I'm an Economist

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An insightful blog about economics and economics related issues. I tackle the most complex economic ideas and offer unique and simple comments and solutions.
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Vote buying with intergovernmental grants (my paper published in Public Choice)

Čet, 23/02/2017 - 06:59
When I started working in the academia a few years back, my friend and co-author Josip Glaurdić asked me which journal would I like to be published in the most? Without hesitation I said: Public Choice
Well, that goal has now been accomplished. I have a publication in one of my all time favorite political economy journals! You can read the paper on this link, it's been published online first. Next big goal: Quarterly Journal of Economics (I will also accept American Economic Review, Journal of Political Economy or American Political Science Review). 
Our paper is on the political bias in the allocation of intergovernmental grants in Croatia. Here's the abstract: "Instead of alleviating fiscal inequalities, intergovernmental grants are often used to fulfill the grantors’ political goals. This study uses a unique panel dataset on more than 500 Croatian municipalities over a 12-year period to uncover the extent to which grant distribution is biased owing to grantors’ electoral concerns. Instead of the default fixed effects approach to modelling panel data, we apply a novel within-between specification aimed at uncovering the contextual source of variation, focusing on the effects of electoral concerns on grant allocation within and between municipalities. We find evidence of a substantial political bias in grant allocations both within and between municipalities, particularly when it comes to local-level electoral concerns. The paper offers researchers a new perspective when tackling the issue of politically biased grant allocation using panel data, particularly when they wish to uncover the simultaneous impact of time-variant and time-invariant factors, or when they cannot apply a quasi-experimental approach because of specific institutional contexts."Basically, we have taken a new spin on a well-researched topic in the field of political economy: does central government allocate local government grants based on selective political criteria? There is a multitude of papers on this for various countries (just check out our references), with the overreaching conclusion being: yes, there is a political bias in the allocation of intergovernmental grants (intergovernmental meaning the flow of funds from the central to the local government). It happens for two main reasons: 1) central government helps its local co-partisans (mayors from the same party as the national government) retain office by giving them more money to buy votes in local election years, and 2) the central government helps itself (increases its own chances of re-election) by giving more money to important districts in national election years. An important district can be either a swing district, where voters often switch from one party to the other, or a core district, where voters always vote for the same party. The literature has found evidence of both. We find that money mostly goes to core districts. Politicians thus want to get as many votes as possible in districts where they are already strong. 
So what makes our paper special? The standard literature approach was mainly to uncover the within unit variation of grant allocation over time. This means that they wanted to see which factors' changes over time affect how much money does a local unit of government get. When uncovering the effect this way the literature usually discards any between-unit variation, i.e. it cannot make any inferences between local units. To clarify here is a sentence from the paper: "For example, finding that larger vote shares for the government within counties result in more allocated grants over time—clearly a within effect—often is misinterpreted as the between effect and generalized into a cross-sectional conclusion that counties received more grants because the government garnered a larger share of the votes in a previous election."
A few clarifications before moving on: A panel dataset means having observations on multiple units over time. This is opposed to a cross-section where you just have observations on multiple units in one fixed time period. Having panel data is great because it allows you to eliminate any changes across units that stay fixed over time (like gender, geography, demographics, or any slow-changing variable like institutions), and focus only on estimating the effect of the changing independent variables on your outcome of interest. It is a very neat way of making correct inferences in the social sciences. 
What we wanted to do is to use our panel dataset to explore the variation both within and between our units of interest. So not only the standard within effect in a municipality over time, but also the cross-sectional effect of the differences between units to see which non-changing factors also could affect our outcome. In our own words:"We test how the effects of political considerations on grant allocation change over time within each entity and how they vary across them. The within-between approach thus allows for the inclusion of potentially influential time-invariant variables, which the fixed effects approach eliminates, as a separate between-entity effect, in addition to keeping all the benefits of the fixed effects estimation. Disentangling the within- and between-entity effects is important as it not only provides a more substantive interpretation, but also enables the researcher to correctly identify the source of variation by not confusing which of the two effects is driving the estimated relationship. By utilizing this particular approach our goal is to offer researchers a new perspective on tackling the issue of grant allocation when one wishes to test for the simultaneous impact of time-invariant and time-variant variables, and when a quasi-experimental setting is unfeasible owing to specific circumstances of the observed political system."The within-between approach is a new method referenced to a great paper by Bell and Jones (2015)
Results
What do we find? As I've said before, there is a clear conclusion that there is a significant political bias in the allocation of intergovernmental grants. The national government favors municipalities that support them in the national elections, and those that were won over by their co-partisan mayors. They give more money during election years (both national and local), and they support core municipalities rather than swing municipalities. 
The within-between approach was most helpful in examining the interaction effect of votes for government and turnout. This is best seen on the figures below:

In our own words: "...in Fig. 1 it is obvious that higher national turnout is conditioning only the within-municipality changes in grants in a positive way, whereas the between effect goes in completely the opposite direction (and also is insignificant). In other words, the government rewards only those municipalities wherein they gain support through higher voter turnout rates across time. In Fig. 2, representing local level estimates, the conditionality of turnout on a between-municipality level is shown to be crucial for concluding that mayors who win on higher voter turnouts are likely to receive larger grants. The within effect plays no role here, so the conclusion regarding the effect of mayoral alignment and turnout on grant allocation is valid only on a between-municipality level. In other words, aligned mayors who win their posts with high voter turnout rates do not get more intergovernmental grants (they do get more such funds, but not conditioned on turnout), while aligned mayors already holding power do get more money if they can increase voter turnout. Both findings make sense, since winning over a new municipality is good for the national party regardless of turnout, while for existing incumbents establishing their dominance with even more support is likely to be rewarded. None of these conclusions would have been possible without the use of the WB approach."
Kategorije: Hrvatska

This Trumpian neomercantilism is ridiculous!

Uto, 31/01/2017 - 15:00
Protectionism never helped anyone. Particularly among the developed nations. I have yet to encounter a case of a rich country becoming even richer after imposing tariffs and trade restrictions. Even when looking at firm-level data over the long run, protectionism never helped. In many cases it arguably made them even less efficient (I provide a real-life example below). The notion that tariffs (taxes on imports) and quotas (limits on import quantities) are in general bad for the economy that imposes them could even be called a stylized fact of the profession. And it is one of those rare 'facts' a vast majority of economists would agree with; even those who like to emphasize that free trade has both winners and losers, and even those who cite the successes of South Korea or China in using state protectionism of infant industries to gain a competitive advantage abroad (although there are a lot more factors explaining their success - plus I have yet to see a good piece of research defending this argument). 
So why then, if the experts are practically unanimous, are calls for protectionism so attractive and can become so politically salient? One reason is because people don't trust experts anymore, but even when they did, they still had a misunderstanding of trade. Trade is just one of those topics everyone seems to have an opinion on, usually the wrong one. I've written before on the ills of the so-called mercantilist fallacy. This fallacy usually attracts anyone who suffers from a zero-sum game mentality. Your gain must imply my loss. If we trade with China and have a trade deficit (we import more than we export), we're "losing to China". This is the same variant of the classic saying that "exports are good while imports are bad". If I export then I get money, if I import I lose money. 
Let me emphasize just how ridiculous this argument is. Saying that imports are bad and exports are good is like saying that selling is good (cause we get money when we sell something) while buying is bad (cause we lose money when we buy something). Far from it! Both transactions are good, because when you buy/import you do it either to resell it at a higher price or consume it. If the transaction is voluntary it is by definition beneficial, both for the seller and the buyer, regardless if the seller/buyer is a foreigner. 
Also, governments, i.e. countries do not import nor export. Companies do. They sell (export) and buy (import) on the international market. In fact, the determinant of the demand for imports comes directly from the consumers themselves. Or companies buying intermediary products that are cheaper abroad. If we as customers have a greater benefit from consuming foreign rather than domestic goods, then there will be a company that will offer them to us. It will import foreign goods knowing someone back home will buy them. We as consumers therefore determine the demand for imported goods. Whether it's clothes or food, that almost any country can produce on its own, or cars and IT goods that most countries cannot.
How the import tariff affects US consumers

So how does all this link to the new US President? Well, it's got to do with the most recent set of ideas on trade policy coming from the experts in the Trump administration (btw, should we trust these experts over all the others? I guess we should, they do work for the President, right?).
Take for instance their idea for imposing a tariff of 20% on all imports coming from Mexico. Guess who will pay the ultimate price of that 20% tariff? Yes, you've guessed it - US consumers! How? Let me explain it in very simple, Trumpian terms.
I am a distribution company (let's call me 'the Middleman') which sells electric equipment (let's call it 'Stuff') all across the US. I don't make them myself, I just sell them. So when I buy the Stuff I want to sell, my main motivation for purchase will be a good (i.e. low) price. I buy most of the Stuff from Mexico, from a firm called Mexico Stuff Manufacturer (MSM) and then sell it to local shops across the country. MSM gives me a good quality product and at a lower cost than if I were to buy domestically.
Now the tariff is implemented at 20% on all imports from Mexico. If I want to buy the Stuff from MSM again I have to pay 20% more. That's not very good news for me given that this would eat up almost my entire profit margin. In other words if I buy the Stuff at a higher price I have to increase my selling price to the shops to stay in business. 
Or, if I don't want to do that I can always find a new supplier, perhaps someone in the US - call it US Stuff Manufacturer (USSM). The thing is, the reason I didn't go there in the first place was because USSM was charging me more than MSM for the same quality Stuff. Now that their prices are, let's assume, equal, I am basically at a standstill since whoever I buy from I still have to charge a higher price to the shops. So I decide to stick with the devil/supplier I know. In each case, whatever I choose to do, my prices will have to go up. 
So I go to the shops and sell them the Stuff at a 20% higher price. What do they do? They push that same price increase on the final consumer and charge them the extra 20% they had to pay me. They're in the same business I'm in - they buy the Stuff from me, and resell it at a higher price to the final consumer. 
But why would the shops pay the higher price? Why would they be the price-taker in this case? Because they are in the exact same position I'm in - they have no choice. In either case, if they buy from me or if they decide to switch and get the Stuff from USSM directly they still need to pay a higher price than before - a price that will always be shifted to the final consumer. The example holds even if the price of Mexican Stuff is now higher than the price of US Stuff, because the price at which we buy the US Stuff for will still be higher than the old pre-tariff price of Mexican Stuff. 
This is why a tariff on imports has the equivalence of a tax on domestic consumers buying foreign goods. This might sound like an attractive way to nudge consumers towards buying more stuff produced domestically, but we're talking about individual preferences here. If I like a foreign car, if I think it's more fuel efficient, I will buy a foreign car, regardless of what my government wants me to do. I would hate to have the government limiting my free choice and telling me what to buy! (Wasn't this the biggest issue some Americans had with Obamacare?)
What if the goods being traded are perfect substitutes? 
In other words what if I can easily switch between domestic and foreign brands, so that by imposing a higher price on Mexican Stuff, consumers will just switch to US Stuff as it will now be more price competitive? In theory yes, in reality - no. Why? Just look at the composition and current prices of the goods the US imports from Mexico
Source: CNN MoneyCan the US produce all this stuff? Sure it can. In fact, it does, and it exports the same stuff to Mexico (see for yourself). Why is there then a demand for these products to come from Mexico? Price competitiveness due to lower wage costs in Mexico could be only one reason (the example above explained how that works). Another very important one are individual preferences. 
Of the top of my head I can remember a very similar protectionist policy applied by the US back in the 1980s against Japanese imported cars. There was a voluntary export restriction imposed by the US government in 1981 limiting the number of Japanese cars to be imported in the States to 1,68 million per year. It was later raised to 1.85 million and to 2.3 million by 1985. It was finally lifted in 1994 (read more here or here). What happened? The policy directly lowered the supply of Japanese cars on the market. With demand remaining high what was the effect? Prices went up. US consumers did not stop buying Japanese cars despite their higher price. They were simply better than US cars. More fuel efficient to be exact. Who profited from this policy? Only one group: Japanese car companies. That's right, the end effect of a protectionist policy aimed to protect the US car industry made Japanese car companies richer. (This is, mind you, an example from the classical textbook by Krugman and Obsfeld on International trade)
Finally, I don't see why Mexico is complaining. Or China. A 20% tax on imports from Mexico and an alleged 40% tax on imports from China is only going to benefit the companies in these countries. Sure, they might sell lower quantities of their products, but they will more than compensate this with higher prices. 
Who will pay the price for this? US consumers. Protectionism is a tax on them. So when Trump says he will force Mexico to pay for 'the Wall' by imposing a tariff on their imports, I hope these examples helped illustrate what this means - it means that US consumers will ultimately pay for the Wall through a tax they won't even realize hit them. 
Kategorije: Hrvatska

2016: a bad year for predictions

Uto, 27/12/2016 - 16:22
Talk about Black Swans, 2016 was full of them! From elections to markets, from hacking to terrorist attacks, it was one unexpected event after another. Each a complete shocker in its own way. Especially in sports and politics. Portugal winning the Euro football tournament, Leicester winning the Premier League, Britain coming in second at the Olympic game medal count, or the Chicago Cubs winning the World Series were as big as Black Swans as Brexit or Trump. 
It goes without saying that a year of Black Swans was a terrible year for forecasters. Even the biggest names of the 'industry' have stumbled and failed to predict the biggest disruptive events of the year: Brexit and Trump. Not my company. We got Trump spot on. Just to remind my readers, we called 47 states including the most important swing states like PA, FL, NC, and OH for Trump. Our unique prediction method, that was further perfected since Brexit, has hit bull's-eye!Our almost perfect prediction for Trump
Oraclum Intelligence SystemsI cannot say the same for myself however. I usually make my prediction at the beginning of each year. So far I boasted some big hits like the UK general election of 2015, the success of anti-establishment parties in the EU 2014 elections, the Scottish referendum, oil prices, interest rates, year-on-year economic growth projections, and even Germany as the winner of the 2014 World Cup
But this year it's been quite a few misses for my beginning-of-the-year predictions. The very title of my January 1st blog signifies the extent of the miss - "women in charge". I predicted that by the end of the year Hillary Clinton is expected to join Angela Merkel, Janet Yellen, and Christine Lagarde (and Irina Bokova as the UN secretary general) to have five out of ten most powerful political positions be held by women. That was a big miss. Hillary lost, Bokova lost, Yellen will most likely be replaced by Donald Trump, and Merkel is facing a tough election next year (although she will probably hold on). The woman I did not see coming was Theresa May, the new UK PM. Even if I had predicted Brexit back then I would have said that Cameron would have been replaced by Boris Johnson, not Theresa May. Again, a true Black Swan. 
Brexit was another big miss. I was categorical in saying that Britain won't leave the EU. I wasn't even sure the referendum would be held this year (this wasn't decided until February, as Cameron wanted to move quickly to capitalize on his general election victory). I had a bunch of rational explanations on why the Brits will not vote Leave. All of which apparently biased by my liberal worldview. I wrote a comment on this after the event, making a couple of other bold predictions on the way. I just can't get enough of predictions, apparently.  
In the US not only was I very bullish on Hillary, I didn't even predict Sanders to give her a run for her money. I did give Trump the biggest probability to win the Republican presidential nomination (I had Rubio second), but I still gave Hillary 55% to clinch the Presidency in November. Interestingly enough I didn't change my mind on Hillary's chances until the last few days of the campaign when I saw our model estimating a Trump victory. It was a shocker, but we did get it right. The lesson was to trust my data, not my guts. 
The second lesson from this was that with election forecasting I should wait for the last few weeks before the elections to figure out how the voters feel. After all I now possess a powerful method to do just that, so I will refrain from making any more election predictions a year in advance. Plus, I'll rather sell this info to our clients rather than boasting on my blog. 
Oh, and I also missed my sports predictions. I said that either Germany or Belgium will win the Euro, but in the end it was a final between Portugal and France, won by - surprise, surprise - Portugal. For the Olympics I was right that the US will win the most medals but I never even dreamed that the UK will come in second. In front of China! Now that was a surprise. 
The hits
It wasn't all misses. I had some good wins. Such as the economy, which unlike politics was rather predictable last year. Ireland was, as predicted, the best performer of the year in the EU, while Greece was the worst. The developed world grew more robustly, although the recovery is still slow, particularly in Europe. The US continued a steady growth trajectory and unemployment fell below 5%. The Fed raised interest rates only slightly in December, while other central banks (ECB, BoE) went for the opposite following the massive political uncertainty in Europe.
Oil prices did not go above $60, China did not go into recession as many were screaming early this year, and Putin came out of the year stronger than ever. Japan is still stagnating, and India overtook China as the fastest growing economy. All of these were good predictions, the kind that were slightly easier to make. 
Oh and here's one big hit - I predicted no terrorist attacks during the Olympics in Brazil or the Euro in France. This was a bold prediction but I was confident nothing would happen given the level of security usually associated with these events. Terrorists will not get away with it if everyone is paying extra careful attention to spot them out. 
Interestingly, with all the Black Swans that happened this year none of them went 'under the radar'. In other words Brexit or Trump had a realistic chance of happening, even if many estimated those chances to be low. Leicester or the Cubs on the other hand - those were the true under-the-radar Black Swans.

Anyway, if you think this year was hard to predict, think of how difficult the next one will be. No one has an idea of what a Trump presidency will look like. No one has an idea how Brexit will turn out (I'm sure Britain will Leave, the question is under which circumstances). Politically it could be another shocker with elections coming up in Germany, France, and the Netherlands. The last two could bring leaders that could spell and end to the EU itself. What about Syria and the EU refugee problem? Will Putin and Trump solve these issues? What about the potential US trade war with China? We're in for quite a ride! 
Kategorije: Hrvatska