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.

Tax Oped -- full version

Source: Wall Street Journal

An Oped at the Wall Street Journal, "Here's what genuine tax reform looks like." I posted the teaser a month ago, now I can post the whole thing.

Left and right agree that the U.S. tax code is a mess. The men and women running for president in 2016 are offering reform plans, and proposals to fix the code regularly surface in Congress. But these plans are, and should be, political documents, designed to attract votes. To prevent today’s ugly bargains from becoming tomorrow’s conventional wisdom, we should more frequently discuss the ideal tax structure.

The first goal of taxation is to raise needed government revenue with minimum economic damage. That means lower marginal rates—the additional tax people pay for each extra dollar earned—and a broader base of income subject to tax. It also means a massively simpler tax code.


In my view, simplification is more important than rates. A simple code would allow people and businesses to spend more time and resources on productive activities and less on attorneys and accountants, or on lobbyists seeking special deals and subsidies. And a simple code is much more clearly fair. Americans now suspect that people with clever lawyers are avoiding much taxation, which is corrosive to compliance and driving populist outrage across the political spectrum.

What would a minimally damaging, simple, fair tax code look like? First, the corporate tax should be eliminated. Every dollar of taxes that a corporation seems to pay comes from higher prices to its customers, lower wages to its workers, or lower dividends to its shareholders. Of these groups, wealthy individual shareholders are the least likely to suffer. If taxes eat into profits, investors pay lower prices for less valuable shares, and so earn the same return as before. To the extent that taxes do reduce returns, they also financially hurt nonprofits and your and my pension funds.

With no corporate tax, arguments disappear over investment expensing versus depreciation, repatriation of profits, too much tax-deductible debt, R&D deductions, and the vast array of energy deductions and credits.

Second, the government should tax consumption, not wages, income or wealth. When the government taxes savings, investment income, wealth or inheritance, it reduces the incentive to save, invest and build companies rather than enjoy consumption immediately. Taxes on capital gains discourage people from moving or reallocating capital toward their most productive uses.

Recognizing the distortion, the federal government provides a complex web of shelters, including IRAs, Roth IRAs, 527(b), 401(k), health-savings accounts, life-insurance exemptions, and the panoply of trusts that wealthy individuals use to shelter their wealth and escape the estate tax. If investment isn’t taxed, these costly complexities can disappear.

All the various deductions, credits and exclusions should be eliminated—even the holy trinity of tax breaks for mortgage interest, charitable donations and employer-provided health insurance. The extra revenue, over a trillion dollars annually, could finance a large reduction in marginal rates. This step would also simplify the code and make it fairer.

Imagine that Congress proposed to send an annual check to each homeowner. People with high incomes, who buy expensive houses, borrow lots of money or refinance often, would get bigger checks than people with low incomes, who buy smaller houses, save up more for down payments or pay down their mortgages. There would be rioting in the streets. Yet that is exactly what the mortgage-interest deduction accomplishes.

Similarly, suppose Congress proposed to match private charitable donations. But rich people would get a 40% match, middle class people only 10%, and poor people nothing. This is exactly what the charitable deduction accomplishes.

Zeroing out deductions, credits, and corporate and investment taxes matters—for permanence, for predictability and for simplicity. If the corporate rate is drastically reduced, or if deductions are capped, it seems that the economic distortions go away. But the thousands of pages of tax code are still in place, the army of lawyers and accountants and lobbyists is still in place, and the next administration will itch to raise the caps, and the rate.

Why is tax reform paralyzed? Because political debate mixes the goal of efficiently raising revenue with so many other objectives. Some want more progressivity or more revenue. Others defend subsidies and transfers for specific activities, groups or businesses. They hold reform hostage.

Wise politicians often bundle dissimilar goals to attract a majority. But when bundling leads to paralysis, progress comes by separating the issues. Thus, we should agree to first reform the structure of the tax code, leaving the rates blank. We will then separately debate rates, and the consequent overall revenue and progressivity.

Consumption-based taxes can be progressive. A simplified income tax, excluding investment income and allowing a full deduction for savings, could tax high-income earners’ consumption at a higher rate. Low-income people can receive transfers and credits. I think smaller government and less progressivity are wiser. But we can agree on an efficient, simple and fair tax, and debate revenues and progressivity separately.

We should also agree to separate the tax code from the subsidy code. We agree to debate subsidies for mortgage-interest payments, electric cars and the like—transparent and on-budget—but separately from tax reform.

Negotiating such an agreement will be hard. But the ability to achieve grand bargains is the most important characteristic of great political leaders.

Mr. Cochrane is a senior fellow at Stanford University’s Hoover Institution.