New working paper

Can Active Labor Market Policy Be Counter-Productive?

Excerpt from the introduction:

This paper studies the effect of active labor market policies (ALMP) in a Mortensen-Pissarides style matching model. ALMPs are modelled as a subsidy to job search, and it is assumed that search activity is observed. A key feature of the model is that workers differ in their productivity, and that search takes place along an extensive margin. The model is used to study the effect of ALMP on the equilibrium, on aggregate welfare, and, equally importantly, on the distribution of welfare across worker types (productivity levels) and current labor market status (employed vs. unemployed).
It is shown that in addition to the usual job search externality, there is a “quality” externality. As search is not directed, an additional job seeker affects the average quality of the pool of unemployed, in addition to the job finding rate. As a result, the usual “Hosios” conditions for an efficient outcome — that the bargaining share of workers match their elasticity in the matching function — are no longer valid. For an efficient outcome, the decentralized equilbrium conditions must match the optimal ones for both the job creation margin of firms and the job search decision of workers, and these two conditions cannot be matched with a single instrument. It is shown, paradoxically, that to replicate the optimum one must select a worker share in bargaining which is larger than their elasticity in the matching function, and at the same time one must impose a tax on job search activity.
Clearly, this prediction does not validate the view that ALMPs are a desirable policy tool. The reason is that they raise workers’ outside option in bargaining, thus contributing to wage pressure, while at the same time reducing the average quality of job seekers. The optimal policy outlined above delivers an improved quality of job seeker, due to the search tax, while the bargaining share in excess of the Hosios level compensates for the implied reduction in the workers’ outside option.

Despite their negative effects on aggregate welfare, we can characterize a coalition in favor of ALMPs. These are favored by the least productive job seekers (or “short-term” unemployed”) and the least productive workers. The former gain directly from the subsidy, and the latter gain from an enhanced outside option in bargaining. On the other hand, more productive workers and job seekers lose from it. They are harmed due to the fall in the job finding rate, which reflects in particular the deterioration in average job seeker quality. Finally, the workers who do not search (or “long term unemployed”) only benefit if they are sufficiently close to the extensive margin of searching, that is, sufficiently productive. The least productive long-term unemployed are too far from the extensive margin of job search to benefit from the policy, and suffer from the financial burden of the search subsidy. Consequently, they oppose the policy. Note however that this analysis would be changed if ALMP were explicitly targeted at the least productive unemployed workers. Here, instead, by monitoring job search irrespective of productivity, the policy is implicity targeted at those workers whose productivity level is immediately below the critical search threshold.

Dowload it from here.

Why is state art obscene ?

There has been a little uproar in France about a recent exhibition by contemporary artist Paul McCarthy. In particular, a giant inflatable reproduction of an erotic toy, known as anal plug, was installed on one of the landmarks of Paris’s classical architecture, the Place Vendôme. The artist was physically attacked and the installation subsequently vandalized, i.e. disinflated. Official representatives, such as Mr Hollande, the President, Mr Valls, the Prime Minister, and Ms Pellerin, the Minister of Culture, have reacted with outrage. So has the cultural establishment, which has predictably invoked freedom of speech and the right of the artist to be provocative and to challenge bourgeois social norms.

It should be pointed out that Mr McCarthy cannot conceivably be rebellious, and even less revolutionary. This is State Art. The exhibition is taking place in a public museum and on public places. It is therefore decided by public officials with the agreement of politicians (and funded by the unwilling taxpayer). These public officials have decided to exhibit pornographic objects, among many other possible choices. They are responsible for this choice. The only rebels in this story are those who disinflated the installation.

For centuries, art was about eliciting an esthetic emotion ; it is now defined as an object, or an action, meant to embody a concept. The more « provocative » and « challenging » the concept, the more this is art. According to those standards, obscenity is the apex of art – although, in practice, the entire establishment applauds the obscenity and is outraged when it is being disinflated. So the real artists, by the very official standards, are actually the disinflaters.

Historically, official art always existed ; its purpose, presumably, is to strengthen the power of the elite. This is why official art usually is monumental and loaded with respect. The Arc de Triomphe in Paris is a typical example. It is not particularly beautiful but quite conspicuous and emphatic ; the sculptures are by talented artists whose task was to associate esthetic emotion with patriotic feelings. This is a bit the same technique, if you want, as that of having a woman in swimsuit posing on a car in order to make you purchase this car (although it appeals to higher kind of emotion).

Most of “contemporary art” is similarly oversized, which confirms its official nature. However it does not convey respect and consensus ; instead, it is supposed to be disrespectful and divisive.

The authoritarian regimes of the twentieth century were predictably keen on official art. Like the Arc de Triomphe, their official art was meant to strengthen society by uniting it in a common emotion. The regime hoped to get approval through the admiration for the representation of muscular aryan or proletarian heroes saturated with willpower. Of course, inevitably, commissioned artists are mediocre more often than not, but this is not systematic. The masterpieces of Eisenstein, Prokofiev, and Shostakovich were propaganda pieces. The regime of Louis the XIV repressed many artists by giving monopoly to a clique (for example, Lulli had the monopoly of Opera) ; but the members of the clique were themselves talented. Fascist architecture has been influential and admired in the democratic world.

Most interestingly, the Soviet and Nazi regimes were very keen on eliminating provocation, absurdity, and obscenity from their official art. Dadaism, cubism, surrealism, expressionism were censored and called degenerate by the Nazis and bourgeois and decadent by the Soviets. Presumably, they thought that this kind of art was ultimately harming them, perhaps because it would breed cynicism in the population, and because that cynicism would eventually be turned against the regime.

So we are faced with a paradox : why would a rational, self-interested elite promote obscenity in lieu of art ? How can they possibly benefit from offending many people with their own taxpayer money ?

Private individuals might want to do so, if only to advertise themselves. And actual art can occasionally be obscene, confer Courbet’s Origin of the world or many paintings of old lesbians and prostitutes by Schiele. However, in those examples, obscenity is not the point ; rather, an obscene subject is treated in an artistic way. In contrast, in McCarthy’s work, obscenity is the whole point. It is because they are obscene that these sculptures fit the official definition of art, because obscenity is the concept.

A naive explanation is that obscenity is what the elite actually likes. But it is hard for me to imagine Mr Hollande or Ms Pellerin purchasing a sex toy to ornate their bedroom. They, at least from the outside, look like reasonably banal individuals with a rather conservative and austere lifestyle. If they own dildos it is unlikely to be for artistic reasons and they are unlikely to publicly boast about it (and rightly so). The former minister of culture Jack Lang was one the key promoters of conceptual art and rebellion ; he was in power when French cities were being devastated by graffiti that, in addition to be mass vandalism, all looked the same. He famously approved of those graffiti as a form of art. Vandalism is art when the Party says so. Vandalism is vandalism when it is the Party’s art which is being vandalized. Yet to my great surprise, I came across Mr Lang while visiting one of the most outdated conservative museums in France, namely Pierre Loti’s house in Rochefort. As an official, Mr Lang was inaugurating conceptual gigantism and praising the vandals. As a private person, Mr Lang was indulging in exquisite late nineteenth century eclectism. From this I conclude that current State Art does not match the tastes of the elite any more than socialist realism fitted those of the Soviet apparatchiks.

If we want to understand why official art is obscene, we have to start discussing what it actually does.

If I was exhibiting the kind of object that was installed on Place Vendôme on my desk while talking to students, I would for sure be indicted for sexual harassment. But when public officials do the same to thousands of passers-by, the notion of sexual harassment suddenly disappears. Some people are more equal than others with respect to criteria for misconduct.

Why do modern western societies criminalize sexual harrassment ? They do so, among other things, on the basis of the feelings of the victim. The victim feels violated in her intimacy, uncomfortable, and insecure. In other words the victim feels bad.

So here we have a clue : obscene pictures make people feel bad. This is why many societies repress obscenity, although one should concede that what constitutes obscenity varies considerably across cultures. In many Asian countries a couple cannot kiss in public. Move an Afghan peasant to a European city, and he will think he is in a whorehouse. In any case, even by common western standards, Mr McCarthy’s works are obscene — granted, these standards are quickly vanishing, but this may actually be intended by the likes of McCarthy.

So we have to ask : Why does the elite want the people to feel bad ?

One answer which is partly correct, is that we are faced with the political agenda of cultural Marxism. Cultural Marxism wants to eliminate bourgeois society from the inside by deconstructing its values. If you constantly attack bourgeois values such as the family, the nation, hard work, and so forth, you are making it weaker, and ultimately less likely to resist the establishment of a collectivist society. This rests on the brilliant observation that since collectivism makes people feel miserable, the only way to bring it about is to make them feel even more miserable in bourgeois capitalist society.  It is an uphill fight, but you never know…

So we can speculate that the cultural Marxists, having conquered a number of key positions, in particular since 1968, are using those positions to promote their agenda. This means, in particular, “deconstructing ” common bourgeois aesthetic standards, i.e. exposing people to a hefty dose of compulsory “contemporary art”. The depressed people, then, will have lost any defensive instinct when the revolution comes.

The problem with this argument is that it rests on the assumption that the cultural Marxists are already in power. If this is so, by weakening society they weaken themselves. They may well be wiped out by the revolution. It is not rational for them to depress people ; instead, they should find some self-congratulatory device that makes people feel good. Like the Arc de Triomphe or the muscular optimistic Aryan or Proletarian.

In fact, there are plenty such devices in operation. Take Paris-Plage, for example. Every summer, the Paris municipality dumps sand on the expressway along the Seine and installs palm trees and recreational devices such as volley-ball grounds. As in The Truman show, everybody smiles and is happy. And the happy people reward the Paris mayor by voting for her. By taking you to the beach, the Paris municipality acts like your mother and makes you feel like a happy little kid. In return, you love them just like you love your mother.

So, the elite does not systematically make people feel bad. More accurately, it makes them feel good in some places, and bad in other places. You feel good in Paris-Plage and you feel bad in Place Vendôme. Could it be that contemporary art is deeply intertwinned with geography ?

This leads us to our next question : Where is contemporary art ? Which places are targeted by contemporary art ? What is the characteristic of Place Vendôme which makes it a specific target ?

The Palais Royal courtyard has a permanent installation, called “colonnes de Buren”. It consists of a series of plain black and white truncated columns, with a lighting that makes it look like an airport track at night. It sparked much protest when Mr. Lang imposed it back in the eighties.

The Louvre courtyard has a glass pyramid, so that you can no longer see its façade.

The Versailles castle is regularly blessed with contemporary exhibitions, that make it impossible to enjoy the decoration of the rooms without at the same time enduring oversized provocative  “installations”.

What do the Place Vendôme, the Louvre, the Palais-Royal, and Versailles have in common ?

They all epitomize the official art of the “old regime”, and by old regime I mean not only the brilliant society of the XVIIth and XVIIIth century, but also the republics that followed, and that were keen on endorsing those symbols so as to benefit from the prestige and boost their own legitimacy.

But now we are in a “new regime”, i.e. the post-modernist faction which took over after 1968. While this faction would not go as far as the Taliban with the Bhuddas, they are nevertheless keen on polluting the official art of the preceding regime with their own “provocations”. The message is clear: this official art of the past is no longer official, and you are not supposed to enjoy it.

This leads to our last puzzle: why can’t the new “regime” do the same as the preceding ones and recycle the official art of the past for its own benefit? Answering such a question would be key to our understanding of the interaction between ideology and power.

In the past, the elite derived its power from being able to unite people, often against some external enemy. Now, post-modernist elites derive power from identity politics, i.e. dividing people between competing groups based on race, “gender”, disability, sexual orientation, etc. So it is somewhat important that official art should be divisive;  the goal is to please the grievance groups upon which the power of the new elite rests, while humiliating and harassing the others.

We observe that each grievance group is targeted with a specific form of “art”. For example we have rap music for blacks and various forms of obscene artifacts (such as Mr. McCarthy’s anal plug) for “LGBT” people.  In both cases, the mainstream, or the former mainstream, is meant to be insulted. Do the members of these grievance groups genuinely enjoy their group-specific form of art? What would Louis Armstrong and Oscar Peterson have thought of rap music? What would Oscar Wilde and Marcel Proust have thought of the giant anal plug? Or do they “enjoy” it only because it is an aggression against the mainstream, i.e. because it artificially unites the group against an “external enemy”?

New forms of power produce new forms of propaganda, and propaganda works as beautifully as ever.

Running out of other people’s money, continued…

The French newsmagazine Challenges recently released a very interesting poll. It asks people what kind of reforms of the welfare state they are willing to go ahead with. Most of the reforms proposed in the poll are cost-saving, and a number of them should have some effects on incentives.

The results match closely what a cynical believer in Homo Oeconomicus would have predicted. The fraction of French people who support a given reform is very close to the fraction of people who do not lose from it upon impact. For example, 80 % of the French support a means-tested child benefit system — and the proposed means-tested system, just implemented, actually concentrates the savings on the top 20 % of claimants. Some 65 % do not oppose a reduction in the length and/or generosity of unemployment benefits. This is more or less the fraction of the workforce employed with stable jobs; the remaining 35 % are either  unemployed or with temporary contracts (and therefore are exposed to unemployment). At the other end of the spectrum, there is a wide consensus against reforms whose burden is widely spread throughout the population, even though the burden is small on paper. Hence the vast majority opposes a 100 Euros per year franchise on health spending; raising the workweek by a couple of hours without a corresponding raise in income is also strongly opposed.

We learn three things from this poll.

First, the French are completely self-interested. For all the talk about solidarity, there is none. Solidarity is generally used as a codeword for “you pay, I keep my entitlement”.  The pretense that French society is more altruistic than its ugly Anglo-Saxon counterparts is a lie that nobody believes

The truth is closer to Bastiat’s aphorism that the State is the fiction behind which each gets richer at the expense of everybody.

Second, the French do not understand incentives. The savings that a 100 Euro Franchise would deliver are, in all likelihood, much higher than those 100 euros. (In fact, experiments with a sheer delay in reimbursement of drugs, as well as the preceding government’s policy of a 1 day franchise for the civil servants’ sick leave, suggest that such methods have large effects. Incidentally, we note that the current government has eliminated that franchise and does not remotely consider reintroducing it as part of its current package of structural reforms. Those reforms are carefully targeted to spare its traditional constituency). Therefore, each French person would have a tax rebate of more than the 100 Euro franchise they have consented. Of course, it does not help that, given the state of public finances, these savings will look more like a lower than expected tax hike than an actual rebate.

More generally, people do not consider the general equilibrium effects of a policy when evaluating its gains and losses. This is clear from the opposition to lengthening the work week, despite our blatant competitiveness problem. People ignore the fact that in the medium run, this policy will eventually boost employment and investment, and eventually living standards would have gone up.  (Unfortunately, the teaching of economics at the high school level is not keen on simplistic conservation laws such as “on average, one can only consume what one produces”; instead, they insist on impressionistic  debates  on great issues, such as “inequality”, “globalization”, and so on. High school students are not equipped to think by themselves on such complex issues, and this opens the door to all kinds of ideological manipulations.)

Third, the French are confident that they can outplay other French people in the zero-sum game of allocating the burden of fiscal adjustment.  Nobody thinks that making concessions now could avoid more painful cuts in the future (for example because rates are going up and the fiscal situation has further deteriorated). Of course, not everybody can be right at the same time…

Running out of other people’s money

There is much agitation in France concerning a number of cost-cutting measures the government is trying to implement in order to comply with the budgetary targets associated with our European commitments. Especially notable are the increase in a tax on pensions and the reform of maternity leave, whereby one is moving from a system where mothers can have up to 36 months of maternity leave, to a system where each parent has 18 months.

It is generally thought that this new system will, under a pretense of “gender equality” actually reduce spending, because most fathers will not take advantage of their eighteen months, while mothers will be compelled to halve their leave relative to the preceding system. It is also believed that the system will increase congestion in publicly-funded daycare centers, unless more slots are created there, which, as day-care centers cost more than 1000 euros per month per child, will wipe out any savings from the shorter maternity leave.

Angry middle class mothers contemplate being forced to separate themselves from their babies at a very early age, and, to add insult to injury, also being forced to fight against competitors for those coveted and rationed day care slots. Resentment builds up in anticipation of the suspicions of corruption, favoritism, and political and ethnic bias in the future allocation of this increasingly congested socialized resource. Ms Le Pen cannot believe her luck and is celebrating.

Generous maternity leave was implemented a couple of decades ago as a joint venture between “Santa Claus socialism” and “old-style feminism”. Old-style feminism recognizes that women are different from men, and concludes that taxpayers’ money should be used in order to promote the formers’  “work-life” balance. In the society that prevailed before the rise of the welfare state, women’s maternity leave was funded by their husbands; this was regarded as a form of exploitation. In order to free women, “society” had to pay for maternity leave. This meant that taxes had to be increased and consent withdrawn from the workers who had to finance those benefits regardless of their own personal choices and marital status. As for Santa Claus, his agenda was to collect votes from naive people by promising them freebies. Who could say no to 20 to 40 years of holidays (aka pensions) or to the dream of taking care of one’s kid at home while being paid an “allocation” and having her job kept warm at the office?

The problem was that as Santa Claus was pounding the population with benefits and entitlements,  costs inevitably soared, while the economy was nearing asphyxia under the burden of taxes and regulations. As people were more and more encouraged to participate in the zero-sum game of claiming benefits, and more and more discouraged to participate in the positive-sum game of voluntary exchange, the cake began to shrink. Santa Claus started realizing that the size of the cake was not sufficient to fulfill each kid’s Christmas list. Some of the children had to be reluctantly informed that there is no Santa Claus.

This is all the more painful than the poor people, after decades of being spoon-fed, can no longer take care of themselves. For one thing, they lost the habit; they cannot conceive that now that the government says they should stop work for eighteen months instead of thirty-six, they might remotely consider disobeying. But we can hardly blame them. The evil husband is no longer in a position to provide for his wife’s maternity leave. Half of his earnings are confiscated before they even land on his bank account, in order to fund, among other things, other people’s parental leave. The woman that the government has freed from the patriarchy has no other choice than organizing her life according to the government’s prescription, which means that the baby will stay with his mother for eighteen months, no more. Enjoy your freedom from the patriarchy!  Unless, of course, the family has enough money left, despite the heavy taxation…

So, in this society obsessed with egalitarianism and the fight against the “reproduction of elites”, we will observe that the children of the lower middle classes will be abducted from their homes at the age of eighteen months, to be taken care of by bureaucrats; at the same time, the children of the upper middle classes (among whom, conveniently, the apparatchiks who impose the Theory) will enjoy the benefits of staying with their mothers, or selected nannies, for much longer. Meanwhile, the boundary between those two social classes moves up, due to the swelling of the Tax Moloch.

Nobody in the establishment, though, will pay attention to that.

For one thing, the establishment is convinced that “professional” public servants do a better job at taking care of children than their mothers. I remember participating in a meeting of officials very concerned about “equality”, and they were brain storming about how to design schemes so as to prevent kids from the lower classes from spending school holidays with their family ( a number of representatives from NGOs which supposedly cared much about families, were nodding in approval). Their general prejudice was that kids from “privileged” families were spending those holidays taking intensive math and language lessons, while those from “disadvantaged” families were at best watching TV.  There was no mentioning of the inherent contradiction between subsidizing fertility at the lower end of the skill distribution and devoting public resources to separate the offspring of those subsidies from their “disadvantaged” environment.

But, more importantly, the Theory has changed. Old-style feminists have been replaced by Gender feminists. Now there is no difference whatsoever between women and men. In fact, there is no longer any presumption that the two parents should be of opposite sexes (actually those parents do not even have a sex, only an ectoplasmic “gender identity”). There is no longer a mother and a father, only a parent 1 and a parent 2. Surely, then, it would be unfair if parent 1 had a different parental leave from parent 2? So why don’t the people just obey and combine eighteen months of parent 1′s with another eighteen month of parent 2′s parental leave? Why does it matter to them? Don’t they know the Theory says it does not?

Now you may object that since — according to the Theory itself — parent 1 and parent 2 are interchangeable, one day of parental leave by parent 1 is interchangeable with one day of parental leave by parent 2. Therefore, why not give a total of 36 months to both parents, and let these two people decide on how to split it between themselves? Remember they are free. What does free mean? Or maybe “free” in “free from the patriarchy” has  a specific, unusual meaning, as in, say, “freedom is slavery“?

Now I am not familiar enough with the apparatchiks who apply the Theory to figure out why this obvious remark has escaped them. But I suspect they believe that Parent 1 and Parent 2, if left free to choose, would decide that the parent with the least stable and/or least paying job would take the maternity, sorry, parental leave.

This has two big drawbacks. First, it is what people want. Second, it is efficient. A Theory which would let that happen would be useless — it would make no difference if the Theory was not around. A Theory which makes a difference is one which compels people to do what they do not want.

The Theory is especially useful when the cake shrinks. It tells you who should have their piece, and who should be denied a piece. Households who prove the theory should have their piece. Households who disprove the theory should have nothing. Households who apply the theory will have 36 months of parental leave. Households who do not will just have 18 months.

You do not know how much you should bend human nature for the Theory to be true.  Lyssenko found out that he could not bend the nature of wheat by enough for his theory to be true. Others died. Our Theory is much more humane than Lyssenko’s; we just impose a little tax on those who do not conform to it. They are welcome to pay it and contribute to the consolidation of public finances; they are also welcome to dutifully take turns in child care between Parent 1 and Parent 2 and show that the Theory works.

 

 

 

Why the Euro cannot work

This text is the basis of my intervention tomorrow (30 september 2014) at the Institut de l’Entreprise, in a debate with Hans-Werner Sinn.

When the Euro was created, most economists were actually skeptical. They contended that macroeconomic shocks were asymmetrical across countries, that prices were sticky and that labor mobility was very low. They generally rejected the idea that Europe was an optimal currency area. At the same time, however, they also thought that while the costs outweighed the benefits, both were small. Estimates circulated that showed that asymmetrical shocks were not that important quantitatively. A number of idealists concluded that the economic costs were worth paying in exchange for an additional step on the glorious road to European unification.
Yet the subsequent experience was not one of asymmetric shocks, but asymmetric trends. Some countries accumulated inflation differentials and large trade deficits with respect to other countries. They appeared unable to curb the sharp increase in unemployment that they experienced during the crisis. As a result the Euro appeared not only as far more costly than was expected, but also as doomed.
Why did we observe such asymmetries? I argue that this is because of structural differences across countries. Some countries have better functioning labor and goods markets that others, because they are less, or better, regulated. As a result their equilibrium level of activity is higher, meaning higher wages and living standards, and their equilibrium unemployment rate is lower. Their economies will be closer to an “optimal” allocation of resources.
In general these discrepancies should not prevent those countries from sharing the same currency. If prices were flexible, or if the ECB could harmonize inflation across countries so as to prevent permanent imbalances from arising, the fact that some economies are less efficient than others would not be incompatible with a monetary union. Such a union would simply settle in a situation where the less productive countries have lower wages and the same price level as compared to the more productive ones.
But monetary union is problematic if governments retain fiscal sovereignty and use it in a discretionary fashion to inflate their economy so as to overcome their structural problems.
Prior to monetary union, Italy always had more inflation than France. And France always had more inflation than Germany. Why was that so? Because the Italian economy was less efficient than the French one, itself less efficient than the German one.
In the short run, governments pick their preferred point on an output/inflation trade-off. In a nutshell, this trade-off tells us that if you create more inflation than expected, firms can sell their goods at a higher price relative to wages, because wages are sluggish and were set in advance on the basis of inflation expectations. Therefore the government can buy an expansion by creating an inflationary surprise, that is by having more inflation than was expected by private agents. Absent such a surprise, the economy settles at its equilibrium output level. But this level is lower, and more undesirable, in Italy than in Germany, because the former economy is plagued by more structural rigidities than the latter. So the Italian government, left to itself, will naturally be tempted to select a higher inflation rate than the German government.
This attempt at creating surprise inflation is hopeless, however, because private agents will anticipate it. Therefore, the Italian government will end up having higher inflation without actually boosting its economy. Italy ends up with both more inflation and more unemployment than Germany. This implies, under flexible exchange rates, that the Lira will continuously depreciate against the D-mark, thus offsetting the competitiveness losses associated with higher inflation in Italy.
The preceding argument is the standard analysis of monetary policy credibility which Robert Barro and David Gordon made more than three decades ago. Discretionary monetary policy by governments create an inflationary bias; their attempts to stimulate output is defeated and one only gets more inflation instead. This bias is larger, the lower the equilibrium rate of output compared to the optimum; that is, the more the economy is crippled by rigidities such as barriers to competition. A consequence is that monetary policy should be based on rules rather than discretion. Hence Italy should refrain from trying to expand its economy beyond its equilibrium level of activity by creating inflationary surprises, by having some commitment against such moves, like, for example, an independent central bank.
Indeed, some of the Euro-enthusiasts at the time pointed out that one benefit that could be derived from European Monetary Union is that governments could solve their credibility problem by delegating monetary policy to the ECB. That is, they would not longer be able to select their preferred point on the inflation/output trade-off in a discretionary fashion, simply because inflation was now controlled by the ECB.
This argument turned out to be wrong. Despite losing monetary autonomy, governments can still choose their preferred point by using fiscal policy. While the ECB controls the average inflation rate of the Eurozone, any individual government can still try and implement an inflationary surprise; all it has to do is to engineer some stimulus to aggregate demand (by raising public expenditures or the budget deficit), to move up along its own output inflation trade-off. Just like monetary stimulus in a country with its own currency, this attempt eventually does not work, because people take it into account in forming their inflation expectations. So, again, one gets more inflation instead of more output–with far worse consequences. The independent ECB eliminates the inflationary bias on average but does not eliminate differences in the inflationary bias across countries.
Countries that have a lower equilibrium rate of output for structural reasons will then systematically have a higher inflation rate than the Eurozone average, and at the same time they are likely to be more profligate in terms of government spending, since this is the lever used by the government in its quest for higher output. Indeed, most of the countries in crisis (Portugal, Greece, Italy) had both greater inflation and greater budget deficits than Germany, while France stood in the middle between these two categories. (One exception, however, was Spain: There, the construction boom delivered enough stimulus which spared the government from having to use fiscal policy. While Spain did accumulate an inflation differential with respect to the rest of the Euro area, its budget situation was sound).
This situation had two important consequences.
First, as aggregate demand was larger, those countries tended to run persistent trade deficits. These deficits were financed by capital inflows at interest rates that were lower than before, because interest rates had essentially converged between all Eurozone countries. These capital flows, per se, are not problematic. It is normal for capital to flow from richer to poorer countries. And one of the benefits of the Euro was that the inflation-prone countries were no longer subject to a “peso problem”, by which they had to pay an interest premium on borrowing to compensate for devaluation risk. However, a number of countries, like Greece, took advantage of those low rates to run a Ponzi game with public debt. And the mystery, to me, is that it took ten years for private investors to realize that default risk had replaced devaluation risk and that they should ask for a greater return on Greek debt than on German debt.
Second, the inflationary differentials gradually accumulated over the years to cripple those countries’ competitiveness, which further depressed activity and raised the demand for an activist fiscal policy, as illustrated by the recent protests against austerity in those countries. This led to mass unemployment and to countries being “stuck” because they had to implement austerity while being unable to substitute foreign demand for domestic demand, because this would have required a large devaluation.
The competitiveness problems were compounded by adverse supply-side policies, like for example the 35-hour week in France, which further widened the gap between France and Germany in terms of equilibrium output.
If this analysis is correct, no amount of debt relief or austerity may save the Eurozone. The imbalances will resume immediately after one exits the crisis. There are three way to tackle this issue, other than dismantling the monetary union. One possibility is implementing structural reforms so as to raise the equilibrium output level. Another is for the inflation-prone countries to implement some built-in device to impose some fiscal discipline upon themselves. For example, some economists have advocated for independent fiscal policy committees. The idea is to prevent politicians from stimulating the economy in a discretionary fashion, which, as we have seen, is counter-productive. Finally one may also envisage a fiscal policy union, which in my view would deepen the democratic deficit and create more problems — such as free-riding — than it would solve. But Euro enthusiasts are keen to take advantage of the crisis as an argument for further integration.
One should note that the growth and stability pact turned out to be unable to countenance those problems. It was designed to prevent public debt in the Eurozone to increase to such levels that the ECB would be tempted to abandon its inflation target and to monetize it (and we are right there). But this is not the only issue: a country can inflate without running a budget deficit — a balaned-budget increase in government spending would work — and yet its selection of a higher inflation rate will nevertheless prove problematic. Furthermore, the European Union has proved unable to impose sanctions on countries that violated the Pact. In this context, it seems that bureaucratic solutions like fiscal policy committees, similarly, are wishful thinking.
So we are just left with structural reforms. But it is unlikely that all Euro area members will implement such reforms so as to end up with exactly the same inflationary bias. A country may be more regulated than another for different reasons. This may be due to sheer policy mistakes that are easy to eliminate. Or it may be due to the ability of some interest groups to preserve their rents. Or it may be due to different “collective preferences” for the size of the welfare state. Countries with more generous welfare states will have more tax distortions, and therefore a larger inflationary bias. It is not obvious to me that such countries are actually willing to live with the negative economic consequences of their generous welfare states, as opposed to believing they are having a free lunch. But it is certainly conceivable that a country would rationally prefer having a bigger government in spite of higher taxes. To align the inflationary bias with that of the other countries, the European Union would have to force it to reduce the size of its government against its will. It does not seem much better than forced transfer of fiscal sovereignty to Brussels.

New textbook: Frictions and Institutions

My e-textbook, Frictions and Institutions is now downloadable online for free at bookboon.com.

Click here to download Frictions and Institutions

This book is based on my lectures on labor market institutions at Humboldt University Research Training Group and IMT Lucca in August and September 2013. It is a textbook which also contains some original research; the latter is presented in a “raw form”, which is relatively close to the way the ideas were originally formulated. Hence there is little dressing up and sweeping under the carpet, which I believe has pedagogical advantages for an audience of graduate students expecting to develop a career in research.

The goal is to induce the student to work with matching models and to perform the required analysis. This is why many analytical results are presented as exercises for the reader. Also, there is substantial emphasis on proving analytical results as opposed to constructing and calibrating a dynamic stochastic general equilibrium model. Mastering the analytics is important because the economic effects being analyzed are explicitly present in the terms of the analytical equations, and interpreting them correctly is a crucial skill any applied theorist should have.

The book introduces the reader to the now largely standard Mortensen-Pissarides (1994) matching model of the labor market, and then builds a number of applications of this model that allow us to study the distributional effects of various labor market policies and institutions. The motivation is simple: many such institutions are considered as harmful for job creation, yet politically difficult to reform. We want to know why, and the framework developed in this book allows us to find out who gains and who loses from those “rigidities”. These rigidities generate conflicts of interest among workers who are otherwise identical but may be in different current situations in the labor market. The currently unemployed have different preferences from the currently employed, and the latter may also differ by the situation of their firm: Workers in firms that are doing well have different interests from workers in firms that are doing poorly.

After having introduced the basics of the matching model, the book considers a number of specific institutions. For each of those institutions, the effect on the welfare of different kinds of workers is computed. The outcome is also compared to the first best, which in most examples coincides with the market outcome if the famous “Hosios conditions” hold. These conditions state that the surplus from a match should be allocated between the two parties in proportion to the relative importance of their search input in generating new jobs, which turns out to be equal to the elasticity of that input in the matching function. That is, the more a given side of the market is important in the job creation process,
the greater the share of the surplus that we want to give it.

I start with employment protection. An important distinction is made between employment protection as a device that enhances the workers’ bargaining power versus employment protection as a tax on separations. I then study the gainers and losers from unemployment compensation. The analysis, by assuming risk neutrality, ignores the insurance dimension of such policies and focuses on its effects on welfare through wage formation and job search. Finally, I study the role of one specific active labor market policy – a subsidy to job search – in a model where workers differ by their productivity level. It is shown that in addition to the usual congestion externality, job search generates a externality on the average quality of the pool of unemployed.

Frictions and Institutions

The attack on meritocracy and the new oligarchy

Ever since Pierre Bourdieu stigmatized the “reproduction of elites”, these elites have felt guilty. That their children’s achievements compare to theirs is perceived as a sign of unfair privilege. And prominent members of those elites do not miss an opportunity to publicly complain about “reproduction” and lack of social mobility, even though privately they spare no money, effort, time and connections to lift their progeny as high as possible in the social ladder.
Reproduction is what life is made of. That social structures reproduce themselves should therefore come as no surprise. Parents transmit genetic, human, financial, and social capital to their kids; this is not only a natural “default” outcome but for many people such transmission is the most important purpose in their life.
For Marxists and partisans of “social justice”, this is unfair because you do not choose your parents. Some kids are lucky to be born in an educated, wealthy family; others are unlucky.
Traditionally this problem had been corrected by putting in place a public education system which was supposed to give everybody the ability to acquire human capital and to progress in society despite an unfavorable initial environment. This system was based on strict meritocratic criteria and was meant as giving opportunities to those who had the will and capacity to seize them; it was not meant to be evaluated on the basis of statistical data regarding the relative outcomes of various social groups.
The system was deemed fair because it was meritocratic, regardless of its outcomes. If indeed the elites reproduced themselves, this was just tough luck for the non-elites who had been on average incapable of seizing their opportunities. Whether or not the system is fair depends on its design and not on its outcomes.
In the era of political correctness, this perception is no longer tolerated. The system has to deliver “equality of outcome”, otherwise it is considered as biased. Furthermore, any person who would claim that the system is fair could be cornered into admitting that members of those groups who do comparatively worse are less deserving, and from them easily accused of racism, sexism, and so forth. This, despite that it is generally the Marxists, not the conservatives, who insist on categorizing individuals by sex, ethnicity, class and other collective characteristics.
As a result the guilty elites are gradually eroding the meritocratic system that brought them to the top, by introducing arbitrary criteria meant to promote “diversity” (a conveniently vague concept) in the recruitment process for elite schools and positions.
So what does it mean to promote “diversity”? To answer that question, we need to note that the criteria by which the system is being evaluated have changed. In 7th century China, participants in the Mandarinate contest had their exams copied by a bureaucrat, so as to make sure that the graders could not recognize the handwriting of the candidates and indulge in favoritism. In the 21th century West, instead, elite educational institutions boast of the proportions of various “disadvantaged groups” in their recruitment, while relying on increasingly opaque and arbitrary procedures.
The two processes go hand in hand: if I am targeting a given statistical distribution for the personal characteristics of my students, I cannot at the same time abide by strict rules that apply to all individuals equally.
The most transparent I could get is to have a segmented recruitment process, by which there would be a fixed number of slots for each group. In such a situation, though, it would be all too obvious that those who are admitted to school X in capacity of their belonging to some anatomical group, are not in the same category as the others. The equality of outcome agenda would simply defeat itself if it were to use such obvious means. Instead, it has to rely on opaque means in order to preserve the illusion that the preferred groups are thriving in a process which does not systematically favor them, but instead relies on criteria that are supposed to have less of a disparate impact on the disadvantaged.
These techniques range from having an admission meeting in order to demote members of the non-preferred groups who would have made it on meritocratic criteria, so as to make room for members of the preferred groups who would not have made it (up to the point where the statistical targets are met), to getting rid of some parts of an entrance exam on the grounds of their alleged disparate impact, and replace them by tests that leave considerably more discretion to the admission committee.
As an example of the first method, I once briefly participated in an NSF-style body in the French university system which was in charge of allocating an important set of grants. After discussing the academic merits of the candidates and ranking them, we then counted the number of people who resided outside Paris and the number of women. If the result was not deemed acceptable by the president of the jury, then some men and some Parisians were demoted from their ranking and replaced by provincials and women. Since I was very uncomfortable in contributing to a process that I do not approve of, I did not last long in that jury, especially given that the president greeted me and the other members by complaining that there were not enough women in the jury (I guess they appointed me just to let me know). This Darwinian elimination process guarantees that the jury will eventually be mostly made of yes-men (and women) who will never challenge its non-meritocratic criteria.
As an example of the second method, the French elite school Sciences-Po has decided to withdraw its general culture test from its entrance exam, on the grounds that “disadvantaged groups” — like recent immigrants — would perform poorly because their background made them less acquainted with mainstream higher French culture (similarly, Pierre Bourdieu advocated that selection at school should emphasize mathematics, which is less culturally loaded than humanities). There were also talks of getting rid of the English language test, on similar grounds that the disadvantaged groups were less proficient in foreign languages, having fewer opportunities to live and vacation abroad. Somebody must have pointed out that English is used to communicate in the modern professional world, and that maybe, just maybe, social mobility would not improve if the Sciences Po graduates, regardless of their family background, were incapable of speaking English. So the English test was finally maintained, but the general culture exam was suppressed.
Which brings the following interesting question: How long can an elite survive, if it recruits its members so as to get rid of any of the characteristics that make it legitimate as an elite? If these people are not more knowledgeable, more proficient in English, nor better at logical reasoning than the average Joe, on what grounds do they hold privileged positions in society? This is of course exactly the question that the eighteenth century enlightened liberals were asking on the eve of the French Revolution. We may speculate that competition in labor markets will do to educational institutions that abandon meritocracy what the French Revolution did to the aristocratic system.
The new criteria that Sciences Po uses heavily favor those applicants who have an “interesting” and “diverse” profile. The fair exam principles borrowed from the Chinese Mandarinate system were well received in a Catholic country for which salvation is a reward for good actions (the selective exams reward hard work, and all candidates who were admitted had “suffered” in preparing the exam; therefore they tend to believe that their suffering was rewarded). By contrast, recruiting “interesting people” is a neo-Calvinist concept borrowed from U.S. universities. Salvation is now an outcome of pre-destination, not of your actions. In fact Sciences Po is remarkably opaque in disclosing how you become an interesting person, because they do not want people to develop a fake personality in order to make it to the school. As a result of the new system, some 40 % of a class had to take no written exam [1] and was admitted on the grounds of a bogus motivation letter which was at best written by their parents, and a 20 minute interview on no specific topic.
The important point here, though, is that these loose criteria, while contributing to the goals of apparent equality of outcomes, at the same time provide the oligarchy with considerable discretion in order to co-opt its members. It is very easy to decide that members of influential networks (financial contributors, political acquaintances, colleagues’ children, media pundits…) just happen to have kids whose profile is wonderfully interesting and diverse. After all, nobody can disprove you and it may even be true! It is easy to imagine that a family located at the center of power has more opportunities for a challenging, original and diverse experience than the children of a regular electrical engineer or manager of a medium-size supermarket in some dull provincial city. And, when one compares these boring middle-class people, whose only claim to upward mobility is hard work and academic excellence, to the Chosen who cannot be bothered being asked demonstrating their skills, all talk of the elite reproducing itself suddenly vanishes [2]. One only opens Bourdieu’s grave when it is convenient.

NB: [1] This ignores specific procedures for foreigners and applicants from “disadvantaged neighborhoods” who also waive any written exam.

[2] The trick is not to distinguish, in the statistics and in the rhetoric, between relatively high skilled workers earning a fair wage on their human capital, and the actual oligarchy in control of power. The dismantling of meritocracy benefits the latter at the expense of the former.