Russell Roberts's Blog, page 1501

Capital markets vs. Wall St.

In this post on inequality, I mentioned:

And some in the top 1% were there in 1980 and are still there because they feed at the great rent-seeking trough. Wall Street, please get a life like the rest of us where bad financial decisions have consequences.

In the comments, PDN wrote:

I agree with 99.9% of this but take issue with your snideness towards Wall Street. First, deep, broad and efficient capital markets are a critical pillar in the free market system that has delivered us our inexorable rise of living standards. It is no accident that the US, with its highly developed capital markets, has led the world in advancing living standards. Second, "Wall Street" is a simplistic term glossing over the fact that the financial services industry is a highly diverse universe where the overwhelming percent of actors DO face the consequences of their decisions. Banks failed, brokerages failed, numerous hedge funds failed, money market mutual funds failed, insurance companies failed and countless investors lost untold billions. The fact that our government panicked and felt the need to throw billions at the cascade of failure that was rolling in (and that a small number of "Wall Streeters" welcomed and encouraged the government) is not justification to take such a sweeping and dismissive attitude toward our capital markets.

Yes, "deep, broad and efficient capital markets are a crictical pillar in the free market system." That's why I worry we don't have a free market system. There is no evidence that US capital markets are efficient in the way that word is used broadly in economics rather than the way it is used in finance. In the broad sense of the word, it means "undistorted" or "minimizes waste" or "encourages people to bear the full costs and benefits of their actions at the margin in order to maximize the size of the pie." That is precisely what we do NOT have in the way financial markets are currently organized. We are right now in the middle of a giant mess at least partly if not totally because over hte last 30 years, policy-makers have systematically reduced the costs of extending credit unwisely on behalf of large financial institutions. That in turn, along with US housing policy, has encouraged leverage, especially for investments in the housing sector which encouraged trillions (with a "tr") of dollars to go into the housing sector.

That was not efficient.

That did not enhance our standard of living. It reduced it. It also allowed politicians to justify an increase in the size of government to fight the mess we're in.

There are parts of our financial system that I think are efficient and that enhance our standard of living. The venture capital market.

And you are right of course–there are parts of Wall Street that are subject to market forces. But as long as creditors in large financial institutions are not in that group, it doesn't matter how many banks or hedge funds or insurance companies fail–the players in the large financial institutions will be encouraged to be over-leveraged and the decision-makers who make imprudent decisions with borrowed money will be highly rewarded as they pick up nickels in front of the steamroller.

Until the relationship between large financial institutions and Washington changes, we will have crony capitalism rather than the real thing.

False Choice

Matt Miller is furious that Pres. Obama won't raise taxes on any Americans.  The reason for Miller's anger is, of course, the children – in particular, America's K-12 students who perform poorly in math.  Far better for the children, Miller asserts, that government raise taxes and spend the money improving education than to let that money remain with the people who earn it.

This thesis rests on several dubious assumptions, but none more questionable than the one that equates higher government spending on education with better education.

Over the past forty years, Washington's inflation-adjusted per-pupil spending on K-12 education has more than doubled.  Yet as the Cato Institute's Neal McCluskey reported last month, "There's been essentially no change in high school math achievement for the last nearly four decades."

To shovel yet more lucre into public-school bureaucracies is to reward failure.  And to do so by raising taxes on income earners is to punish success.  That formula just doesn't compute

What's Wrong with Keynes

This is a very long post. It's the latest version of my thoughts on Keynesian stimulus, the idea that spending creates prosperity or supports our economy or rescues it from the doldrums. John Papola, my collaborator on the video projects at EconStories, continues to push the two of us to think about these issues. So the thoughts that follow have been stimulated greatly by those conversations. Some of my earlier thoughts on stimulus and spending are here, here, and here. This isn't as well organized as I'd like so read on at your own peril.

In particular, I've been thinking about the idea that in times of high unemployment, the government can borrow money and give it to people to spend creating beneficial effects—either  job creation or via the idea of a "multiplier," creating income gains in addition to those received by the people who get the initial gift. And that in turn will create jobs.

For many people, economists and non-economists, nothing could be more intuitive than the idea that giving people money stimulates the economy. I think they have two fundamental ideas in mind, two ideas that are somewhat related. The first is the multiplier. If the government gives A one dollar to spend, A spends it on something B produces, encouraging B to hire more workers. But it doesn't end there. Now B has money now who spends it on C and so on. Because people save part of what they spend, A's spending is less than a dollar, say .9. Then B spends .81 cents (.9 x .9) and so on. If you do the math (and if everyone spends 90% of what they earn) then this infinite series leads to a total amount of spending equal to $10.

There are two standard criticisms of this idea. One is that the money has to come from somewhere. If you tax D to raise the dollar, and D has the same spending rate as everyone else of 90 cents for every dollar received, then there is no increase in total spending. If you borrow the money, then some people who are going to pay the taxes will put aside money now in anticipation of future taxes and that will cancel out some or all of the $10 gain.

(I am ignoring the Keynesian implication that savings is just waste. But savings usually funds investments for the future that in turn create output. It's all spending. But you can argue that in today's investment climate, extra savings doesn't fund much investment–people are just sitting on it.)

If people don't anticipate future taxes or don't respond to them today, then yes, says the standard argument, you will get $10 of stimulus today, but it will be offset by $10 of losses tomorrow. The Keynesian then responds with the second idea behind using government spending to stimulate the economy. That's the idea that when we're in a recession, the economy is broken. The engine of the economy needs a jump-start. The pump needs priming. By giving people money who start spending now, the whole system gets going so it can be once again be healthy and self-sustaining. It's like the battery of your car. If you drain your battery because you left the lights on overnight, the car needs a jump. Once it gets going, it will recharge simply by driving. So in the economic analogy, once people get spending, the circular flow of spending gets going once again, the people who were unemployed soon get employed, they start spending and the economic engine will once again be healthy and keep going. This is what Keynes meant when he talked about "magneto trouble."

This metaphor of the car that needs a jump start or the ship that needs a push because it's hit a patch of water that's windless, has a certain compelling feel to it. But it really has no intellectual content. It's an ex-post story to make you feel good about spending money. There's no there there. So when a Keynesian is confronted with the fact that about $800 billion dollars of spending was promised in February of 2008 (and more than half of it has been spent) but unemployment has barely budged, well that just proves how bad the economy was in February of 2008.

It's like saying that using these jumper cables will get your car started but sometimes, a regular jump isn't sufficient. You have to power up the healthy car when you do the jump because the car with the dead battery is so far gone that a regular jump won't do it. That's true with cars. But is it true with economies? It might be. It's possible that the economy was so sick in February of 2008—the cancer had spread more widely than we realized so we needed more and stronger chemo, to pick another metaphor. The problem with the metaphor is that it has no content. With a battery you can measure the strength before you jump it. You can do a CT scan of a cancer patient. But we don't have a diagnostic tool for the economy other than static measures like the current unemployment rate that tell us nothing about the expected or possible trajectory of the economy over time. So the current Keynesian stories of why the stimulus didn't work are just stories. Ex-post stories. They can't be distinguished from the hypothesis that we don't know what we're talking about or the hypothesis that stimulus spending is a sham.

I remember a cartoon where the driver of a stalled car gets out, opens the hood and there, underneath the hood, is a giant switch that is set to the "Off" position. So that's the problem, he says. In fact the economy is nothing like a stalled car. Here we are in the worst recession of my lifetime, the worst since 1933 yet over 90% of the workforce has jobs and millions of jobs are getting created every month. Just not quite enough to match the numbers that are looking for work. The economy isn't broken, just not working quite as well as it usually does. This is another reason that it's really hard to know what is wrong and how to fix it. There isn't an switch we need to turn back to "on." And it probably isn't as simple as boosting spending back to some larger level.

Having said all that, the logic of the circular flow idea, that spending begets further spending and that payment to labor leads to demands for products which leads to supply of products is pretty attractive. But part of the circular flow story is misleading because spending–the expenditure and receipt of money—can be very deceptive as a measure of prosperity.

For example, proponents of "buy local" will argue that it's good because it keeps the spending within the community. It keeps the money within the community. But we don't care about money, per se. If we only buy from each other (our local neighbors in our small town or even a big city), all the money will stay local but it won't go very far in both senses of the word. The prices will be high because we won't be able to fully exploit the division of labor and specialization that comes from trading with a wide group of people. We'll be very poor if we keep all of our money circulating among ourselves. What we really care about is not money, but what the money can buy. We care about our prosperity, not the dollar value attached to our paycheck. If we only trade among ourselves, our productivity will be relatively low. We will have a low standard of living. We will be poor even though we'll have all the money. Money by itself, is not a good measure of prosperity.

Money, after all, is just a way to avoid having to barter for stuff and avoid the coincidence of wants. If I want a chicken and potatoes for dinner, I don't want to find someone who raises chickens and grows potatoes who is also interested in getting a degree in economics. If the person who is interested in a degree in economics is a furniture maker, I can give her an economics lecture in exchange for a chair and then try to find a chicken farmer who needs a chair. Very time-consuming, what economists call high transaction costs. Better to take some general measure of purchasing power, money, from the furniture maker and buy a chicken.

So money is a veil. It hides the underlying reality that what I can consume depends on what I can produce. And what I can produce depends on the people I can exchange with and cooperate with economically. The division of labor is limited by the extent of the market. If I have a lot of people to exchange with, then I can be more specialized and via technology, get a lot richer than if I trade with a small circle of locals. If I trade widely, I'll have more money, but the amount of money I have is an effect not a cause. The existence of money is a cause–that creates wealth because it allows me to trade without have to find the chicken farmer who wants an economics lecture. But that's it.

The whole circular flow idea that underpins the Keynesian story is bizarre. It's a veil that disguises what's really going on–the trades and exchanges I'm able to make as a worker and consumer. The car analogy is flawed. What keeps the economy going is our mutual creativity and cooperation, not our spending. The spending is just a result of our underlying productivity and desires to consume out of what we produce. Part of the circular flow story is correct–there are a set of forces that keep the whole thing going on its own–but those forces are my skills and productivity and your skills and productivity and how they all fit together–what Arnold Kling has been calling PSST, patterns of sustainable specialization and trade. I would remove the word "sustainable" and stick with PST. The word "sustainable" suggests a transience or fragility that may or may not be important. Suffice it to say for now that in good times, the patterns of specialization and trade are changing constantly, as demand for products changes, as new entrants to the labor force bring different skills to the market, as tastes change and so on.

The web of work and wants that we create as employees, entrepreneurs, managers, and consumers is remarkably sustainable on its own. But it appears to work better in some times than others. In 1997 if you had a computer skill and applied that skill by working in a firm suddenly went out of business through no fault of your own, you could find another job pretty quickly. That was less true in 2001. And even less true now. Losing your job today is much scarier than losing your job in 1997. Having said that, the highly educated friends that I know who lost their jobs in the last three years have found work. It was scary but they didn't stay unemployed for very long. Longer than they would have liked and one had to move to find a new job, but they both did OK. They weren't unemployed for 99 weeks.

But there are people who have been unemployed for a very long time, who aren't being integrated into the existing pattern of specialization and trade. There could be many reasons for that. As I said earlier, this is why it's so tricky. The labor market isn't really broken. It's just not working quite as well as usual.

For now, let's ignore the reason or reasons that more people than usual are out of work for a lot longer than usual. What I want to consider now is the potential role of various kinds of spending to help those people, what the Keynesians call boosting aggregate demand.

Suppose 5% of the workforce is in the construction business. They're making houses that people like. Now it turns out people don't want to buy houses as much as they did before. Forget the reason. Doesn't matter. A bunch of construction workers are now  unemployed. Now consider two scenarios:

1. The unemployed construction workers find something else productive to do. They go and find work, take the money they receive from doing that new thing, and buy shoes.

2. The unemployed construction workers receive checks from the government. They use the money to buy shoes.

What's the difference? Don't both scenarios "stimulate the economy?" The difference is that in case 2, we only get more shoes. Maybe. But in case 1, we get more shoes and more of something else. Why is that relevant? Because purchasing power (via cash alone) is not prosperity. We know that via reductio ad absurdum. If the government sends big enough checks to the construction workers (and does so forever, to make it easier to think about) to get them to NOT find a new career, that doesn't create prosperity. That creates the ability of the construction workers to lay claim to lots of stuff. But they produce nothing. Widen the pool of people who get the checks. That expansion of aggregate demand REDUCES GDP because it takes even more people out of productive activities.

(This is obviously related to Bastiat and the broken window fallacy.)

Or consider this case:

3. The government borrows money and gives it to renters who use the money to buy houses. The government gives away enough money to enough renters so that they buy all the vacant houses and then demand enough new houses to employ all of the out of work construction workers.

I choose this example because a standard criticism of the stimulus is that it was poorly designed. It took too long. Not enough of it was targeted to real production and infrastructure. My question is whether this makes any difference. It's all supposed to boost aggregate demand and all of it does boost AD in Keynesian terms. Keynes did say and I have heard Joseph Stiglitz say that paying people to dig holes and fill them back in stimulates the economy, it just isn't as good as doing something productive which stimulates the economy and produces something of value at the same time.

So scenario 3 as I've crafted it, is a perfectly designed stimulus plan–it's targeted and puts the people back to work, right?

It is worth mentioning that while Keynesians like to talk about sticky wages, nobody thinks housing prices are terribly sticky. They're a little sticky. Someone who paid $1 million for a house  and who is moving and can't find a buyer to pay the $1.2 million he was expecting to collect will eventually lower the price. It may take a while because the seller isn't sure of the market price. But he will eventually catch on and lower his price. Look at the data. The price of houses is falling. And that's in a world where the government is artificially propping up the price as best as it can via Fannie Mae, Freddie Mac, the FHA, and artificially low interest rates.

So if the government would let those prices fall, that would clear out the stock of empty houses fairly quickly and help get those construction workers back to work without any Scenario #3 stimulus at all.

What's the difference between these two cases? Are they the same with respect to construction employment?

Here's the problem with case #3. Suppose because of really bad housing policy and bad financial policy, there is a huge expansion of construction employment. When the housing market collapses, suddenly there are a lot of people who are unemployed. We can put them back to work by paying renters enough money to buy up the stock of empty houses and to build enough new houses to soak up all those unemployed workers. That would put the workers back to work but at a very high cost. But we don't want to re-create that world. That's the fundamental problem–too many people were allocated to housing (and too much lumber and too many bricks and so on). To sustain that pattern of specialization is trade is very expensive–it means continuing to over-produce houses to keep those workers unemployed.

If the government would let the price of housing fall then it would also eventually help some of the unemployed construction workers get back to work as the stock of empty houses disappeared and eventually a demand for new houses would return. But the price wouldn't fall low enough to put the whole mass of unemployed construction workers back to work building houses.

The deeper puzzle is this. In good times, industries are rising and falling, jobs are being created and destroyed. But in good times, more jobs are being created than destroyed. In bad times, the opposite is the case. What is going on today that makes it hard for workers to find new opportunities and what happens in good times to make it easy? Why is it so hard for construction workers and others who are unemployed to find ways to use their skills? It wasn't hard in 1999 when millions of jobs were also being destroyed.

Ironically, I think the fundamental reason that Keynesian stimulus is mostly ineffective is the anxiety decision-makers have about the future. In good times, when someone buys a pair of shoes, the shoemaker is encouraged and considers making more shoes. The shoemaker considers hiring more workers or expanding or buying better shoe-making equipment. But in bad times, those actions which are risky in the best of times look even riskier. So the circular flow mechanism of spending begetting more spending, doesn't work in quite the same way. And reason is that the underlying patterns of specialization and trade get harder to re-establish in bad times. And that is true because the people with capital, the people who make decisions about expansion get more risk-averse about the future.

So the fundamental stimulus question is this: does government borrowing a lot of money and spending it on tax rebates and grants to the states and some infrastructure (not much) and some other things, does that make people less confident or more confident about the future. Who knows? There's no easy way to measure confidence, especially among the people who are relevant, those who are considering hiring new workers. But it is plausible that running up much bigger deficits reduces confidence and increases anxiety. It is plausible that the whole Keynesian circular flow story breaks down or at least works less effectively when people are anxious about the future.

The bottom line for me is that Keynes was very right about one thing–people's perception of the future plays a big role in their willingness to take risks. What he was wrong about is the ability to use government spending as a way to encourage a positive perception of the future or to produce real economic results that lead to prosperity and increased employment.

Taxes in the real world

A reader responds to this post on the incentive effects of taxation:

In 2004, as a rural solo Iowa general surgeon, I made roughly $500K gross income. However, I then had to subtract:

$50K office expenses

$100K malpractice insurance

39.6% marginal Fed income tax

15.3% self-employed FICA & Medicare

9.98% Iowa income tax

and consider that I also had to pay

6% Iowa sales tax for items bought

$6K property tax

$1K medical license, organization fees, DEA license

Anyway, I figured that my marginal rate was >70% tax on what I was making, and my malpractice cost was headed for $144K.

As a non-economist, I very much felt as you said, "I do believe there are eventually incentive effects from raising marginal tax rates", to the point that I quit medicine. I now teach, make ~$50K, but pay no Federal and little state income tax, given my family, and am quite clearly one of those who believes he had previously tried to live on the wrong side of the Laffer curve. The people who determine incentive effects are people like me. And now, given what the .gov is doing to health care, even in hindsight I feel I made the right decision. Although my gross income is 1/10 of what it used to be, my disposable income is at least 1/3 of what it used to be, and that's sufficient.

I recall Greg Mankiw recently said much the same regarding taking on additional engagements – the extra income just wasn't worth it. When your uncle's name is Sam, you learn that life in a doghouse is preferable to life in a squirrel cage.

The Cutest Animals on the Planet

Planet Money is running an economics experiment. Cast your votes on cute animals here.

John Lennon

I shake my head at much of the media coverage of the 30th anniversary of the death of John Lennon.

No one has been a Beatles fan longer, more consistently, and more devotedly – even obsessively – than me.  But Lennon was a gifted songsmith, period.  His political philosophy was puerile and as predictable as sightings of peace symbols in Haight-Ashbury during the summer of love.  "Love" is not all the world needs, and whenever I imagine no possessions I see only a sanguinary free-for-all.

I'll continue to enjoy Lennon's music.  But his political 'philosophy' is to human enlightenment what, say, a rock concert by Milton Friedman would have been to human entertainment.

(UPDATE: Mark Skousen, in an e-mail, righty points out that Lennon's "Revolution" at least dissed Chairman Mao.)

Fumbling at the Fed

Here's my and Russ's GMU Econ colleague Larry White discussion the Fed yesterday on C-SPAN.  Larry's appearance starts around the 47-minute mark.

I'm reading now – for the first time, I'm chagrined to admit – Vera Smith's 1936 book The Rationale of Central Banking and the Free Banking Alternative.  It's outstanding.  Here's a quotation from pages 4-5 of Smith that is especially relevant in light of Larry's remarks:

Neither do we find that the authorities responsible for introducing central banks into countries previously without them have any clear idea of the benefits to be obtained therefrom….

An examination of the reasons for the eventual decision in favour of a central banking as opposed to a free banking system reveals in most countries a combination of political motives and historical accident which played a much more important part than any well-considered economic principle.

Worth more than a thousand words

One reason Keynesian stimulus is so ineffective is the aggregation problem. Boosting "aggregate demand" hides the complexity of the economy and the fact that parts of the economy are fine and parts are sick.

One major problem we have in this recession is that 2 million of the 8 million jobs that have been lost are in construction. Giving researchers in St. Louis government grants to study Parkinson's doesn't help out of work construction workers in Florida. In this map, the metropolitan areas with high unemployment are in red. Average or low are in yellow. I am not surprised to see the red areas are in California, Florida, Nevada, Arizona, and Michigan, the places that had the biggest housing booms and the biggest housing busts. Could be a coincidence, of course. And it does play to my confirmation bias. I am open to other interpretations. Please share them.

Tax cuts for the rich

A few observations on extending the Bush tax cuts:

1. The action is not a tax cut for the middle class or the rich. It is a decision not to raise taxes. It is only a two year rather than a permanent extension so I don't know if the incentive effects are very large.

2. People argue that we should raise taxes on the rich because they have gained x% of the increase in income since 1980. There is no "they" there. The people who were in the top 1% today are not the same people who were there in 1980. Some of them are dead. Some dropped out of the top 1% because they made bad decisions or had bad luck. Some of the top 1% today were not there ten or twenty years ago. Sergey Brin and Larry Page founded Google. They were not in the top 1% in 1980. They were 7 years old. Their parents as far as I can tell were not in the top 1%. Now they're both very wealthy because they created something that is gloriously pleasant in our lives. Thank you, gents. Some who were in the top 1% are still in the top 1% and received a lot of income and wealth by making great products are providing great services. Bill Belichick might be in that group. In 1980 he was an assistant coach for the New York Giants. He was probably very well paid. Now he makes a lot more as head coach of the New England Patriots. Congrats, Bill, on your commitment to excellence and your success. And some in the top 1% were there in 1980 and are still there because they feed at the great rent-seeking trough. Wall Street, please get a life like the rest of us where bad financial decisions have consequences.

3. Whether you think any of these people should be taxed more than they currently are is mix of philosophical issues, incentive issues, and market forces. Some people seem to think that all tax increases on the rich are good because the ideal distribution of income is one where everyone gets the same access to consumption. That is not my ideal and I do believe there are eventually incentive effects from raising marginal tax rates. I don't think we have a very good idea of the magnitude of those effects. I also think that much (most?) of any tax increase is offset by changes in pre-tax wage rates. This last inconvenient truth is usually ignored by people on all sides of the tax debate. It is just presumed that changes in tax rates have corresponding effects on the distribution of income. This is not true.

4. It is always good to have some idea of what the rich actually do pay in taxes. It's also good to remember that payroll taxes are not personal investments and add to the tax burden. They should be eliminated and replaced by a more transparent system.

Few Words, Plenty of Wisdom

Arnold Kling on Dwight Lee.