Volume 7, Issue 1, November 2005

The Research Agenda: Fabrizio Zilibotti on the Equilibrium Dynamics of Policies and Institutions

Incorporating politico-economic dynamics in general equilibrium macro models entails some analytical difficulties. The standard logic of competitive models, where agents optimize taking future equilibrium outcomes (e.g., prices) as given, breaks down when political choice is considered, since the current political choice has non-negligible effects on future equilibria, and it would be irrational for agents to ignore them. There are two avenues for tackling this problem. The first is to analyze the set of game-theoretic dynamic equilibria involving reputation and collective punishments. The main problem with this approach is that such set of equilibria is large. Moreover, enforcing punishments requires significant coordination among agents. The alternative approach focuses on Markov Perfect Equilibria (MPE). MPE emphasize lack of commitment entailed in democratic political processes by focusing on equilibria which are limits of finite-horizon equilibria. While restricting attention to MPE reduces the number of equilibria, their characterization is not straightforward. A first generation of papers has resorted to computational analysis (see, e.g., Krusell and Ríos-Rull, 1999). While useful, this approach entails two major limitations. First, the complexity of the analysis makes it difficult to transmit its insights to broad audiences including students and policy-makers, and, second, MPE often involve discontinuous policy functions which are hard to track even through numerical methods.

In a series of recent papers with various coauthors, I have tried to overcome these hurdles, and propose "tractable" dynamic macroeconomic models embedding politico-economic factors. The virtue of small-scale models is their transparent mechanics. This makes it easy to solve problems involving functional equations through guess-and-verify methods, even when equilibria exhibit discontinuous policy functions. The distinctive features of the theory are that (i) policies are decided through period-by-period voting without commitment and (ii) they affect asset accumulation decisions. In this environment, the current political choice affects the future income distribution, and this, in turn, affects the future political equilibrium. This dynamic feedback opens the scope for strategic voting: agents vote taking into consideration how their choice today affects politics tomorrow.

Fiscal Policy and Redistribution

The theory offers two main insights. First, if a temporary shock triggers sufficient support to initiate redistributive policies, these remain sustained over time, even after the effects of the shock have vanished. This result is due to high current redistribution reducing investments, implying that a larger share of future voters will benefit from redistributive policies. Thus, the welfare state survives beyond the scope for which it had been originally started. This prediction conforms with the evidence that the welfare-state system proved persistent after its first introduction. At the time of the Great Depression, many governments stepped-in with large programs aimed at reactivating the economy and supporting the impoverished generation. However, welfare-state programs would not be abandoned after economic recovery and would, on the contrary, grow in size and scope after World War II.

Second, there exist equilibria where an existing welfare state is irreversibly terminated, even when benefit recipients are initially politically decisive. The breakdown of the welfare state is more likely when pre-tax wage inequality is large, since this strengthens the incentives for private investment and reduces, ceteris paribus, the constituency of the welfare state. Strategic voting motives are key to the existence of this type of equilibria: if agents took future policy as parametric, there could be no welfare state breakdown. This result can cast some light on the dynamics of the Thatcherite revolution in the 1980's. First, it came about during a period of growing wage inequality, and second its effects proved to be long-lasting. Even after the Tories went out of office in 1997, the constituency for traditional welfare-state policies seems to have faded in the UK. Labour governments by and large continued the economic and social policies inaugurated by Mrs. Thatcher, with limited public pressure for their reversal.

While Hassler, Rodriguez-Mora, Storesletten and Zilibotti (2003) focus on inefficient redistribution, public redistribution may be ex-ante desirable to societies. Hassler, Krusell, Storesletten and Zilibotti (2005a) analyze one such scenario where agents are risk-averse and markets incomplete. The political mechanism is also different: instead of a standard Downsian model, we consider a probabilistic voting mechanism à la Lindbeck and Weibull (1987), where the winning politician maximizes a weighted average of the utility of all groups in society. In this environment, the equilibrium features positive redistribution in the long run. The reason is that by having a higher marginal utility of income, the poor exert a stronger influence on the determination of policies (in the jargoon, there are more "swing voters" among the poor). The transition towards the steady-state may exhibit monotonic dynamics or dampening fluctuations in tax rates, depending on the extent of risk aversion. An interesting result is that oscillating tax rates are not due to political distortions. On the contrary, a benevolent policy-maker with commitment power would choose sharper fluctuations, possibly non-dampening ones, than in the political equilibrium. Political distortions generate an inefficiently persistent fiscal policy. This finding lies in sharp contrast with the predictions of the literature on political business cycles arguing that political economy exacerbates fluctuations (see Alesina, Roubini and Cohen, 1997).

In Hassler, Krusell, Storesletten and Zilibotti (2005b), we extend the analysis of the dynamics of fiscal policy to a Chamley-Judd model of capital taxation, where we show that the absence of commitment can lead to sizeable inefficiencies in both the steady-state levels and the transitional dynamics of taxation. For instance, we show in a "calibrated" example that the steady-state Ramsey tax (with commitment) is 22%, while it is 50% rate in the political equilibrium. Moreover, in the Ramsey economy, taxes are negatively serially autocorrelated, while they are highly persistent in the political equilibrium (with an autoregressive coefficient of 0.4 on a four-year basis).

A large share of government spending is used to finance public goods. In Hassler, Storesletten and Zilibotti (2006), we investigate the political economy of public good provision in a model where governments finance their expenditure via income taxation and taxes are allowed to be age-dependent. Since the tax burden falls more heavily on agents with high labor earnings, the poor want more public good than the rich. The equilibrium is shown to be indeterminate, independent of the initial income and skill distribution among agents. There exists one "sincere" equilibrium with high taxes, where the poor are politically decisive, and a range of "strategic" equilibria with lower taxes, where the rich are politically decisive. In the latter, voters restrain taxation to induce a future majority that will keep taxes low, thereby strengthening the incentive of investors and enlarging the current tax base for the public good. This multiplicity can explain the existence of large cross-country differences in the size and composition of government expenditures. For example, in Scandinavian countries, the average size of government measured by tax revenue is more than half the size of GDP, while it is below one quarter of GDP in the United States and Switzerland. The theory shows that such differences are not necessarily due to variation in exogenous factors or preferences. Another interesting finding is that taxation and public good provision may be inefficiently too low -- in contrast with the standard emphasis in the politico-economic literature on factors leading to excess taxation --.

An important aspect of the macro-policy debate is government debt. When debt policy is determined through repeated elections, and agents are less than fully altruistic towards future generations, there is a politico-economic force pushing towards progressive debt accumulation which arises from the lack of political representation of the future generations on which the burden of public debt largely falls. If debt cannot exceed a ceiling (e.g., equal to the maximum PDV of future taxation) governments would find it increasingly hard to finance public good programs. Thus, private affluence can be accompanied by growing "public poverty": even though productivity and income grow at a sustained rate, public funding of education, health and other public services becomes subject to growing pressure. Indeed, over the last decade, many countries have been under strain to contain their public spending and to face a growing public debt (including both explicit and implicit debt through pension liabilities).

In Song, Storesletten and Zilibotti (2005), we analyze these issues with the aid of a politico-economic model of overlapping generations where the government finances public good provision through labor taxation and by issuing debt. First, we show a negative result: when taxation is not distortionary, public debt grows and converges asymptotically to its maximum level. Thus, both private and public consumption tend to zero in the long run. Then, we introduce distortionary effects of taxation on labor supply (a Laffer curve). Not surprisingly, an endogenous limit on taxation prevents private consumption from falling to zero. A less obvious result is that it can also prevent "public poverty", namely, it reduces the incentive to accumulate debt. Intuitively, political support for growing public debt is sustained by the belief that future governments will continue public good provision by increasing taxes. However, when agents realize that this is not feasible (or increasingly expensive to achieve), they are induced to support more responsible debt policies today. In other words, endogenous limits to taxation discipline fiscal policy.

This result has implications on the effects of international tax competition. Such competition serves as a commitment device to avoid increasing future taxes above the international level. Consequently, tax competition may actually lead to lower debt and avoid the public poverty trap.

Labor Markets and Child Labor Laws

While child labor is today regarded as a cruel practice that deprives children of rights and opportunities, from a historical perspective, this view of child labor is of a relatively recent origin. In Western countries, until the nineteenth century most children worked, and there was no stigma attached to earning income from children's work. A change in attitudes towards child labor occurred around the mid-XIXth Century, under the pressure of the union movement. How can this change be explained? According to our theory, the increasing political support for child labor regulation can be explained by economic motives. In particular, we identify two factors behind the increasing support to child labor restrictions. The first is the drive to limit competition: unskilled workers compete with children in the labor market, and therefore stand to gain from higher wages if child labor is restricted. Different from other types of competition, the potential competition comes (at least partly) from inside the unskilled workers' families. For this reason, workers' attitudes regarding child labor laws depend not only on the degree to which they compete with children in the labor market, but also on the extent to which their family income relies on child labor. The second motive is parent's altruism: when the returns to education are sufficiently high, most parents prefer to have small families and educate their children. Then, the support to child labor restriction grows.

To formalize these ideas, we construct a model where altruistic agents age and die stochastically, and decide on fertility, education and family size. A ban on child labor is introduced when supported by a majority of the adult population. First, we derive some analytical results, showing that multiple politico-economic steady states can exist. In one steady state, child labor is legal, unskilled workers have many working children, and there is little support for banning child labor. In the other steady state, child labor is forbidden, families are small, and the ban is supported by a majority of voters. In each case, the existing political regime induces fertility decisions that lock parents into supporting the status quo. The existence of multiple steady states can explain why some developing countries get trapped in equilibria with a high incidence of child labor and weak political support for banning child labor, while other countries at similar stages of development have strict regulations and a low incidence of child labor.

Then, we use a calibrated version of the model to replicate the historical changes which occurred in Britain in the XIXth Century. A prediction of the theory which is in line with the empirical evidence is that the change in workers' attitudes towards child labor occurs gradually. In the early stages of the transition, the working class does not unanimously back restrictions, since families with many children continue to depend on child labor. However, increasing return to schooling eventually induces newly-formed families to have fewer children and send them to school. Eventually, a majority of the unskilled workers support the banning of child labor. This explanation for the introduction of child labor restrictions is consistent with the observation that child labor regulation were first introduced in Britain (as well as in other Western countries) in the nineteenth century after a period of increasing wage inequality. Moreover, the introduction of child labor restrictions was accompanied by a period of substantial fertility decline and an expansion of education, which is once more consistent with the theory.

This study contributes to the debate on the introduction of child labor laws in developing countries. Even in countries where the majority currently opposes the introduction of child labor regulations, the constituency in favor of these laws may increase over time once the restrictions are in place. Naturally, this requires that other conditions be met. In particular, the cost of schooling must be sufficiently low, so that poor parents actually decide to send their children to school, once the restrictions are in place.

References

EconomicDynamics Interviews Peter Ireland on Money and the Business Cycle

EconomicDynamics: In your 2003 JME, you show that one cannot reject the stickiness of nominal prices at business cycle frequencies. In your 2004 JMBC, you argue that money plays a minimal role in the business cycle. Do these two papers contradict each other?

Peter Ireland: I do not think there is any substantive contradiction, as those two papers address somewhat different sets of issues.

In the 2003 JME paper on "Endogenous Money or Sticky Prices," I try to distinguish between two interpretations of the observed correlations between nominal variables, like the nominal money stock or the short-term nominal interest rate, and real variables, like aggregate output.

The first interpretation, present most famously in the work of Friedman and Schwartz, attributes this correlation to a causal channel, involving short-run monetary nonneutrality, running from policy-induced changes in the nominal variables to subsequent changes in real variables. The second interpretation, first associated with James Tobin's critique of the Friedman-Schwartz hypothesis but also advanced by others--most notably by Scott Freeman in some of his best work--attributes these correlations instead to a channel of "reverse causation," according to which movements in real output, driven by nonmonetary shocks, give rise to movements in nominal variables as the monetary authority and the private banking system also respond systematically to those shocks. My JME paper finds that an element of monetary nonneutrality, perhaps reflecting the presence of nominal price rigidity, does seem important in accounting for the correlations that we find in the data. But the endogenous money or reserve causation story contains an important element of truth as well--a full understanding of the postwar US data, in order words, requires that one take seriously the high likelihood that causality runs in both directions.

The 2004 JMCB paper on "Money's Role in the Monetary Business Cycle," as I said, addresses a slightly different set of issues. It asks, conditional on having a model with monetary nonneutrality, whether the effects of monetary policy are transmitted to real output through movements in the nominal interest rate or through movements in the money stock. That paper finds that, at least when it comes to explaining the post-1980 US data, movements in the nominal interest rate seem to be what really matter for understanding the dynamic behavior of output and inflation. Importantly, though, that result by no means implies that policy-induced movements in the monetary base or in the broad monetary aggregates have no impact on output or inflation--to the contrary my estimated model does imply that movements in M matter. The point is more subtle: movements in M do matter, but they matter because those movements in M give rise first to movements in R.

Your question is a good one, though, since it gets at a much bigger and more important result that comes out of the recent literature on New Keynesian economics. The dynamic, stochastic, New Keynesian models of today are very, very different from older style Keynesian models in that they admit that output can fluctuate for many reasons, not just in response to changes in monetary policy or other so-called demand-side disturbances, but also in response to shocks like the technology shock from Kydland and Prescott's real business cycle model. Likewise, these New Keynesian models also admit that to the extent that output fluctuations do reflect the impact of technology shocks, those aggregate fluctuations represent the economy's efficient response to changes in productivity, just as they do in the real business cycle model. This insight runs throughout all of the recent theoretical work on New Keynesian economics: by Woodford, by Clarida, Gali and Gertler, by Goodfriend and King, and many others. Meanwhile, empirical work that seeks to estimate New Keynesian models, including my own work along those lines, has consistently suggested that monetary policy shocks have played at most a modest role in driving business cycle fluctuations in the postwar US--other shocks including technology shocks consistently show up as being much more important. Those results echo the findings of others, like Chris Sims and Eric Leeper, who work with less highly constrained vector autoregressions and also find that identified monetary policy shocks play a subsidiary role in accounting for output fluctuations.

And so, the recent literature on New Keynesian economics draws this important distinction: historically, over the postwar period, Federal Reserve policy does not seem to have generated hugely important fluctuations in real output--shocks other than those to monetary policy have been much more important. But by no means does that finding imply that larger monetary policy shocks than we've actually experienced in the postwar US would not have more important real effects. The models imply that bigger monetary policy shocks would have bigger real effects.

ED: Is the Friedman Rule optimal?

That is another great question--a question that together with the one that asks why noninterest-bearing fiat money is valued in the first place represents one of the most important questions in all of monetary theory. A lot of great minds have grappled with both questions without arriving at any definitive answers, so far be it from me to suggest that I have any clear answers myself. But issues concerning the optimality of the Friedman rule have run through a lot of my published work and those issues still intrigue me today.

More recently, what has fascinated me is this alternative view of low inflation and nominal interest rates that contrasts so markedly with the view provided by Milton Friedman's original essay on the "Optimum Quantity of Money." Friedman argues that zero nominal interest rates are necessary for achieving efficient resource allocations in a world in which money is needed to facilitate at least certain types of transactions, and that result is echoed in many contemporary monetary models: cash-in-advance models, money-in-the-utility function models and so on. But then there is this alternative view that the zero lower bound on the nominal interest rate implies that in a low-inflation environment, the central bank can "run out of room" to ease monetary policy in the event that the economy gets hit by a series of what, again, might loosely speaking be called adverse demand-side shocks.

In his 1998 Brookings paper, Paul Krugman provocatively associated this zero-lower-bound problem with the old-style Keynesian liquidity trap and around the same time that paper was published, Harald Uhlig also had a paper asking what links might exist between those two ideas. Reconciling these two views of zero nominal interest rates--the Friedman rule versus the liquidity trap--remains, I think, one of the most important outstanding problems in monetary economics. I took my own initial stab at understanding certain aspects of the problem in my recent IER paper on "The Liquidity Trap, the Real Balance Effect, and the Friedman Rule," recent work by Joydeep Bhattacharya, Joe Haslag, Antoine Martin and Stevee Russell grapples with similar issues. But this is clearly an area in which much more work remains to be done.

Before closing, I have to mention that these possible connections between the Friedman rule and the Keynesian liquidity trap were to my knowledge first alluded to in a paper by Charles Wilson, "An Infinite Horizon Model with Money," edited by Jerry Green and Jose Scheinkman. That amazing paper by Wilson is jam-packed with insights and consequently has provided the inspiration for countless others. Hal Cole and Narayana Kocherlakota's great paper from the Minneapolis Fed Review on "Zero Nominal Interest Rates: Why They're Good and How to Get Them"--that is another great paper that picks up on some of the results scattered throughout Wilson's; and then my 2003 article from RED on "Implementing the Friedman Rule" just builds on Cole-Kocherlakota. It seems that anyone who reads Wilson's article comes away with ideas for yet another new paper--without a doubt it is one of the classic contributions to the field of monetary economics.

References

Review of Economic Dynamics: Letter from the Coordinating Editor

This quality is reflected in a new journal ranking done by two economists at the Federal Reserve Bank of Boston. It shows that the Review of Economic Dynamics ranks 13th (!) among all economics journals in terms of impact per article, where impact is measured in terms of impact on economics journals. (See Table 2 of FRBB 05-12 for details.) This is a remarkable achievement for so young a journal. Gary Hansen and Tom Cooley have indeed done a fantastic job of getting the journal off the ground.

I want to use the rest of this essay to share my ideas about the journal. One aspect of the journal that I especially like is its broad scope. Some people perceive the RED as a macroeconomics journal. But this perception is wrong. The mission of the Review of Economic Dynamics is to not to be a field journal in macroeconomics, but to serve as the flagship journal for the Society for Economic Dynamics. The scope of the Society is much broader than macroeconomics. (After all, the next President of the Society is David K. Levine, who is best known for his contributions to economic theory.) Our board of associate editors at the RED reflects this large scope. It includes such scholars as Wolfgang Pesendorfer (economic theory), Urban Jermann (financial economics), and Thomas Holmes (industrial organization). I can't put it any better than the journal's website does: "We publish contributions in any area of economics provided they meet the highest standards of scientific research." The scope of the journal is defined not by any particular field description, but by the interests of the members of the Society.

I hesitate to be more precise about what those interests are. The journal has published papers that are contributions to pure theory. It has published papers that are contributions to pure measurement. It has published papers that use econometrics in sophisticated ways to explore the match between theory and data.

Nonetheless, I do believe that there is a kind of work that has a special home in the Review: the work that is called "quantitative theory." Many in the economics profession remain hostile, or at best ignorant, about applications of this methodology. The Review regards it as the essential tool for addressing many of the most important questions in economics. If you've written a quantitative theoretic paper of any kind, the Review provides the most constructive and useful reviewing process available.

I have two goals as co-ordinating editor. First, I want to do what all editors want to do: to improve throughput speed without reducing the quality of the review process. My aim is to get turn-around times down to 4 months or less on the vast majority of our submissions. From my years of experience as editor/associate editor at various journals, I see no reason why the review process should take longer than this.

My second goal is more important. For all of us in the Society, the annual SED conference has become the most exciting intellectual event of the year. I would like to see more of this energy translated into the journal. There is a simple way for this to happen: the members of the Society all need to treat the RED as our primary field journal. What does this mean in practice? All members of the Society should follow the Rule:

If you have a paper that is appropriate for the SED meetings, and you're not sending it to a top five journal, send it to the Review of Economic Dynamics.

If we all follow the Rule, I guarantee that the RED will reflect, even more than it does now, the intellectual excitement that we see at the SED conference. I look forward to receiving your submissions and being your editor in the next five years!

Narayana Kocherlakota, Coordinating Editor
Review of Economic Dynamics

Society Economic Dynamics: Call for Papers, 2006 Meetings

The program will be made up from a selection of invited and submitted papers. The Society now welcomes submissions from any area in economics. The deadline for submissions is February 15, 2006. Further details and instructions on how to submit a paper are available at http://www.EconomicDynamics.org/currentSED.htm.

Society for Economic Dynamics: Letter from the President

The 2005 meetings of the SED, held in Budapest, Hungary, were a great success. Nine or ten parallel sessions ran at a time for three days, with 340 papers presented. For the high quality of the content we should thank the program organizers Rob Shimer and Marco Bassetto.

The 2006 meetings will be held in Vancouver, July 6-8, 2006. Details are at http://www.economicdynamics.org/nextSED.htm and some of the planned events are already listed there. The program co-chairs are Matthias Doepke and Esteban Rossi-Hansberg, and the plenary speakers are Peter Klenow, Elhanan Helpman, and Hugo Hopenhayn. The submission deadline is February 15, 2006.

Now, some good news about personnel changes at the SED:

First, we welcome Narayana Kocherlakota as the new coordinating editor of RED. Narayana succeeds Gary Hansen, whom we thank for the great work he put into managing RED over the past six years. I urge you to submit your best work to RED.

Finally, David K. Levine will take over as SED President in July 2006. David is an able administrator and a stellar intellect. We are very lucky that he will lead the SED.

I look forward to seeing you in Vancouver.

Boyan Jovanovic, President
Society for Economic Dynamics

Review: Heer and Maussner's Dynamic General Equilibrium Modelling

Yet another book on computational methods, but that does not mean the market is crowded yet. While several other books already focus on applications of discrete time stochastic dynamic general models with representative agents, this one distinguishes itself in two respects. First, it aims at being more practical, for example by giving tips on how to overcome various traps like initial conditions. Second it expands into heterogenous agent models, including those with aggregate uncertainty. All algorithm examples are supported by programs in FORTRAN and/or Gauss on a companion website.

The representative agent part, after going through some modelling basics, covers the most popular methods: the linear-quadratic method, parametrized expectations and projection methods. In the heterogeneous agent part, the authors introduce the Hansen and Imrohoroglu (1992) borrowing contraint model and show how to obtain its invariant distribution. From there, various models and methods are discussed, including transition dynamics. Aggregate uncertainty in these models is tricky, and recent advances have made it somewhat tractable to address it. Heer and Maussner discuss the Krusell and Smith (1998) method and apply it to various models. The books concludes with a discussion of overlapping generation models and how to solve them, with and without aggregate uncertainty. One last part contains various mathematical tools (or refreshers) that complement the discussion in the previous chapters.

While the authors claim this book to be accessible to advanced undergraduates, it is really for graduate students (and former ones), who are the ones most likely to need to customize algorithms to their needs beyond what is already available on the Internet. This book is most helpful for this purpose, and it can be used as a textbook for a "methods" class.

"Dynamic General Equilibrium Modelling" is published by Springer.

Impressum

The EconomicDynamics Newsletter is published twice a year in April and November.

Subscribing/Unsubscribing/Address change

join economicdynamics myfirstname mylastname
stop

leave economicdynamics
stop

The EconomicDynamics mailing list has very low traffic, less that 8 messages a year. For weekly announcements about online papers in Dynamic General Equilibrium or relevant conferences, you may to subscribe to nep-dge, in the same way as described above.