Regulations and Growth

Bentley Coffey, Patrick McLaughlin, and Pietro Peretto have an interesting new paper on The Cumulative Cost of Regulations. They attack two of the big problems in quantifying the effect of regulations on the economy.

First, measurement. To get past regulatory horror stories,  just how do we measure the problem? They use the Mercatus Center's new RegData database, which is based on textual analysis of the Federal Register.

Second, functional form. How should we relate regulations to output? Here they use a detailed industry growth model. You may object, as to any model, but at least the mechanisms are explicit and you can choose different ones if you want. (I haven't plowed through all the equations, and am interested to hear comments from those of you who have.)

Third, estimation. They use the variation in industry outcomes related to differential regulation of those industries to estimate the  effects of regulation on investment.

The bottom line is pretty startling:

Economic growth in the United States has, on average, been slowed by 0.8 percent per year since 1980 owing to the cumulative effects of regulation:

If regulation had been held constant at levels observed in 1980, the US economy would have been about 25 percent larger than it actually was as of 2012.

This means that in 2012, the economy was $4 trillion smaller than it would have been in the absence of regulatory growth since 1980. This amounts to a loss of approximately $13,000 per capita,...

 A graphical summary:

(It's interesting that the standard errors are so weighted to the up side. I checked with the authors, this is indeed how the distributions of uncertainty work out in their estimation.)

I also found this nice graph from Chad Jones,

Chad's graph differs from mine for a few reasons. First, his index of "social infrastructure" from the world bank is more comprehensive, including Accountability of politicians, Political stability, Government effectiveness, Regulatory quality, Rule of law, Control of corruption. Second, he has total factor productivity on the Y axis. The vertical axis is a log scale, so read carefully. 1.6 (Singapore) is a lot more than 1.0, though they are compressed on the graph.

Global Imbalances

I gave some comments on “Global Imbalances and Currency Wars at the ZLB,” by Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas at the conference, “International Monetary Stability: Past, Present and Future”, Hoover Institution, May 5 2016. My comments are here, the paper is here 

The paper is a very clever and detailed model of "Global Imbalances," "Safe asset shortages" and the zero bound. A country's inability to "produce safe assets" spills, at the zero bound, across to output fluctuations around the world. I disagree with just about everything, and outline an alternative world view.

A quick overview:

Why are interest rates so low? Pierre-Olivier & Co.: countries can't  “produce safe stores of value”
This is entirely a financial friction. Real investment opportunities are unchanged. Economies can’t “produce” enough pieces of paper. Me: Productivity is low, so marginal product of capital is low.

Why is growth so low? Pierre-Olivier: The Zero Lower Bound is a "tipping point." Above the ZLB, things are fine. Below ZLB, the extra saving from above drives output gaps. It's all gaps, demand. Me: Productivity is low, interest rates are low, so output and output growth are low.

Data: I Don't see a big change in dynamics at and before the ZLB. If anything, things are more stable now that central banks are stuck at zero. Too slow, but stable.  Gaps and unemployment are down. It's not "demand" anymore.


Exchange rates. Pierre-Olivier  "indeterminacy when at the ZLB” induces extra volatility. Central banks can try to "coordinate expectations." Me: FTPL gives determinacy, but volatility in exchange rates. There is no big difference at the ZLB.

Safe asset Shortages. Pierre-Olivier: driven by a large mass of infinitely risk averse agents. Risk premia are therefore just as high as in the crisis. Me: Risk premia seem low. And doesn't everyone complain about "reach for yield" and low risk premia?

Observation. These ingredients are plausible about fall 2008. But that's nearly 8 years ago! At some point we have to get past financial crisis theory to not-enough-growth theory.

But, finally, praise. This is a great paper. It clearly articulates a world view, and you can look at the assumptions and mechanisms and decide if you think they make sense. I am in awe that Pierre-Olivier & Co. were able to make a coherent model of these buzzwords.

But great theory is great theory. To a critic, the assumptions are necessary as well as sufficient. I  read it as a brilliant negative paper, almost a parody: Here are the extreme assumptions that it takes to justify all the policy blather about "savings gluts" "global imbalances" "safe asset shortages" and so on. To me, it shows just how empty the idea is, that our policy-makers understand any of this stuff at a scientific, empirically-tested level, and should take strong actions to offset the supposed problems these buzzwords allude to.

I hope this taste gets you to read  my comments and the paper. 

Delong and Logarithms

Brad Delong posted a response to my oped on growth  in the Wall Street Journal. He took issue with my graph, reproduced here,

by making his own graph, here

He characterizes the difference between our graphs with his usual gentlemanly restraint,

"Extraordinarily Unprofessional!!:" "total idiocy" The University of Chicago and the Wall Street Journal Have Very Serious Intellectual Quality Control Problems

and so forth.

If you read Brad, you may wonder what skulduggery I used to make the plot. I will now reveal the dark secret. It's a clever Chicago-school mathematical trick:

Logarithms.

Yes, I plotted log income vs. ease of doing business index.

Now just how much of a sin is this? Well, growth theory is about growth, so it's pretty hard to do without logarithms. If thinking about percentage growth and running regressions with log income on the left hand side is a devious right-wing trick, I'm afraid we're going to have to throw out about 99% of growth theory and empirical economics, including much done by Brad's colleagues at Berkeley.

Furthermore, just look at the graph.  I invite anybody who has sat through a first-year econometrics class where they teach this devious technique to ponder my and Brad's plot, and think whether a level or a log fit is appropriate.

Brad raises one valid concern with all of empirical economics: Endogeneity. The graph is a correlation. How do we know that better ease of doing business causes better business, and not the other way around? In Brad's view, it is equally likely, I guess, that first a contry gets rich, and then it improves its laws and regulations.

I didn't mention this in the Journal, simply for lack of space (try to write anything in 950 words). In a previous blog post, here, I wrote a little bit about it.

One might dismiss the correlation a bit as reverse causation. But look at North vs. South Korea, East vs. West Germany, and the rise of China and India. It seems bad policies really can do a lot of damage. And the US and UK had pretty good institutions when their GDPs were much lower. (Hall and Jones 1999 control for endogeneity in this sort of regression by using instrumental variables.)

(This post isn't hard to find. I linked to from my growth oped post. And if one is curious about "what does John have to say about endogeneity?" -- a rather obvious question, which I ask about twice at every seminar -- it is also possible to email me. )

That post goes on to survey a lot of academic literature on just how important good institutions are to economic growth.

But just think about it. Did North Korea or East Germany first get poor and then get bad institutions? Did the UK and US first get rich, and then develop our rule-of-law and property rights traditions? Is reverse causality at all a plausible explanation for the correlation? Just about every historical episode you can think of goes the other way.

Endogeneity is always an issue in economics, but Brad's case that I am too dumb to have even thought about it, or that this correlation obviously goes the other way,  does not hold up.

But apparently, Brad doesn't know about google, fact checking, or emailing for simple clarifications either. Otherwise he would know that I don't work at Chicago anymore, hardly a secret.

The notion that universities should practice "intellectual quality control" is interesting in this era of declining free speech. Brad, be careful what you wish for.  "Controlling" basic professional ethics may come first.

If anyone is still curious, I posted my data and program to my website, and this post describes it some more. I didn't clean it up well, as I never thought this would be controversial, but at least it documents what I did. Feel free to play with it as you wish.

Update: It's clear from many comments and the twitter storm that many readers, even trained economists, missed this basic point. My graph is an illustration of a conclusion reached by hundreds, if not more, papers in the academic literature. It is not The Evidence, or even particularly novel evidence. Were it so, standard errors, specification search, endogeneity, much better measures of institutions, etc. would be appropriate, as many suggest. My graph is just a quick graphical illustration of the conclusions of much growth economics, including much work by Jones, Acemoglu, Barro, Klenow, and many many others. Institutions matter to economic growth; bad governments have amazing power to ruin economies.  As always in writing, I should have made that clearer; but I thought this literature was familiar to the average economist-blogger.

Update 2: There is, I think, an important mis-specification in a regression of log income on the ease-of-doing business index, which Evan Soltas implicitly points out.  I referred to the index as "simple" and "crude" for this reason, but again it looks like this seemingly obvious point needs expanding.

The World bank's measure is mostly focused on the ease of starting small businesses. When we look at the regulatory sclerosis in the US, it is a much wider phenomenon, encompassing the tax code, social program disincentives, the  recent huge expansion of federal involvement in health and finance, general spread of cronyism, reduction in rule of law, and so forth. These affect large businesses as much or more than small businesses.

Clearly, as we look across countries, the ease of doing business is correlated with these wider legal and regulatory problems. Countries with bad institutions overall also have bad ease of doing business scores. But just as obviously, only fixing the ease of doing business indicators without fixing the larger legal and institutional failures that correlate with those indicators, won't do a whole lot of good, which is what Evan seems to find.

The regulatory program I outlined there and in the longer essay on growth (blog post here, html here,   pdf here) went far beyond ease of doing business indicators, for just this reason.

Update 3: Or, seemingly obvious point #3 that seems to need an answer. A few commenters have questioned  how far "out of sample" one can go. At some point, yes, institutions are perfect and more income will not result from improving them. Where is that? 90? 100? 110? I don't know. But the local derivative is still high, no matter how you fit the "out of sample" points. If you don't think you can draw the line out to 100, going from 82 to 83 still has very large effects.

Growth Interview

I did a short interview with the WSJ's Mary Kissel about my growth oped. If you can't see the embed above, try this direct link or this one. 

WSJ Growth Oped

I did an oped on growth in the Wall Street Journal, titled "Ending America’s Slow-Growth Tailspin." I'll post the full thing here in 30 days.

Blog readers will recognize a distilled version of my longer essay on growth (blog post here, html here,   pdf here), and the graph from Smith v. Jones blog post. I think out loud. The growth essay is much more detailed on diagnosis and especially on policy.

There are three basic ideas (two too many for a good oped).

1) Growth is everything. Increasing growth will do way more for every problem you can name than anything else on the economic agenda. Even if workers in 1910 could have taken all of Rockefeller's wealth, they would have been disastrously poor compared to today.

2) Can policies actually improve growth? The tut-tutters mocked Jeb Bush's 4% aspiration. I outline the "we've run out of ideas" school of thought, most recently in Bob Gordon's thoughtful book; the "everything is right but the zero bound" secular-staglation school, and the view that the growth giant is being held back by a liliputian army of politicized regulators.

As evidence,  I improved on the graph from an earlier post of the World Bank's ease of doing business score vs. GDP per capita,

(if you can't see the graph, click here)

This graph adds a few things relative to the one in WSJ. I added some outliers. Libya and Venzuela seem like countries with good reasons to have temporarily more GDP than their institutions can long support, Rwanda and Georgia the opposite. So the correlation is even better than it looks. Given how crude the world bank measure is, it's surprising it works so well. It's mostly about the difficulties of starting small businesses. I added Greece too to gives some sense of variation within the Euro-US world.

The point: Bad policies can do dramatic harm. Ipso facto, good policies must be able to do a lot of good. The US is not perfect!

A famous economist challenged my view that regulation is causing a lot of problems, noting that all of the big business types he talks to don't complain that much. But I think that's a horrendous selection bias. If you talk to the people still in business, you are talking to the ones that have figured out the political and regulatory game. Go talk to the ones whose businesses are closed, or not even started.

Another point, regulation has been getting worse for decades. Why the slump now? I think that a lot of the government onslaught's effect has been to make the economy less resilient. For example, social security disability is not a problem as long as you have a job. When you lose a job, and go on disability, now the huge disincentive to work, study, move, kicks in.  Recovering from a recession needs new jobs, new businesses, new innovations.

3) A very brief outline of policies to get growth going again. I think the key is to move past the standard rhetoric that defines our current partisan bickering. It's not how much we spend, really, it's how we spend it. Free market economics is not "trickle-down" economics, it's about incentives, simplicity, rule of law, and so forth.

Gordon on growth 2

PBS covers Bob Gordon's The Rise and Fall of American Growth.



[Embedded video. These aren't picked up when other sources pick up the blog, so come back to the original if you don't see the video.]

PBS and Paul Solman did a great job, especially relative to the usual standards of economics coverage in the media.  OK, not perfect -- they livened it up by tying it to partisan politics a bit more than they should have, though far less than usual.

I don't (yet, maybe) agree with Bob. I still hope that the mastery of information and biology can produce results like the mastery of electromagnetism and fossil fuels did earlier. I still suspect that slow growth is resulting from government-induced sclerosis rather than an absence of good ideas in a smoothly functioning economy.  But Bob has us talking about The Crucial Issue: long term growth, and its source in productivity. The 1870-1970 miracle was not about whether the federal funds rate was 0.25% higher or lower. And the issue is not about opinions, like the ones I just offered, but facts and research, which Bob offers.

The issue of future long-term growth is tied with the issue of measurement, something else that Bob has championed over the years. GDP is well designed to measure steel per worker. Information, health and lifespan increases are much more poorly measured. This is already a problem in long-term comparisons. In the video, Bob points to light as the greatest invention. The price of light has fallen by a factor of thousands since the age of candles, to the point where light consumption is a trivial part of GDP. It's a worse problem as all the great stuff becomes free. I suspect that we'll have to try to measure consumer surplus not just the market value of goods and services.

And congratulations to Bob. The economics profession tends to focus on the young rising stars, but he offers inspiration that economists can produce magnum opuses of deep impact at any point in a career.

Disclosure: I haven't read the book yet, but it is on top of the pile. More when I finish. Ed Glaeser has an excellent review.

Update: Tyler Cowen's review, in Foreign Affairs