New working paper (in French): Social networks and socialism

This new piece of research studies the role of social networks in a “socialist” economy where access to goods is rationed (in the paper, this is because of a price cap, but the argument may apply to other forms of regulations). In the model, social networks develop as an alternative device to access a trading opportunity for those goods. As a result, people overinvest in social networks — at the margin, they make friends with people they do not really like, or spend too much time with their relatives, because such networking may provide useful consumption opportunities.
The most interesting result is that regulation may be sustained as a self-fulfilling political equilibrium. This may hold provided some people benefit from it. Here regulation maintains prices below their market clearing level. It benefits the “poor” because they have to pay less for the goods. It harms the “rich” whose income is lower in the regulated society (in the model it is because they own shares in the firms that produce the rationed goods). These “rich” include the “average” individual, who is also harmed due to the price distortion brought about by regulation. Only poor enough people benefit, and that is only because more efficient forms of redistribution are not available.
If people’s ability to invest in their social network is heterogeneous, the expectation of a regulated economy will lead to the emergence of a social group who is well equipped in social capital (and therefore expects to do well in a regulated economy), but with relatively low income. This social class benefits from regulation because they have a privileged access to the goods that are rationed, thanks to their superior social network. They benefit from low prices while not suffering too much from rationing. On the other hand, they are not poor enough to support regulation should they have not invested in their social capital. Therefore, these people validate expectations: if it is anticipated that the economy will be rigid, they invest in social networks and, because they are winners in the social networking game, end up voting in favor of regulation. If it is anticipated that markets will be left unregulated, they do not invest in social networks and vote against it. If this group of people is large enough, both rigidity and flexibilty are self-fulfilling outcomes.
The argument applies to social-democratic societies where a wide range of publicly provided goods are subjected to a price cap (or even free) and rationed. We may mention access to social housing, day care, medical care, summer camps, pension homes, music conservatories, and good schools. The model tells us that the system is supported by a social class of people who are relatively modest economically but well positioned to access those goods thanks to these connections. This article by Eric Le Boucher laments how opacity and complexity in the French higher education system ultimately favors the well-connected (in particular high school teachers) who know how to get into the right track. Indeed, high school teachers are modestly paid, but they are in an excellent situation to use their connections to get their children in the right place. And they have more free time than others that they can use to develop connections and gather information. They match the caracteristics of the social group I have just described.
Along similar lines, this article by Capital points out the pervasiveness of favoritism in the allocation of social housing in France; while sheer bribing is rare, social connections (and affinities) with the key decision makers is essential. One does not need to be miserable to be eligible for social housing. According to the article, 50 % of households in the Paris region are eligible — the proportion of social housing is less than 20 %. It is easy to figure out that among those 50%, the more connected and least poor among the eligible would be better-off in a free market system where they would not have spent as many resources to establish connections. But these resources are sunk costs and they end-up locked in in a situation where they gain from rigidity.

On the art of clientelism

Besides the train strike (which is basically over), there is another protest movement by the so-called “intermittents du spectacle” (henceforth “intermittents”). These are employees of the cultural/media industry who enjoy a specific unemployment benefit system. Essentially this system allows them to move back and forth between temporary employment and unemployment benefits, while other temporary workers (say in the tourism industry) would have to spend a larger fraction of their time in employment in any given year to be eligible for benefits. Beyond the eligibility rules, being on benefits has become a way of life for the intermittents. As a result, their specific unemployment benefit system has an annual deficit of about 1 billion euros, which is about the same, for 250.000 contributors, as that of the general system, which covers 16 million people. This is a transfer from the rest of society (including poorer people and people who have far less enjoyable jobs) to the intermittents.

As a result, the social partners, who are supposed to negotiate the financing of the welfare state, have regularly tried to cut on these conditions. In general there has been enough consensus between unions and employers on these reforms, because the intermittents are perceived by regular working class employees as privileged, while employers want to cut on labor costs and social security contributions. Thus the main private sector labor union, CFDT, has generally gone along with the employers’ proposals to cut the benefits. By contrast, the CGT labor union which represents mostly public sector employees is opposed to the cuts, and is active in organizing the intermittents. This is rational: While the CFDT median voter has to finance the intermittents scheme by paying higher contributions to the unemployment benefit system, public sector workers have job security and therefore do not contribute to the system.
In 2003 a reform was implemented and met by protests that perturbed a number of summer cultural festivals, up to the point that a sacred cow of French cultural mythology, the Avignon theater festival, had to be cancelled.

The same scenario is being played out right now as another agreement by the social partners has managed to put some mild cuts into place for the intermittents’ specific system. The movements should be less popular than ever, given the punitive tax increases that have been inflicted on most of the population since 2011. Nevertheless the Valls government has already yielded to the intermittents by transferring part of the costs to the tax payer; the agreements between the social partners is, then, purely cosmetic. The financing of the system is being put into the general government budget instead of the “social accounts”.

[Quite remarkably, exactly the same trick was played after the 2003 reforms. But you have to read the austere report of the "Cour des Comptes" (a committee of Cassandrae who open closets and lift carpets, then write reports on what they have found, and whose wise recommendations are invariably ignored by the politicians) to figure out how. The 2003 reform made eligibility rules stricter. But a special fund, financed out of the government budget, was put in place to guarantee a smooth landing for those who were no longer eligible. The fund was supposed to be temporary (like the jobs of the intermittents), but never trust a temporary measure.]

The existence of the intermittents is a remarkable example of political clientelism. Over the years, the eligible population has been multiplied by 10. This reflects the explosion of “cultural” spending by successive governments. Short-time unemployment compensation is a way of life for most people involved in “spectacle vivant” (theater, dance, clowns, happenings) and is also used by television and radio channels, including the State-owned ones, to pay their technicians.

The rise in the number of people working in the “cultural” sector, maintained by subsidies at an artificially large size, is a way for the political left to recruit its own electorate. The intermittents are a captive electorate, because the excess size of the entertainment sector puts them constantly under theat. They know that a substantial fraction of them would have to relocate to other industries (and lose part of their human capital) should the subsidies be cut. They also know that employers, and more generally union representatives for private sector employees, have targeted the intermittents benefit scheme as a priority for implementing cuts in social spending. This means that the threat they face is associated with the political right, implying that they need the left to be in power so as to protect their rents.

Distributing rents is not sufficient for successful clientelism. If the beneficiaries of the rents think that the opposite political party will treat them just as well, they have little incentives to reward your clientelism with votes. The rent must therefore be designed in such a way that your political opponents will try to eliminate it. By having the intermittents UB scheme being financed out of the UB system instead of the general budget, one makes the cost to other workers more apparent. That is, as you create the rent, you create a constituency against that rent at the same time. And that constituency is important in convincing your clientele that your opponents will attempt to eliminate their rent. The price to be paid for it is that the scheme will come regularly under attack; but these attacks secure loyalty among your supporters.

While the rent has to be fragile, it has to be resilient at the same time. You will need your clientele as an army to reconquer power if your opponents win the next election. But this army will not be around should the next government eliminate the scheme by a stroke of pen. To prevent that, make sure that the rent is not a discretionary subsidy scheme. Instead, it should be embodied in some form of entitlement.

The clientelism scheme will also work better if you can recruit more people into it. This means that the rent should be relatively small, so as to save resources for raising the number of beneficiaries. And if your clientele is an occupation or an economic sector, entry into it should be relatively easy (of course entry cannot be costless because that would simply eliminate the rent). Indeed many of intermittents are relatively mediocre artists who would have elected a different occupation in the absence of the scheme. Lowering standards and promoting amateurism goes hand in hand with the ability to enroll many people. Conversely, one would not go very far politically by promoting “excellence” in the arts instead.

Finally, make sure to “leverage” your clientelism by designing it so as to enroll indirect supporters in addition to direct ones. Suppose you are the mayor of a small city; you get more support by giving municipal jobs to members of large families than small families. By hiring one employee, you not only make him happy, but also his parents, sister, cousins, and so forth. In that respect, targeting the entertainment industry is a clever idea, since they can potentially enroll the audience. By targeting artists and intellectuals for your clientelism, you also achieve leverage. By virtue of their profession, these people influence public perceptions; and a dog does not bite the hands that feed him. Indeed each election a cohort of artists and intellectuals duly endorse the left in the media, while the right has to content themselves with a handful of athletes, movie stars and popular singers (who in fact reach out to far more people than the artists and intellectuals, but the point here is that many of the latter benefit from government subsidies).

I can only speculate about why over the years the right-wing governments have proven impotent in reducing the size of a scheme which, in addition to being considered unfair by many people, runs against them politically. Perhaps an explanation is that the educated bourgeoisie, who consume a substantial amount of “elite” cultural products, does not want their music and theater festivals to be sabotaged. This is a form of hostage taking but the hostages seem to be struck by some sort of Stockholm syndrome, perhaps rationally so. They contribute more to the system than they get, but as consumers of cultural products they do get part of their taxes back in the form of low prices and an abundant supply. They expect to lose more from a less profligate and more expensive cultural sector than they would gain from reduced social security contributions if the cuts were to be implemented.

Remarks on quantitative easing

The following post is a bit long and can be downloaded in pdf here.
The issues discussed in this text are, quite naturally, the subject of a lively online debate among US economists. See here for an entry point into the discussion.

The so-called “Great Recession” has led, almost overnight, to a new conventional wisdom in macroeconomics. This new conventional wisdom roughly amounts to the view that monetary and fiscal stimulus are costless and should be used without restraint. One justification is that interest rates are stuck at a zero lower bound and the economy runs the risk of a deflationary spiral: As inflation becomes negative, real interest rates go up and the central bank is unable to reduce them because its policy rate cannot go below zero. What should be done to lift the economy off this deflationary spiral, the conventional wisdom goes, is to raise inflationary expectations. This will prompt people to get rid of the money they are hoarding by spending more. How do you raise inflationary expectations, since this is not a policy variable? The answer is that it is not easy. But the dominant view, it seems, is that “Quantitative Easing” — increasing the money stock by massive purchases of government securities — is likely to raise inflationary expectations and get us out of the dreaded liquidity trap. The argument is fuzzy because it is rational to believe that once one gets out of the liquidity trap, the central bank will resume its usual monetary policy, and will not let inflation go beyond its target. The central bank’s supposed virtue and consistency is running against its attempt to raise inflation expectations. For it to work, we would need that people irrationally believe that the central bank has shifted to (for example) a constant money growth policy starting from a new inflated money stock. Conversely, appointing an inflation-prone central banker (as Russia has in the 1990s) should be enough to raise inflationary expectations without having to resort to QE.
Besides the fact that the government simply does not control them, the idea that one should raise inflationary expectations, even in a liquidity trap, is highly dubious.
For one thing, inflationary expectations is the worst way to raise aggregate demand, because at the same time it reduces aggregate supply. The effect may be weak if in a recession the aggregate supply curve is locally very flat, as would be the case if, for example, there is also a zero lower bound on nominal wage increases; that is, there could be so much slack in the economy that a rise in inflationary expectations would not be reflected in increased wage pressure. Even so, it is always a better idea to move along the aggregate supply curve than to shift it in the wrong direction. Thus using fiscal policy looks like a better idea than QE (my preferred option being public infrastructures, since they do not commit future expenditures as compared to, say, hiring government workers). Indeed, mainstream economists believe that the fiscal policy multiplier is quite large at a zero lower bound (a view that was present in macro 101 textbooks already in 1970). So why insist on pushing monetary stimulus further when it has reached its “physical” limit?
Furthermore, QE may even fail to raise aggregate demand, because it is likely to raise future uncertainty about inflation and therefore activity. If consumers make precautionary savings, then they will react to that uncertainty by reducing current consumption, and the stimulus policy will in fact contract aggregate demand. This criticism applies, of course, to any stimulus strategy which raises uncertainty about the future; for this reason, transparency, predictability, and credibility are a crucial component of any successful stabilization policy.
The purported motivation for QE (the risk of a deflationary trap) is also dubious and vastly exaggerated . In the monthly inflation series shown below, inflation has been negative only three times. It is around 2 % since April 2011 and the most recent data indicate an acceleration.

fed funds

Despite these developments, the policy rate remains stuck at zero.

fed funds

As a result, short-term real rates remain largely negative. This is not unusual, as this was also the case in the preceding recession, although they are even lower since then the Fed did not indulge in zero rates. The following graph shows how volatile real interest rates are due to the Fed’s active stabilization policy.

Real short rate

From those data I was tempted to conclude that the monetary policy regime has changed and that the Fed has shifted from an inflation targeting rule to a debt monetization rule. But it is too early to draw such a conclusion. The reality is that the Fed is willing to engineer enormous swings in real interest rates in order to fulfill its targets — which of course makes it more likely to hit the zero lower bound, compared to the ECB which is less reactive. Despite the steady fall in unemployment, the Fed has maintained its zero-rate policy. But the unemployment rate is still relatively high (6.3 %); this is about its peak level during the preceding recession, during which real rates were reduced to similar negative levels, and the zero lower bound was not hit because inflation was a bit higher than now.

civilian unemployment

An interesting way to look at the Fed’s monetary rule is to correlate the short-term real rate with the unemployment rate. We see a steep negative relationship, which confirms the very strong reaction of the Fed; we may ask whether it is a good idea to have so wide fluctuations in real rates, an important allocative price. We also note that the relationship shifts down at some point; the shift takes place somewhere around mid-1997, after which a lower real rate is tolerated. In my view, this captures a more expansionary monetary policy rule (there was a view at the time that potential output growth has improved, but inflation crawls up after this shift until the collapse of the Internet bubble).
The circled zone represents the crisis period during which monetary policy hits the zero lower bound and interest rates cannot be reduced further; the Fed is then compelled to deviate from its real rate/unemployment schedule. The graph makes clear that we have exited this zone; the last available point is not far from the usual rule. Hence my conclusion that we can’t conclude that the rule has changed, although we may ask whether it is not too expansionary (is -2 % at 6 % unemployment sending the right signals to the economy?). Another reason to believe so is the sharp acceleration of inflation in the run-up to the crisis, which suggests that 4.5 % is below the natural rate of unemployment, and therefore that the U.S. economy may not be that far from it.

unemployment vs real rate

Some people believe that the unemployment rate is a poor indicator of slack because participation has fallen during the crisis. According to this argument, there are discouraged workers out there who do not bother to register as unemployed but would be happy to hold a job should they find one. Therefore, these people say, the Fed is justified in pursuing the zero interest rate policy despite that the unemployment rate is only one point above the natural rate.
Just because something evolves during a crisis does not make it cyclical. The distinction between trend and cycle may be misleading. A crisis is a situation where actions are highly correlated across agents, and these actions may be permanent and indicate structural change. For example, the Spanish construction sector collapsed during the crisis, but will probably never recover to the same levels. The structural change in the sectoral composition of Spanish economic activity is taking place during, and being facilitated by, the crisis. This is the (painful) way the economy “learns” its sectoral allocation of activity is inadequate.
Looking at participation rates separately for men and women confirms that the evolution of participation is mostly structural. The female participation rate is flat and has been so (at 75 %) since 1996. There is no surge in female discouraged workers during the crisis. The male participation rate is trending downwards from the mid-sixties. The trend was indeed slowing down before the crisis, and has sharpened since the onset of the crisis. Interestingly, the process continues despite the steady recovery of the American economy.

female participation

male participation

The downward trend in male participation is due to the decomposition of family structures. Statistically, half of households will be dissolved by divorce and custody will be awarded to the mother in the vast majority of cases. The return to labor market participation for men is much lower than in the past; the need for their earnings is reduced both due to marital instability and rising female participation. On the other hand, divorce is associated with a substantial tax on those earnings, with little counterparts. The contrary holds for women who can expect to end up as a sole provider in a single-headed household with substantial probability. For those reasons we may even think that female participation will end up being higher than male participation. At present this is not the case, though.
Hence, the case for a purely cyclical downturn in participation rates seems rather weak to me.
How effective is the Fed at raising inflationary expectations (remember it is not a good idea)? The following graph shows some consumer survey data. The median inflationary expectation is remarkably stable around 3 %. Despite a little blip in 2011, agents return to that level; if the goal of quantitative easing is to raise those expectations above their normal secular value, this goal has not been achieved. On the other hand, these numbers have been above realized inflation since the beginning of the crisis, so perhaps QE has indeed raised inflation expectations a little bit (and we don’t really know why).
Finally we may believe that the zero lower bound rhetoric is just an ideological justification for monetary financing of the deficit. I am quite tempted to believe that, but if the economy is in a liquidity trap, then money and bonds are perfect substitutes. Therefore, in principle the public is willing to hold government bonds at the going, zero, interest rates, and it is not clear why the central bank should purchase them instead. While one may dispute the merits of monetary policy, at the end of the day what matter is the equilibrium interest rate, not the way in which money is injected into the economy. If, say, the zero lower bound were reached by massive injections of liquidity into banks instead of bond purchases, the government would not find it difficult to float its debt on the market at the going rate.
Things are different, of course, in the case of purchases of troubled member states debt by the ECB. While part of these purchases act by killing the expectation that the country might leave the Euro, the other reason why they act is by indirectly mutualizing the debt between member states. The seignoriage revenues paid by a member state to the ECB are more or less proportional to the share of the monetary base that is present in that state. But if the proceeds are used to purchase Portuguese debt, those revenues accrue disproportionately to the Portuguese state (and this indirect transfer, and the associated implicit guarantee, naturally reduces the cost of borrowing for the Portuguese government).

Inflation expectations

The non-employment society: two anecdotes

There is a musical theater near where I live which has a very active and wonderful season. It produces a number of operas. We all know that operas are long and theater halls pretty hot. As a result there are intermissions, during which the thirsty people rush to the bar. At the bar there is a single waiter who is visually impaired. Despite that, he does an extraordinary job at attenting everyone he can, delivering the drinks at an incredible speed. Managing all these customers in the limited intermission period is a stressful and physical activity. Despite all his efforts, there is so much congestion that many people give up on the possibility of buying a drink. The price of a glass of Champagne is 10 Euros. There are perhaps 8 glasses in a bottle, and let’s say the bottle costs 20 Euros to the theater. The theater makes 7.5 Euros per glass sold. The hourly cost of an employee (who could for example be a student) is around 10 Euros. Make it 20 with payroll taxes. This means that the theater would recoup the cost of an extra employee, paid one hour, if only that person sold 3 extra glasses of Champagne. While space is limited, the bar can accomodate more than one waiter — at least 3, perhaps 4. 

I can only speculate why this highly profitable transaction does not take place. Presumably the new recruit will only be employed a few hours per week. While regulation makes this increasingly difficult (what’s the point of having a socialist government if it does not reduce economic freedom?), it is not impossible. It is possible that local unions block such hirings, out of an ideological stance against “precarious” forms of labor (they prefer people to be on the dole). It could be employment protection, which makes it difficult to get rid of the worker if something goes wrong. It could be a lack of managerial incentives, since the theater is indirectly State owned and has little incentives to maximize profits. Or it could be the general cultural aversion toward hirings which pervades French society. Since the early eighties, when a host of restrictive labor laws was implemented, rationally inattentive managers have adopted this simple strategy: only hire when strictly necessary.

My other example comes from a TV program, which described how French driving schools were being opened in Barcelona. The French driving license is aberrantly difficult and costly to obtain. I was supposed to know the formula for kinetic energy, the meaning of signs that were only relevant for trucks my potential license did not allow me to drive, and many other irrelevancies. Things do not seem to have improved since then. In particular, according to the TV program, the administration in charge of running the practical part of the exam is under-staffed, an ironical feature in a country where 25% of employees work for the government. As a result, people have to apply for that part months in advance, and, if they fail (which is frequent), they lose another six months. Many people, especially among the low skilled, cannot find a job because they do not have a driving license. Furthermore, while waiting for the exam, people continue to take regular driving lessons. At the end of the day, their driving license has cost them a fortune. The extent to which the driving school is coercing them into taking all those lessons is unclear to me. Why don’t people apply six months in advance and start taking driving lessons, say, two months before the exam? The sector is somewhat open to competition but once one has elected a school, it processes your application to the exam, so it has some power over its clients.

In any case, according to the TV program, in Barcelona one can take the exam 12 days after applying. Furthermore, wages, labor taxes, and gasoline taxes (an important cost item for such a business) are substantially lower there. And by virtue of the European Single Market, Spanish driving licenses are, I suppose, recognized in France. So people find it worth to purchase a low cost plane ticket (thanks to air transport deregulation), rent a room for a month there, and take the exam. Hence, some clever French people opened a driving school, thus giving lessons in French to their French clients. And the Single Market, again, guarantees that the Spanish or Catalan authorities cannot prevent them from running their business. 

Why are French trains on strike this time?

The main Marxist unions are going on strike as a protest against the merger between “Réseau Ferré Français”, the rail operator, and “SNCF”, the train operator. I was not aware of this merger plan, for the simple reason I did not think it would even be possible. The rail operator had been split from the train operator, following guidelines from the European Union, to introduce competition in train services. While the infrastructure per se is considered a natural monopoly, the business of operating trains is not, and therefore the European Commission has tried to introduce competition there, as was done long ago in the U.K.
Indeed, private operators have been allowed in the freight business (the SNCF market share in that sector is around 85 %), but no government has dared to confront the unions by introducing competition in the passenger business. As a result, SNCF has been able to reap substantial rents. According to a report, the price of a train ticket has been rising twice faster than inflation between 2002 and 2009. The celebrated TGV often costs almost as much as an Air France ticket on the same route. In a country obsessed with sustainable development, travelling by car is generally more economical than using the train.[1]
The monopoly power of SNCF (and therefore its unions) is supported not only by restrictions on intramodal competition, but also on intermodal competition. It is illegal to operate a bus route between two places that are served by SNCF. A famous trick to go from Paris to Strasbourg by bus consists in purchasing a Paris/Warsaw bus ticket and ask the driver to drop you while passing through Strasbourg. And of course the Paris/Warsaw bus ticket is cheaper than the Paris/Strasbourg train ticket.
While the French governments’ going along with the Brussels deregulation plans has always been mostly cosmetic, I would not have thought that it could openly go backwards and engineer a merger between the network operator and the national train company. Any future operator who believes it could compete fairly with a publicly funded rival which has captured the network operator has to be a fool (similar considerations explain why Air France has a 96 % market share on domestic flights).
The European Commission does not plan to remain idle in response to this insult, but how many divisions does it have?
Why do those unions oppose the merger? It should make it easier for them to preserve their rents in the long term. It is in particular making sure that any private operator will be bound by the same collective agreements regarding wages and working conditions as SNCF. But the unions fear that the merger could make SNCF more efficient, which would of course destroy some jobs and even allow management to keep labor costs down. So the unions are not against the merger per se but they would have liked further provisions to make sure productivity cannot go up. For example they asked for a plan to “re-humanize” train stations, i.e. replacing ticket vending machines by people, although they are probably content with keeping the machines while having those people sitting idle at some information booth instead of selling tickets.
In any case, it is hard to believe that these fears are sincere. Mergers lead to efficiency gains only in a reasonably competitive environment. As long as the system is rigged to maintain a very high market share for SNCF, the conglomerate will prefer to buy social peace, knowing the taxpayer will eventually foot the bill. In particular, the reform has a provision to involve the regional governments in the management of SNCF. These regional governments generally insist to maintain lines that have very few customers but that they deem essential for “territorial development”. This provision is making it less likely that SNCF will shut those politically sensitive, but inefficient train lines.
It is more likely that the strike is part of the general offensive against the Valls government, which is highly suspected by left-wingers of being a “social-liberal” modernist one, economically aligned with Brussels. Indeed the same unions are also organizing taxi drivers and temporary workers in the cultural industry (who have a specific unemployment benefit regime). Their nightmare is to have to deal with a French variant of Felipe Gonzalez, a deregulating, privatizing and tax-cutting socialist. And where would such a hybrid individual be born, if not slightly south of the Pyrénées?

Note:
[1] There are, however, other explanations for the drift in ticket prices. One is that ticket prices were initially too low, for political reasons; they ended up being high because at the end of the day rail transport is not a very efficient technology. The other is that ticket prices simply reflect the upward trend in the fees charged by RFF to SNCF for using its network. This may sound incredible: how can a publicly owned operator charge a markup to its public client, despite that its mandate should be to keep prices close to marginal costs and that double marginalization is highly inefficient? The answer, I believe, lies with the under-researched issue of government schizophrenia. The bureaucrats in charge of RFF do not internalize the wider social welfare or even the wider government budget constraint; some government representative on the board considers it as his job to raise the profits of RFF, independently of the net effect of RFF’s pricing policy on the economy and the general government budget.

Springtime for madcownomics

Should Creutzfeldt and Jakob get the Nobel prize in economics? Probably, except that they are dead, and did not really foresee how the mad cow disease would hit the economic sphere.
Under the impulse of Eurostat, European Countries are now supposed to include parallel activities — in particular drugs and prostitution — in their GDP computations. The pro argument is that these are mutually profitable transactions, and, as they are legal in some countries, it will facilitate cross-country comparisons. A similar adjustment takes place for owner-occupied housing, which contributes to GDP in the form of imputed rents. This allows to eliminate the bias that countries where renting dominates have an artificially greater GDP than those where owning dominates.

Where the mad cow disease strikes is here: How can the same government decide that an activity is illegal, ergo harmful, and at the same time include it in GDP, i.e. decree that it raises welfare? And, furthermore, if it is illegal, how are we supposed to measure it? And why should national accounts be harmonized between a country which thinks that drugs are bad and a country which thinks that drugs are good? [1]

Another pro argument, beyond ludicrous, is that those computations will mechanically reduce the debt/gdp and deficit/gdp ratios, making European countries look better in terms of “Maastricht”. Except that the reason why we divide debt or deficits by gdp is that we want to express them in relation to some measure of the tax base that will serve to pay back the debt. Including an illegal, and therefore untaxed activity is therefore absurd.

There is no limit to what can be included in GDP. When you watch TV, your TV is performing a service. The TV channels’ advertising revenues widely underestimate the value of this service (in fact they value a totally different service, the grabbing of your attention, which generally comes as a deduction of yoour own utility of watching TV). We could well impute the value of watching TV in GDP. There is no logical difference between doing this and imputing owner-occupied housing. In both cases we put a price on a service that people provide for themselves with the capital they own, so as to make it comparable to the same service sold on the market.

It turns out that each French person above 4 on average spends a daily 3 hours and 50 minutes in front of TV. Let’s make it 4 hours. We can value that on the basis of the price of movie theaters, which is something like 8 to 10 euros for a 2 hour sequence. As many people watch TV because they are not willing to pay that amount for what they see, we have a little bit of a truncation bias here, so let us divide this amount by 2. This eventually values the hour of TV watching at 2 euros per hour. Let us make these 4 hours 2 hours, because some people actually watch pay-tv, which is recorded in GDP. Putting these things together, the value of watching TV is evaluated at 2*2*365 = 1500 euros per year. There are some 60 million French people above 4. We should therefore raise French GDP by 90 billion euros, i.e. 4.5 points of GDP.

[1] In France and other places, the buying of sex is illegal, but the selling of sex is not. Similar absurdities prevail for drugs. For Marxists, feminists, and their ilk, there are no such things as good actions and bad actions; only good people and bad people. A voluntary transaction between a good person and a bad person is therefore good and bad at the same time. From there the Marxist/Feminist has two escape routes. He can claim, in an Orwellian fashion, that good = bad. Or, he can decide that good people are not endowed with free will, implying that the transaction is not voluntary. In the latter case, the life of the good people (women, the poor, etc) has to be regulated by the government. But, if good people have no free will, regulation can only be enforced by bad people…

Famous hoaxes in economic theory: 1. The market for lemons is inefficient

The celebrated Akerlof paper on the market for lemons – i.e., used cars – analyzes a so-called market inefficiency due to the unobservability of product quality to the buyer. The argument runs as follows: Suppose people know the quality of their car and have the option of continuing to use it rather than sell it. Then the higher the market price, the higher the average quality of the cars sold on the market. Conversely, suppose the welfare of the buyers is increasing in quality and decreasing in price; then they are willing to pay a higher price for cars if the average quality of the cars sold in the market is greater. Thus the demand curve may be increasing in price over some range, and there may be multiple equilibria, or even no equilibrium at all. In particular, we may construct examples where a low-price, low-quality equilibrium is dominated by any other equilibrium with a higher price and a higher quality. For example, assume buyers are willing to purchase any number of cars if they know that their quality on average is greater than their price. The demand curve is such that quality equals price. At a high price, high quality equilibrium, more sellers sell their cars at a higher price. Sellers are strictly better-off than in the low price, low quality equilibrium. Buyers are indifferent, since in both cases they derive a zero surplus from transactions, as price equals quality. Consequently, the higher price equilibrium dominates the low price equilibrium.
Now, what is wrong with this argument?[1] Suppose the economy is in a low price, low quality equilibrium and that there exists a superior equilibrium that it could reach. Suppose people are rational, meaning they know the structure of the economy and in particular the probability distribution of car quality. Then a buyer (or an intermediary) can offer a price slightly lower than the superior equilibrium; almost all the sellers that sell their cars in that equilibrium, including of course those who are currently selling it in the inferior equilibrium, are going to propose their cars to this intermediary. The average quality will be the same as in the good equilibrium, and the buyer will obtain a positive surplus[2]. Clearly, this destroys the initial equilibrium.
The inferior equilibria are based on the assumption that market participants take prices as given and, consequently, the buyers cannot affect the quality of the cars they purchase. It is however not rational for market participants to hold such belief. I know that if I deviate by posting a higher price I will on average get offered higher quality cars. This error comes from a misunderstanding of the real meaning of price taking in Walrasian equilibrium. While this is spelled out mathematically as an assumption in the definition of an equilibrium, in logical terms price taking is not an assumption, it is a result. The actual economic assumption is perfect competition. Perfect competition means that a given firm, if it charges a higher price than the market one, will not sell any good. If it decides to charge a lower price, it will get the whole market. Therefore, if the firm underbids the market price, it is rational for it to pick a price arbitrarily close to it. [To prove this we need to first show that the market price is unique and below the monopoly price, which is true]. Therefore, everything takes place as if market participants took prices as given.
But the conclusion that perfect competition implies price taking no longer holds in markets where the characteristics of the good depend on the price, as is the case with the market for lemons. Instead of a single price, there is an equilibrium price schedule relating prices to the characteristics of the good, and perfect competition means that market participants cannot move this schedule. However they are perfectly free to move along it, which is what one does when offering a price higher than the low equilibrium one in the above example. There are a number of examples where inefficient outcomes do not survive if we view competition that way. Consider for example competition between swimming pools: a cheaper swimming pool will attract more clients and be more congested. Here again, the quality of the good depends on its price. Yet if market participants arbitrage correctly, they will internalize the correct trade-off between price and congestion, and this trade-off will be reflected in an equilibrium price schedule which will allocate people to swimming pools efficiently. The congestion problem is not an externality, as it is internalized by the owners of the pool. The congestion cost of more crowded swimming pools is exactly reflected in their lower price. Indeed nobody ever wrote a paper to show that the market for swimming pools is inefficient. Yet the market for lemons is essentially similar; what drives the action is the relationship between price and product characteristics, not imperfect information, which in this case is just a side show. What imperfect information implies is that the relevant welfare benchmark is a second best constrained optimum where the unobservability of car quality is taken into account.
This fallacy illustrates that mathematical assumptions are different from economic assumptions. There is more economics in a mathematically formulated model than what is just written in the mathematics. It is convenient to define walrasian equilibrium as a system where market participants take prices as given, but some economic reasoning has taken place before one decides to actually make this formal assumption.
One may argue that it is more difficult for the economy to reach the good equilibrium than to attain an efficient Walrasian equilibrium in an economy with observable goods characteristics. This is true. In the latter case, any situation which is not an equilibrium will entail an imbalance between supply and demand. Suppose the price is too high. What do sellers need to know in order to have an incentive to reduce their price? They need to know that they can get an arbitrarily large number of additional customers by charging a price arbitrarily smaller than the market one. That is, they need to know that competition is perfect. Any seller who is rationed and knows that will reduce his price. In the market for lemons case, in order to offer a price different from the “low equilibrium” one, the buyer needs to know the entire distribution of car quality, including those that are not currently for sale. Knowledge of the relationship between price and quality locally around the “low equilibrium” is not enough. If that situation is locally “stable”, meaning that a small increase in price will raise quality by less than the price, no buyer has an incentive to offer a price slightly higher than the equilibrium one. While in a Walrasian economy a disequilibrium with rationing is broken by a slight deviation, here the deviation must be large.
Indeed people need more information to reach the good equilibrium in the market for lemons than in a Walrasian market. But if the economy is stuck at a bad equilibrium because they do not have enough knowledge, we are in a case of cognitive failure, not market failure.[3] Note however that it is probably not difficult for the economy to learn the good equilibrium; all we need is a sufficient inflow of mutants who offer random prices and replicate if their strategies are successful. Clearly a mutant which offers a price in the vicinity of the good equilibrium price will do better than buyers in the bad equilibrium. Thus we can conjecture that the only evolutionary stable outcome is the good equilibrium.

Notes:

[1] What follows is by no means a discovery. The formal treatment of the lemons problem in the textbook by Green, Whinston and Mas-Colell parallels the arguments made here. Yet the view that the market for lemons is inefficient pervades popular wisdom, partly because of the uncritical exposition in many undergraduate textbooks.
[2] In fact the average quality will also be slightly lower, but strictly greater than the price. This requires the good equilibrium to be “stable”, in the sense defined later in the text. It is possible to show that the highest price equilibrium is always stable.
[3] This critique does not apply to all markets with imperfect information. In a Rothschild-Stiglitz insurance market, the incentive compatible contract is subject to some pecuniary externality which may deliver an inefficient separating equilibrium. See Bisin and Gottardi, Journal of Political Economy, 2006.