied in the paper, females have higher average years of schooling than men. Yet the male labor force participation rate seems to be way higher than the female labor force participation rate. So why is this the case? What factors shape the distinct incentives that females and males face to participate in the labor market? I think these questions also are good research questions in themselves.

As an aside: Female and male labor force participation rate for China are 75% and 85% respectively while there is hardly any difference between average schooling at 8.1 and 7.3 respectively. As there is a frequent comparison between India and China, it might be worthwhile to see how Indian numbers compare to these. The average years of schooling for females and males in India is 7.59 and 4.81 respectively while the female and male labor force participation rate is 30.3% and 83.1% respectively. So not only that an average Chinese male is twice as educated than an average Indian male but the female labor force participation rate in China is more than double that in India. So any suggestions about India overtaking China anytime soon have to be taken with a fistful of salt!

Leave a comment

Filed under economic growth, gender, labor markets, macroeconomics, social perspectives