Brad DeLong has a piece linking to Rajnish Mehra’s survey of the literature on the equity premium puzzle, that is, the fact that the risk premium demanded by investors in private equity is much higher than seems reasonable on the basis of standard assumptions about individual preferences and capital market efficiency. My view is that no monocausal explanation can work but that the puzzle implies that the obvious gaps in financial markets (the absence of private unemployment insurance and the big wedge between borrowing and lending rates for individuals) have profound effects on the supply of equity capital.

To misquote Marx, the problem now is not to explain the equity premium but to derive its policy implications. To some extent, of course, the implications depend on the explanation. Still the framing of the problem as a puzzle has led to an excessive focus on puzzle-solving. Simon Grant and I have been looking at this question for a number of years. You can read our survey article here (PDF file).

Some of the implications reinforce common ideas. For example, the common view that recessions are socially very costly (compared to a stable rate of output growth with no booms and no recessions) is hard to sustain on a standard welfare analysis assuming efficient capital markets. Consideration of the equity premium implies that recessions are indeed socially costly.

Other implications are more surprising at least to those who have imbibed the current conventional wisdom. In this piece (PDF file), which just came out in Economica, we show that, if explanations of the equity premium based on market imperfections are accepted, the rate of return for public investments should be lower than the rate demanded by private investors in projects with similar risk characteristics. An immediate implication is that, other things (such as operational efficiency) being equal, privatisation will reduce welfare and nationalisation will increase it. Of course, other things are rarely equal, so the analysis supports a mixed economy with some services being provided by public enterprise and others

In this piece, which came out in the American Economic Review last year, we show that market failure explanations of the equity premium puzzle support the Clinton plan to invest some of the Social Security fund in stocks as opposed to the Bush plan of creating individual accounts.

The struggle for economic literacy goes on. At the Age Ken Davidson points out, again, the nonsensical thinking behind the use of “net debt” as a policy target. Meanwhile, at the SMH, Ross Gittins gives a good explanation of movements in the exchange rate, pointing out that the $US/$A rate fluctuates around the “purchasing power parity” value of $A1.00 = $US0.70 and that an appreciation in the exchange rate is not good for everyone, particularly not for exporters.

I have two small quibbles with Ross. First, he misses the chance to point out that the $US/$A rate is not “the” exchange rate, or even the most important one.

Second, he says that we’ll never see a return to parity ($A1.00 = $US1.00) noting that the PPP rate of $A1.00 = $US0.70 is below parity because Australia had higher inflation than the US in the 1980s. But when it hit $A1.00 =$0.48, the $A was about 40 per cent below PPP. It’s just as likely, in the long run, to fluctuate 40 per cent above PPP which would reach parity. (I confess that I took a small bet on this some time ago, at long odds, but, as I often do, underestimated the time it would take to return to, and overshoot, the long run equilibrium value).

While I’m catching up on my email, I’ll point to this updated Budget simulator from Nathan Newman.

An excellent piece in the Times (free registration required) on the balance sheet manipulations associated with public-private partnerships in the UK.

The National Audit Office (NAO) said that Network Rail was a state entity: its assets and liabilities should be kept on the Government’s balance sheet, because the Government would bail it out if it ran into difficulties. But the ONS classified Network Rail as private, on the basis that Whitehall did not directly control it. Despite the urging of the Statistics Commission, ONS and NAO have still not agreed: they have agreed to differ, on the flimsy basis that the ONS was governed by EU accounting rules while the NAO was not. Yet the Treasury seems happy to let the ONS’s view prevail, which has the useful result of reducing the national debt by something in the order of £25 billion.

The Treasury’s attitude to London Underground is similarly ambiguous. It has happily issued to Tube contractors letters of comfort, which are effectively a guarantee that the Treasury would be the lender of last resort, while claiming that private contractors deserve a healthy premium under the Public Private Partnership (PPP) because they are bearing the risk.

National institutions like hospitals and railways must be kept on the books because governments will never let them go bust.

I had a go at this topic, pointing out the similarities to the Enron fiasco, here.

In considering the ‘brilliant supply-side academics’* proposed by Stephen Moore as alternatives to Greg Mankiw for CEA Chairman, I left for later the allegation made by Moore that Mankiw had misrepresented supply-side economics with his claim that a small group of economic ‘cranks and charlatans’ had convinced then-candidate Ronald Reagan that tax cuts could increase revenue. Moore like his colleague Bruce Bartlett, vehemently denies this. They are supported by Alex Robson and William Sjostrom

The first problem here is that there are two competing claims about what ‘supply-side economics’ means. In one usage, it refers to anybody who thinks economic policies aimed at increasing the productive efficiency of the economy are more important than Keynesian policies aimed at stabilising aggregate demand. In Australia, the same idea was captured in the shift of attention from macroeconomic management to microeconomic reform. The group of economists who are supply-siders in this definition is large, arguably a majority of the profession.

A narrower definition , more popular nowadays, confines the term ‘supply-side’ to supporters of large tax cuts and particularly to followers of economist Arthur Laffer and Wall Street Journal writer Jude Wanniski.

Laffer’s name is associated with the famous Laffer curve, but as everyone in this debate is agreed, the Laffer curve itself is neither new nor controversial.

The controversial points are what I’ll call:
(i) The ‘Laffer-Wanniski tax proposition’ namely that, as of 1980, tax rates in the US were such that the government was at or beyond the point at which tax reductions would actually increase revenue
(ii) The ‘Laffer-Wanniski Reagan claim’, namely that Laffer and Wanniski sold this idea to Ronald Reagan

It seems pretty clear that both Laffer (a senior economic adviser to Reagan) and Wanniski (an influential writer at the time) did in fact advance the Laffer-Wanniski tax proposition. The piece linked below implies it, though it doesn’t directly state it. I’ll try to locate an unambiguous statement of the proposition in Laffer’s 1982 book when I get time.

As regards the ‘Laffer-Wanniski Reagan claim, here’s what Wanniski has to say.

“In my 1978 book, The Way the World Works , I named that curve after Arthur B. Laffer, who was the first economist to turn the ancient intellectual concept into a visual graphic. I’d spent the previous four years trying to persuade liberal Democrats that while it is imperative that the richest citizens bear the greatest burden of government, there comes a point in the rates where the rich avoid paying the higher taxes, and the burden falls on those who are not rich. When no Democrats showed interest, I changed my party affiliation and, with the help of Irving Kristol, Jack Kemp, and The Wall Street Journal , sold the idea to Ronald Reagan. That’s the history.

Wanniski’s claim to have convinced Reagan is rejected by (broad sense) supply-siders who were around at the time , like William Niskanen (quoted by Alex Robson), and it seems unlikely that the truth can be determined.

Mankiw’s takes a middle course, saying that

… the argument was appealing to Reagan, and it shaped the 1980 Presidential campaign and the economic policies of the 1980s./.

This seems pretty much unassailable to me. The idea certainly was appealing to Reagan and his campaign – hence Bush Senior’s attacks on ‘voodoo economics’. Reagan and his administration may not have officially endorsed the Laffer-Wanniski tax proposition, but it certainly did shape the policy debate, making the extreme claims of people like Stephen Moore and Bruce Bartlett (soon to be enshrined in the Budget process as ‘dynamic scoring’) seem modest and reasonable by comparison.

*Kieran Healy reports that the National Review has quietly deleted the word “academic” from Moore’s description of his supply-side CEA candidates Malpass, Vedders and Wesbury. I suppose I can count that as a concession of error on my main point. Perhaps now Moore, Sjostrom or Robson will enlighten us as to what contributions these guys have made that would rank them as “brilliant” successors to Feldstein, Stiglitz, Greenspan et al.

Update Brad DeLong has more. He refers to my agnostic conclusion about Reagan’s mental states as “nihilistic-relativistic”, but then appears to endorse it “What Reagan thought in his heart-of-hearts is not very important ” and most of the rest of my analysis, with a lot more supporting detail. William Sjostrom also has more. He advises, contrary to what I inferred above, that he doesn’t have a view on Mankiw’s merits or the substance of Moore’s claims. He also has interesting discussions of why he’s not a macroeconomist and of the value (or otherwise) of a PhD.