Simon Johnson's Blog, page 5

Conflicts and Corruption

By James Kwak

To be clear, the idea that Donald Trump will be president while he or his children effectively own a company that does business all over the world is preposterous. (Quick primer on trust law: A trust is managed its trustees for the benefit of its beneficiaries. In this case, we know the trustees include two of Trump’s children, and the beneficiary is likely to be either Trump or his children.) If people, companies, and foreign governments want to pay bribes to the president of the United States, they need only give favorable deals to the Trump Organization. An in any of his official actions, the president will have the temptation to do what’s right for his company, not for the country.

The point I wanted to make in my Atlantic column today, however, is that this is just the most obvious and egregious example of the larger problem of corruption: government officials acting in the interests of themselves, their family and friends, or their business associates. The example I focus on is estate tax repeal, because that one thing alone would be worth more than $1 billion to the Trump family. It’s a classic example of a president doing what’s in his own personal interests and the interests of his core constituency of gazillionaires, while pretending it’s for the good of the country.

Betsy DeVos is another great example, perfectly illustrated by this graphic from the AFL-CIO:

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The way American politics works is that people and organizations with money—today, largely billionaire families—invest in politicians and demand policies that favor their private interests. Donald Trump just eliminated the middlemen—not only winning the presidency, but also inviting fellow billionaires like DeVos into his cabinet. This is why, beyond the ongoing catastrophe that is the Trump presidency (which technically hasn’t even started yet), we still need to fix our democracy, so everyone has an equal say in our government.

For more, see the full article in The Atlantic.

Economism Typo Contest

By James Kwak

Today, you may be getting your copy of Economism: Bad Economics and the Rise of Inequality in the mail. Or you may even be able to buy it in a bookstore. But before you crack it open, I want to tell you something.

I hate typos.

I try to read each of my book manuscripts carefully before submitting them. I hire my own line editor to go through my writing for grammatical and stylistic errors. The publisher then does a copy edit. When I get the “galleys” back from the publisher, I hire my own proofreaders to scour them again for mistakes. But inevitably typos sneak into the published books. Here’s one from 13 Bankers:

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(That should be “economic policy,” in case you’re wondering.)

Furthermore, I am almost incapable of reading anything that I’ve written before. It’s just too boring when you already know what the next sentence is going to say; at best I can skim. So it’s very hard for me to catch mistakes in anything that I’ve published. Out of sympathy to my fellow writers, I often circle typos when I find them in books that I am reading. Sometimes I even email the author out of the blue with a list of mistakes, if there is still time to fix them in the paperback version.

So, before you start reading, I’d like you to know about the Economism Typo Contest. If you are the first person to find and tell me about a mistake, I will send you a limited edition, spiral-bound, 5×8 notebook with the jacket cover of Economism on the front (signed on the inside if you like). Or, if you prefer, I will pay you ten dollars in cash money.

The detailed rules and instructions for submitting mistakes are over at the version of this post over at Medium.

Thanks for your help.

Economism and the Future of the Democratic Party

By James Kwak

I haven’t written much about the election itself (except to point out that the same data can be interpreted in diametrically opposing ways). That’s because the election was so close that the fact that Clinton lost can be explained by any number of but-for causes, and much of the Democratic Internet has been a cacophony of people insisting that their preferred cause (Comey, Russian hacking, not enough attention to African-Americans, too much attention to minorities, not enough attention to the white working class, too much emphasis on Trump’s personality, etc.) was the One True Cause.

I do think, however, that if Democrats (a group in which include myself) want to return to power and change the overall political dynamics of this country, one thing we need to recognize is that Republicans have been crushing us on the economic messaging front for decades. We have adapted by becoming Republicans Lite—no longer the party of jobs and the working person, but now the party of minimally intrusive market regulation, technocratic expertise, and free trade agreements.

This is the subject of my article in Literary Hub today, “The Failure of Democratic Storytelling.” Now that Democrats are out of power virtually across the board, we have the opportunity to develop a new vision, without having to compromise with Joe Manchin, Arlen Spector, and Susan Collins to squeak legislation through Congress. The question is what we make of that opportunity.

A Change Is in the Air

By James Kwak

There was one moment, when I was finishing up the manuscript of Economism, that I thought someone had already said what I was trying to say in the book. This is what I read:

“The beauty and the simplicity of such a theory are so great that it is easy to forget that it follows not from the actual facts, but from an incomplete hypothesis introduced for the sake of simplicity. … The conclusion that individuals acting independently for their own advantage will produce the greatest aggregate of wealth, depends on a variety of unreal assumptions …

“Individualism and laissez-faire could not, in spite of their deep roots in the political and moral philosophies of the late eighteenth and early nineteenth centuries, have secured their lasting hold over the conduct of public affairs, if it had not been for their conformity with the needs and wishes of the business world of the day. …

“These many elements have contributed to the current intellectual bias, the mental make-up, the orthodoxy of the day.”

That’s from the third section of “The End of Laissez-Faire,” the published version of a lecture delivered by John Maynard Keynes in 1924 and 1926.

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Photo from Wikimedia Commons (CC BY-SA 3.0)

Keynes’s argument goes something like this:

Beginning in the late eighteenth century, economic theory extended the political philosophy of democratic individualism (epitomized by John Locke), providing a supposedly scientific basis for “the idea of a divine harmony between private advantage and the public good.”
That idea in its simple form, however, was not a correct statement of what leading economists actually believed. Instead, it was the work of “the popularisers and the vulgarisers”: “the dogma had got hold of the educational machine; it had become a copybook maxim.”
Economists themselves understand that the world is considerably more complicated. However, “many of those who recognise that the simplified hypothesis does not accurately correspond to fact conclude nevertheless that it does represent what is ‘natural’ and therefore ideal.”
The ubiquity of laissez-faire ideas is ultimately due to the interests that it serves: the business world. “To suggest social action for the public good to the City of London is like discussing the Origin of Species with a Bishop sixty years ago. The first reaction is not intellectual, but moral. An orthodoxy is in question, and the more persuasive the arguments the graver the offence.”

Although Keynes was writing in the 1920s, this also describes of the state of the intellectual and political world over the past few decades. The idea that market forces necessarily produce optimal outcomes, and that government should generally stay out of the way, has dominated public policy discourse since the late 1970s. This is obvious for Republicans, but consider also the deregulatory policies of Jimmy Carter, Bill Clinton proclaiming that “the era of big government is over,” the end to “welfare as we know it,” bipartisan financial deregulation, and Obamacare’s reliance on markets—indeed, the current Democratic orthodoxy that government should simply identify and correct for discrete market failures.

It is also widely claimed that the universal superiority of competitive markets is some fundamental law of economics—that the minimum wage necessarily increases unemployment (because it is a price floor), or that taxes on investment income necessarily reduce savings and investment (because they reduce the returns to saving). Yet, just as in the 1920s, few economists actually believe in such immutable laws, although some do think of them as some Platonic ideal for how the economy should behave. What happened is that a handful of simple economic concepts was picked up, vulgarized, and popularized by a network of foundations, think tanks, and media outlets. A few prominent economists played important roles in this process—notably Friedrich Hayek in The Road to Serfdom and Milton Friedman in Capitalism and Freedom and Free to Choose—but their ultimate influence depended on the reach of organizations such as the American Enterprise Institute, Heritage, and the op-ed page of The Wall Street Journal.

To take one example of how this works, consider the tens of millions of dollars that large company CEOs make, or the hundreds of millions of dollars that hedge fund and private equity fund managers take home. According to a simple Economics 101 model of the labor market, everyone’s compensation is exactly equal to her marginal product—the value of the work she does for her employer—and therefore those huge pay packages are both fair and necessary (or otherwise business superstars would choose to do something else with their time). Yet, as the Economist reminds us, academic economists have known for nearly half a century that information asymmetries undermine the textbook functioning of labor markets. (For a longer discussion of this topic, see chapter 4 of Economism).

The idea that pay equals marginal product is not economic truth, but ideology. Like any powerful ideology, it makes the interests of a class seem conterminous with the interests of society as a whole. As Marx wrote in The German Ideology, each ruling class “has to give its ideas the form of universality, and represent them as the only rational, universally valid ones.”

So when Ray Dalio says, “Society rewards those who give it what it wants. That is why how much people have earned is a rough measure of how much they gave society what it wanted,” he’s not speaking as someone who knows anything about economics. He’s speaking as a member of the ruling class—a billionaire hedge fund manager (and now Donald Trump cheerleader). If you’re a billionaire, it’s nice to think that your wealth simply reflects your contributions to society. It’s also useful for other people to think so, so they don’t raise your taxes. But that doesn’t make it true.

In the 1920s, Keynes thought the dominance of the laissez-faire ideology was coming to an end. “We do not even dance yet to a new tune,” he wrote. “But a change is in the air.” He was right. Increasing dissatisfaction with the unregulated capitalist system helped produce fascism in Germany and Italy and a much greater degree of government intervention in the United States, the United Kingdom, and France.

Could the same be true today? It is undeniable that the rapidly widening gap between the very rich and the middle class has undermined popular support for the economic status quo. Throughout the advanced, post-industrial democracies, there seems to be a brewing revolt against technocratic elites who appear insensitive to the plight of ordinary working people. In the United States, the Bernie Sanders insurgency demonstrated the tenuous hold of the Clinton-Obama-Hamilton Project-Center for American Progress coalition over the Democratic Party, while Donald Trump overthrew the Republican establishment.

While Trump has his own fascist, racist, and sexist tendencies, however, most of his actual policy proposals come straight out of the conservative playbook. This is not surprising, given that he is (probably) a billionaire, his most important backers are billionaires, and he shows few signs of intellectual curiosity, originality, or honesty. So in the short term, we are going to see four more years of economism triumphant—less regulation of businesses, particularly banks; lower taxes for corporations and the very rich; and a return of the bad old pre-Obamacare days, when people without employer health plans had to fend for themselves in an unregulated individual market. One thing we can be sure of is that a Trump presidency will do nothing to solve the economic problems facing the poor and the middle class, or narrow the widening gap between them and the 1%.

At the end of his essay, Keynes wrote:

“For the most part, I think that Capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that in itself it is in many ways extremely objectionable. Our problem is to work out a social organisation which shall be as efficient as possible without offending our notions of a satisfactory way of life.”

That remains our challenge today. If we cannot solve it, the election of 2016 may turn out to be a harbinger of worse things to come.

The Curse of Credentialism

By James Kwak

I just finished reading J. D. Vance’s memoir, Hillbilly Elegy. I don’t feel like adding to the torrent of instanalysis of the “white working class,” however, so I’ll just comment on the description of Yale Law School—which, in the book, serves the dramatic function of introducing the author to the Elite.

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Photo by Shmitra at the English language Wikipedia (CC BY-SA 3.0)

There are a few details that seem unfamiliar to me—I can’t recall attending a single one of the “cocktail receptions and banquets” that Vance describes as the school’s social rituals—but then again I was thirty-nine and married with a child when I started law school. But there is one thing that Vance nails: the culture of credentialism.

Yale Law School is undeniably an elite institution, the undisputed number one school in a field that is intensely (and toxically) hierarchical. Also, because it is a law school—as opposed to other elite institutions such as West Point or the UConn women’s basketball team—it is filled with people who have never had any idea of what they wanted to do other than be successful and gain access to the best opportunities out there.

One of the curious things about Yale is that it is impossible to compete over grades; the first semester is pass/fail, and for reasons not worth going into the grading scheme is essentially meaningless after that point. I thought this was wonderful, but I’m sure at least some of my classmates experienced it as a disappointment. So what do you do if you’ve spent your life trying to prove that you’re smarter than other people? Some people use their newfound freedom to do truly great things: the Iraqi Refugee Assistance Project (now International Refugee Assistance Project), for example, was founded by a few students in the class before me. Many others pour themselves into clinics that make a huge difference in people’s lives. (The challenge to the Connecticut public school system that recently won in the trial court began in a Yale clinic.) I wrote a book.

But a common reaction is to find other things compete over. And, as Vance describes, the two primary candidates are membership of the Yale Law Journal and post-graduation federal court clerkships (which is a competition that goes on and on, because it takes at least a second, and often a third year of clerking to make it to the Supreme Court). The institutional culture communicates that the most prestigious distinctions are Journal membership and federal clerkships (I’m simplifying slightly, but that’s pretty close). As Vance writes:

“No one seemed to know what value the credential actually held. We were told that the Journal was a huge career boost but that it wasn’t that important, that we shouldn’t stress about it but that it was a prerequisite for certain types of jobs.”

This is like a mind-altering drug for those twenty-somethings whose modus operandi is to accumulate badges of excellence that will open as many doors as possible. Most students come to law school with little interest in 35,000-word legal theory articles (and no interest in editing and cite-checking those articles, which is mainly what law review editors do), yet come springtime they become intensely interested in the pathologically stupid citation formatting, or “Bluebooking” test (what Vance calls “the  most important test of our first year”) that represents the first step toward Journal membership.

The same goes for clerkships. I should point out that my friends who did clerkships—doing research and writing for a judge—generally thought they were a good experience (as opposed to the Journal). But that’s not why most Yale law students want them, at least not at first. It’s because they are the closest thing to graduating with honors, given that Yale doesn’t give honors at graduation. And because there are hierarchies among clerkships—appellate courts beat district courts, and within each level famous judges beat less-famous judges—a clerkship is the closest thing you can get to class rank at a school that has no class rank (or GPA, for that matter). Vance admits trying to get a clerkship with a “high-powered federal judge with deep connections to multiple Supreme Court justices” until his primary recommender—you have to have one of these to get a top-shelf clerkship, so the intermediate thing people compete for is relationships with well-connected professors—pointed out that he was doing it solely for the credential. He pulled out and got a less-prestigious clerkship where he could be close to his girlfriend. Good for him.

As you may have guessed, I didn’t apply to the Journal or to any judges. But that was because I had a family, and I didn’t want to spend any more evenings away from them to do cite checking. I also had a career and enough accomplishments behind me that I was emotionally secure enough not to pursue credentials for their own sake. But if I had been single and in my twenties, I’m sure I would have played the game. That’s what our educational system teaches smart young people: that there are universal, objective markers of achievement and ability, and that’s what you’re supposed to get.

At the end of my first year, I wrote an email to the school’s mailing list proposing that the Journal simply be opened to everyone. My basic point was that the Journal competition was an unnecessary zero-sum contest that existed solely for the purpose of having a something to compete over. If I recall correctly, the public email responses were in favor by a large margin. But the Journal gets to make its own rules, so nothing changed.

As things go, whether Yale Law School 1Ls waste dozens of hours immersing themselves in the stupidest citation system known to man  (“the acme of absurdity in legal expression,” says Judge Richard Posner in Divergent Paths*) is decidedly trivial. But the broader problem of credentialism is real. For one thing, the pursuit of brass rings because they are shiny creates unnecessary stress and unhappiness. More generally, when you give out prizes based on idiosyncratic criteria, ambitious people adjust their behavior to excel at those criteria—which may not be particularly valuable in the real world.

Then there’s the cost to society. A world in which success means Rhodes/Teach for America/Goldman/McKinsey followed by Yale Law School/Harvard Business School followed by Blackstone/Bridgewater/Facebook is one in which too many talented, well-intentioned people follow the same path and end up doing the same few things. (Since I graduated from college a quarter-century ago, the only real additions to the hierarchy have been TFA and the technology behemoths.) In their famous paper, Kevin Murphy, Andrei Shleifer, and Robert Vishny found that countries with more engineering majors tend to grow faster and those with more law students tend to grow slower. A society in which smart, hard-working young people with generic ambitions tend to become hedge fund and private equity fund managers, management consultants, corporate lawyers, and strategists for technology monopolies is probably not one that is allocating talent effectively.

The reasons for credentialism go beyond any easy cure. One is the innate (personal) conservatism of people who play by the rules and excel at school. One is the high degree of inequality in contemporary society, which inflates the costs of not landing at the top end of the income distribution. One is the homogenization of culture, which means that most smart young people in the United States grow up in the same informational environment, evaluating the same set of options. Finally, for the most part, credentialism is individually rational: it’s “work for Goldman now, save the world later.” But after too many years in that environment, people come to believe that working for Goldman is saving the world (I believe the phrase is “doing God’s work“). And that’s where credentialism can lead you.

* Posner is just getting started: “The law review editors who enforce its mindless dictates are pod people. Its relentless growth threatens to lobotomize the legal profession.”

Larry Kudlow and Economics in the Trump Administration

By James Kwak

Noah Smith (along with a fair section of the Internet) has some concerns about Larry Kudlow as chair of the Council of Economic Advisers: he’s overconfident, too much of a partisan, and fixated on nonexistent problems (e.g., inflation). I’m not so worried that he’s on Team Republican; after all, Donald Trump gets to pick the advisers he wants, and they shouldn’t be rejected solely because they take political sides. But I am worried about what Kudlow’s appointment means for the relationship between economics and policy.

The world is a complicated place. Anyone who studies society in depth should learn to have respect for that fact. At any given moment, we have only a hazy understanding of what combinations of transitory phenomena and underlying structural factors produce what outcomes. (For Exhibit A, see the election that took place on November 8.) This tweet at the beginning of Game 7 of the Cubs-Indians World Series, channeling the great French historian Fernand Braudel, is one of my all-time favorites:

Buck: Will we see history tonight?
Smoltz: Yes!
Braudel: No man can see history. This is the foam. The current of history is beyond our ken.

— Old Hoss Radbourn (@OldHossRadbourn) November 3, 2016

Contemporary research economists have become incredibly sensitive to the difficulties of explanation. The papers that get the most attention—like Chetty et al. on intergenerational mobility, or Autor-Dorn-Hanson on the impact of Chinese imports on labor markets—are no longer purely theoretical. Instead, they analyze large datasets, often compiled with tremendous amounts of effort, to try to tease out the relationships between different variables. Any empirical paper in a good journal will discuss which way the causal arrows points and include multiple robustness checks to try to ensure that the results are not the product of outlier observations or an idiosyncratic specification. Good economists know that the answer to most questions is: It depends.

This is one of the important contributions that economics can make to public policy: the understanding that the world is complicated, and the dedication to uncovering rather than masking that complexity. In a presidential administration, you would expect this perspective to come from the Council of Economic Advisers. The treasury secretary is a public spokesperson, a diplomat, and the manager of a huge organization; the director of the National Economic Council is a policymaking coordinator; and the director of OMB is a budget planner.

I don’t particularly care that Larry Kudlow doesn’t have a Ph.D. in economics. Paul Volcker didn’t have one either (as far as I can tell), and few Democrats would have seriously objected to him as chair of the CEA. What concerns me is that he has been working as an economist for decades—that is, he makes money by thinking and talking about economic issues—yet his conception of the discipline seems limited to the simple, theoretical relationships of Economics 101.

Most of Kudlow’s thinking about economic issues appears to boil down to three ideas. The first is that tax cuts increase economic growth—a mantra that conservatives have repeated for decades, yet is not supported by reviews of existing research. The second is that expanding the money supply will necessarily generate high inflation, on which basis Kudlow predicted a “major inflationary plunge” just as the Great Recession was beginning. The third is that an expensive currency—what politicians call a “strong dollar,” but Kudlow calls “King Dollar” (with the capitals)—is good for the economy.

The first two ideas are things you would expect to hear from a first-semester college freshman (like Jeb Hensarling in his Texas A&M days). They make sense on a two-dimensional diagram, but they are at best distant approximations of how the world works. The third—King Dollar—is just weird. The value of a currency is the outcome of various factors, such as interest rates, and it doesn’t make sense to think of that outcome in isolation from the things you would need to do to produce that outcome.

Studying economics is a process of indoctrination and then de-indoctrination. First you learn that competitive markets produce optimal outcomes; then you learn that this is only true in rare circumstances, that real markets are imperfect in a myriad of ways, and that in any case perfect market outcomes are not necessarily optimal in any meaningful sense. Larry Kudlow, whether naively or disingenuously, still seems to be stuck on Economics 101. That’s the essence of what I call economism, the subject of my new book: a worldview that assumes that society operates according to a small set of fundamental principles, and that public policy can be shaped on that assumption.

With Kudlow as chair of the CEA, Donald Trump is giving up even the pretense of trying to understand economic reality, instead doubling down on a handful of abstract slogans that have little to do with our current challenges. That’s hardly surprising, given that Trump is basically just an extreme caricature of contemporary conservatism, but that doesn’t make it any less concerning.

How Not to Invest

By James Kwak

Forty years after John Bogle launched the Vanguard 500 Index Fund, passive investment funds now account for about one-third of the mutual fund and ETF market. You would think this would pose a threat to traditional asset managers that charge hefty fees for actively managed mutual funds, and this is true in part. On average, index funds charge 73 basis points less than active funds, and the average expense ratios for actively managed funds have fallen from 106 bp to 84 bp over the past fifteen years (Investment Company Institute, 2016 Investment Company Fact Book, Figure 5.6).

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The asset management industry, however, has been quite adept at defending its traditional share of investors’ assets. One response has simply been to go along with the index-fund wave—without lowering fees to reflect the considerably lower expenses of using simple algorithms instead of humans.

In the Wall Street Journal, Micah Hauptman summarized a recent paper by Michael Cooper, Michael Halling, and Wenhao Yang on mutual fund fees. They find, as did previous research, tremendous differences in prices for S&P 500 index funds. The variation between the fees charged for these virtually identical products has actually increased since it was first measured in 2004; in recent years, the difference between the 10th percentile and 90th percentile S&P index funds (by expense ratio) has been a staggering 116 basis points. That means there are people paying well over one percentage point of assets per year for a product that only costs 16 bp at Vanguard (5 bp for a minimum investment of just $10,000). Furthermore, Cooper, Halling, and Yang analyze variation in prices across all U.S. stock mutual funds, in part by identifying funds with similar holdings. Again, they find large price discrepancies that cannot be explained by fundamental fund characteristics.

For an investor, the lesson is very simple: If you are paying more than 16 bp for an S&P index fund (5 bp if you have more than $10,000 in the fund), you should get out and buy a cheaper one instead, unless you’re locked in because of large, unrealized capital gains.

For society as a whole, however, there is a more interesting takeaway. According to very basic economic theory—the kind you get early in your first year—this type of price dispersion cannot occur. It’s as if oil were selling for $16 per barrel in one place and $132 per barrel in another place. Now, that can happen with oil if, say, there’s an embargo or a blockade going on. But the market for U.S. stock mutual funds and ETFs is supposed to be highly transparent and liquid; it usually only takes few minutes and a computer to sell one and buy another. Wide variation among prices for identical products with minimal search and transaction costs is proof that the simple story taught in Economics 101—prices for identical products must converge because buyers will only buy the cheap ones—is sorely incomplete. Something else is going on, and therefore we cannot count on markets to protect investors. (For example, one thing that could be going on is retirement plan administrators only offering expensive index funds to captive plan participants.)

Yet that faith in markets is endemic in large parts of our political and legal systems. For example, Judge Frank Easterbrook of the 7th Circuit dismissed evidence of excessive mutual fund fees in 2008 as follows:

It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest.

As evidence, he cited a purely theoretical law review article written twenty-five years earlier—even though the evidence about index fund price dispersion was already out there for everyone to see. This absolute conviction that the world must operate the way it does in theory is another example of economism in its purest form. (Easterbrook was overruled by the Supreme Court, but on other grounds.)

The asset management industry’s other brilliant revenue-maintaining innovation was the target date fund. The theory behind these funds is plausible, although not entirely compelling. The idea is that you pick the date when you expect to retire, and the funds reallocate your holdings from an aggressive mix (more stocks) when you’re young to a conservative mix (more bonds) when you’re old. I say this isn’t entirely compelling because there is no particularly convincing theory of what your asset allocation should be (well, there’s the CAPM, but that doesn’t hold up in practice), let alone what it should be at any given age. For example, it makes no sense that a very rich person and a middle-income person should have the same allocation just because they are the same age.

That said, target date funds could be a solution for an investor who (a) follows the conventional wisdom that you should shift from stocks to bonds as you age and (b) doesn’t want to have to rebalance manually every few years. But in practice, they are just a clever marketing vehicle for complexity and high fees. I was looking at Fidelity target date funds for a friend (who is locked into Fidelity by her retirement plan, which is not too unusual). Here’s the Fidelity Freedom 2040 fund:

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Thirteen U.S. stock funds? Remember, the whole point of a mutual fund is each one is already diversified; if you buy thirteen funds within the same market, you’re just getting lots of overlap in unknown quantities. The sole purpose here is to provide a veneer of sophistication (Wow, I can get twenty-five different investments with just one fund!) to justify a fee of 77 basis points. Vanguard, by contrast, puts your money in four index funds covering the global equity and bond markets, and charges just 16 bp.

Since 2006, the share of 401(k) plan participants holding target date funds has more than doubled, from 19% to 48% (ICI 2016 Investment Company Factbook, Figure 7.14). Because retirement plan administrators typically only offer one series of target date funds (rather than a passive option and an active option), by getting participants to focus on the benefits of target date funds, they can take the passive investing option off the table and quietly funnel everyone into actively managed funds.

Again, the lesson for the individual investor is this: If you are investing in a target date fund, figure out what’s in it, and figure out if you can make essentially the same investments more cheaply. And the lesson for society is this: Even when the products are basically pretty simple (U.S. stock funds), companies will manufacture complexity and barriers to entry in an effort to boost prices well above marginal cost. That’s how the economy works—not the way you learn on the Economics 101 blackboard.

Jeb Hensarling and the Allure of Economism

By James Kwak

The Wall Street Journal has a profile up on Mike Crapo and Jeb Hensarling, the key committee chairs (likely in Crapo’s case) who will repeal or rewrite the Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s clear that both are planning to roll back or dilute many of the provisions of Dodd-Frank, particularly those that protect consumers from toxic financial products and those that impose restrictions on banks (which, together, make up most of the act).

Hensarling is about as clear a proponent of economism—the belief that the world operates exactly as described in Economics 101 models—as you’re likely to find. He majored in economics at Texas A&M, where one of his professors was none other than Phil Gramm. Hensarling described his college exposure to economics this way:

“Even though I had grown up as a Republican, I didn’t know why I was a Republican until I studied economics. I suddenly saw how free-market economics provided the maximum good to the maximum number, and I became convinced that if I had an opportunity, I’d like to serve in public office and further the cause of the free market.”

This is not a unique story. Robert Bork, who took economics at the University of Chicago Law School, recalled the experience as a “religious conversion” that “changed our view of the whole world” (quoted in Sidney Blumenthal, The Rise of the Counter-establishment, p. 303).

Introductory economics, and particularly the competitive market model, can be seductive that way. The models are so simple, logical, and compelling that they seem to unlock a whole new way of seeing the world. And, arguably, they do: there are real insights you can gain from a working understanding of supply and demand curves.

The problem, however, is that the people who are most captivated by the first theorem of welfare economics (the one that says that competitive markets produce optimal outcomes) are often the least good at remembering the assumptions that don’t apply and the caveats that do apply in the real world. They forget that the power of a theory in the abstract bears no relationship to its accuracy in practice.* As Paul Samuelson said in one of my two favorite passages of the original edition of his textbook (p. 36):

“Even [Adam Smith] was so thrilled by the recognition of an order in the economic system that he proclaimed the mystical principle of the ‘invisible hand’: that each individual in pursuing only his own selfish good was led, as if by an invisible hand, to achieve the best good of all, so that any interference with free competition by government was almost certain to be injurious. This unguarded conclusion has done almost as much harm as good in the past century and a half, especially since too often it is all that some of our leading citizens remember, 30 years later, of their college course in economics.”

Hensarling, who likes to quote market principles in the abstract, doesn’t appear to have moved on much from Economics 101. The Dodd-Frank Act, he has said, “is gradually turning America’s largest financial institutions into functional utilities and taking the power to allocate capital—the lifeblood of the U.S. economy—away from the free market and delivering it to political actors in Washington.” The alternative he proposes is to “restore market discipline, end taxpayer bailouts and protect consumers with innovative, competitive markets policed for fraud and deception.” This ritual invocation of markets ignores the fact that there is no way to design a contemporary financial system that even remotely resembles the textbook competitive market: perfect information, no barriers to entry, a large number of suppliers such that no supplier can affect the market price, etc.

As Samuelson continued, our economy “is neither black nor white, but gray and polka-dotted.” Regulatory policy that presumes well-functioning markets that don’t exist is unlikely to work well in the real world. Actually, Bill Clinton and George W. Bush tried that already, and we got the financial crisis. But to people who believe in economism, theory can never be disproved by experience. Hensarling is “always willing to compromise policies to advance principles,” he actually said to the Journal. That’s a useful trait in an ideologue. It’s frightening in the man who will write the rules for our financial system.

* Actually, one could argue that, because of competition among theories, those that are more powerful in the abstract are less likely to be accurate in practice.

Economism: Special Holiday Offer

By James Kwak

As you may have noticed by now, I have a new book coming out. It could be a perfect holiday gift for, well, maybe a handful of people out there—the father-in-law who wonders why our country’s economic policies are so screwed up, or the annoying libertarian niece who insists that we should get rid of private schools and privatize the police force, or the progressive friend who studied anthropology and is unnecessarily intimidated by economics. But even if you pre-order it, you won’t get it until around January 10.

So, here’s the offer: If you pre-order a copy of Economism as a gift for someone, I will mail you a signed card with the image of the book jacket on the front and, on the inside, an explanation of what the recipient is getting (i.e., a book that will arrive in January). That way you can give the person the card instead of the book. If you want a card, send me an email at james.kwak@uconn.edu with your name and address and the name of the person I should inscribe it to. I am planning to mail the cards out by first class mail on Saturday, December 17 (from Massachusetts), which will give them a full week to get to you before Christmas. If you need one sooner for a different holiday, let me know and I’ll do what I can.

If you send me an email by Sunday (December 11), I expect to be able to send you a card. After that point I can probably do it, but I can’t guarantee it because it depends on how many extras I order in advance.

Have a happy holiday season.

More on the Deduction Fairy

By James Kwak

[Updated with Mnuchin’s position on charitable contribution deduction.]

I wrote two days ago about the fairy tale that you can lower tax rates for the very rich yet avoid raising their actual taxes by eliminating those mythical beasts, loopholes and deductions. The basic problem with this story is that, at the very high end of the distribution, deductions and exclusions (with the possible exception of the deduction for charitable contributions) just don’t amount to very much as a percentage of income. Therefore, eliminating those deductions may increase rich people’s taxes by tens of thousands of dollars, but that is only a tiny proportion of their overall tax burden, and not enough to offset any significant rate decrease.

Unlike me, Daniel Hemel and Kyle Rozema are actual tax scholars (Hemel has a blog on Medium), and their detailed research largely tells the same story. They have a forthcoming paper that analyzes the mortgage interest deduction (MID) and shows that, while it is worth more dollars to rich people than poor people (for all the well-known reasons—bigger houses, higher marginal rates, itemizing), the MID causes people in the top 1% to pay a larger share of the overall tax burden. Therefore, eliminating the MID and using the increased tax revenue to reduce tax rates for everyone (what Mnuchin proposed in concept) would be a large windfall for the top 0.1% and a small windfall for the rest of the 1%.

The numbers are in the last column of this table:

The Proportionate column shows the distributional effects of repealing the MID and using the money to reduce everyone’s taxes in equal proportion, which are even worse. (The only good outcome is the Per Household column, which uses the revenue from eliminating the MID to give every household a flat $558 tax rebate, but no one is talking about that.)

Hemel and Rozema do a similar analysis of the deduction for state and local taxes, which I didn’t mention in my post (and which many rich families can’t take because of the AMT). The basic story is the same: repealing the deduction to lower rates is, again, a windfall for very rich families.

The only deduction that turns out to increase inequality under this approach is the one for charitable contributions, because there is no practical limit to the possible size of such donations. (And guess what? Mnuchin doesn’t want to touch this one!) Eliminating this deduction could cause the rich to pay more in taxes, but they could easily maintain the same level of disposable income simply by donating less to charity. In other words, tax revenues would go up, but the money would effectively be coming from charities, not from rich people.

So, there is no deduction fairy. You can’t cut tax rates in anything like the way the Trump administration proposes without vastly increasing inequality. Once again, it’s a conceptually plausible idea that is providing air cover for a massive raid on government services to benefit the very rich.