Chris Dillow's Blog, page 187

Inefficient and unfair

The three main party leaders have all recently made speeches on capitalism. All three - though Clegg to a lesser extent - seem to be stuck in an out-dated mindset.

What I mean is that  for years, politicians from the centre-right leftwards agreed that capitalism was unfair but at least delivered the goods. However, it is now questionable that it can even do the latter. The problem is not, then, simply that capitalism is predatory, irresponsible, unfair or immoral. It's that it is inefficient too. As Faisal Islam rightly says, the party leaders just don't see this.

Now, before the closed-mind libertarians whine, I'll agree that capitalism has been a massive force for global prosperity. But on this, everyone agrees. It was Marx, not Hayek, who wrote that capitalism "during its rule of scarce 100 years, has created more massive and more colossal productive forces than have all preceding generations together." However, to presume that this must continue is to mere inductive reasoning, of the sort the chicken commits when he expects to be fed by the farmer, only to have her neck wrung.

I'll also agree that capitalist economies are superior to centrally planned ones. This is as true as the fact that I'm a better fiddle player than Abu Hamza - and as relevant.

Instead, what I mean is that there are (at least) four problems with capitalism, which the current crisis has revealed rather than caused:

1. The rise of low-wage competition from Asia, the slowdown in the rate of innovation, and the difficulty of monetizing some innovations has lead to a long-standing dearth of profitable investment opportunities and thus to slow real growth. One effect of this has been that money has flowed into malinvestments instead, creating a tendency towards speculative bubbles and slumps.

2. Top-down control of companies is inefficient, both for Hayekian reasons (bosses haven't the knowledge or rationality to control big organizations) and because of perverse incentives and selection effects.

3. Capitalism concentrates ownership of (some) risky assets into a few hands, and thus creates greater fragility and vulnerability to crises than is technically necessary.

4. There's a division between ownership and control. The problem of collective action, allied to the fact that the key asset in many firms is human rather than physical capital, means that shareholders are unwilling and unable to control firms. The result is that they become mechanisms whereby bosses and key workers can tunnel assets away from formal owners to those with real power.

One can, of course, question how severe these problems are. We shouldn't expect an economic system to be perfect; as Adam Smith said, there is a lot of ruin in a nation.

And one could argue that these problems can be mitigated or glossed over by better macroeconomic policy - though I'd be sceptical of this; in an economy lacking investment and capacity, increased aggregate demand would lead to inflation before full employment.

My point, though, is simple. The flaws with capitalism are, increasingly, not merely those of fairness but of efficiency too. And the political parties don't seen sufficiently aware of this.

Tax morale and self-fulfilling beliefs

Should people like Richard Murphy be taxed more heavily than the likes of Tim Worstall?

There's a simple reason to think so. The revenue-maximizing tax rate will depend on, among other things, people's attitudes to tax.

If you think taxes are state-sanctioned theft used to line the pockets of idiots, tyrants and con-men you'll be likely to try to avoid tax by retiring, emigrating, exploiting legal loopholes, cooking the books or whatever. This means a high tax rate will in fact be expensive; it will lead to a loss of revenue and GDP and to high compliance costs as governments employ lots of tax men to chase down evaders.

If, however, you think, with Oliver Wendell Holmes, that tax is the price we pay for a civilized society, then you'll be more willing to pay and so a high tax rate will be feasible.

This means the optimal tax rate depends upon tax morale. The happier people are to pay tax, the higher is the optimal tax rate. A society of Murphys, then, would have a higher optimal tax than a society of Worstalls.

The empirical evidence bears this out. A new paper shows that, controlling for income, "groups with high tax morale systematically face higher average and marginal tax rates."

Now, I'm not advocating that individuals should be taxed according to their political views; this has obvious drawbacks.

Instead, the point is that the response of tax revenues to tax rates - the shape of the Laffer curve - is not a primitive, fundamental datum. Instead, it depends upon tax morale. A rise in tax morale shifts the Laffer curve right, a fall shifts it left.

For this reason, Tim is not quite right to say that we'll find out whether the 50p tax rate raises revenues when this year's self-assessment returns are analyzed. Instead, the revenue response to higher taxes is subject to the Duhem-Quine problem. It tells us about a joint hypothesis - the interaction of tax rates and tax morale - not a single one.

Let's imagine the numbers were to show that the 50p rate has led to a reduction in tax revenue. The left could reply that this shows not that taxes are too high, but rather that tax morale is too low. Years of neoliberal ideology - and declining trust in government - have increased people's willingness to dodge taxes, they might say.

Conversely, if it appears that the 50p rate has led to increased revenues, libertarians might say that this just shows that people are still duped by statist ideology into a supine acceptance of high taxes.

In other words, we have a problem of multiple  belief equilibria. If people believe that high tax rates are acceptable then they will be consistent with high revenues. And if they don't, they won't.

In other words, ideologies can be self-fulfilling. Anti-statist ideology leads to lower tax morale and so the claim that high taxes are damaging becomes self-fulfilling. And conversely, statist ideology raises tax morale and thus optimal tax rates.

Why Miliband's looks matter

I'm no judge of male pulchritude, so I can't say whether Ed Miliband is too ugly to become Prime Minister*. But I can say that his appearance matters. There's evidence around the world that better-looking candidates tend to get more votes (I stress "tend" here because looks aren't everything, as Michael Gove's electoral success demonstrates). This shouldn't be surprising. Beauty pays in the labour market generally, so why shouldn't it pay in the political labour market too?

What's worrying, though, is: why do looks matter in politics? We can dismiss the possibility that it is because looks are correlated with ability, because most studies find a beauty premium for earnings even controlling for observable qualifications. Whilst it might be the case that Oxford PPE graduates are better looking than the population generally, it is not so obvious that the better-looking PPE graduate is more able than the less good-looking one.

Instead, I fear there is another reason why  look matter. Rick Wilson and Catherine Eckel have found (pdf), from laboratory experiments, that people are more inclined to trust the better looking. Given that labour contracts, like the implicit contracts between politicians and voters, are incomplete, this means that employers and voters are inclined to hire the better looker.

But here's the thing. This trust is unwarranted. Wilson and Eckel found that attractive trustees were no more likely to repay that trust than others. And other research has found attractive people (measured by facial symmetry) to actually be meaner, in the sense that they are more likely to defect (pdf)  in prisoner dilemma games, and more likely to make low offers (pdf) in ultimatum games.

Good-looking politicians might win more votes, then, but it doesn't follow that they behave better when elected; insofar as Nick Clegg is good-looking, he corroborates this theory.

In this sense, voters' preference for good looks is not just unfair, as Norm says. It is irrational. And it might be an expensive irrationality at that.

* I can say that his brother was quite popular with the laydeez in his youth - but then I suppose that if the alternative was me…

Pitfalls in employee ownership

I'm in two minds about Nick Clegg's call for greater employee ownership.

On the one hand, he's right to say that such firms "often perform better". There's good evidence that they are more productive than orthodox capitalist firms and are just as likely to grow. This isn't simply because employee owners are more motivated than ordinary workers. It's also because in a world of bounded rationality and knowledge, the pursuit of growth and profits might be something best done obliquely rather than directly.

But I have two quibbles.

You might think that one of these is that companies sometimes need to raise more capital than they can get from workers investment alone, and so need external owners.

Not so. Between 2003 and 2007, UK companies were actually net buyers of shares, not sellers; they only became issuers in 2008, when banks needed to boost their capital bases. The stock market, net, is not really a source of capital; for most mature firms, growth is financed internally.

In this sense, when employees buy shares, they do so not to increase their firm's capital, but rarger to respect the property rights of existing shareholders. Clegg's proposal seems to be that workers should buy in to capitalism, rather than take control of it. 

And there are two problems with this.

One is that a little bit of employee ownership might not be enough to have the "hugely transformative effect over corporate culture" that Clegg desires. Bear Stearns and Lehman Brothers had large employee shareholdings - so did Enron, come to that - but both were incompetently and capitalistically managed.

Secondly, employee share ownership violates the first rule of investment - don't put all your eggs in one basket. The worker who owns shares in his employer is risking not just his human capital but also his financial capital in the same venture. This is dangerous.

Granted, there's an upside to this concentrated risk; the possibility of big losses can be a good incentive. But if this possibility is not accompanied by genuine control, then we have the worst of both worlds; workers take risk, but not power.

Herein, I fear, lies a blind spot that liberals have long had. They've long thought that the middle way between left and right is better than either. But it might be worse.

Bosses & profits

Do bosses increase profits? The justification for the mega-million salaries is that they do. But at an aggregate level, this is not obvious.

To see what I mean, start from the basic national accounts identity that GDP equals consumer spending (C), investment (I), government spending (G), plus net trade (X-M), and also equals wages (W), profits (P) and taxes (T). Rearranging gives us:

P = (C - W) + I + (G - T) + (X - M).  

Aggregate profits, then, can only rise if one of the right hand side variables rises.

This tells us something important. Bosses cannot increase aggregate profits merely by cutting their wage bill. If workers respond to the lower wages or job cuts by spending less, C - W doesn't change. One firms' higher profits are another's lower demand. It is only if consumer spending holds up as wages fall that profits will rise. But this depends to a large extent upon factors outside of CEOs' ordinary powers - such as consumer confidence and credit availability.

Yes, bosses can increase aggregate profits by going on an investment boom or export drive. But these are two things that have not happened in the US or UK economy in recent years.

Now, you might reply here that bosses' organizational skills raise firms' efficiency and productivity. Let us suppose this is true (which it isn't really, as most productivity growth comes from entry and exit (pdf) rather than internal restructuring). Higher productivity means only one of two things. One is the same output from fewer workers. But we've already seen that this doesn't raise aggregate profits. The other is higher output from existing workers. But how will this output be sold? It is only if macroeconomic conditions permit. But these conditions depend upon factors exogenous to the firm such as policy and external demand.

Take an example. Say the economy is pootling along as normal and then a great CEO comes along with a new product he's invested, such as Steve Jobs with the iPad. Clearly, this increases Apple's sales and profits. But it doesn't necessarily increase aggregate profits. If people cut their spending on other goods in order to buy the iPad, Apple's profits only rise at the expense of other firms. It is only if macro conditions permit increased aggregate spending that aggregate profits will rise.

This means that even if bosses are not exploiters, shysters and rent-seekers but do genuinely add value, they do not necessarily do so at the aggregate level. Instead, they raise their own firms' profits at others' expense.

This in turn means that bosses' high pay might well be due to an arms race. Each individual firm bids to get the best CEO, with the result that aggregate spending on them is sub-optimally high; if CEO pay were cut across the board, there'd be no overall loss - just a transfer from CEOs to shareholders.
In other words, you don't need to believe my rants against managerialism in order to suspect that bosses are overpaid. They might be even if they really do add value.

Now, you might object here that I'm ignoring the possibility that although bosses don't raise profits they do raise welfare; if the iPad displaces other consumer spending, consumer surplus rises.

True. But this is not the only form of innovation. Not only is there Jobsian innovation, which raises consumer surplus. There's also O'Learyan innovation which aims at capturing it for the firm. It's not clear which type is dominant. 

Child benefit, ideology & bias

The coalition's plan to cut child benefit for 40% tax rate payers seems to have run into confusion. Which raises the obvious question: why bother? If you want richer folk to bear a bigger share of austerity, why not simply raise the 40% rate by 2p, and raise its starting point a little, which would bring in the same £1bn as the removal of child benefit.

Such a scheme would avoid the horizontal inequity whereby a household getting £80,000 split evenly between two earners would keep child benefit whilst a single-earner household on £45,000 would lose it. It would also avoid the problem of enormous marginal tax rates for people who get a small pay rise that puts them into the 40% band. It would also allow the government to boast about taking people out of the top tax bracket, and be administratively simpler.

So why not do this, rather than faff around with child benefit?

Some might say it's because the coalition wants to attack the principle of universal benefits. But I've another theory. It's about framing.

Tax is a burden - theft if you're a libertarian - whereas child benefit is, well, a benefit. And it's more comfortable - for the government and its target voters - to withdraw a benefit than to increase a burden.  So we have a messy policy rather than a neat one, even though the effects are overall pretty similar.

Which brings me to my problem. Cameron has a behavioural insight team which hopes to manipulate our cognitive biases to make us behave better. But cognitive biases aren't something which ignorant citizens have and which wise governments are free of. Policy-makers are also prone to them - either because they are as irrational as everyone else or because they have to pander to an irrational electorate. One of my big complaints against Nudge is that it fails to appreciate this sufficiently, and so panders to the ideological fiction that policy-making is or can be entirely rational and evidence-based.

Not seeing ideology

David Cameron says the role of government should be to help film-makers "to make commercially successful pictures."

Leaving aside the question of whether governments should be involved in the film industry at all, this runs into a problem - that it is impossible to predict what films will be commercially successful. The best brains in Hollywood devote themselves to this question, and they cannot succeed - which is why they so often rely upon sequels, boring proven formulae and multi-million salary stars.

So obvious is this point that it has led to the strange sight of right libertarians supporting Ken Loach.

However, when an intelligent man says something so silly, something must be at work. That something is ideology. What we see in Cameron's remark is an extreme manifestation of managerialism - a belief that something unpredictable (the public's film tastes) can in fact be foreseen in advance by experts in government.

This sort of hubristic failure to acknowledge unpredictability could only exist in people who have no knowledge of actual management or business. As Hopi says, the political class are people with almost no credentials who think that "changing Capitalism requires only a couple of press releases, a press conference, and a pamphlet from a friendly think tank."

But herein lies something odd. We've seen in the last few days media outrage about tweets by Diane Abbott and Ed Miliband; "Blackbusters" - the term they use in Uruguay, I gather - made the front page of the Sun. But these were casual, off-the-cuff remarks. Why, then, has the media made so much less fuss about an equally stupid remark which was made after some thought, and which has genuine policy consequences?

It could be because we have a dumbed-down Tory-biased media that obsesses only about trivia.

It could be because those tweets play to the prejudices that Ms Abbott is a racist firebrand and that Mr Miliband is just hapless - and the function of the press is to reinforce prejudice.

But maybe something else might be happening. The media share the ideology of the political class, and also believes in the fiction of a predictable and manageable world. It is therefore incapable of seeing the absurdity of Cameron's remark.

In this sense, managerialism is a truly powerful ideology, as its blinds its possessors to the fact that it is (to say the least) a partial and contestable view of the world.

Austerity & equality

"We can deliver fairness even when there's less money around" said Ed Miliband yesterday.

This is not a theoretical claim. It's a historical fact. The 1945-51 government inherited a debt-GDP ratio three times today's level and yet built the modern welfare state, created the NHS and increased income equality* whilst running a budget surplus. 

Poor public finances, therefore, are no obstacle at all to egalitarian policies. So what are? There are,

I suspect, five differences between now and then:

1. Social solidarity. After 1945, the recipients of redistribution were regarded as deserving - people who had risked all in the war. Today, they are more commonly regarded as scroungers - a largely erroneous idea which Labour, to its shame, doesn't challenge. This weakens support for redistribution.

2. Mobility. After 1945, the rich were to large extent captive and could thus be taxed heavily. Today, though, there is perceived to be a danger that high taxes will cause an emigration of talent. Whether this perception is correct or not is, however, another question.

3. Statism. In 1945, people had faith in the state - Hayek's The Road to Serfdom was popular precisely because it was a counterblast to the dominant ideology - not least because it had defeated the greatest-ever threat to civilization. Today, the state's CV looks shabbier, so confidence in its ability to achieve "fairness", or anything else, is much diminished.

4. Full employment. The need for post-war reconstruction  generated a high demand for even unskilled labour; a lot of what equality was achieved in the post-war period was due to full employment rather than tax and welfare policy. Today, there's no hope of this.

5. Rising costs. Baumol's cost disease means that the relative cost of state services such as health and education has risen. Combined with points (1), (2) and (3), this threatens to crowd out other redistributive policies.

The question is: what to do about these problems? Adam Lent, acknowledging (5), says:

If Labour is serious about a major shift in spending priorities to promote jobs, growth and inherent fairness in the economy, then the party will almost certainly have to face up to the need to save money in the big spending areas of welfare, health, and pensions.

But this raises the question of where such savings will come from, given that the notion that top-down government can find efficiency savings is just a managerialist fiction.

I'd suggest two other things - which Miliband did not sufficiently address.

One is to look to expand the tax base - for example through land value taxation; people can emigrate, but land cannot. This implies having an open mind about the top income tax rate; let's just find out what rate causes people to flee.

Another would be to empower labour against capital. Naturally, this'll be tricky when there's an excess supply of the former. But support for stronger trades unions - an efficient alternative to laws - and more worker power on boards would be a start.

* The 1979 Royal Commission on the distribution of income and wealth estimated that the share of after-tax income going to the richest 10% fell from 34.4% in 1938 to 27.1% in 1949.

Mechanisms vs models

Simon Wren-Lewis asks a good question about Robert Lucas's and John Cochrane's apparent misunderstanding of the balanced budget multiplier: how can very clever people make silly errors?

He suggests two good answers. I'd like to suggest a third. There are two different ways of thinking about economics - the model paradigm and the mechanism paradigm, and the former has crowded out the latter.

Simon says:

If you spend X at time t to build a bridge, aggregate demand increases by X at time t. If you raise taxes by X at time t, consumers will smooth this effect over time, so their spending at time t will fall by much less than X. Put the two together and aggregate demand rises.

This is clear and true. And it would be obvious to anyone using the mechanism paradigm. If you ask "What is the mechanism whereby higher taxes reduce consumer spending?" you pretty much walk into the notion of consumption smoothing. Equally, though, the paradigm also leads one to other reasons to be sceptical of the practical efficacy of the balanced budget multiplier. 

But lots of brilliant economists don't think merely in terms of mechanisms but rather build impressive models. And like photographers, they tend to fall in love with their models which distracts them both from others' models and from mechanisms.

This matters, because the importance of particular mechanisms varies from time to time. The social sciences, wrote Jon Elster:

can isolate tendencies, propensities and mechanisms and show that they have implications for behaviour that are often surprising and counter-intuitive. What they are more rarely able to do is state necessary and sufficient conditions under which the various mechanisms are switched on. This is [a] reason for emphasizing mechanisms rather than laws. Laws by their nature are general…Mechanisms by contrast make no claim to generality. (Nuts and bolts for the social sciences, p 9-10)

A good example of this lies in the idea of expansionary fiscal contraction. The virtue of this idea is that it draws our attention to mechanisms (a falling exchange rate, better corporate animal spirits, whatever) whereby fiscal contraction might boost the economy. The drawback is that these mechanisms are just unlikely to operate here and now. Yes, there's a model that tells us that expansionary fiscal contraction can work. And there are models that say it can't. But arguing about competing models misses the practical point.

Now, there is an obvious reply to all this. Models have the virtue of ensuring internal consistency, and thus avoiding potentially misleading partial analysis. However, I'm not sure whether this is an argument against mechanisms so much as against poor thinking about them.

When I was a student (back in the 80s!) I learned lots of models (OK, a few), but when I became a practising economist, I found them to be less useful in thinking about the economy than Elsterian thinking about mechanisms.

This is not to dismiss models entirely. I'm just saying that, insofar as they have uses other than as mental gymnastics for torturing students, it is because of the mechanisms contained within them. The parts might be more useful than the sum.

Stereotypes matter

What causes discrimination? Conventionally, there are two views on this. One is taste discrimination; some people would rather not hire blacks or women or gays or whatever simply because they don't like them. The other is statistical discrimination; employers believe (rightly or not) that a particular group is, on average, less able and so are reluctant to hire from that group.

However, a recent experiment suggests that there's another form of discrimination that is harder to eliminate - a simple lack of Bayesian reasoning.

Researchers first got people to perform some mental rotation tasks, and then split the performers into two groups. In one group, which they called K, 43% were top performers (who got 13 or more of 24 right) and 57% poor performers. In the other group, called L, 14% were top performers and 86% poor ones.

A separate group of people were then given a choice. They could take a small sum of money, or they could gamble on an individual being drawn from group K or L where they would win €20 if the performer were top but nothing if they were not.

Obviously, in this gamble one has a 43% chance of winning if you can choose from group K.

But here's the thing. Subjects were told that the draw from group L was rigged, in such a way that someone would be drawn from group K and if s/he were a top performer, a top performer from L would also be picked. This means that subjects had a 43% chance of winning, whether they drew from group K or L.

However, despite knowing this, subjects preferred to bet on group K. In other words, they paid attention to base rate probabilities (43-57 vs. 14-86) even though they were irrelevant. This is Bayesian conservatism.

This is not taste-based discrimination, because K and L are neutral terms. Nor is it statistical discrimination because subjects' actual odds of  success were identical in both groups. It's plain irrational.

This might have nasty implications in labour markets*. It suggests that group labels stick to individuals, even if the particular individual does not have that particular attribute. So, for example, if an employer is loath to hire women for fear they will leave to have children, he might be reluctant to hire even women who could prove they have no such intent; though lesbians earn more than straight women, they earn less than men. Fannie Hurst's line that a woman has to be twice as good as a man to go half as far might, therefore, be true.

In this sense, stereotypes are dangerous not merely because they can be self-fulfilling, but also because they damage the life-chances even of people who do not conform to them.

* The standard objection here is that hiring decisions have bigger stakes than lab experiments, and so people are more likely to behave rationally. I find this objection implausible, partly because many hiring decisions are taken by people who are using other people's money, partly because of the Yerkes-Dodson law, and partly because of casual empiricism; look how many idiots are in good jobs.