Thought Food

The Road to European Unification: There and Back Again?

2011-07-25T10:09:00.000-07:00

Crisis? What Crisis?

The unthinkable suddenly appears possible: the politicians, popular media and the European public alike are openly discussing the possibility of some countries defaulting on their public debt or leaving the Eurozone or even committing both of these ‘sins’. How has it come to this and where does it lead?

Sovereign defaults and Eurozone exits have been proposed as possible solutions to the on-going debt crises in the peripheral member countries: Greece, Ireland, Portugal and Spain. The immediate causes of these countries’ troubles are similar: they found themselves with excessive stocks of public debt at a time of a major global recession. Their paths to their shared destination, however, differed.

In Greece, the root of the problem was reckless spending by the government to finance generous provision of public goods, create public-sector jobs, offer attractive pension terms and the like. Excessive fiscal spending was made easier by convergence of interest rates in the Eurozone countries following the the advent of the euro. As a result, the interest rate fell in the peripheral countries and borrowing became cheap. In Ireland, the government policies remained comparably sound but the general public and the banking sector alike got overexcited by the sky-rocketing house prices. The housing market boom, in turn, was fuelled, you guessed it, by the low interest rates that were brought about after adopting the euro. Once the housing market collapsed, this left the Irish banking sector on the brink of bankruptcy. The Irish government sought to avert this by guaranteeing and eventually taking over the banks’ bad loans. Portugal and Spain, finally, lie in between Greece and Ireland: Portugal shares some similarities with Greece while Spain’s troubles are not too dissimilar from Ireland’s predicament.

Debt crises have important elements of self-fulfilling prophecies. Once investors cease to believe in the ability of a given country to repay its debt, they will charge ever increasing interest rates to extend new loans – if they offer it any loans at all. Unable to refinance their debts and being hit by prohibitively high interest charges, default becomes ever more likely, which makes investors even less willing to lend to them and so on. As the situation continues to worsen, eventually a default becomes the less painful option. This was, for instance, how Argentina concluded its foreign-exchange and debt crisis of 1999-02.

The Eurozone’s response, so far, has been to deny that there is a major crisis and instead to prop up the flailing countries with vast amounts of cash. They are not doing this only out of solidarity and altruism: allowing a sovereign default of one country would produce contagion effects: if one is allowed to go bust, the market would expect the remaining countries to meet a similar fate. Furthermore, the crises need not stay limited to the aforementioned four peripheral countries. Italy and Belgium could well be next: both have debt to GDP ratios that are only exceeded by Greece within the EU.

So far so good: the bailouts of Greece and Ireland, while politically controversial, were agreed upon by the Eurozone members (with the notable exception of Slovakia, the most recent and the poorest euro member, which refused to pay for Greece’s past mistakes). It is, however, widely assumed that Spain will be too big to save. In that case, the earlier bailouts may only serve to postpone the euro’s downfall, without preventing it.

Looking for the Exits

If the Eurozone breaks up, would the euro disappear altogether or would only certain countries leave the common currency (or be expelled)? As many have pointed out, a complete break up would be very costly, destabilizing as well as practically very complicated: replacing all currency in circulation in 16 countries is no trivial matter and certainly it could not be pulled off at a short notice.

A more likely scenario would see Greece, and possibly a few other crisis-stricken countries, leave in order to reintroduce their own national currencies. The euro would remain live and kicking in the remainder of the Eurozone. Less realistically, Germany, perhaps with a few likeminded countries (such as Austria, Netherlands and maybe one or two others) could leave, setting up a new and improved currency union for themselves and leaving the euro to the rest. In either case, the key to the successful execution of the exit strategy is to carry it out before the collapse of the euro becomes widely expected. If, for example, Greece were expected to abandon the euro, both international investors and Greeks themselves would have a strong incentive to move their funds out of Greek banks and into a safe haven such as Germany (or hide it under their mattresses). In fact, they would probably want to take out a large loan and stash that money safely away too, in order to make a handy profit after their country dumps the euro and the new currency depreciates. This would lead to a modified Gresham’s Law: one would want to hold assets in strong Eurozone countries and liabilities in the weak ones.

The advantages of the crisis-stricken countries leaving the Eurozone would be substantial. The leavers would be able to devalue their new currencies and thus to improve their competitiveness and revitalize their economies (if they stay in the Eurozone, they can only achieve a similar effect by real depreciation driven by falling prices and wages). The resulting growth acceleration would allow them to lower the deficit without as drastic tax rises and spending cuts as would be required otherwise. Their debt, as long as it is subject to their national law, would be redenominated in the new currency. Once the currency depreciates, the euro value of debt would thus fall. The domestic lenders would not be hurt by this but the foreign ones would effectively receive a ‘haircut’ equivalent to the size of the subsequent depreciation, without the country formally defaulting on its debt.

The stayers, in turn, would benefit too: they would avoid the fiscal cost of propping up the flailing countries and would be left with a currency union that is smaller in size but is more robust and less crisis-prone.

United We Stand, Divided We Fall

The background of the current troubles of the Eurozone can be understood quite well in the light of Robert Mundell’s Theory of Optimum Currency Areas (American Economic Review, 1961). Mundell argued that common currency is optimal for regions or countries that either encounter symmetric shocks or that possess effective mechanisms for absorbing the adverse effects of asymmetric shocks. The core Eurozone economies are closely integrated and therefore broadly meet this definition: the shocks that affect them tend to be similar and/or spillover easily through flows of trade, capital and, to a lesser extent, migration. The same cannot be said about the peripheral countries.

What about the adjustment mechanisms that are the second part of the optimum currency area definition? Mundell’s article emphasized labor mobility which is known to be low in Europe, especially across national borders. Another solution is fiscal transfers. The EU thus may need to turn into a transfer union, a term which has been giving the Germans sleepless nights lately. The contrast between the EU and the US is striking: not only are Americans much more mobile than Europeans, the US Federal government wields fiscal tools that allow it to intervene fiscally in any State. Even more importantly, no one questions the preparedness of the Federal government to do so in times of crisis. In Europe, in contrast, the willingness of the Eurozone nations to continue helping their troubled counterparts is widely doubted.

Besides international comparisons, helpful lessons as well can be also found in Europe’s not so distant history. The EMU is not the first attempt at monetary integration in Europe: its predecessors include the Latin Monetary Union (formed by Belgium, France, Italy and Switzerland in 1865) and the Scandinavian Monetary Union (Sweden, Denmark and Norway, from 1873 onwards). Both of these ultimately failed in the late 1920s or early 1930s. Benjamin Cohen (“Beyond EMU: Problem of Sustainability,” Economics and Politics, 1993), analyzed these cases. He concludes that economics matters when determining the stability of monetary unions but international politics matters even more: the two previous attempts at monetary unification failed because the participating countries did not to share a feeling of common destiny. This lesson could not be more pertinent now: as long as some countries in the Eurozone are willing even to contemplate throwing in the towel on other countries, no matter how deserved it would be to do so, the Eurozone in its present form is doomed.

Don’t Panic!

Besides the lack of political commitment, there is another reason why allowing the crisis to run its course may be a good thing. Crises, whether of the fiscal or foreign-exchange kind, are caused by unsustainable policies. Often, the fact that the policies are unsustainable is widely understood, yet it is still difficult to abandon them. We may all agree that the budget deficit is excessive, but how do we cut it? Should we cut spending on national defence, health care, welfare benefits, civil-servant salaries, or pensions? Should we raise the income tax across the board or only for the highest or the lowest tax bracket? Or raise the VAT instead? Greece is a case in point. The country has been teetering on the brink of default and bankruptcy for over a year now. Yet every couple of weeks, it is paralyzed by a massive strike by those who stand to lose out as a result of the proposed austerity measures. Civil servants don’t want to accept lower salaries. Truck drivers are angry that the excise tax on fuels has gone up and changes in regulation make it easier for new firms to enter the market and drive down freight rates. Pensioners and students alike are furious that the government is going to be less generous to them. And virtually everyone is seething because a German newspaper had the audacity to suggest that Greeks should sell some of their islands or, god forbid, the Acropolis.

A full-blown crisis tends to put a stop to bickering about who should pay for the required reform. This argument has been made convincingly by Alberto Alesina and Allan Drazen at the beginning of the 1990s (“Why are stabilizations delayed?” American Economic Review 81 (5), 1170-1188, 1991). Their arguments was motivated primarily by the experience of Latin American countries, several of which experienced episodes of fiscal recklessness and/or run-away inflation in the preceding years. Alesina and Drazen argue that stabilizations are delayed because of disagreement over who should bear the cost of the required adjustment. In such cases, a war of attrition ensues. The crisis then continues unabated until one of the groups affected by the stabilization throws in the towel and agrees to bear a disproportionate share of the cost. This happens when that group is better off accepting the adjustment rather than allowing the crisis to continue. For instance, the civil servants may decide that it is better for them if they receive a 20% salary cut rather than risk that the government goes bankrupt and is unable to pay their salaries at all. Or employers may agree to pay higher taxes rather than face the uncertainty associated with run-away inflation.

Crisis, in other words, begets reform, and things therefore may have to get really bad before they can start getting better. Or, put differently, unless things get really bad, people won’t be prepared to accept short-term costs in return for the promise of a long-term improvement in the future.

So far so good, but does Alesina and Drazen’s argument hold in real life? Their article is theoretical and therefore we need to turn to empirical analysis to test its predictions. Allan Drazen and William Easterly found some supporting evidence (“Do crisis induce reform? Simple empirical test of conventional wisdom,” Economics and Politics 13, 129-157, 2001). Specifically, they found that countries with extremely high inflation tend to report lower subsequent inflation rate compared to countries that experienced moderate inflation. Similarly, countries with very high black-market premiums manage to stabilize their currency markets more effectively than countries with moderate premiums. In another paper, Hans Pitlik and Steffen Wirth (“Do crises promote the extent of economic liberalization? An empirical test,” European Journal of Political Economy, 565-581, 2003) conclude that deep crises foster market-oriented reforms. Hence, both theory and empirical evidence suggest that crises indeed do beget reforms.

This is all very good but how about the impact of crises on economic growth? Crises are accompanied with sharp economic downturns. Hence, even if the crisis leads to reform, the country in question may end up poorer in the long term because of the economic contraction caused by the crisis. In a joint paper with Ariane Tichit of University of Auvergne (entitled “How I Learned to Stop Worrying and Love the Crisis”), we there pursue the effect of crises further. Since crises and reforms are relatively rare occurrences, we focus on a sample that experienced both in sufficient measure – the post-communist countries in Eastern Europe. During the 1990s, these countries underwent crises of varying severity and, roughly at the same time, attempted economic reforms with varying success. Our measure of the crisis severity is thus the depth of the economic contraction between 1989 and the trough of the output trajectory. We find, reassuringly, that the depth of the output fall translates not only into more rigorous subsequent reform but also into faster economic growth. Hence, crises beget reform and growth alike.

For the time being, Greece, Ireland and Portugal are off the hook, thanks to the solidarity and generosity of Eurozone countries. This may have stopped the crisis from spreading, at least for the time being. This short-term gain, however, may come at the cost of allowing these countries to avoid undertaking a fundamental reform of their economic policies and especially public finances.

Is the Queen Good Value for Money?

2011-07-06T04:28:00.000-07:00

It has been reported recently that the cost of the Royal Family to the UK taxpayers was £32.1 million during the last fiscal year. Is this a lot? Are we getting good value for money?

Having a royal family used to be a very foreign concept to me. I gradually developed a liking for it, however. Many other countries have a president who does little beyond holding a largely ceremonial office: Germany is a good example. Such presidents are not much more useful than monarchs. Royal families, however, have an important sideline in providing entertainment to their loyal subjects. The recent royal weddings – here in the UK or in Monaco – are evidence of that. I wouldn’t be surprised if someone found evidence that events such as royal weddings or births of royal babies are good for the economy. At 52p per person per year, which is what the £32.1 million amount to, I think we are getting a good deal.

Until recently, my favourite example of inefficiently expensive public goods was multilingualism in the EU. This costs way more than the UK Royal Family: the cost of maintaining 23 official languages is estimated as over €1 billion per year. Per person, this amounts to approximately €2.30 – 4 times as much as the Queen and her extended family. Plus the entertainment value of official EU business is usually close to zero.

The €2.30 figure, however, is misleading. Nearly two Europeans out of five speak English well (either as native speakers or because they have learned it). Therefore, the remaining 22 official languages cater to less than two thirds of Europeans. Moreover, if the six largest languages – English, German, French, Italian, Spanish and Polish – were the only official languages of the EU, only 16% of the EU population would not be able to speak any of them. The bulk of official languages, 17 of them, are thus needed only for one sixth of the people. Moreover, even the remaining 17 languages are not all equal: the cost per person per year ranges from around €7 for Hungarian to a whopping €831 for Maltese (assuming translation and interpretation services are only required for those who do not speak English, German or French; these figures are based on my article with Victor Ginsburgh published in the European Economic Review in 2007).

But even these figures pale with the costs of the on-going Greek bailout. The one-off cost of that exercise has been estimated currently as in excess of €500 euros per household. Moreover, over the next three years, this figure is expected to increase to €1,450 per household (these estimates are due to Open Europe, a think tank). Assuming the average household has 2.5 members, this comes up to £524 or the cost of the UK Queen and the whole Royal Family over the course of a millennium! Some of it can be recovered subsequently but few believe that €1 in Greek government bonds is worth anywhere close to that value. Of course, the bailout will bring certain benefits: Greece need not go into a sovereign default (which would in turn be costly for many European banks), it forestalls contagion to other vulnerable countries and prevents the embarrassment of Greece being potentially forced to leave the Euro area. Whether all this is worth the costs, I have my doubts.

The cost of the Greek bailout is to be borne by Eurozone taxpayers so that the UK is off the hook. We can consider ourselves lucky that we only have to put up with supporting the Queen.

Jan Fidrmuc

Why We Should Tax the Tall and the Fat

2011-07-05T07:41:00.000-07:00

Taxes play a number of roles. First, they are a way to raise revenue to finance public goods. Maintaining law and order or invading another country is not cheap and it is easier to finance such projects by compulsory levies than by voluntary contributions. Second, taxes can be used discourage undesirable behavior. Many countries, for example, levy ‘sin’ taxes on alcohol and tobacco to discourage their consumption and thus to reduce their harmful effects. Finally, taxes redistribute income from those who are (relatively) rich to those less fortunate. The taxes that we all pay reflect these various objectives: virtually all of us pay taxes but those of us who are relatively well-off and those who engage in ‘sinful’ activities such smoking, drinking or driving a car tend to pay more, sometimes a lot more, than others.

The current tax system, however, is far from perfect. Consider redistribution. Surely, it is only fair to tax the rich and subsidize the poor. Life is a lottery in many respects. If we care about equality, we should therefore redistribute so that those who happen to have drawn the short straw are compensated for their bad luck. This argument, however, only holds if distribution of earnings is sufficiently random. Earnings are not random, however: they reflect one’s wage (which may be, to some extent, determined by luck) as well as effort (broadly defined to include both the amount of hours that one works as well as their investment into education and other human capital). If we tax effort, we will discourage people from working and acquiring human capital. Therefore, a far and egalitarian tax system should tax the income-earning ability but not effort.

The problem is that it is not always easy to tell what part of one’s income is due to luck or effort. We do know, however, that some people tend to earn more than others. It is well know that men tend to earn more than women and whites tend to paid better (and find jobs more easily) than members of ethnic minorities. There is more: a well-known paper by Daniel Hammermesh and Jeff Biddle (American Economic Review, 1994) found that attractive people get higher wages. Another study, by David Jonhston (Economics Letters, 2010) concludes that women with blond hair get paid more than women with hair of other colors. And, finally, tall men and women also earn more; this is in addition to enjoying other benefits such as having higher education and being on average more confident, happier and less likely to suffer various psychological problems (see the discussion in my own paper with Michèle Belot in Economics and Human Biology, 2010).

Therefore, a fair and egalitarian tax system should take into account characteristics that are related to tax-payers’ ability to earn high wages. Beauty is highly subjective and hair can be dyed. Height, in contrast, does not change during a person’s adult life and can be measured easily. It would make, therefore, an ideal criterion for setting tax rates. This insight is not mine: a similar idea was originally formulated by George Akerlof (American Economic Review, 1978) and a recent article by Gregory Mankiw and Matthew Weinzierl (American Economic Journal: Economic Policy, 2010) fleshes this proposal out.

Not surprisingly, this idea is controversial: one person that I tried to convince about its merits even likened it with the Nazi predisposition to decide one’s fate based on their physical characteristics. Yet the labor market puts a premium on certain physical characteristics, even on those which (unlike education or hair color) workers can do little about. Taxing according to height would only correct for this inherent unfairness of earnings distribution. Under the present system, two persons with the same income usually pay the same tax. Under height-dependent tax, the taller one would be taxed more. This is fair because, holding everything else constant, the taller person has an easier time to earn a given level of income while the shorter person has to work harder for it.

Now how about the role taxes play with respect to discouraging undesirable behavior? One particularly pressing issue these days is the increasing prevalence of obesity. This has grave consequences: obese people are significantly more likely to suffer from heart disease and diabetes. This, in turn, is costly for the public purse (plus it lowers the wellbeing of obese people and their families). The increase in obesity rates reflects unhealthy life style choices: mainly caloric intake that is too high and too little exercise. We already have so-called sin taxes on alcohol and tobacco that seek to remedy this. In the UK, the VAT rate is higher (20%) for sugary drinks and salty and fatty snacks than for other food (0%). A recent Finnish paper (“Health and distributional effects of differentiated food taxation,” by Kaisa Kotakorpi, Jukka Pirttilä, Tommi Härkänen, Pirjo Pietinen, Heli Reinivuo and Ilpo Suoniemi) argues that taxing sugar at a relatively modest rate of 1€ per kilogram would result in a 6% reduction in the prevalence of type-2 diabetes as well as lower incidence of heart disease in Finland. They also argue that these higher sin taxes should be complemented by lower taxes on healthy food such as fruit, veg and fish (which is already the case in the UK).

Sin taxes, however, are a blunt instrument. Taxing sugar would also affect the prices of other foodstuffs (bread, for example). More importantly, this change would hit equally those who are obese and those who are not: two persons can have very similar sugar intakes and yet have very different BMIs (body mass index, a common measure of obesity, computed by dividing one’s weight in kilograms by the square of their height in meters), depending, for example, on how much exercise they do. Taxing them based on their BMI, therefore, should be preferable to taxing sugar, fat and/or alcohol content of foodstuffs and beverages.

Income tax should therefore depend on how far one is from the median height (1.75m for men and 1.62m for women in the UK) and also on how far their BMI is from the ideal range of 20-25. One problem, however, is that a person’s current BMI reflects their life-long choices. Therefore, linking income tax with the level of BMI would unfairly penalize them for their actions before this reform. To avoid this, the tax could be levied according to one’s height and the annual change of BMI. Variations in one’s BMI within the 20-25 range should be ignored, while those with BMI above 25 should be taxed more if their BMI increases. This obesity penalty should be further increased for those with BMI over 30 (the threshold between being overweight and obese).

If this idea catches on, being audited by the tax authorities may soon mean that you would need to strip down to your underwear to have your height and weight checked.

Jan Fidrmuc (height 1.83m, BMI 29.6)

Will the UK Ever Move to the Right?

2011-02-15T07:10:00.000-08:00

(Despite the title, this article is not about politics. Read on to find out more.)

Ever wondered why your computer runs on Windows operating system and why the keys on your keyboard are arranged the way they are? Why some mobile phones don’t work when you try to use it in the US or Japan? Why cars drive on the right in some countries and on the left in others?

These are all examples of standards. Often, there are several alternative standards and some users or countries choose one while others may choose a different one. Sometimes, multiple standards may be used in parallel to one another. For instance, you can use Windows on one computer and Linux on another. With other standards, you may not have much of a choice: it’s very much in your interest to stick to the same side of the road as other road users when driving, even if you prefer to drive on the other side.

Sometimes, standards are chosen for a good reason but often their origins are unclear and probably arbitrary. For instance, it is said that the Japanese convention of keeping to the left side of the road was originally adopted so that two samurai could pass each other without their swords – worn on their left side – knocking. In North America, on the other hand, wagon drivers preferred to keep to the right as the driver would usually sit on one of the last two horses (heavily laden wagons were pulled by multiple pairs of horses). Since most drivers were right handed, they preferred to sit on the left rear horse which allowed them to control the horses with the whip held in the right hand. Being seated like this, they preferred to keep to the right when passing wagons going in the opposite direction so that they could make sure that the two wagons’ wheels did not collide. In England, instead, horse-driven wagons and carriages had a driver’s seat and therefore keeping to either side of the road offered no particular advantage.

Once adopted, standards are often maintained even if subsequent progress makes them obsolete or inefficient. A particularly poignant example of this is the ubiquitous QWERTY keyboard, discussed in a well-known article by Paul David (American Economic Review, 1985). A common problem with early typewriters was that pressing two keys in close succession resulted in the keys jamming. Therefore, the keyboard layout, which originally had the keys arranged alphabetically, was modified to make this less likely. In other words, the keys were rearranged to slow the speed of typing. Subsequent typewriter designs made jamming of keys less of an issue (part of the problem with the early designs was that the paper was placed into the typewriter face down so that the typists could not actually see what they were typing and did not necessarily notice when the keys jammed), but the QWERTY layout stuck. This was despite the fact that an alternative design, the Dvorak keyboard, was later proposed, which is said to be easier to learn to use and allows typists to reach faster speeds: the world’s fastest typist ever, Barbara Blackburn, for example, used to use the Dvorak keyboard.

The continued prominence of QWERTY keyboards over potentially better designed alternatives appears perplexing at first sight, even if we discount the claims of Dvorak keyboard’s superiority (a subsequent article by Stan Liebowitz and Stephen Margolis, Journal of Law and Economics, 1990, argues that neither keyboard design offers a significant advantage over the other). The reason for the persistence of an inefficient standard is a combination of sunk costs and network externalities. Originally, much of the sunk costs were in the value of QWERTY typewriters that firms and individuals owned which would become worthless if everyone switched to the Dvorak keyboard. These days, keyboard layout can be changed very easily on any computer: Windows, for instance, comes with Dvorak keyboard as one of the available alternatives. However, switching is still costly – anyone used to QWERTY will experience a sharp though (hopefully) temporary fall in productivity after switching to the Dvorak keyboard. Network externalities present an additional barrier: if most computers use QWERTY while you are used to Dvorak, you will struggle whenever you use someone else’s machine. The same argument also explains why many of us hate Windows and Office applications yet we continue using them.

Standards are thus path dependent: an initial choice of a standard tends to be persistent and makes subsequent changes or upgrades more difficult. This, for example, is one (though not necessarily the only) reason why Britain, once the first country to introduce a railway network, is stuck with some of the slowest trains in the developed world.

This brings me, finally, to the question posed in the title. These days, most countries drive on the right. As a result, UK drivers are more likely have accidents abroad or be involved in accidents caused by foreign drivers in the UK. It is also more difficult to move to another country in Europe if you own a car made for driving on the left – you may have to sell the car or make costly modification (replacing the headlights and mirrors and you will still be stuck with the steering wheel on the wrong side). Moreover, car manufacturers are in a better position to charge higher prices in the UK market because UK consumers cannot easily import cars from abroad. Prices in the second hand market, similarly, are probably lower given that the option of exporting used cars abroad is limited. Hence, switching to driving on the right would bring a stream of small yet probably significant gains to UK residents and foreign ones alike. However, doing so would imply high one-off switching costs. Those costs would arise because of the need to replace road signs, rebuild intersections and roundabouts, refit buses with doors on the other side, as well as because most of the existing car stock would drop in value dramatically overnight. There would also be important non-pecuniary costs due to increased frequency of accidents immediately after the change. Crucially, these costs would be borne by UK residents only, unlike the gains.

While there are probably no reliable estimates of switching costs for the UK, according to Wikipedia, the Japanese government spent $150 million in 1978 to switch back to driving on the left in Okinawa (a Japanese island which was controlled by the US government between 1945 and 1978). This would be equivalent to $0.5 billion in today’s prices (the population of Okinawa is 1.4 million at present) and the costs would be probably several times higher today because more people own cars and cars and buses tend to be more complex now than in 1978.

Few countries ever switched from one side of the road to the other voluntarily. Contrary to what most Europeans probably believe, most if not all of Europe used to drive on the left. The legend has it that the French switched after the French Revolution, to symbolize the beginning of a new era (although others insist that the French always used to drive on the right). Thereafter, Napoleon imposed driving on the right onto the countries that he conquered or otherwise controlled: Belgium, Netherlands, Germany, Italy, Spain, Poland and Russia. Most of the remaining European countries continued to drive on the left (as did some provinces of Canada and half of China). Many contemplated switching to right-hand driving during the interwar period but only Portugal did so, in 1928. Austria was an especially peculiar case: some provinces chose to switch to driving on the right while other, including Vienna, the capital, continued driving on the left. Czechoslovakia similarly contemplated the switch but never implemented because of a popular opposition to it. The change eventually happened in Czechoslovakia – and was completed in Austria – only because of the German occupation: instead of listening to the popular sentiment, the invading Germans simply ordered everyone to drive on the right.

Sweden, which was not invaded by Germany, held a referendum on this issue in 1955: 83% favored to keep driving on the left while less than 16% voted for the switch. The Swedish case for change was especially compelling, as the country shares a long land border with Norway (with few border posts thus making it easy for drivers to cross the border without realizing that they have done so), a border with Finland and is near Denmark, all of which drove on the right. Moreover, most cars had the steering wheel on the left even before the switch so they could be driven more comfortably on the right – yet the people still overwhelmingly voted against it. The Swedish government learned a lesson from this failure of popular democracy – and dully ordered the country to switch anyway in 1967, without asking the voters a second time.

So is there any hope that the UK will ever move to the right? Unlike Sweden, the UK as an island is more isolated and therefore the rationale for the change is less compelling. The public would be vehemently opposed to any change. This is not surprising: the costs would be large and immediate while the gains would be small and would only accumulate over time: it is very well possible, that a social planner maximizing expected utility with an infinite horizon would conclude that the switch has a negative net present value. The governments are not social planners with infinite horizons. Instead, they want to get reelected some time during the next four years. It is well possible that any government that would contemplate going Swedish on this would be brought down before the change would be effected. Unless the French finally manage to invade, I see only one possible solution: a massive subsidy from the EU to alleviate the switching costs. This would address the fact that the rest of Europe would benefit from the UK switching too: think of all the Polish, German and French immigrants living and working in the UK and, most importantly, driving their cars here. Admittedly, this outcome is not very likely and the UK seems bound to keep left for the foreseeable future.

Goodbye Euro?

2010-12-17T03:48:00.000-08:00

The unthinkable suddenly appears possible: the politicians, popular media and the European public at large are openly discussing the possibility of abandoning the euro. How has it come to this?

The end of the euro is being discussed in the context of the bailouts of peripheral members of the Eurozone. Greece and Ireland have already received assistance. Portugal, Spain and perhaps even Belgium can be next in line. Some speculate about Italy being close to the brink too. The immediate cause for these countries’ troubles is the same: high stock of government debt and unsustainable deficit made the financial markets doubt their ability to repay their debts in full. Consequently, they are increasingly finding it difficult to sell new bonds.

The Eurozone’s response, so far, has been to prop them up with vast amounts of cash. They are not doing this only out of solidarity and altruism: allowing a sovereign default of one country would produce contagion effects: if one is allowed to go bust, the market would expect the remaining countries to meet a similar fate. Pulling the plug on one would thus hasten the downfall of others in a manner of a self-fulfilling prophecy.

So far so good: the bailouts of Greece and Ireland, while politically controversial, were agreed upon by the Eurozone members (with the notable exception of Slovakia, the most recent and poorest euro member, which refused to pay for Greece’s past mistakes). It is, however, widely assumed that Spain will be too big to save. In that case, the earlier bailouts may only serve to postpone the euro’s downfall, without preventing it.

If the Eurozone breaks up, would the euro disappear altogether or would only certain countries leave the common currency (or be expelled)? As many have pointed out (including a recent article in The Economist), a complete break up would be very costly, destabilizing as well as practically very complicated (replacing all currency in circulation in 16 countries is no trivial matter and certainly it could not be pulled off at a short notice).

A more likely scenario would see a few of the crisis-stricken countries leave, with the euro live and kicking in a shrunk Eurozone. The trick is to do this before it is widely expected. If, for example, Greece is expected to abandon the euro, both international investors and Greeks themselves would have a strong incentive to move their funds out of Greece and into a safe haven such as Germany (or hide it under their mattresses). In fact, they would probably want to take out a large loan and stash that money safely away too, in order to make a handy profit after their country dumps the euro and the new currency depreciates. This would lead to a modified Gresham’s Law: one would want to hold assets in a strong Eurozone country and liabilities in a weak one.

The advantages of this would be non-negligible. The countries leaving the Eurozone will be able to devalue their new currencies and thus to improve their competitiveness and revitalize their economies. If they stay in the Eurozone, they can only achieve a similar effect by real depreciation driven by falling prices and wages. The resulting growth acceleration would allow them to lower the deficit without as drastic tax rises and spending cuts as would be required otherwise. Their debt, as long as it is subject to their national law, would be redenominated into the new currency. The domestic lenders would not be hurt by this but the foreign ones would effectively receive a ‘haircut’ equivalent to the size of the subsequent devaluation, without the country formally defaulting on its debt.

The background of the current troubles of the Eurozone can be understood quite well in the light of Robert Mundell’s Theory of Optimum Currency Areas (American Economic Review, 1961). Mundell argued that common currency is optimal for regions or countries that either encounter symmetric shocks (or, put differently, whose business cycles are synchronized) or that possess effective mechanisms for absorbing the adverse effects of asymmetric shocks. The core Eurozone economies are closely integrated and therefore broadly meet this definition: the shocks that affect them tend to be similar and/or spillover easily through flows of trade, capital and, to a lesser extent, migration. The same cannot be said about the peripheral countries. For a while, these countries seemed to thrive with Eurozone membership as it allowed them to enjoy low interest rates: monetary policy was driven by economic conditions in the core countries which used to be much more sluggish than the periphery until recently. Eventually, however, this backfired: low interest rates encouraged reckless public spending in Greece and fuelled housing-market bubbles in Ireland and Spain.

What about the adjustment mechanisms that are the second part of the optimum currency area definition? Mundell’s article emphasized labor mobility which is known to be low in Europe, especially across national borders. Another solution is fiscal transfers: the EU thus may need to turn into a transfer union, a term which has been giving the Germans sleepless nights lately. The contrast between the EU and the US is striking: not only are Americans much more mobile than Europeans, the US Federal government wields fiscal tools that allow it to intervene fiscally in any State; even more importantly, no one questions the preparedness of the Federal government to do so in times of crisis.

Besides international comparisons, history provides helpful lessons as well. The EMU is not the first European attempt at monetary integration: its predecessors include the Latin Monetary Union (formed by Belgium, France, Italy and Switzerland in 1865) and the Scandinavian Monetary Union (Sweden, Denmark and Norway, from 1873 onwards). Both of these ultimately failed in the late 1920s or early 1930s. Benjamin Cohen (“Beyond EMU: Problem of Sustainability, Economics and Politics,” 1993), analyzed these previous cases. He concludes that economics matters when determining the stability of monetary unions but international politics matters even more: the two previous attempts at monetary unification failed because the participating countries did not to share a feeling of common destiny. And this is where my discussion completes a full circle: as long as some countries in the Eurozone are willing even to contemplate throwing in the towel on other countries, no matter how deserved it would be to do so, the Eurozone is doomed.

Birth Lottery

2010-11-05T04:51:00.000-07:00

Your date of birth is random. Of course, your parents’ wishes and desires had something to do with it but by and large the date of conception is determined by chance (luck or accident, whichever you wish to call it). The length of pregnancy is, similarly, difficult to predict with a great deal of certainty: some are born before the due date, others after.

Does it matter then when you happened to be born? As it turns out, it does matter quite a lot. Among the first to understand this were sport scientists: they noticed that a lot of top footballers and ice-hockey players were born during a particular period of the year. For example, an article by Baker and Logan (Developmental contexts and sporting success: Birth date and birthplace effects in national hockey league draftees 2000–2005, British Journal of Sports Medicine, 2007) found that, during the first half of the 2000s, 64% of NHL players were born in the first half of the year (National Hockey League covers both the US and Canada). Sherar et al. (Do physical maturity and birth date predict talent in male youth ice hockey players?, Journal of Sports Sciences, 2010) found an even more skewed pattern when looking at teenage ice hockey players from Saskatchewan. Among their initial sample, 55% were born in the first half of the year. After two rounds of rigorous selection, 78% of the final and much reduced sample were born in the first half of the year.

To make things even more complicated, being born in the first half of the year is not always the key to success in sports. Another article, by Delorme, Boiché and Raspaud (Relative age effect in elite sports: Methodological bias or real discrimination?, European Journal of Sport Science, 2010) found that significantly more (grown-up) French footballers were born during the months of August and October than in any other three-month interval.

If this all seems puzzling, the explanation is in fact rather simple and centers on the notion of ‘relative age’. Football and ice hockey clubs recruit new players from among children born within a particular age cohort and the span of that cohort is typically one year. This means that some children within a given cohort are relatively old while others are relatively young; the difference between the oldest and the youngest may be as much as one year less one day. North American ice hockey clubs recruit children born in a given calendar year: the Saskatchewan study covered youths born in 1989. French football clubs, in contrast, recruit players born between August of one year and July of the following year (or, more precisely, used to do so until 1982 when they switched to calendar years). The clubs in principle seek to select players based on talent. However, in sports where physical strength is important, older children have a physical advantage. Correspondingly, they may be perceived as being more talented. As a result, the relatively older players do well and succeed while those who are relatively younger do poorly – and are more likely to give up too.

Now how about economics? It turns out that when you were born also has economic implications – and I don’t that if you were born in December, you are less likely to earn the kind of salary that David Beckham gets (who, incidentally, was born in May). School enrolment is also organized by cohorts. In most European countries, a particular year includes children born from autumn of one year until the end of summer of the following year. Here, physical strength hopefully does not play much of a role but the relative maturity may be important: at the age of 5 or 6, a difference of almost one year is potentially large. The relatively older children, correspondingly, perform better in school. This effect is surprisingly long lasting: a Dutch study by Eric Plug (Season of birth, schooling and earnings, Journal of Economic Psychology, 2001) found that boys born in autumn (October to December, to be precise) are 12% more likely to attend university than the rest; autumn girls are 16% more likely to do so. A Japanese study by Daiji Kawaguchi (Actual Age at School Entry, Educational Outcomes, and Earnings, to be published in the Journal of Japanese and International Economies) similarly reports that those born in April to June (in Japan, the critical date for school entry is 1st April) have better test results and acquire more education than those born between January and March. Moreover, while Plug only found some tentative indications that relative age affects earnings, Kawaguchi’s results are more conclusive: Japanese men born from April to June earn 4% more than those born from January to March (the difference in earnings is not significant for women). 4% may not seem like a lot, but over one’s lifetime it would make a rather large sum.

Could these differences in education and earnings based on one’s month of birth be reduced by policy? The answer, in my opinion, is yes. Relative age effects would be smaller if school enrolment is staggered: it could take place in cohorts corresponding to three or six months, for example. The relative age differences within any given cohort would then be halved or quartered. Many schools are large enough to accommodate multiple cohorts per year. Universities could easily admit students in each term rather than only in Autumn. An added advantage would be that the job market for graduates would not be flooded by new entrants during the summer but the inflow would become staggered too.

A policy change that would deliver more egalitarian distribution of educational attainments and earnings at little or no extra cost might well be the proverbial 100$ bill lying on the sidewalk that is just waiting to be picked up.

Don’t Panic

2010-10-11T07:21:00.000-07:00

Crises don’t get a lot of positive buzz these days. In fact, I recently became aware that the current economic and financial crisis is sometimes referred to as “The Panic of 2008.” The term crisis is apparently a bit too vague and mundane: it is routinely applied to a rather broad range of occurrences, from crises of confidence to mid-life crises. Panic, on the other hand, has a nice ring to it. Crucially, it clearly suggests that the event bearing such an accolade is extraordinary in some sense.

Crises, depressions and panics, however, are not necessarily all bad. Crises are generally caused by unsound and unsustainable policies. Monetary policy is too lax. Credit is too easily available. Government spending is out of control. Trade unions are too greedy and make excessive demands in wage negotiations with employers and/or government. Or, as was largely the case with the present crisis, all of the above apply. Crises help highlight the unsustainable nature of such policies. And, with a bit of luck, they put a stop to them.

It is not easy to abandon unsustainable policies, even when everyone agrees that they are indeed unsustainable. We may all agree that the budget deficit is excessive. How do we cut it then? Should we cut spending on national defence, health care, welfare benefits, civil-servant salaries, or pensions? Should we raise the income tax across the board or only for the highest or the lowest tax bracket? Or raise the VAT instead? Greece is a case in point. The country has been teetering on the brink of default and bankruptcy for at least the last six months. Yet every couple of weeks, it is paralyzed by a massive strike by those who stand to lose out as a result of the proposed austerity measures. Civil servants don’t want to accept lower salaries. Truck drivers are angry that the excise tax on fuels has gone up. Pensioners and students alike are furious that the government is going to be less generous to them. And virtually everyone is seething because some Germans had the audacity to suggest that Greeks should sell some of their islands or, god forbid, the Acropolis.

Of course, I am not the first to make this observation. Alberto Alesina and Allan Drazen made this argument at the beginning of the 1990s (“Why are stabilizations delayed?” American Economic Review 81 (5), 1170-1188, 1991). Back then, their arguments build primarily on the experience of Latin American countries, several of which experienced episodes of fiscal recklessness and/or run-away inflation in the preceding years. Alesina and Drazen argue that stabilizations are delayed because of disagreement over who should bear the cost of the required adjustment. In such cases, a war of attrition ensues and the crisis continues unabated until one of the groups affected by the stabilization throws in the towel and agrees to bear a disproportionate share of the cost. This will happen when that group is better off accepting the adjustment rather than allowing the crisis to continue. For instance, the civil servants may decide that it is better for them if they receive a 20% salary cut rather than risk that the government goes bankrupt and is unable to pay their salaries at all. Or employers may agree to pay higher taxes rather than face the uncertainty associated with run-away inflation.

Crisis, in other words, begets reform. Things have to get really bad before they can get better. Or, put differently, unless things get really bad, people won’t be prepared to accept short-term costs in return for the promise of a long-term improvement in the future.

So far so good, but does Alesina and Drazen’s argument hold water in real life? Their article is theoretical and therefore we need to turn to empirical analysis to test its predictions. Allan Drazen and William Easterly found some supporting evidence (“Do crisis induce reform? Simple empirical test of conventional wisdom,” Economics and politics 13, 129-157, 2001). Specifically, they found that countries with extremely high inflation tend to report lower subsequent inflation rate than countries that experienced moderate inflation. Similarly, countries with very high black-market premiums manage to stabilize their currency markets more effectively than countries with moderate premiums. However, they found no evidence that crises improve economic growth or other aspects of economic performance.

In a joint paper with Ariane Tichit of University of Auvergne (entitled “How I Learned to Stop Worrying and Love the Crisis”), we pursue the effect of crises further. Since crises and reforms are relatively rare occurrences, we focus on a sample of crises that experienced both in sufficient measure – the post-communist countries in Eastern Europe. During the 1990s, these countries underwent crises of varying severity and, at roughly the same time, attempted economic reforms with varying success. Our measure of the crisis severity is the depth of the economic contraction between 1989 and the trough of the output trajectory. We find, reassuringly, that the depth of the output fall translates into more rigorous subsequent reform and faster economic growth. Crises also affect institutional development but here the pattern is more complex: institutional quality declines at first, in proportion to the severity of the crisis, but the crisis then translates into an institutional improvement later on.

For the time being, Greece appears off the hook, thanks to the solidarity and generosity of the other Eurozone countries. This may have stopped the crises from spreading to the remaining PIGS (Portugal, Ireland, Greece and Spain). This short-term gain, however, may come at the cost of allowing Greece to avoid undertaking a fundamental reform of its economic policies and especially public finances.

Soccernomics

2010-06-20T14:06:00.000-07:00

The football World Cup in South Africa has been going on for barely a week and it’s already generated more than its fair share of controversy. The players don’t like the ball because when they kick it, there’s no way telling where it will end up going (strangely enough, that is exactly what happens every time I play football too). And even if they could control the ball, they can’t concentrate on the game because of the constant noise of thousands of vuvuzelas. And then there is the woman who turned out to be a man… but hang on, that was a different competition.

So what is an economist’s view of football? Let’s start with the vuvuzela-blowing spectators. Cheering your own team and booing the opposing team gives you pleasure and makes you bond with your fellow spectators. It is also thought to give an important moral boost to the players, this is referred to as the home advantage: a team is more likely to win if they are playing at home rather than away. At the World Cup, South Africa would therefore enjoy an obvious advantage. Similarly, any country with a larger number of supporters than the opposing team would have an advantage. The North Korean team, most notably, cannot count on too many vuvuzelas cheering them.

But is it really the players who are subject to the home advantage? A recent paper by Mikael Priks and Per Pettersson-Lindbom of Stockholm University (Behavior under Social Pressure: Empty Italian Stadiums and Referee Bias, Economic Letters, 2010) suggests it is in fact the referees who are influenced by noisy spectators. How do you go about testing this? The answer is simple: let some games be played without spectators (treatment group) and compare the actions of the referees in those games with those played with spectators (control group). Of course, few clubs would accept this: they would loose both the home advantage and revenue from ticket sales. Instead, Priks and Pettersson-Lindbom managed to find what is referred to as a natural experiment. In 2007, the Italian government responded to an incident of hooligan violence by banning spectators from games at stadiums that did not meet minimum safety standards. As a result, a small fraction of games in Southern Italy were played without any spectators. Using this variation, they found that the referees behaved differently depending on whether spectators are present or not. In particular, the away team is punished more harshly (in terms of recognizing fouls and issuing yellow or red cards) when spectators are present. In contrast, they found no difference in the player’s behavior. In other words, the home bias is important but not because it boosts the home team’s performance. Instead, Priks and Pettersson-Lindbom argue, the referees are susceptible to social pressure from the crowds. So those complaining about the noise of the vuvuzelas are right and wrong at the same time. The vuvuzelas are affecting the outcome of the game but not because they distract the players or affect their concentration. Such an effect would presumably affect both teams equally and therefore it would be neutral with respect to the game‘s outcome. The vuvuzela effect is much more sinister: it can potentially bias the decisions of the referees in favor of the team with more numerous and more vocal supporters.

Another important complaint with this year’s World Cup has been the low number of goals scored in most games. This lowers the spectators’ enjoyment and leads to a relatively large number of games ending up in a tie. Some commentators attribute this to the already-mentioned balls used this year, which the players supposedly have a hard time controlling. Another explanation is that this is a an outcome of the players utility maximization. To score goals, players need to play aggressively, which is costly: it requires physical effort, increases the risk of injury and you risk spreading yourself too thin and thus giving the other team an advantage if they get possession of the ball. As a result, both teams have an incentive to play cautiously and defensively. In an attempt to alter this incentive, the payoff to winning has beeny increased from 2 points to 3 (a draw brings 1 point to each team) but that does not seem to have done the trick. A recent paper by Juan Carrillo (“Penalty Shoot-outs: Before or after Extra-time?” Journal of Sports Economics, 2007) suggested a further rule change: penalty shoot-outs should take place before rather than after extra time, with their outcome binding only if extra time ends in a draw again. This increases the stakes and alters the incentives of both teams: rather than both playing cautiously, the team that lost the penalty shoot-out now has an incentive to play an aggressive game while the other team needs to be defensive. This prediction, however, is only theoretical: would it also hold in practice? And how is it going to affect the outcome of the game? When one team plays more aggressively while the other team becomes more defensive, it is not a-priori clear whether this should leads to the aggressive team scoring more goals or the defensive team warding off such goals.

Lian Lenten, Jan Libich (La Trobe University) and Petr Stehlik (University of Western Bohemia) think they found a way to test this (“Penalties Before or after Extra-time? An Empirical Assessment of Footballers‘ Incentives,” manuscript). They point out that the proposed scheme is similar to the away rule whereby, if extra time ends in a draw, the team which scored more goals in away games wins. Scoring a goal during the first few minutes of extra time changes the incentives of the two teams in the same way. In either case, one team – the one with the lower number of away goals or the one which conceded a goal at the beginning of extra time – has to play more aggressively while the other team needs to defend their advantage. They use data from thousands of games played in 2007-9 and find that the away rule or a goal during the first five minutes of extra time indeed increases the probability of scoring in extra time – by approximately 45-60%. Economics is the study of incentives. This research shows that by moving the penalty shoot-outs forward – and thus holding them more often – it is possible to alter the underlying incentives and indeed the game itself in such a way that the outcomes of penalty shoot-outs decide fewer games. The World Cup organizers should perhaps take a leaf out of economists’ book. The result will be a more interesting and more enjoyable game.

Yes, Prime Minister

2010-06-20T14:02:00.000-07:00

The highlight of the election campaign for me was the ‘bigoted woman’ remark made by Gordon Brown just a few days before the election. My initial reaction was that Ms Duffy, the woman in question, deserved it because she complained about Eastern European immigrants coming to the UK – and hence she showed herself indeed to be a bigot. But on second thought, things are less clear cut and this incident raises several intriguing questions.

The first question is: did this woman deserve to be called bigoted? The answer is no. A bigot is someone who dislikes or despises foreigners or people of a different race, religion, etc. Ms Duffy’s complaint about Eastern European immigrants, instead, reflects plain and simple rational self-interested utility-maximizing behavior. The immigration from the new member countries of the EU was massive by any account – in the range of 1 million since 2004. The vast majority of Eastern European immigrants went for low-skilled low-paid jobs. By doing so, they directly threaten the employment prospects and wages of low skilled low paid UK workers (for more on that, see below). Ms Duffy is retired and therefore she would be little affected herself but many of the people she presumably cares about – her neighbours, friends and family – may well be affected.

Next, did the prime minister address her concerns well? Following her complaint (‘all these Eastern Europeans coming in, where are they flocking from?’) Brown replied: ‘A million people come in from Europe, but a million British people have gone into Europe.’ In other words, he says that British workers benefit from the free mobility of labor within the EU too. That is true enough, except it is not necessarily the same kind of workers. You don’t hear many stories about British plumbers or construction workers moving to France, Spain or indeed Poland. So Brown was really telling Ms Duffy that the hardship experienced by her children or neighbours is compensated by the gains enjoyed by British consultants, bankers and managers moving overseas. As the prime minister, he should indeed care about the wellbeing of all citizens, regardless of their social class or bank balance. But he cannot expect Ms Duffy to feel the same.

Now, is immigration good or bad for the UK labor market? The answer is that immigration can be good or bad, depending on who you ask. Recent work of Christian Dustmann of UCL (with various co-authors) sheds light on this question specifically in the UK context (in particular, his articles in the Economic Journal in 2005, with Fabbri and Preston, and in the Oxford Review of Economic Policy in 2008, with Glitz and Frattini). Let’s consider first what the theory says. Most people intuitively think of a standard demand-supply framework. If the number of workers goes up because of immigration, the supply curve shifts out and as a result the price of labor, or wage, falls. Or, if the wage is fixed, for instance because of trade-union pressure or minimum-wage rules, then the result is involuntary unemployment. However, this framework assumes autarky – no trade with the rest of the world and no mobility of the other factor of production – capital. Once we consider an open economy, things change. If the structure of immigration is the same as that of the native population, then immigration has no long-term effect. Increased supply of labor initially exerts downward pressure on wages, this increases firms’ profits and more firms enter the market. In other words, the economy adjusts to immigration by importing capital.

Most of the Eastern European immigrants, however, are low skilled. Hence, they are substitutes for low-skilled workers like Ms Duffy. In contrast, they are likely to be complementary with high-skilled workers. In this case, the labor-market impact of immigration becomes varied: wages of low-skilled workers go down while those of their high-skilled counterparts go up. Overall, the average effect on wages is close to zero and is in fact even likely to be positive, leading to the so-called immigration surplus.

What about empirical evidence? Dustmann and his co-authors look at the wage impact of immigration along the entire distribution of UK natives’ wages. They find that if immigration increases by one percent, the average wage goes up by 0.35 percent. This increase, however, is not universally shared by all. The effect is negative for those with the lowest wages, positive for those with intermediate wages (median wages increases by 0.6 percent) but becomes insignificant again for those with the highest wages. This pattern nicely mirrors the relative distribution of immigrants to the UK: most are low-skilled but there are also quite a few very high-skilled ones. Hence, immigration is good for this country, on average, but has distributionary implications: it produces both winners and losers.

And finally, is Ms Duffy an exception in her dislike of immigrants? As I explained above, her remarks make economic sense: low skilled workers should be opposed to immigration while high skilled workers should be in favor. Or, to be more precise, this pattern should prevail in the UK and other developed industrialized countries in which skilled labor is relatively abundant. Such countries should import the relatively scarce factor of production – unskilled labor – and export the abundant factors – capital and skilled labor (the opposite should hold in less developed countries where low-skilled labor is abundant and low-skilled workers should be therefore in favor of unrestricted migration). This is again the reason why Brown’s argument about Brits moving to other European countries doesn’t hold water with Ms Duffy. It turns out that Ms Duffy’s view of immigration indeed holds more generally. This is confirmed by recent work by Kevin O’Rourke and Richard Sinnott (European Journal of Political Economy 2006) and Anna Maria Mayda (Review of Economics and Statistics 2006). They look at preferences over immigration expressed by respondents in large multi-country opinion surveys and find, as the theory suggests, that high-skilled individuals are more likely to be in favor of immigration in rich countries than in poor countries. Hence, Ms Duffy is not a bigot, she’s part of the mainstream.

Some food for thought instead of a conclusion: if immigration hurts the low-skilled and the less well-off and benefits the high-skilled and those relatively well-off, and given that Conservatives traditionally draw their support from among the well-off while Labour seeks to represent the working class, why are the Conservatives and not Labour opposed to immigration?

[Originally published in Economics and Finance Newsletter, Brunel University, May 2010]

Freakonomics, Bananomics and Lovenomics

2010-06-20T13:52:00.000-07:00

Economics is good fun. Not always, for sure, but often it really is. Those of us who have chosen to pursue an academic career in this discipline of course know it – and so we frequently fall into passionate discussions whether a particular relationship might be endogenous, we marvel at the elegance of a new theoretical proof, and we travel to conferences to boast about our new and exciting research to our colleagues and peers. Yet, the rest of mankind often fails to appreciate the beauty of economic and considers it rather boring (and I suspect that even some of our students may feel that way!). But every now and then, an economist comes up with a new article or book that makes even the non-economists smile and think.

Freakonomics was just such a book. Published in 2005 by a University of Chicago economist Steven Levitt, it succeeded in convincing the popular public that economics can be fun and also that it can shed light on important real-world questions at the same time. The book encompasses a broad range of topics, from analyzing results of school tests or sport events to identify cheating, through arguing that abortions helped lower crime in the US, to analyzing the economics of drug dealing. The book quickly became a best seller – and soon a sequel, blog and movie followed on the coat tails of its success.

Of course, Steve Levitt is not the only academic economist capable of producing research that is publishable and fun to read at the same time. As the title of this short contribution suggests, I want to talk about two other examples. And only one of them is shameless self-promotion.

I am writing this on my way from an international conference where I have seen a presentation by Richard Jong-A-Pin from the University of Zurich entitled “Are Banana Republics Banana Republics?”. The term banana republic is used to denote countries marked by high degree of political instability and dysfunctional state institutions (Woody Allen’s movie “Bananas” depicts the stereotypical image of a banana republic rather well). So Richard in his paper asks a simple and intuitive question: do countries producing bananas really suffer from higher political instability? This question, however, is more complicated than the first look suggests, because there is a possibility of reverse causality: what if politically unstable countries are more likely to produce bananas? Richard resolves the question of endogeneity by means of instrumental variables – he uses a set of third variables, unrelated to political instability, to predict whether a particular country produces bananas and then uses the predicted banana production rather than the actual one to explain political instability. This approach ensures that the regression analysis only picks up causality going from bananas to political instability and not the other way around. Doing so, he finds that banana republics indeed have higher political instability than countries that do not produce bananas.

Now this result begs the follow-up question why banana republics are banana republics. In other words, why are bananas apparently detrimental to political developments? Richard's paper does not address this question but a plausible explanation was suggested by Ronald Wintrobe (University of Western Ontario) who commented on Richard’s paper at the same conference. Bananas, as some other agricultural crops, perish quickly and this creates fertile ground for rent seeking. Let me explain. Suppose I want to buy a truck load of bananas and find a farmer – in an anonymous banana republic – who is happy to sell his bananas to me. We agree the terms of the deal months in advance – but when the bananas are ready to be delivered, I renege on our original agreement and insist on a substantial discount. The farmer now has few options other than accept my ultimatum: he will have a hard time finding a different buyer at such a short notice while taking me to court would take months – and his bananas would rot in the meantime. My bargaining position is therefore much stronger than his and in the end I can get almost any discount I want. The eventual outcome of this, however, may be that banana-producing countries develop a culture of rent seeking – and this eventually translates into political life too. Hence, producing bananas indeed breeds political instability. Watches, on the other hand, are not perishable and therefore Switzerland is not a banana republic.

And now for something completely different. Studying the formation (and dissolution) of relationships has a long tradition in economics, especially since the publication of Gary Becker's seminal “Theory of Marriage” in the Journal of Political Economy in1973. In my recent paper entitled “Anthropometry of Love,” written jointly with Michèle Belot from Oxford, we analyze a peculiar – and at a first sight puzzling – feature of interethnic marriages: men and women belonging to the same ethnic minority group are not always equally likely to intermarry with whites. Among blacks, it is black men who intermarry much more often than black women. The reverse holds for East Asians (for example the Chinese): in this case, women are much more likely to have a white partner than men. These asymmetries could be due to a number of factors. For example, it may be that black men and East Asian women are more numerous in the British society due to the supply of immigrants and/or due to past immigration policies. But that does not appear to be the case, as a quick look at the summary census figures confirms. Another possibility is that men or women of a particular ethnic group are more likely to possess characteristics that make them attractive in the marriage market, such as being more educated or richer. But again, data fail to confirm this view. Instead, we propose an explanation based on physical characteristics, in particular height. There are sizeable differences in height across the different ethnic groups in the UK: the whites and blacks are the tallest, followed by Indians, Pakistani and Chinese while Bangladeshi happen to be the shortest. This can have important implications for marriage-market participation of ethnic minorities and for interethnic marriage as across all ethnicities, we can observe a strong preference for the husband to be taller than his wife. This implies that men and women from the same ethnic group face different distributions of potential marriage partners in the white segment of the marriage market. Specifically, relatively tall men and short women have a wider choice of white partners than short men and tall women. Hence, black men, being relatively tall, are ‘on the top of the food chain’ (to quote an unnamed Brunel student), unlike black women. And, similarly, Chinese and other East Asian women have a similarly wide choice, unlike their male counterparts. So far so good but do the data support this explanation? Using data from the Millennium Cohort Study, we estimate regressions explaining the probability that a member of an ethnic minority has a white partner. We include in our regressions controls for the share of suitable partners – defined for men as those who are shorter and for women as those who are taller than the individual in question – both within the white population and within one’s own ethnic group. Doing so improves the quality of the regression and helps reduce the unexplained variation in the patterns of intermarriage. Height, however, is not the only explanation of intermarriage patterns; cultural norms, for example, are certain to matter too. But it is one of the factors underlying the observed differences. Furthermore, the importance of height for inter-ethnic marriage has some unexpected implications. Firstly, as social attitudes towards interethnic marriage become more liberal, this increases the number of potential marriage partners for black men and East-Asian women but may reduce it for black women and East-Asian men. Secondly, immigration has a marriage-market effect which is different for men and women. And how about policy implications? I am afraid there are none: love and the marriage market are (so far) largely free from government interference. Should this change, I would suggest subsidies for couples involving East-Asian men and black women.

[Originally published in Economics and Finance Newsletter, Brunel University, April 2010]