Two revised papers

I have thoroughly revised two papers, and I believe they have substantially improved. So I uploaded them to my file repository to make them accessible.

The first one is “The scope for ideological bias in structural macroeconomic models”. It can be downloaded here. This is the abstract:

ABSTRACT:  This paper studies the trade-offs that an expert with ideological biases faces in designing his model. I assume the perceived model must be autocoherent, in that its use by all agents delivers a self-confirming equilibrium. The exercise is carried in the context of a simplified AS-AD model, where in principle the expert can influence policy by manipulation a number key parameters, including in particular the Keynesian multiplier, the Phillips curve parameters, and the variances of supply and demand shocks. The analysis suggests that ideological bias may arise in the construction of macroeconomic models, in a way that resembles well-known historical controversies. Typically, for example, a larger reported Keynesian multiplier is favored by more left-wing economists, as is a flatter inflation output trade-off.
Another important aspect of the analysis is that autocoherence conditions imply constraints and trade-offs between parameters. For example a larger reported Keynesian multiplier must be associated with a lower interest elasticity of aggregate demand for the economists’s model to match the data. Also, some parameters or some combinations of parameters must be truthfully revealed for the expert to remain autocoherent. These are the parameters that are “identified” from the empirical moments of the distribution of observables. This illustrates the tight link between parameter identification and the scope for bias that is generated by the autocoherence conditions.

The second revised paper is “A quantized approach to rational inattention”. It is downloadable here.

Here is an excerpt from the Introduction:

In this paper, I study optimal behavior under rational inattention when one imposes the constraint that agents must follow deterministic rules. The idea is that the choice variable may be a deterministic function of an exogenous shock with continuous support and still make use of a finite amount of information if the choice variable is discrete rather than continuous; that is, the mapping from the realization of the exogenous variables to the endogenous ones is piece-wise constant, reflecting the fact that the agent can only elect a finite number of values for the choice variable, because of the informational constraint.
Thus, limited information is now a source of lumpiness in behavior, rather than a source of noise. The state space faced by the agent is partitioned into clusters and all points in the same cluster yield the same action. Of course, limited information is not the only source of lumpy behavior; it is well known that there are other sources, such as fixed or linear adjustment costs. But the approach proposed here yields many potentially testable predictions: In general, we expect that the greater the information processing ability of an economic entity, the less lumpy its behavior.
Section 2 provides some preliminary results. Under a deterministic assignment, the mutual information between the exogenous and endogenous variables is simply equal to the entropy of the endogenous variable. This property, which is evident in the discrete case, is extended to the case of a continuous exogenous variable and a discrete endogenous variable. It is then shown that, for preferences satisfying a generalized single-crossing condition, optimal clusters are typically convex. In the one dimensional case, they will be intervals. Consequently, agents will pursue behaviorial rules that has been studied in the information theory literature under the name of entropy-coded quantization (ECG). That is, they partition the set of realizations of the exogenous variable into intervals, assign a constant value of the endogenous variable to each interval, and determine the optimal partitioning and assignment by maximizing their utility subject to a constraint on the entropy of the endogenous variable. Next, some discussion is provided about the allocation of attention across clusters, based on optimality conditions that were derived in Farvardin and Modestino (1984).
Finally, some results are provided regarding the quadratic case, that will be used in the application to price-setting. First, I show that the size of clusters goes to zero when information capacity becomes infinite, which is not obvious if the support of the exogenous variable is unbounded. Second, I discuss and numerically tabulate optimal clustering in the standardized normal case, from which optimal clustering for any normal distribution can be straightforwardly derived. A interesting aspect is that it is optimal to devote considerable attention to the tails of the distribution.
Section 3 applies this to a static New Keynesian model of optimal price setting when there are aggregate money shocks as well as idiosyncratic productivity shocks. The effect of aggregate money shocks on output and prices is studied. The main result of the paper, Theorem 3, shows that as the variance of idiosyncratic shocks become large, the aggregate log price level converges to a linear function of the aggregate money shock, with a coefficient which is strictly between 0 and 1. Consequently, unanticipated aggregate money shocks have real effects on output, in contrast to the sticky price model of Caplin and Spulber (1986). But these effects are smaller than in standard rational inattention models or in the Lucas (1972) misperception model.

Limited government, consent, and supermajority

When you try to promote the notion of limited government in front of an audience, academic or otherwise, you are invariably confronted with two objections:

1. How dare you propose that the government should not intervene to redistribute money in favor of the poor and provide them with health and education?

2. We obviously need the government to intervene in order to correct market failures, the most important one being environmental externalities, and in particular global warming.

At this stage, you are in trouble. The first objection (often phrased in a borderline ad hominem formulation) makes you look like an unpleasant person. The second one makes you look like an idiot.

Of course none of these objections change anything to the fact that the government implements involuntary transfers under the threat of force.  From a libertarian perspective, there is no difference between environmental taxation and Greenpeace committing armed robbery in order to finance the cleaning of a river. Or between public welfare and a poor man getting 100 $ from you at gun point. Indeed, utilitarians should condone such muggings, as long as the marginal utility of wealth is larger for the criminal than for the victims.

Utilitarians know these difficulties and the reason why they lend so much legitimacy to government is because they dress its interventions under a pretense of consent. A naive concept of consent is the will of the majority, by which it is legitimate for two wolves and a lamb to vote over what to have for dinner. This parable illustrates that majority voting is not a source of legitimacy but (at best) a lesser evil, and that it makes sense only in places where a constitution imposes substantial restraints on the scope of government intervention. A less naive notion of consent is that of the “veil of ignorance”, by which we all pretend not to know who we are when making decisions. In the extreme, everybody would have the same preferences, which would conveniently turn out to be identical to some utilitarian social welfare function, with the weight on a person’s utility being equal to the probability that one is incarnated into that person’s type. If only people voted under such a veil, the allocation of resources would always maximize that social welfare function. All externalities would be addressed, and optimal redistribution would take place. In fact, such redistribution would rather be interpreted as insurance against being born poor. And all these policies would be consented to unanimously by the polity. Except that, in reality, there is no unanimity; instead there are salient conflicts of interest, which is prima facie evidence against people voting under a veil of ignorance. Therefore the question of consent seems untractable for utilitarianism. The only entity which voluntary submits to the policy prescribed by utilitarianism is an abstract being who pre-exists history and thus can vote under the veil of ignorance, or, worse, Rousseau’s “general will”.

Libertarians have exactly the opposite problem. By insisting that any transfer of resources must take place under the consent of both parties, they run into the issue that obvious gains from trade involving the coordination of a large number of agents (such as solving environmental issues) may  not take place. Even enforcing private contracts requires resources, and people would free ride by trying to undercontribute to the enforcement infrastructure.  It looks like operating society under consent, unless you believe that all the functions of government, including contract enforcement, can be delegated to the private sector, is a practical impossibility.

In principle, though, that is not the case. There may be a coordination problem in creating the infrastructure which is necessary for the conduct of the collective decision-making process. But once such an infrastructure exists (and historically it has been provided by the coagulation of violent armed gangs into actual governments), there is no reason why public policy should violate the natural rights of private individuals.  The reason is that if a policy (such as clean air) indeed improves social welfare, it can be implemented in such a way that all individuals are better-off. In other words it should command unanimous support, and therefore will not be implemented against the consent of any citizen. Indeed, imposing such discipline would compel authorities to systematically come up with a satisfactory scheme of transfers in order to compensate the losers from their policies. And if they cannot come up with such a scheme, it means the proposed policy cannot increase social welfare.

Of course, this remains theoretical. There are plenty of informational problems involved in eliciting the costs and benefits of policies; and some voters will lack the cognitive ability to make the correct choice. Nevertheless this suggests that, if we take consent seriously, there is considerable legitimacy in imposing that public interventions should be supported by a supermajority rather than simple majority. For example, a constitution should prescribe that any policy which involves imposing coercion on individuals needs approval of, say, 75% of the electorate.

Such a supermajority rule would compel policy makers, when proposing laws that solve an externality, to actually implement a side-transfer scheme that would compensate the losers.

For such a rule to respect natural rights, it is of course necessary that the default option – the option that is implemented absent a 75% majority in favor of a proposal — obeys liberal principles and has minimal government coercion. If the initial status quo is such that the corporation of shoemakers is highly subsidized, and if shoemakers amount to 26 % of the population, a supermajority of 75 % will be insufficient to remove the subsidy. A liberal constitution should make sure that the default option remains the one with minimal government intervention. In other words the default option should be different from the status quo. If the status quo were the default option, under the influence of shocks such as technical progress, one may end up with a situation where neither consent nor natural rights are respected. Suppose, for example, that a car toll for entering London is in place, so as to reduce pollution. Suppose that clean, non polluting cars based on nuclear energy are invented. The car toll should be removed. But if it is designed in such a way that 26 % of the relevant constituency benefits, it won’t go away. Or it could go away in exchange for large transfers in favor of those beneficiaries, which is unfair (it is fair to compensate you for a violation of your property rights; it is not fair to compensate you for losing a rent based on violation of other people’s property rights). In other words, public interventions should not be designed as entitlements, but as renewable schemes that must pass the 75% majority test each time they have to be renewed.

Where does that leave the need for “social justice”? For one thing, simple majority rule itself has no reason to deliver “social justice”. Indeed the most important items of the welfare state (health, education, and pensions) cater to the median voter. It is unclear to me why, in a modern affluent society, these people could not pay for their own health, education, and pensions (which they do, to a large extent, through the taxes they pay, except that it funds other people’s health, education, and pensions). As for the welfare state items that benefit the poorest members of society, since they benefit only a minority of people, they must either be the outcome of altruism or of the objective of avoiding “social unrest”. As for altruism, it has no reason to be mediated by the government: people can and do contribute to charities. Furthermore, what is considered as poverty in advanced economies is not poverty but inconvenience. For example, in the US, 95 % of households own a car, and of the 5 % that remain, many are affluent urban families for whom owning a car is just impractical. The fraction of households that are truly needy must be small enough for voluntary transfers to take care of them. As for the concern for “social unrest”, it is an externality and therefore there must exist a redistributive scheme for tackling it that should pass the test of supermajority.

 

This vicious world

I was recently contacted by a French media outlet who wanted me to comment on the “vices” of capitalism. They were a bit nervous about what I might say, so they ran a pre-interview to check whether my views were palatable to them. In fact they called twice to run such a pre-interview. I made clear to them that my position was in many respects critical of the general contempt in which most commentators and intellectuals in France hold capitalism. This does not seem to have pleased them, because they never got back to me to do the actual interview.

The incident is emblematic of a number of interesting phenomena.

First, you do not say something good about capitalism in the French media. Indeed, in an earlier episode with a French newspaper, I tried to pour some cold water on the hysteria against excess executive compensation and excess bonuses for traders. There was no way I could get the piece published.

Capitalism is deemed immoral even by the capitalists themselves. Unlike socialism, a label claimed by many political parties and states throughout the world and throughout history — including the Nazis and the Soviets — no entity on earth says it is capitalist. There is no capitalist party, nor is there any capitalist republic. No ruler ever decreed that his country will operate under a capitalist system. Conversely, I do not expect any French media outlet to run a piece on the “vices” of socialism. Socialism may fail, but it is generally considered as virtuous, unlike capitalism which works but is immoral. The general opinion is that the Soviets were good guys who failed, while the Nazis called themselves socialists just for fun, they were not really serious about it.

Of course, a key problem is that if there is no place on earth which claims to have a capitalist system, it is difficult to find out what capitalism really is and why it is so evil. Take France, for example. Many people call it a capitalist country, but that is a confusion due to the fact that it was in the Western block during the cold war. France may be a market economy, but is certainly not a capitalist economy. For one thing, 57 % of GDP is confiscated by the State. Also, private ownership of means of production is largely an empty notion. Firms are mostly in the business of implementing the myriads of regulations that specify their modus operandi–and they have to write a number of reports for the administration, to prove their compliance with the administration’s policy agenda. They are best viewed as semi-autonomous branches of the State. From an ideological point of view, no French businessman would publicly state that his business is about maximizing profits. Nor would he ever call himself a capitalist. Instead he says that he in in some sort of public service, and fully endorses the government’s ideological goals concerning sustainable development, the promotion of women in the workplace, the socially responsible enterprise, and so on. By doing so the businessman is slowly renouncing his rights to operate his business and is converting himself into a bureaucrat. But this is fine because, after all, the life of a bureaucrat is less stressful than that of a businessman, and we all hate capitalism.

I suppose some would say that capitalism is like pornography. They cannot define it, but they recognize when they see it. For example, how about a firm laying off workers despite that it is not making losses? Isn’t that immoral? They do not have to do it, so it must be out of selfishness and greed. Isn’t this ugly, capitalist, and indefensible?

In fact, this is not more indefensible than a consumer switching from an expensive brand to a cheap one, or from a bad bakery to a good bakery. Presumably the bad bakery needs your money more than the good one. And eating bad  bread is not the end of the world. Why don’t you buy your bread at the bad bakery instead of the good one, so as to preserve the bad baker’s job? That is, just like pornography is other people’s eroticism, capitalism is other people’s self-interest.

More importantly, not only selfishness and greed are presumably the reason why those workers were hired in the first place, they are not going to disappear by magic under a socialist system. These are not properties of a system, but human traits. Under a capitalist system, one can give in to these instincts while making other people better-off through voluntary exchange. This is actually fascinating: imagine the number of people, working at Apple, Vuitton, Toshiba or BMW, who are paid to figure out what your neeeds and desires are? Instead, under socialism, where resources are allocated by the government, one plays a zero-sum game trying to extract resources from others through political mobilization, lobbying or corruption. Which situation is more immoral?

The second lesson from the episode is about how the media make use of “experts” so as to promote their own view. It is virtually impossible to read an article that does not interview      some sociologist or economist. One could naively believe that the journalists have an utmost respect for those experts and are genuinely interested in finding out the scientific truth about contemporary issues…Of course this is not the way it works; the experts are just there to validate the editorial line. The journalists cherry-pick them and then cherry-pick the statements that they need from the interview. I remember having spent 45 mn on the phone with a journalist from “Le Monde” who was desperately trying to make me say that Sarkozy’s immigration policy was wrong. This was so obvious that I, somewhat sadically, carefully avoided any clear derogatory comment about that policy. Not hearing what she wanted to hear, she did not bother to use the interview or mention my name in her article.

 

Successes and failures in crisis countries

Below is a short statement made in front of the European Parliament in a hearing about “Successes and failures in adjustment program countries”. I was specifically asked to make a few references to Greece, Portugal and Italy.

——————————————————————————————————————

STATEMENT

The objectives of adjustment countries are two-fold :

  • In the short run, they need to reduce the financing needs of public administrations in order to restore fiscal sustainability
  • In the long run, they need to raise the level of potential output through structural reforms.

 

The financial crisis has induced policy measures that address both issues. Yet, at present, these economies show little sign of improvement. Unemployment has reached critical levels in Portugal, Greece and Spain. Growth remains anemic and the outlook for public debt is unfavorable despite the painful efforts that have been consented.

The structural adjustment strategy operates under considerable political constraints:

  • In the short run, to offset the contractionary  effects of fiscal adjustment, aggregate demand should be reallocated toward exports, which implies a depreciation of the real exchange rate. Because of the Euro, this is not doable through a currency depreciation. The only alternative is more downward flexibility of nominal wages, which in some countries (Portugal) simply does not seem to be happening, while in others  (Greece) is a protracted painful process replete with political risks.
  • In the long run, to increase incentives to work one needs to reconsider the generosity of the welfare state.  But this runs counter to the political platforms that most political parties had been selling to the electorate for decades. To increase competition one needs to remove barriers to entry in goods markets; but such barriers benefits some well organized interest groups that are likely to oppose deregulation.

These constraints reduce the margin of manoeuver of policy makers and make it all the more important to come up with the best possible structural adjustment package. To date, I believe the measures that have been implemented fall short of that objective, in particular because the consistency between the two objectives mentioned above has been ignored. For structural adjustment to be successful,

  • We need to avoid policy measures that consolidate the accounts in the short-run but have adverse effects on competitiveness and productivity in the long run, and
  • We need to avoid reforms that boost competitiveness and productivity in the long-run but have an immediate negative impact on economic activity and/or fiscal revenues.

 

The pitfall of ignoring those caveats is that the reform package may be unsuccessful overall, as different items in the package will have offsetting effects on both the short-term and the long-term performance of the economy.

Let me now discuss some aspects of structural reforms in program countries under the light of those principles. I will pick some items in the comprehensive reform packages of Portugal, Greece and Italy and discuss the extent to which there is some coherence between their long-run and their short-run effects.

  • Regarding the short-run fiscal adjustment, priority should be given to expenditure-reduction measures as opposed to revenue-augmenting ones. The latter must be associated with a greater tax burden which as such has negative long-run distortionary effects on the economy.  There is a unanimous consensus over the benefits  of greater tax compliance, which is part of the reform package in all program countries. Indeed, in principle, a greater efficiency in tax collection should allow to collect the same amount with lower tax rates, thus reducing distortions. Yet it may also pave the way for future tax increases by opportunistic governments – by simply making such increases less costly, and expectations of such developments may be harmful for investment and growth.
  • In Portugal, severance payments for workers with permanent contracts have been considerably reduced, bringing them in line with the European average. While this reform was long overdue, and will certainly raise productivity and reduce unemployment duration in the long run, I believe it should have been postponed. Its immediate impact is to trigger a wave of job destructions in the middle of the recession, which jeopardizes the country’s short-term macroeconomic objectives. Furthermore, it will have little impact on job creation because most new hires are under temporary contracts whose terms are not affected by that reform.
  • Symmetrically, the attempt to tax temporary contracts in Italy (and France) may be viewed as a useful step toward a unified labor contract that would do away with the inefficiencies of the dual labor market system. But in the short-run it may critically reduce job creation and postpone recovery.
  • On the other hand, the reform of collective bargaining in Portugal, which among other things limits the automatic extension of wage agreements to an entire sector, especially whenever those agreements are signed by unions representing a minority of workers, yields positive benefits both from a long-run and a short-run perspective (A somewhat similar reform in Italy tries to allow firms to bypass collective bargaining by resorting to individual bargaining). In the long-run, it will reduce the equilibrium rate of unemployment, in particular since intersectorial labor reallocation will proceed through wage differentials instead of unemployment spells . In the short-run, it makes it easier to obtain the necessary level of wage moderation in order to restore external balance and bring down unemployment back to acceptable levels. I should hasten to add that, in the case of Portugal,  unfortunately this is likely to be insufficient, as the required adjustment in wages is probably around a 10-20 % reduction in nominal wages, which could only be obtained through a devaluation that the Euro precludes.
  • Presumably in order to alleviate the immediate consequences of the crisis, in particular the very high unemployment rate, Greece is extending its social safety net.  This includes relief jobs, vocational training, basic guaranteed income as well as an extension of health benefit coverage.  These programs are being financed by European structural funds and by the World Bank.  While these measures are understandable given the political context, they are unwise; relief jobs are inefficient and  schemes like basic minimum income are very difficult to undo and will create poverty traps. Greece probably cannot afford a level of social protection on par with Scandinavian countries. I believe this illustrates how a poor macroeconomic situation may create political support for policies that have long-run adverse consequences for the economy.
  • Deregulation of protected professions – that is part of the reform package in Greece and Italy – should have positive effects both in the long run and in the short run. In the long run, the allocation of labor is more efficient and the cost of services to consumers falls. In the short run, the unemployed may enter those professions which alleviates the unemployment problem.

The severe fiscal crisis has brought forward a “day of reckoning” which has led countries to implement a catch-all adjustment program including many structural reforms that had long been discussed under different macroeconomic contexts. I think the above examples illustrate that one should have been more discriminating in selecting those reforms given the specificities of the Euro sovereign debt crisis.

 

 

The political economy of the Breton upheaval. II: A symptom of collective mad cow disease.

que_la_fete_commence18_w_450

I will continue my discussion of the Breton upheaval by discussing its economic, or rather mad-cow-nomic, roots.

Over the last two decades French public opinion has become increasingly vocal against globalization. All political parties have to some extent a protectionist stance, if only a nominal one. The “extreme” parties are outright protectionists. The ruling parties’ platforms include a cosmetic industrial policy agenda to make-up for the fact that they will abide by international treaties and therefore are in no position to close frontiers.

The arguments of the opponents to globalization are simple. How can a French firm with high labor costs compete with a Romanian firm with low labor costs? The French firm will have to close and its employees will be out of jobs. If globalization puts people out of jobs, why does the European Union write reports saying it is good for the economy? And why is it imposed upon the French people, increasingly against their consent?

At the same time, there is much less support for protectionism in other countries with similar levels of developments, such as the U.S., the U.K., Sweden or Germany. These countries seem to adapt better to globalization, in fact they are more globalized than France; the Bolkestein directive has been implemented to a greater extent in the UK and then Germany than in France, and yet their population is more sympathetic to trade. Indeed, in Germany the unemployment rate has constantly fallen throughout “the worst crisis since the great depression” and is now at a minute 5 %. (According to a French magazine, this is “the example not to be followed”.)

We could believe that the French are brainwashed, and that may be true to some extent, but facts seem to confirm their views. Every day a prominent firm announces that it will close or downsize, and the Breton food and agricultural industry is one of the most exposed ones. Could it be that globalization is good for Germany and bad for France? And what differences between these economies could account for that?

To answer those questions, we need to understand why wages are low in Romania in the first place. And we need to understand why we may gain from trading with them despite that some firms can’t compete with their low wage producers.

Suppose we only trade with countries with a similar level of development. Then, clearly, no firm would have to shut down because its foreign competitors have lower costs. Consumers would gain not because they would import cheaper products, but only because they would consume a broader range of products. Yet even in such a situation, some firms would have to close, because they are less productive than their German competitors; and some German firms would have to close, because they are less productive than their French competitors. This should be no problem; because France and Germany have a comparable distribution of skills, trading between them does not impact the distribution of wages. So if lose my job because some German firms are more efficient than my employer, I can expect to find another job at a similar wage elsewhere. In fact, reallocating resources to the most productive competitors increases the productive capacity of both economies and makes everybody better-off.

Yet if you describe this scenario to a French, he will object that once he has lost his job, he won’t find another one. The scenario only works if the economy is sufficiently flexible to smoothly reallocate labor between firms. And that is not the case of the French economy.

Suppose now that instead of trading with Germany, we trade with Romania. These people earn much lower wages. Yet that must be for a reason. If they were as productive as the French in all sectors, they would have the same real wage and real living standards. Any differences in nominal wages would then just be a matter of exchange rate misalignment. The Romanians must therefore be less productive than the French. But if they were uniformly less productive than the French, they would not be able to undermine the competitiveness of French firms. A French firm which pays 100 to workers who produce 100, can sell its good at the same price as a Romanian firm which pays 50 to workers who produce 50.

The problem comes from the fact that the Romanians are not uniformly less productive. They may be far less productive at making airplanes, but equally productive at producing poultry. They only earn 50 because of their low productivity at making airplanes, but their poultry firms pay 50 to their workers who produce 100, while the similar French competitor has to pay 100 and needs to sell its production at twice the price. When forced to compete with the Romanian firm, the French firm has to close unless its own wages fall down to 50. If that happens, its workers will become much more attractive to hire for the aircraft industry and will relocate there. The aircraft industry will grow and indeed it would attract all the former workers of the poultry industry if workers were identical. Given that the aircraft industry does not suffer from competition from Romania, eventually no worker has suffered a wage loss and people are better-off because they can consume cheaper Romanian chicken that is financed by exporting aircrafts. But perhaps workers in the poultry industry are not so productive in the aircraft industry because they are  “unskilled”, and through trade they have to indirectly compete with Romanian unskilled workers who are relatively more abundant. Then the unskilled workers end up with lower wages, but their wage losses are smaller, the better their ability to relocate.

Then, you might ask, why would the unskilled accept trade with Romania if their wages fall? The answer is: they wouldn’t! But in theory we may design the shift to globalization in such a way that they are compensated for the wage losses. We could levy a tax on the consumers, who benefit from cheaper imports, and finance a transfer to the unskilled, who also benefit from cheaper imports but not enough for this to offset the effect of their wage losses, in such a way that everybody is better-off. This is because free trade generates global net gains at the aggregate level.

Of course, one does not have to do it. It is written nowhere that the losers from public policies have to be compensated. In fact most public policies are zero-sum (or even negative-sum) redistributive ones such that compensating the losers is impossible because the policy does not generate any gains. Its legitimacy comes from “consent” of at least a majority of voters. But, as we have seen, that kind of “consent” has been denied to the French in the case of the Eastern enlargement of the European union.

But the central issue is that the French economy does not work as described. In fact it has been designed in such a way that participation in a free-trade zone with low wage countries has catastrophic consequences.

On the one hand, market rigidities make the adjustment to foreign competition more painful, and magnify the losses for the social groups exposed to it. Workers who can no longer compete with their Romanian counterparts have to lose their jobs, because minimum wages and collective agreements make it impossible for them to have a wage cut. Regulation makes it harder for them to relocate to another industry or location. For example, they would have to buy a costly license should they want to become a taxi driver, or to spend years getting a degree should they want to open a hair salon. They would lose their order of priority in access to social housing should they want to accept a job elsewhere.

On the other hand, participating in a global market increase the economic distortions associated with taxes and regulations. For example, in a closed economy, an increase in social minima would make unskilled labor more expensive to hire, and firms that employ lots of unskilled workers could adjust by raising prices. This would generate some employment losses and welfare losses for consumers. But these losses would be smaller than in an open economy, where those firms could no longer raise prices, since their customers would then shift to foreign competitors. Instead they would have to close and their workers would become unemployed.

Many other handicaps compound those issues, such as the working time regulation, the gradual piling up of safety and environmental regulations, the ever crawling up payroll taxes, and the Euro.

With a rigid economy, losers lose more, and gainers gain less, from globalization. It is no longer obvious that there are aggregate gains from trade. To compensate the losers one needs a greater tax hike than in a flexible economy, and it may be impossible for everybody to gain.

The  inherent contradiction in French economic policy is to insist on implementing ideologies that hamper markets, while at the same time participating in globalization, which makes flexible markets more necessary. French politicians live under the delusion that they can survive that contradiction by making it up with subsidies. Last week only the government spent 5 billion Euros of taxpayer money to appease interest groups, including the angry Bretons. They hope that they can find some more malleable people willing to remain silent while they have to pay more taxes to finance the subsidies that the more vocal, connected, or violent groups managed to get for themselves.

Suggested reading: Saint-Paul, Gilles (2007) Making Sense of Bolkestein-Bashing: Trade Liberalization under Segmented Labor Markets.Journal of International Economics, 73 (1). pp. 152-174.

Suggested movie: Que la fête commence, by Bertrand Tavernier, with French actor jean-Pierre Marielle at his best in the role of Breton dissident Pontcallec.

The political economy of the Breton upheaval: I. No taxation without representation

 

pontcallec

The central government in Paris is facing an old-style peasant wave of unrest in the westernmost part of the country. Small entrepreneurs, workers, farmers and many other people have congregated to oppose, with some degree of violence, a new tax on commercial road transport (with the trendy P.C. label “écotaxe”) that is currently being implemented and had been decided by the preceding government in the name of “sustainable development”.

France is famous for its street protests of a more or less violent form, and this tradition is continuing because it works. Historically, governments have backed down on many policy measures because opponents managed to make life impossible for them.

On paper, there is nothing legitimate in trying to cancel the choices of a democratically elected government through violence. And Brittany has given a large majority to the current government in 2012, thus endorsing more expenditures, more redistribution, more regulation, and more taxes. Who did they expect would foot the bill?

If however we turn to the substance, the root cause of the upheaval is two-fold. First, if you administer people a hefty dose of mad-cow-nomics, they predictably become crazy. Second, people are increasingly taken hostages by a ruling elite which seems totally out of control.

The mad-cow-nomics of the Breton upheaval are the following. On the one hand, people are asked to be competitive in the European single market. On the other hand, the institutional context in France and most recent policy measures are just prohibiting them from becoming competitive. The écotaxe is just the turburlence which triggers the final blast of the pressure cooker.

On the one hand, the Breton agricultural producers are supposed to compete with large German plants that reportedly hire workers from Romania and Bulgaria at Romanian and Bulgarian wages, thanks to the Bolkestein directive.

On the other hand, they have to pay their own workers French minimum wages, topped up by high social security contributions, abide by a myriad of costly regulations, and are a privileged target for more regulations and taxes in the name of “sustainable development”. In particular, the Bolkestein directive is not implemented in France to the same extent as Germany, so they cannot replicate the German strategy of importing cheap labor from the East. The French road transport tax is more severe for medium-size trucks than the German one, adding to the problem. And Schröder-style reforms are unheard of around here, meaning that the minimum wage has kept crawling up — some 17 % of the employed are paid the minimum wage, an astronomical proportion by international standards.

Historically these handicaps were offset by subsidies. But as the subsidies are phased out, the Breton producers can no longer break even.

In the context of the upheaval, we notice repeated attacks on speeding radars, which may sound anecdotal. In fact people have been furious against those radars from the start; they epitomize the contempt of the ruling class for them. They are strategically located at places where the speed limit is abnormally low given the configuration of the road. They impose a mental torture on drivers, especially of course on those who have to drive constantly in their profession. Nobody believes they have anything to do with road safety. They are a consequence of a global ideology where politicians incarnate some moral principle — sustainable development, gender equality, public health, solidarity, European unification — and consequently people are accountable to politicians instead of the other way round. In turn this ideology serves as an excuse for the elites to increase their power and extract more resources from the population.

In 2007 people voted for Sarkozy because he sounded more receptive to the actual problems of the people. Immediately after he was elected he scattered the territory with those radars, while at the same time hiring politicians from the defeated socialist party in his government. At that point people understood that they had been grudged.

How can one explain to the Bretons that there is any good for them in enlarging the European Union to the East and in implementing the Bolkestein directive? This is made more difficult by the fact that there is no democratic legitimacy to such enlargement. Nobody in France was asked their opinion about whether Bulgaria, Slovenia or Latvia should be part of the Union: There was no referendum. To be sure, the parliament agreed. But the two main parties are unanimous over everything European. That is, the scope and scale of the European Union are simply taken out of the debate — in the former Eastern Germany there were 11 political parties; but things like freedom of speech, a market economy or reunification were, similarly, taken out of the debate.

At the same time as we have no say on the frontiers of the Union, we are told that we need more political unification, which of course makes it even more important that enlargement should be subject to referendum. It’s as if the U.S. congress suddenly decided that Mexico, Venezuela and Colombia would now become U.S. states. What would the American people say? In fact such a scenario is not even conceivable.

Once upon a time, transfers of political sovereignty to Brussels were subject to referendums. In 1992 the French said yes to the Maastricht treaty, after a campaign which skillfully lumped together membership of the Euro area with the very existence of the EU (then EEC). In 2005 the French said no and since then there has not been a referendum. We are allowed to have referendums only if we say yes.

The Bretons are angry because they (and other French people alike) have not given consent to any of the things that are imposed on them. They have not consented to the Eastern enlargement, they have not consented to the Bolkestein directive, they have not consented to the écotaxe, and they have not consented to the speeding radars (another bipartisan consensus).

From 1300 to 1660 the kings of France, when levying new taxes, needed the consent of a popular assembly called the Etats Généraux. While political representation was not equal across people, the members of this assembly were not professional politicians but genuine representatives of their constituency. It was not rare for the assembly to say no to a tax proposed by the king. The scope for manufactured consensus to make a mockery of popular representation was lower, precisely because the representative of shopkeepers was not a career politician but a shopkeeper, who would personally experience the pain of any new tax on shopkeepers. Circa 1660 the Capetian dynasty stopped resorting to the Etats Generaux and became a dicature called absolutism. It lasted another 130 years.

The evolution of the “French social model” and the Theme Park Hypothesis

It is generally considered that to maintain a respectable level of development, a country must have a sufficiently high level of human capital. In the era of globalization, this implies remaining attractive enough to skilled workers. In France, those social categories have traditionally borne the burden of financing the welfare state through various forms of taxation, with (up to recently) little noticeable effects on emigration. This is because the “French Social Model” was a social compact in which all stakeholders contributed, but also got something in exchange. While skilled workers paid more in social security contributions, their pensions and unemployment benefits were proportional to their contributions. Furthermore they could access some cheap publicly provided goods (especially higher education but also subsidized “culture”) so that overall, even though they were net contributors to the system, there remained some proportionality between what they gave and what they got in exchange.

This social contract is gradually being demolished under the pressure of recurrent fiscal crises and the refusal of successive governments to curtail the welfare state (in facts new redistributive programs are constantly piling up). Attempts to fight unemployment through a reduction in employers’ social security contributions have been matched by raises in the social security contributions of workers earning more than 1.5 times the minimum wage, which has depressed the post-tax wages of college graduates. Child tax allowances for upper-middle class families are being severely reduced, while taxes on capital income, once added together, are becoming nearly confiscatory. There is talk of establishing a ceiling on unemployment benefits, as some complain that high wage earners get “too generous” compensation. More progressivity in pensions is also sneaking in, as less educated workers can retire earlier and pension rights have been enhanced for workers with irregular work history.

Elite educational institutions are increasingly raising tuition fees, in a way generally indexed on  income, without of course any compensating reductions in marginal tax rates. Public spending on education is increasingly concentrated on the bottom of the distribution of income, often with an explicit target on ethnic neighborhoods or rural areas. One can see lavish high schools in those areas with small classes and I.M.Pei style architecture, while bourgeois pupils are packed in run-down central city schools with classes of 35-40 students. Congestion in access to hospitals and increased bureaucratic hassle  make it less interesting for the upper-middle class to use the public health system.

At the same time, the world is becoming more global. Big cities look increasingly alike, are populated by diverse communities (the French population in London is estimated at 200,000-400,000 persons), and tend to offer a standardized basket of goods and services (Starbucks, the gym, Body Shop…). Communication takes place in English. As cultural idiosyncrasies vanish, locational choices will increasingly be motivated by pure utilitarian considerations. Indeed having a grown-up child working in Hong Kong, Singapore or Shanghai is becoming a social marker for the knowledge elite. As the upper-middle class gets excluded from the French social model, it will simply pack and go away. This will negatively impact productivity and living standards, and, since skilled labor will become a scarce resource, the French economy will have to reinvent its specialization structure. With less human capital, how can one prevent living standards to fall down to the level of middle income countries?

A possible survival strategy is becoming a huge theme park — i.e. replacing the skilled labor force, as a factor of production and source of tax revenues, by the unique resource of landscape and monuments. It is unlikely that the Eiffel tower or Versailles could be outsourced to a low tax country. The tourists who come to see them are somewhat captive. Yet they can arbitrage between the Eiffel tower, the Sixtine chapel or the Taj Mahal, so the option does not preclude maintaining competitiveness. To successfully reorganize the country around this theme park activity, changes will have to be made. Issues will have to be solved such as street cleanliness, the proliferation of shantytowns (e.g. next to the “Stade de France”), vandalism, shopping hours, taxi availability, waiting too long in restaurants, english language proficiency of workers, the devastation of the landscape by urban sprawl and wind turbines, and so forth.

It may be argued that making a living as a cultural theme park is a sad fate for the country of Concorde and TGV. Yet it is perfectly congruent with contemporary French mentalities, that are characterized by a paranoid fear of any kind of change, whether economic or technological. As an example, we have recently witnessed an offensive against retail outlets that open on Sundays or after 9 pm, along with a confirmation of a law that prohibits the exploitation of shale gas. The theme park hypothesis is the perfect solution. It allows us to keep up with world economic growth despite the exodus of human capital, by simply raising the prices charged for hotels and sightseeing (as the rest of the world gets richer, people are willing to pay more to enjoy France). At the same time, once the necessary adjustments have been made, society can be freezed into a self-replicating, self-congratulatory environmental and cultural “heaven”, while hopefully enough resources could be generated to leave the “French social model” untouched.