A short note on optimal taxation of bads

I have been turning the idea of taxing bad stuff (where the costs of producing or consuming a good has adverse consequences that are not adequately compensated for). The normal economic idea is to assume that if a cost will be borne by third parties, there should be a tax to discourage that by an optimal amount commensurate with the costs it imposes. I think this basic idea is correct, but that there are cases where direct parties to a transaction (the producer or consumer) will bear a cost, but they do not respond appropriately.

Think of this: smoking imposes a future cost on the smoker. This means that a rational smoker should save more than a non-smoker because they can expect higher medical costs in the future. My instincts tell me this is not true or, even if it is, smokers probably don't set aside an actuarially appropriate amount.

I have another thought about taxing bads, which I think a lot of people fall into. Quite often, one will find that an individual will estimate the cost of producing or consuming a bad by multiplying the cost for outcomes that are associated with the bad by the number of incidences to come up with the total costs of the bad in question. While this would be acceptable if there was strict causation, such that if you don't do X, Y will not result, but if you do X, there is a probability that Y will result, this is not a general case. In my own estimation, there is usually a probability that Y will result, even without consuming or producing X. Thus, the appropriate cost is actually determined by the conditional probability of Y, given X, minus the conditional probability of Y, given not X. In a concrete example, there is a correlation which is most cause-effect between the abuse of alcohol and the incidence of family violence (just to make this a more pure externality), but even without alcohol abuse, there still exists a risk of family violence. Thus, the cost of alcoholism with regard to increased risk of family violence is determined by the costs associated with family violence times the probability of family violence, given alcoholism, minus the probability of family violence without alcoholism.

My final point is about delayed effects of the production or consumption of a bad. There is always a temptation to use the current costs being incurred and dividing by the production or consumption of the bad to determine a proper tax, but while in some cases this may work out well, it only works if the effects are immediate. If, however, all or part of the effects are delayed, then the proper method is to have a tax based upon the present discounted value of the costs imposed by producing or consuming the bad today. Let us say that we want to tax coal emissions because of negative health effects on people who live near a coal power plant. While some health effects may occur today, much of them would probably be things like the development of emphysema or lung cancer. Most of the costs would be delayed for many years, so the appropriate measurement of the costs is the present discounted value of the future costs of emphysema and cancer, etc.

I hope this may have been instructive. I have wanted to discuss these issues for quite a while, as I am generally a believer in pigouvian taxes and want to develop my own thoughts on the intricacies of such policies.

Guam's Growth Strategy, Part I: Why Guam is Not Ireland

I have recently reviewed a technical report of the Pacific Center for Economic Initiatives out of the University of Guam called "The Making of the Pacific Tiger: Lessons from the Celtic Tiger", which is available online. I know and like the author and co-authors of the paper and there are many elements of the paper which I think are on-point, but there are others with which I tend to disagree (although I am overall supportive of the basic strategy which is endorsed in the paper).

The paper is essentially a search for an appropriate growth strategy for Guam's economy, to deliver the type of robust, sustained growth that were achieved by the "tiger economies", like Singapore, Taiwan, Hong Kong, South Korea or Ireland. The authors conclude that Ireland presents the most appropriate model for Guam to follow. I fundamentally disagree with the comparison with Ireland which, although there are some points of similarity, there are some glaring differences, including geography, structure of the economy and the homogeneity of the populations. 

Geography

First, although both Guam and Ireland are islands, the distances between each and economic centers in the regions are very different. Dublin, Ireland, which is not on the coast, is about 285 miles from London, England, about 470 miles from Amsterdam, Netherlands, about 485 miles from Paris, France and about 665 miles from Hamburg, Germany, all major commercial centers of Europe. Guam, on the other hand, is about 1,560 miles from Tokyo, Japan, about 1,595 miles from Manila, Philippines, about 1,710 miles from Taipei, Taiwan and about 1,790 miles from Busan, South Korea. Consider, additionally, that Ireland is located close to many of the richest countries in the world by per capita income, while the only countries in the region that come close are Japan (definitely is), Taiwan and South Korea, all of which are about 3 times further from Guam than similar markets in Europe are from Ireland.

Comparison between Guam and Ireland's Proximity to Wealthy Countries

Ireland’s Neighboring Countries			Guam’s Neighboring Countries
Country	Distance	P/C GDP	Country	Distance	P/C GDP
United Kingdom	285	36,941	NMI	130	13,599
Netherlands	470	42,194	Palau	515	13,758
Belgium	480	37,883	FSM	815	7,346
France	485	35,548	Japan	1,560	36,266
Germany	665	39,028	Philippines	1,595	4,119
Denmark	770	37,657	Taiwan	1,710	38,749
Norway	785	55,009	South Korea	1,790	32,272
Spain	900	30,557	Marshalls	1,850	8,683

Why does this matter? Because if the basic strategy to be employed is an export-oriented growth model, then proximity to wealthy (potential) trading partners is a major advantage. The three countries within 1,000 miles from Guam have per capita incomes of less than half any of the more than eight countries within 1,000 miles of Ireland. This is a significant difference, which could have major impacts on the success of any export-oriented growth strategy.

Structure of Guam's Economy

Second, the similarities between Guam and Ireland's societies are not very much in evidence, when you compare the primary bases of each's prior relative economic success.  As the authors pointed out, Ireland's economy was "a non-diversified economy during the pre-Celtic Tiger years, with strong focus on agriculture and a large rural population," whereas Guam's economy is a "non-diversified economy relying heavily on tourism, and to a lesser extent, on the military presence on the island."  After the "Celtic Tiger" years, the main exports of Ireland are pharmaceuticals, machinery of different types, medical equipment and foodstuff.  Guam's main exports are transshipments of goods manufactured elsewhere and, more importantly, tourism[1].  Neither the pre-Celtic Tiger Irish economy nor the post-Celtic Tiger Irish economy bears much resemblance to Guam.

Multicultural Society

Third, as the authors point out, Guam is a multicultural society and assert that Ireland has become more multicultural.  Maybe that's true, but the idea that there might be a point of similarity here seems incorrect.  Note that, in Guam, there is no ethnic group which is a majority, but note the distribution of ethnicities in Ireland represented in the following chart:

This is a much less diverse population.  Less than 10% of the population is non-caucasian.  Although this probably does not have much weight as to the choice of a growth strategy, the existence of various minority groups in Guam could have positive impacts for the development of more favorable trade relations with relatively close countries.

What, if not Ireland?

It may be debatable whether I have proven that Ireland is not the appropriate growth model for Guam, but I think laying out an alternative model could be a better demonstration.  If I were to choose a state to emulate in terms of a growth model, I would find an argument more compelling if the state chosen were Singapore.  Here are a number of features that I believe make Guam and Singapore better points of comparison:

• Singapore and Guam have very few natural resources to give them a leg-up, except their labor forces.
• Singapore had to draw upon the resources of the surrounding region and was mainly a transshipment hub for Southeast Asia and, although the scale is smaller, Guam is a transshipment hub for the islands of Micronesia.
• Singapore was not surrounded by wealthy nations, as Guam generally is not, either.
• Singapore is very diverse, as is Guam.
• Significant minorities in Singapore are ethnic Malay or Indonesian, the primary ethnicities in neighboring countries, while some of Guam's Chamorros have ties to the Northern Mariana Islands and there are significant minority populations of Filipinos, Japanese, Koreans Chinese, Palauans, Micronesians and Marshallese.
• Singapore was colonized by the United Kingdom and remained a member of the Sterling area until 1972, during which time its currency was pegged to the Pound Sterling, then was briefly pegged to the U.S. dollar and after which it had been pegged to a basket of undisclosed currencies until 1985, all of which made the monetary policy of Singapore dependent upon other nations' policies. Singapore still operates a similar system, but with a more flexible band of values for the peg. Guam uses the U.S. currency, which gives it no monetary flexibility.
• Singapore is a center of banking in Southeast Asia. Guam is a center of banking within the Micronesian region.

While I think there are more similarities between Singapore and Guam than Ireland and Guam, I recognize that there are still significant differences between Singapore and Guam that would make emulating their performance challenging. Particularly, I would note that immigration of Chinese into Singapore during the earlier stages of Singapore's development may play a large role in the success of Singapore's model.

I believe in a more eclectic approach to developing a growth strategy. I will discuss more areas of agreement and disagreement with the authors of the paper in terms of actual strategy in my next post.

[1] Tourism is considered an export in gross domestic product because of the cross-border flow of funds.

Reasons to be (modestly) optimistic about Guam's economy

I am cautiously optimistic about how Guam's economy will fare over the next few years. First, a recap of where I believe we are, then I shall discuss some reasons for thinking positive and finish off by taking the punchbowl away.

I believe it is evident that Guam's economy has been depressed for quite a while (to say the least). In recent years, the inflation rate has been declining. This and the persistently high unemployment rate make me believe that there has been a sustained output gap.

There are a number of reasons to believe things may get better:

(1) as per my last post, the indicators I cited may portend that the US (and presumably Guam) are headed toward a recovery, which I largely credit to the Fed's more credible statements of future policy.

(2) every cloud has a silver lining (lol). I believe that policy-makers in Washington, DC, may significantly increase non-buildup-related spending on military forces on Guam because of the perceived threat of North Korea.

(3) the government of Japan has undertaken a bold new monetary policy, which I believe can "deliver the goods." The plan is to attain a 2% inflation rate. As Joe Bradley (chief economist of the Bank of Guam) has implied, the yen-dollar exchange rate "sweet spot" is about 110 yen per dollar. At about 99 yen per dollar, it would take a 10% devaluation of the yen to reach 110, so we have a way to go before a yen devaluation would hurt Guam's economy. In fact, I ran a simple regression that showed that in recent history, a weaker yen usually is a positive for tourist arrival numbers from Japan to Guam.

Okay. That's pretty positive, but now for the cold water:

(1) sequestration will hurt Guam's economy.

And

(2) fiscal consolidation tends to hurt growth in the short-run, when it is not counteracted by monetary policy.

These effects in both directions might leave the net effect indeterminate, but I think there is more reason to be optimistic than pessimistic given these conditions. I hope I'm right about that.

Is the US economy finally recovering?

This will be little more than a note. I just read a post by Professor David Glasner at uneasymoney.com on the "bursting" of the "gold bubble." My gut tells me that there is a gold bubble. My own analysis is that, at the zero-lower bound, a scramble for decent returns by investors is making them inflate the price of gold, bonds and stocks. I think even with that rationale about the gold price, there is still a bubble on top of that. And it's hard to read stocks because they could rise in price because of a recovery or the search for returns as the yield curve compresses (sorry for the technical language)... let's say the extra returns that investors demand for holding either long term or riskier securities are declining (in my own interpretation of the data) when we face the zero-lower bound in a general depression. But there may be room for optimism:

Note that, even though short-term treasuries are still hovering around zero, corporate bond yields have recently jumped up (not that this is the only case since we entered near-zero territory), gold prices have been declining lately, and the stock market is rising, as measured by both the Dow Jones Industrial Average and the S&P 500. The price of gold has not declined a lot and it might just be randomly bouncing up and down at a currently higher level; the bond yields might just be experiencing normal fluctuations and the robust growth stocks may not be based on an improved macroeconomy, but this still could be a real indicator of change that's in the wind.

If this is true, what does it mean for my own quasi-IS-LM model? It means that the Wicksellian equilibrium interest rate has been restored.  Obviously if employment gains don't pick up, I'll abandon hope again and start rending my garments and covering myself with ashes.  But for now, I'm getting more hopeful. 

Doesn't the Stock Market recovery disprove the liquidity trap argument?

Yes, the headline is basically a straw-man. I am not aware of anyone who has made that argument, but I'm only using it to (a) draw attention and (b) make a point: the stock market "rally" is, if anything, confirmation of the basic story about the liquidity trap.

According to basic microeconomic theory, the price of a good is expected to be positively correlated with a change in the price of its substitute. If a gala apple and a jazz apple are each $1 apiece (equilibrium) and the price of jazz apples go down, one would expect for the consumption of gala apples to decrease and the consumption of jazz apples to increase, such that a new equilibrium price of each would result. Thinking of stocks and bonds as substitutes (in that each are claims on future revenue streams), one could conclude that it is only natural that as yields in the bond market decline (due to monetary policy and general pessimism about the economy), investors would turn to stocks in search of yields.

Here are some facts about the current market rallies:

(1) the S&P and DOWJIA are booming:

(2) Bond yields are down (bond prices are up):

(3) Gold is up:

And, obviously, the short-term treasury interest rates and the effective federal funds rates are up against the zero lower bound, which means the bond prices for treasuries are also high.

I ask simply: are these the signs of a recovered economy when unemployment is still really high and there is a large persistent output gap?

The answer is an emphatic NO!  Clearly what is happening is that the demand for investment opportunities is outstripping supply.  The real rate of interest that currently prevails is too high to restore full employment, despite the efforts at Quantitative Easing. 

The conventional mechanism to bring about full employment in such conditions is for the central bank to conduct open market operations to decrease the nominal interest rate, but when short term rates are hovering around zero, there's nowhere to go but up.  The two remaining ways to bring about recovery are to undertake fiscal stimulus, which would increase the supply of investment opportunities (because of an increased deficit financing the extra spending) and, by some mechanism, triggering inflation expectations, which would lower the real interest rate, even at the zero lower bound.

Maybe it's time to talk devaluation

Here's my most radical thought yet about what the United States could do to bring about a recovery: currency devaluation.

The way I'm looking at it, this would bring on a few somewhat related effects that would be beneficial in the current liquidity-trap environment:

(1) boost exports/decrease imports. As common sense tells us, if the cost of buying things from a country goes up, it becomes more attractive for foreigners to buy that stuff, which would increase exports. Devaluation also means that foreign goods would seem more expensive, so imports would decline.

(2) raise inflation expectations. As stated in (1), the prices of foreign goods in terms of domestic currency would rise, so the price level for domestic goods would be expected to rise so that a new equilibrium domestic price level would develop. It might not work as well as one would hope, however, because of the share of global trade that the U.S. has. If exports from the US go up and imports go down, the global price level could decline somewhat. The result should still be positive, just not as effective as a similar policy for a small economy.

(3) end of the liquidity trap. If a devaluation occurs, the liquidity trap which the U.S. economy faces could end . When inflation expectations pick up, the real interest rate will decline, potentially enough that the nominal interest rate targeted by the Fed could rise above the current rate, which is against the zero lower bound (ZLB) without raising the real interest rate.

I can think of reasons this would not be such a good policy. Among others, it would immediately give everyone with US dollar-denominated assets a "haircut", but I am also cognizant of the constraints which may make a first-best policy impractical. The Federal Reserve Board seems unwilling or unable to bring about a quick recovery from this depression. The state and local governments are unwilling or unable to spend enough to bring about recovery within their jurisdictions. The Federal Government is unwilling to undertake any policy other than a premature austerity. Maybe a devaluation is the fourth-best policy (laughs sardonically).

If it were possible

There are many levels on which I think the "ideal" solution for Europe would not come about and I'm not even sure if it's technically feasible, but here goes:

I just read a very brief post by Marcus Nunes (Historinhas) where he illustrated that the European Central Bank looks like it has been targeting NGDP for Germany and Austria, both of which are not estimated to have any significant output gap, at all. Which makes me think: instead of imposing austerity on the peripheral nations while keeping monetary policy tight, why not loosen monetary policy a lot, so that the GDP gaps close in the periphery and impose austerity on the "core" (Austria and Germany)? What's nice about that is that it would improve the budget balances of all the other nations and Germany and Austria could work down their debt levels or cut back their welfare states (not that I endorse that)... Better just to prepare for the moderate demographic problems they face in the future... in fact, maybe it's time to increase the redistributive element of the European Union and help cut some of the excessive debt in other nations of the EU.