Fed cuts rates to 4.75%

I don’t have time to say much, but I will say that the Fed’s decision to cut rates 50 basis points was silly. They are pretty much telling the market that they will bail them out when the shit hits the fan from taking on overly risky investments. Although this decision may forestall a recession in the US, how many future recessions will be the result of the relatively new Fed governor Ben Bernanke showing that he will follow the whim of the asset market.

People are comparing this situation to 2000/2001 when Alan Greenspan cut rate significantly to stop a recession. If this was even true it would be an indictment of today’s decision, as in some ways the ease with which rates were cut in 2000/2001 lead to the asset bubble we are now facing.

However, todays decision is even worse than the 2000/2001 decision, as inflationary pressures are HIGHLY elevated. A good central bank should first and foremost control inflationary pressures. However, it seems that many central banks are starting to forget their primary goal.

Slavery and growth

Many writers have noted that colonisation contribute to the sad state of many African economies today. Now Nathan Nunn claims that the slave trade may also have had a long-term impact on economies. The author

…find[s] a robust negative relationship between the number of slaves exported from a country and current economic performance. To better understand if the relationship is causal, I examine the historical evidence on selection into the slave trades, and use instrumental variables.

This analysis indicates that “…it was actually the most developed areas of Africa that tended to select into the slave trades”, which points to a causal relationship running from slavery to poor economiic performance. The author suggests that the reason might be that “…procurement of slaves through internal warfare, raiding, and kidnapping resulted in subsequent state collapse and ethnic fractionalization.”

Yet another reason why the West is morally required to help African nations out of their current strife?

A framework for normative economics

This is a post that Matt really should have written, but unfortunately he’s snowed under at work at the moment. Having said that, it’s not really much more than a plug for Steven Landsburg’s fascinating new paper entitled “The Methodology of Normative Economics”. Economists tend to shy away from making normative judgments: when constructing a social welfare function they claim to be maximising efficiency. Yet the form of that welfare function determines the form of the efficient solution. Moreover, people clearly have strong feelings about what constitutes an appropriate welfare function for a regulator to maximise.

Given that people feel strongly about what form this function takes it makes sense to model people as having preferences over different forms of the welfare function. For a welfare function to be ‘consistent’ it must predict that it is itself the optimal welfare function to use. Landsburg shows that, if rich people care about equity, there is only one such function that exists. Even if people are selfish and don’t care about equitable distribution of income, there are only a limited number of consistent welfare functions.

What I really like about Landsburg’s paper is that it forces economists to confront the normative judgments that they inevitably make when they talk about welfare. Yet it forces them to do so by using an analytical framework that they are comfortable with. Rather than forcing them to make value judgments, it allows them to talk about the normative framework of their model without having to resort to moral or philosophical discourse that they are ill-equipped to deal with.

Check out another of Landsburg’s methodology papers here if this stuff dings your bell.

An alternative ‘fat tax’

Matt’s talked in the past about fuel taxes to reduce emissions and reduce the time cost of congestion. This paper suggests that there may be further benefits to a fuel tax. Using US data the author estimates that

…a $1 increase in gasoline prices would reduce obesity by 15% in the U.S., saving 16,000 lives and $17 billion per year. These monetary savings would offset approximately 16% of the increased expenditures on gasoline. Additionally, …13% of the recent rise in obesity from 1979 to 2004 can be attributed to the decline in real gas prices.

He attributes this to both an increased time spent on incidental exercise and a reduction in eating at restaurants. It seems almost too good to be true, and perhaps it is, but it’s certainly an interesting alternative to taxing unhealthy foods.

Insiders vs outsiders

Government departments are constantly criticised for their lavish spending on outside consultants. Why, the newspapers ask, couldn’t they rely on the inside talent that taxpayers are already forking out for. This paper, mentioned by Eliezer Yudkowsky may give some clue. It turns out that people are not only incredibly bad at predicting how long it will take them to complete a task, they also get worse at predicting it as they know more about it.

A person who knows the ins and outs of a project will estimate the completion time of the project by taking in to account all of the things that they know need to be done for that particular project. In doing so they tend to disregard all of the unforseen stuff-ups that could happen along the way. An outsider will tend to estimate completion time by looking at how long similar projects have atken in the past. It turns out that the latter approach is not only far more accurate, but also estimates completion times far, far longer than ever predicted by insiders.

Could it be that, in some cases, ministries are actually saving us money by getting an outside perspective on a project? Quite conceivably, the money spent hiring the consultant improves project planning to the point that less money will be wasted on false expectations of the project’s success. We should also disregard the protestations of the ministry insiders that the hiring of the consultant was a waste of money because the consultants know very little about the project. It is precisely because they are not involved in the micro-management of the project that they can provide a realistic estimate of the project’s expected success and completion time. Of course, advocating more government spending on consultants is hardly an election winning strategy.

Has the Fed cut rates without telling anyone

Greg Mankiw noticed that the Fed target is still 5.25%, however the effective rate in August was only 5.02%.

This is interesting, in NZ you could not do this as the Bank is willing to release any amount of money for a given interest rate (that is what our OCR target implies), the constraint in this case is money demand. In American they have a Federal Funds rate, which acts as there target rate. However, they also target a certain money supply level and use open market operations to get there.

Now you can’t arbitrarily choose the combination of the price (interest rate) and quantity of money in the market place, it depends on money demand. As a result, the Fed can only truly control one of these variables, as if they want to hit their target rate there is only one level of money supply that will allow it (given a strictly downward sloping money demand curve).

According to Mankiw, the Fed is pretty good at choosing the right amount of money supply so as to achieve the Federal Funds rate. By deviating from this they are loosening monetary policy, even if they haven’t said they have. The fact that the Fed has control of money supply as well as money demand allows them to be loosen monetary policy quickly without making the market feel like they are. However, it makes them less transparent, which in the long run is not a good thing.