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 is 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 it 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.