Archive for the 'Economics' Category

Overprotective Parents, Falling Optimists, and Other Dangers

My friend and former colleague (and our occasional commenter), James Kahn, weighs in on Federal Reserve policy in a thoughtful piece over at Fox Business.

Some highlights:

Proponents of the Fed’s ZIRP (zero-interest rate policy) will quickly point out that the low inflation numbers in recent years belie any claim that policy has been too loose. In a sense they are right: Policy has not been as loose as interest rates suggest, because the Fed has been pushing forward on one lever (asset purchases) while pulling back on another (paying interest on bank reserves). With the economy’s mediocre fundamentals (those supply factors mentioned above), banks are happy to hold large reserves of cash, thus blunting the impact of the Fed’s enormous balance sheet increase.

Bernanke’s gloating about the lack of inflation is thus somewhat misplaced. The concern about losing control of inflation (in one direction or the other), has always been (or should have been), on the Fed’s ability to manage the transition back to normalcy, i.e. the unwinding of its balance sheet, the raising of interest rates, and the drawing down of bank reserves. The Fed may be able to manage all this, but so far it is just lots of rhetoric – it brags about the ability to do so while postponing actually doing it.

In other words, thoughtful critics have said all along that there’s an inflation risk associated with the (future) transition back to normal monetary policy. Less thoughtful counter-critics have claimed to refute that observation with the counter-observation that right now, inflation doesn’t seem to be a problem. Like the optimist in free fall, they figure we’re doing alright so far.

Another highlight:

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McCloskey at Chicago

deeFor an upcoming Festschrift, I was recently asked to write an account of Dee (then Don) McCloskey‘s years as a brilliant teacher at the University of Chicago, her influence on a generation of economists, and my own enormous debts to her. This was a great pleasure to write. A draft is here.

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Minimum Logic, Part 2

Yesterday’s post touched on several related points, and I’m afraid the most important one got buried near the end, so I want to repeat it:

1) In the presence of an effective minimum wage, all benefits of the earned income tax credit are transferred to employers. This is, as they say, a matter of Economics 101. (Edited to add: As Bennett Haselton points out in comments, I should have said “dissipated”, not “transferred to employers”. The point remains that the benefits don’t go to the workers, which, for this discussion, is what matters.)

2) Paul Krugman argues that we should have an effective minimum wage in order to prevent some of the benefits of the earned income tax credit from being transferred to employers.

In this context, it should be remembered that Krugman ordinarily reserves his deepest scorn for those who, according to Krugman, willfully ignore the lessons of Economics 101.

Let’s review the argument for 1), with reference to the graph below. In the presence of, say, a $5-an-hour minimum wage, employers will hire 1000 workers. Because more than 1000 people want to work, employers can extract extra concessions in the form of reduced on-the-job-training, shorter breaks, and harsher working conditions. They can get away with exactly $1-an-hour’s worth of this, because even at an effective wage of $4, there are still 1000 people willing to work.

Edited to add: I am assuming that these concessions are of relatively little value to employers (otherwise they wouldn’t have waited for the EITC to demand them!), so that the quantity of labor demanded does not change.

Now let’s add a $3-an-hour earned income tax credit, which shifts the labor supply curve to the dashed position. Ordinarily, this would lead to a lower equilibrium wage, transferring some of the benefits of the EITC to employers. But in the presence of the $5 minimum, wages can’t drop, and employment remains fixed at 1000, though now even more people want to work, allowing employers to impose even harsher conditions until the effective wage drops to $1 an hour (the wage at which there are still 1000 people willing to work). This process transfers all the benefits of the EITC away from the workers.

Continue reading ‘Minimum Logic, Part 2′

Minimum Logic

The question is often raised: “Why would you ever want to raise the minimum wage when you could raise the earned income tax credit instead?”. In other words, if you’ve got a choice between two ways to increase the effective wage rate, why would you choose the one that reduces employment over the one that increases employment?

Paul Krugman has an answer. He’s argued on numerous occasions that the EITC and the minimum wage are complements, not substitutes — that is, each makes the other more effective. So, according to Krugman, once you’ve raised the EITC, the case for a minimum wage hike becomes stronger, not weaker.

Here’s his argument: When you raise the EITC, more people enter the labor market. The increased supply of labor tends to drive wages down, which transfers some of the benefit from the workers you intended to help to the employers and/or consumers who you presumably care about less. To prevent this perverse consequence, one needs a hike in the minimum wage.

The other day, a colleague (who I’m not naming because I’m not sure whether he’d want to be quoted) pointed out that this argument makes not a shred of sense. Here’s why: Any effective minimum wage (that is, any minimum wage set above the wage rate that would prevail in an unregulated market) suffices to do the job Krugman wants it to do. At best, then, Krugman has made an argument for having some minimum wage, not a case for raising it.

Here’s the picture:

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This Would Be a Great Illustration of Comparative Advantage if It Weren’t Such a Great Illustration of Absolute Advantage

diracPaul A.M. Dirac was a pioneer of quantum mechanics and quantum field theory. His work pervades all of modern physics. He was, by almost all accounts, one of the top 10 physicists of all time, and by many accounts one of the top 2 physicists of the 20th century. And he’s one of my personal heroes.

When Dirac was awarded the Nobel prize in 1933, he was asked to say a few words at the banquet that kicks off the multi-day Nobel celebration — and chose, against tradition, to speak about a subject other than physics. Here is Paul Dirac on the source of all our economic problems:

I should like to suggest to you that the cause of all the economic troubles is that we have an economic system which tries to maintain an equality of value between two things, which it would be better to recognise from the beginning as of unequal value. These two things are the receipt of a certain single payment (say 100 crowns) and the receipt of a regular income (say 3 crowns a year) through all eternity. The course of events is continually showing that the second of these is more highly valued than the first. The shortage of buyers, which the world is suffering from, is readily understood, not as due to people not wishing to obtain possession of goods, but as people being unwilling to part with something which might earn a regular income in exchange for those goods. May I ask you to trace out for yourselves how all the obscurities become clear, if one assumes from the beginning that a regular income is worth incomparably more, in fact infinitely more, in the mathematical sense, than any single payment? In doing so I think you would then get a better insight into the way in which a physical theory is fitted in with the facts than you could get from studying popular books on physics.

True to form, then, Dirac set an agenda that others scurried to follow — the agenda in this case being the exploitation of the Nobel prize as a license to spout economic gibberish. Almost a century later, his program continues to flourish.

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What’s Fair is Fair

Suppose you’ve got 1000 students to assign to two schools, each with 500 slots available. Everyone prefers the Good School to the Bad School. Which of the following is a fair way to decide who goes where?

Method A: Give each student a coin to flip and count on the Law of Large Numbers to insure that just about exactly 500 will flip heads. Those students go to the Good School.

Method B: Randomly assign each student to one of two groups. Then flip a single coin to determine which group goes to the Good School.

Method C: After taking note of the fact that, coincidentally, exactly half the students are white and half are black, flip a single coin to determine which race goes to the Good School.

Method D: Assign all the white students to the Good School.

(There’s also of course Method D-prime, where you assign all the black students to the Good School, but I don’t think we need to consider this one separately.)

I ask this question because economists have been very involved with the design of school-allocation mechanisms, particularly in Boston, and one of the things they worry about is fairness. So it seems important to stop and think about what fairness means in this context.

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How (not) to Redistribute Income (Warning: High Wonk Content)

I just spent a little while trying and failing to construct a homework problem for my honors class. Although it didn’t turn out the way I wanted it to, I thought it might serve as a good illustration of how economists (often) think about income redistribution.

The idea is that different people are born with different talents, and that if it were possible for us all to meet in a shadowy pre-birth world (what the philosopher John Rawls called “behind the veil of ignorance”), we’d want to insure against landing in the shallow end of the gene pool — so we’d probably agree that the lucky ones — those with a lot of talent — would help to take care of the rest.

The further idea is that because we’d presumably all have voluntarily signed on to such an agreement, there’s at least a plausible case for enforcing it. (I’ve argued elsewhere that this plausible case does pretty much nothing to justify the actual sorts of redistribution that are practiced by, say, the United States government — but for present purposes, that’s neither here nor there.)

The big problem is to figure out exactly what terms we’d have all agreed on. Jim Mirrlees won a Nobel Prize for a major attack this problem. But I don’t want to ask my college sophomores to digest a Nobel-worthy body of work, so my goal is to construct a sort of baby version of the Mirrlees approach — which I hope might also interest at least one or two blog readers.

Now if governments were omniscient and omnipotent, the problem would be pretty easy — you’d take a whole lot from the rich and give a whole lot to the poor, and you’d forbid talented people to respond by working less.

In practice, though, governments face a lot of constraints. The one I want to focus on is that our talents and/or incomes might be at least partially invisible to the government. You can’t “take from the rich” if you don’t know who the rich are.

One solution is, instead of taking directly from the rich, to tax things that only rich people buy.

So my idea was to imagine that everyone has a natural talent, and an associated natural income, ranging from 0 to 1. You can spend all your income on corn (in whatever quantity you can afford), or you can spend part of your income to buy a car, for a price of 1/2. Obviously, only people with incomes over 1/2 can even consider buying a car, and even some of them might prefer not to.

Continue reading ‘How (not) to Redistribute Income (Warning: High Wonk Content)’

What Is Larry Summers Thinking?

Larry Summers, writing in the Washington Post, tells us that:

While the recent decline in energy prices is a good thing in that it has, on balance, raised the incomes of Americans, it has also exacerbated the problem of energy overuse. The benefit of imposing carbon taxes is therefore enhanced.

He might have an argument in mind, but he doesn’t seem to have presented it.

The benefit of carbon taxes, as Summers says, comes from “the recognition that those who use carbon-based fuels or products do not bear all the costs of their actions.” In other words, without a tax, people use more oil than they should. I’m with him so far. Now what Summers appears to be thinking is that when the price of oil falls, people use more oil, which increases the gap between what they do use and what they should use. What this overlooks is that when the price of oil falls, there are increases in both the amount people do use and the amount people should use — and hence no particular reason to believe that the gap has grown.

Having made such an argument, one should draw a picture to make sure it’s right. Here are the demand and supply curves for oil. Points on the demand curve show the value to consumers of individual gallons of oil; points on the supply curve show the cost to producers of supplying those individual gallons; points on the social marginal cost curve show the cost to society (including pollution costs) of supplying those individual gallons:

Ideally, oil would be supplied only up to the point where demand crosses social marginal cost and no further. Unfortunately, it’s supplied up to the point where demand crosses supply. Those excess gallons create social losses measured by the skinny rectangles in the left-hand panel (the social loss from a gallon of oil is equal to the social cost of providing that gallon, minus its value to a consumer). These add up to the area labeled X on the right. The value of an appropriate-sized carbon tax is that we’d avoid that social loss. That is, the benefit of a carbon tax is measured by area X.

Now suppose oil becomes available more cheaply. This shifts both the supply curve and the social marginal cost curve vertically downward by the same amount and shifts area X to a new location. As you can see in the picture, there’s no particular reason to think that the area’s gotten any bigger:

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In yesterday’s post about Eric Garner, I wrote:

Suppose you are a typical street vendor of an illegal product, such as, oh, say, untaxed cigarettes.

Suppose the police make a habit of harassing such vendors, by confiscating their products, smacking them around, hauling them off to jail, and perhaps occasionally killing a few.

I have good news: The police can’t hurt you.

Here’s why: Street vending can never be substantially more rewarding than, say, carwashing. If it were, car washers would become street vendors, driving down profits until the rewards are equalized. If car washers were happier than street vendors, we’d see the same process in reverse. (The key observation here is that it’s very easy to move back and forth between street vending and other occupations that require little in the way of special training or special skills.)

Because police harassment of street vendors has no effect on the happiness of car washers, and because street vendors are always just as happy as car washers, it follows that police harassment has no effect on the happiness of street vendors.

So if you’re a street vendor, the police can’t hurt you. On the other hand, when the police go around putting people in deadly chokeholds, they’re clearly hurting someone. So the question is: Who?

Answer: Not the vendors, but their customers. Fewer vendors means higher prices. That hurts consumers, and the sum total of that harm adds up to the harm that we see in the viral videos.

Several commenters jumped in to question the claims that:

  1. If you’re a street vendor, the police can’t hurt you.
  2. The costs of police harassment ultimately fall on consumers.

I’d like to thank those commenters — particularly David Sloan, Keshav Srinivasan and Eric — for keeping me honest and for persisting when I was initially too quick to dismiss their questions.

With regard to the first point, what I actually should have said was:

  • If you’re a street vendor, the police can’t hurt you more than an eentsy weentsy bit.

That’s because harassment causes street vendors to move into a great many other occupations, one of which is car washing. For every displaced street vendor we get, say, 1/2000 of an extra car washer — bringing wages ever so slightly down in the car washing industry and therefore making both car washers and street vendors ever so slightly worse off.

I do not consider this a significant correction.

With regard to the second point, it would have been more accurate to say this:

  • The greater the harassment, the more of its burden falls on consumers in the harassed industry.

More precisely, if we consider the harassment equivalent to a tax of T, then the burden on producers tends to grow linearly in T while the burden on consumers in the harassed industry tends to grow quadratically in T.

However, here are two points I now realize I’d overlooked:

  1. The linear/quadratic thing is at least partially misleading, because there is a limit on how big T can be — if T grows beyond a certain point, then the first industry disappears entirely. So we’re not looking at arbitrarily large T’s here, making “growth rates for large T” less relevant. Thus workers collectively can in fact — and in contrast to what I said yesterday — bear a substantial burden of the cost.
  2. While consumer surplus in the first industry shrinks quadratically in T, consumer surplus in the other industries grows quadratically in T, and in fact, the total consumer surplus across all industries can increase as a result of the street harassment. Thus it’s possible for workers to bear more than the entire burden of the harassment!

Here’s an explicit model:

Continue reading ‘Corrections’

Three Short Essays on Eric Garner


If you asked me to make the best possible argument in favor of the police action that led to the death of Eric Garner, it would go like this:

  1. Cigarettes are taxed.
  2. You can’t have taxes without enforcement. In this case, the enforcers are the police.
  3. Where there are enforcers, there will be confrontations.
  4. When sellers refuse to cooperate, the enforcers have only two options: Walk away, or resort to violence.
  5. Enforcers who walk away soon lose their credibility and their effectiveness. This is more than doubly important for a police officer, who needs that credibility when he confronts far more dangerous criminals.
  6. Therefore, we cannot fault the police for resorting to violence.
  7. Violence is sometimes catastrophic. That’s sad, but it’s not news.

If you asked me to make the best possible counterargument, it would go like this:

  1. You could say exactly the same thing about a protection racket.

That is, every protection racket needs an enforcer. When shopowners don’t pay up, the enforcer has only two options: Walk away or resort to violence. To walk away would sacrifice credibility. Therefore we cannot fault the enforcer for resorting to violence. Sometimes violence gets pretty messy. So it goes.

The force of that reductio ad absurdum depends on the analogy between taxation of cigarettes and the demand for protection money. I think that reasonable people can disagree about the depth of that analogy.

But the lesson remains that every law must occasionally be enforced through potentially catastrophic violence, or, to put this more succinctly, all legislation is deadly. Violence is part of the cost of making laws, and it’s a cost the makers of new laws would be well advised to contemplate.

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Two Questions for Bob Murphy

Bob Murphy objects to my recent defense of Jonathan Gruber. I have two questions for Bob.

Suppose a newly elected Republican president wants to exempt all investment income from taxation. There are two ways to do this:

1) Retain the income tax, but exempt all interest, dividends, and capital gains (while also abolishing the corporate and estate taxes).

2) Scrap the income tax and replace it with a national consumption tax.

The president’s chief economic advisor, like all economists, is well aware that these two policies are essentially equivalent in the sense that, once prices, wages and interest rates adjust to the new policies, each individual taxpayer is burdened exactly as much by policy 2) as by policy 1). More precisely, at least following an initial adjustment period each individual taxpayer enjoys exactly the same lifetime stream of consumption under policy 2) as under policy 1).

Let’s suppose also that the chief economic advisor believes that policy 1) is vulnerable to scurrilous class-warfare-themed attacks and therefore cannot be sold to the American people. Policy 2), however, stands a chance of passage. He therefore goes around honestly touting what he perceives to be the clear virtues of policy 2), choosing not to mention that it’s equivalent to policy 1).

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Borderline Disorder

Here’s one difference between me and Paul Krugman: He enthusiastically supports President Obama’s new immigration policy, which he calls a matter of human decency. I grudgingly support President Obama’s new immigration policy, which I call a bit less indecent than the policy it replaces.

krugHere’s another difference between me and Paul Krugman: I believe it’s the job of an economics journalist to call attention to unpleasant tradeoffs and offer frameworks for resolving those tradeoffs. Krugman apparently believes it’s the job of an economics journalist to sweep all tradeoffs under the rug in the name of advancing your policy agenda — appealing, if you will, to the stupidity of the American op-ed reader.

Krugman, for example, tells us that he opposes deportations because they’re cruel, but also opposes open borders because they’d make it both economically and politically impossible to maintain the modern American welfare state.

In furtherance of which, he offers this kind of claptrap:

Second, there are large numbers of children who were born here … but whose parents came illegally, and are legally subject to being deported.

What should we do about these people and their families? There are some forces in our political life who want us to … deport the undocumented parents of American children and force those children either to go into exile or to fend for themselves.

But that isn’t going to happen, partly because, as a nation, we aren’t really that cruel

Dammit, I hate this stuff. Krugman says (and I agree with him) that it’s cruel to deport people. He ignores the fact that it’s also cruel to keep other people out. Krugman says (and I agree with him) that letting more people in would put pressure on the welfare system. He ignores the fact that allowing people to stay also puts pressure on the welfare system. Why should we prioritize kindness to those who are already here over kindness to those who are clamoring to get here?

There might be a really good answer to that question, but you’d never know it from reading Krugman. In fact, the takeaway from Krugman’s column is that the cruelty of deportations is unacceptable only because Krugman says so, and the cruelty of closed borders is a necessary evil only because Krugman says that too. So the next time you want to know whether some other policy is unacceptably cruel or not, the only way to find out is to ask Paul Krugman.

And then there’s more:

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In Defense of Gruber

Regarding Jonathan Gruber and the Cadillac tax, I think a little historical context will be useful:

1) Our tax system subsidizes employer-provided health insurance. That’s dumb. Pretty much all economists agree that it’s dumb.

2) On the other hand, it’s politically hard to eliminate a subsidy once people get used to it.

gruber3) In 2008, we had an election. The candidates were named Barack Obama and John McCain. Exactly one of those candidates took the politically courageous step of proposing to eliminate the subsidies (and replace them with other subsidies, far more sensibly designed). The other candidate took the low road, leaping to the defense of subsidies he had to know were indefensible, playing to the crowd, and staking all on what could reasonably be called “the stupidity of the American voter” (though I myself would prefer to call it “the inattentiveness of the American voter”). That candidate won in a landslide.

4) Once elected, President Obama’s demagogy came back to haunt him. On the one hand, he knew that you cannot have sensible health care reform without curtailing those subsidies. On the other hand, he’d publicly committed himself to preserving them.

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Amazon’s Bargemen

In early 20th century China, goods were frequently transported by barges pulled by teams of six men. The men were paid only if they delivered their goods on time. Therefore they all agreed to pull as hard as possible.

This is a classic example of what economists call a Prisoner’s Dilemma — a situation where everyone wants to cheat, regardless of whether he believes the others are cheating. Any bargeman might reason that “If the others are pulling hard, we’re going to make it anyway, so I might as well relax. And if the others are not pulling hard, we’re not going to make it anyway — so I still might as well relax .” Therefore they all relax and nobody gets paid.

According to my late and much lamented colleague Walter Oi, the bargemen frequently solved this problem by hiring a seventh man to whip them whenever they appeared to be giving less than 100%. You might suppose, at least if you’re a person of ordinary tastes, that hiring a man to whip you is never a good idea. There’s a sense in which you’d be right. But hiring a man to whip your colleagues can be a very good idea indeed, and if that requires getting whipped yourself, it might prove to be an excellent bargain.

If I’d lived in China a hundred years ago, I believe I’d have gone out of my way to buy goods from the teams with whipmasters — partly because that’s where I’d expect the best service, but also partly because I’d feel a certain combination of admiration and loyalty for the teams who were working so hard to earn my business.

That’s how I feel about the folks at Amazon. Based on the fabulous service I’ve been getting, I’m confident these people are knocking themselves out to do a good job for me. In fact, it’s been widely (and perhaps accurately) reported that during a heat spell a couple of summers ago, workers in an un-airconditioned Pennsylvania warehouse continued to fill orders even as several were being treated for heat sickness.

There’s a narrative going around that tries to paint these workers as victims, though I’ve heard no version of that narrative that makes clear who, exactly, is supposed to have victimized them — the stockholders? the management? the customers? the do-nothing Congress? But there’s little point in trying to make sense of this narrative, since it’s so obviously wrong to begin with.

Imagine a team of ambitious but relatively low-skilled workers. They know that if they all push themselves to the limit, they’ll all be more productive and therefore earn higher wages. They also know that if they all promise to push themselves to the limit, they’ll all break their promises, figuring that success or failure depends almost entirely on what the others do.

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Letters and Numbers

Four years ago, roughly two dozen economists and financial theorists signed an open letter to Ben Bernanke urging him to back off the policy of quantitative easing, citing, among other things, the risk of inflation.

Bernanke was apparently unmoved, and quantitative easing went ahead as scheduled. Inflation has not materialized. This raises a number of questions for the signers of the letter. Should they be ashamed? Do they have anything to apologize for? Should they renounce everything they thought they knew about economics and relearn the subject from scratch?

Cliff Asness, one of the signers, responds here. This is a terrific essay, not just on the specific topic of quantitative easing but on the general topic of the lessons we should and should not learn from our mistakes and/or from concerns that don’t materialize.

Postscript: True to form, Paul Krugman concludes that Asness, because he disagrees with Krugman, must be entirely ignorant of all the macroeconomic literature on liquidity traps. I wonder if Krugman wants to draw the same conclusion about Asness’s fellow signer John Taylor, whose likely future Nobel prize, unlike Krugman’s (who won for trade theory and economic geography), will recognize Taylor’s widely acknowledged first-rate scholarship and influence in the field of macroeconomics.

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A Little Perspective

As recently as a few months ago, doctors were held in high esteem and educated people believed that medicine could be useful. All that changed, of course, with the medical profession’s stunning failure to prevent or even predict the breakout of ebola in West Africa. Worse yet, many doctors to this very day cling to their old ways of thinking, writing prescriptions, setting broken bones, and performing surgery in bull-headed defiance of the urgent need to jettison everything we know about medical practice and start over from scratch.

Nobody, of course, writes such nonsense about medicine. Why, then, do so many write equivalent nonsense about economics?

Most economists failed to predict the 2008 financial crisis and ensuing recession for pretty much the same reason most doctors failed to predict the 2014 ebola epidemic — their attention was, quite reasonably, directed elsewhere. It’s easy to say in hindsight that if economists had paid more attention to the shadow banking system, they’d have seen what was coming. But attention is finite, and if economists had paid more attention to the shadow banking system, they’d have paid less attention to something else.

For a little perspective, have a look at this chart showing U.S.~per capita income in fixed (2005) dollars:

That little downward blip you see near the top is the recent crisis. The somewhat bigger downward blip in the 1930s is the Great Depression. The moral is that in the overall scheme of things, recessions don’t matter very much. At the trough of the Great Depression, people lived at a level of material comfort that would have seemed unimaginably luxurious to their grandparents. Today, while Paul Krugman continues to lament “the mess we’re in”, Americans at every income level live far better than Americans of, say, 1980. If you doubt that, you surely don’t remember what life was like in 1980. Here’s how to fix that: Pick a movie from 1980 — pretty much any movie will do — and count the “insurmountable” problems that the protagonist could have solved in an instant with the technology of 2014. Or reread any of the old posts on this page.

Continue reading ‘A Little Perspective’

Discussion Question

Imagine a world where everyone is equally risk-averse, and where there are two assets available: You can hold stock in an umbrella company, or you can hold stock in a sunscreen company. Depending on the (quite unpredictable) weather, one of these stocks is sure to gain value at 100% a year while the other is sure to lose value at 95% a year, but it’s impossible to know which is which.

Given this, the smart thing to do is to hold a balanced portfolio of the two assets and earn a comfortable 5% per year. Most people in this imaginary world are smart enough to figure this out. But a small number are stupid enough to put all their eggs in one or the other basket. Half these people are quickly wiped out; the other half become super-rich.

Now we have a society in which nobody smart is especially rich, and everyone rich is especially dumb.

Question: Does this parable contribute anything useful to understanding some aspect (obviously not all aspects!) of the wealth distribution in the world we inhabit? Discuss.

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The Coinflipper’s Dilemma

flipperThis is the story of how I came to write a little paper called The Coinflipper’s Dilemma.

When I was in high school, my English teacher must have had a free period at the time when my math class met, because every day he would march into the math class and empty his pockets on the table, whereupon my math teacher did the same. Then whoever had put down the most money scooped up everything on the table.

I am ashamed to admit that it took me until this summer to think about computing the equilibrium strategy is in that game.

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Tipping the Scales

Former economist Paul Krugman has actually managed to get these words past an editor at the New York Times:

There is, however, one big difference between corporate persons and the likes of you and me: On current trends, we’re heading toward a world in which only the human people pay taxes.

Now I think we can be quite sure that even Paul Krugman, with his gargantuan capacity for forgetting everything he once knew, is well aware that we already live in a world where only human people pay taxes. That’s an instance of the general principle that the legal incidence of a tax does not determine its economic incidence. The corporate income tax is levied by law on corporations, but its economic effects are felt entirely by humans.

Why then, did he write this in the first place? Well, the charitable reading — and I am all in favor of charitable readings — is that all he’s saying is that the legal incidence of taxation has shifted somewhat from corporations to individuals.

But why would that be interesting? And why would it be, as Krugman seems to take for granted, a clearly bad thing? Suppose that in 1990, I received a $1 dividend and paid a 25% tax, keeping 75 cents in my pocket, while in 2014, due to a fall in corporate rates (leading to higher dividend payouts) and a rise in personal rates, I received a $1.50 dividend and paid a 50% tax, keeping 75 cents in my pocket. Who cares?

Well, perhaps there are reasons to care, involving some non-obvious incentive effect of the sort that it takes an economist to notice. Well, that, then, is where the economist comes in — his job being to explain why he thinks these things matter. In this case, I don’t offhand see the argument, but I’m perfectly happy to believe there might be one. On the other hand, if Krugman actually has an argument in mind, one wonders why he’s so reluctant to share it.

Oh, he does pay lip service to the need for an argument, but all he offers is sophistry:

Continue reading ‘Tipping the Scales’

The Free Marketeers

Yesterday’s brief post raised an eyebrow over a congressional candidate who manages simultaneously to call himself a “free-market economist” and to support strict controls on immigration. Here are a few more words for those who don’t quite see the problem.

First, I can imagine two possible meanings for the adjective “free-market”. Either it means you place a high value on freedom as an end in itself or it means you believe that freedom is, in general, a highly effective means to other ends you care about, like prosperity or security. I happen to be a free marketeer in both senses, though I can easily imagine being a free marketeer in either sense alone.

I see my preference for freedom as an end in itself as being similar to my preference for well done meat — you either share that preference or you don’t, and if you don’t, we’ll just have to agree to disagree — there’s no right or wrong here. One exception: If your preferences strike me as inconsistent — if, that is, you seem to make a lot of choices that indicate a strong preference for freedom while denying that freedom is terribly important to you — then I’m apt to point to that inconsistency and suggest that you might want to think a little harder about what your true preferences really are. That was the thrust of what I once tried to do in a book called Fair Play, where I suggested that the choices we make as parents often reveal values contrary to those we express in the voting booth — and that by reflecting on those choices, we might become more thoughtful voters.

On the other hand, if you doubt that freedom is an effective means toward prosperity, then I’m pretty sure you’re just wrong, and that if you thought about it harder you’d change your mind. A lot of my other writing has tried to explain how to think about it harder, and to demonstrate that this is a subject where hard thinking can be fun.

Now I’m not sure in which sense our congressional candidate considers himself a free marketeer, but surely if you’re a free marketeer in either sense, you’ll tend to endorse statements like these:

Continue reading ‘The Free Marketeers’

On Piketty and Capital

Important disclaimer: I have not read Thomas Piketty‘s book on Capital in the Twenty-First Century, and therefore cannot possibly have given it a fair reading.

I do, however, trust Per Krusell and Tony Smith to have given it a fair reading, because Krusell and Smith have long track records as diligent and thoughtful scholars. And their analysis appears to devastate both Piketty’s model and his prediction that income inequality is destined to grow explosively over time.

Here’s why:

All of Piketty’s predictions depend on his assumptions about how much people save. The simplest respectable model (that is, a model that economists generally feel comfortable using for many purposes, and which fits fairly well with observations) says that we save a fixed percentage of our incomes — say 30%. (There are also more sophisticated models in which this percentage can change as economic conditions change.)

Piketty, by contrast, assumes that our net saving is a fixed percentage of our net incomes, where “net” means “after subtracting depreciation of our assets”. That’s a very different assumption, and, according to Krusell and Smith, not at all a plausible one. It’s implausible first because it has extremely odd implications. Most notably, it implies (though this is not immediately obvious) that if economic growth slows to zero, we will eventually choose to save 100% of our incomes(!!). Beyond that, Krusell and Smith argue in considerable detail that, compared to the more traditional models, Piketty’s does a poor job of fitting the last seventy years’ worth of data.

According to Krusell and Smith, Piketty demonstrates correctly that under his assumptions, slowing economic growth must lead to massive inequality over time. But under the far more plausible assumptions found in modern textbooks and modern research papers, that conclusion goes away. In fact, after substituting those assumptions, Piketty’s arguments yield something like the opposite conclusion — as growth slows down, changes in inequality become pretty much negligible.

If this analysis is right — and given the identities of the authors I’ll be very surprised if it’s wrong — then there appears to be very little reason to buy into Piketty’s story. That doesn’t mean he’s wasted his time. We learn a lot by making a variety of different assumptions and figuring out where they lead us, even when the assumptions are ultimately unsupportable. But a serious intellectual exercise is not the same thing as a serious prediction.

Something to Celebrate

Here’s a key lesson of economics: Trade is good, but trade with people very unlike yourself is even better. I’m a teacher who eats beef, drives a car and lives in a house. I don’t need other teachers so much as I need students, ranchers, autoworkers and architects. If your neighbors love gardening as much as you hate it, you’ll find it easy to hire a gardener. If it’s the other way around, you’ll do well in the gardening business.

The lesson spills over beyond the markets for goods and services. We learn new ways of thinking and new ways of living from people who think and live differently than ourselves.

We thrive on diversity — diversity of skills, diversity of interests, diversity of lifestyles, diversity of religious and political outlooks, diversity of culinary and artistic tastes, diversity of lifestyles, and, lest we forget, diversity of income. Capitalists need workers and workers need capitalists. A wealthy factory owner won’t stay wealthy for long if here’s nobody to work the assembly lines. A middle-class assembly line worker won’t be middle-class for long if there’s nobody building factories.

Let us then celebrate diversity, not try to extinguish it. And let’s not forget that diversity of income — or, if you prefer, “income inequality” — is just as much a blessing as diversity of skills, preferences, cultural outlooks, and ways of living.

Continue reading ‘Something to Celebrate’

Housing Problems

Josh Barro observes that home ownership is a really bad investment strategy insofar as it involves putting an awful lot of eggs in one basket — indeed, for many people it involves putting more eggs than they’ve got in one basket, since the mortgage market allows you to sink more than your entire net worth into a single house.

In fact, it’s even worse than Josh says. If your house is located anywhere near your workplace (in other words, if you’re almost anyone) then a local economic downturn can devastate your home value at exactly the same time that it’s costing you your job. That’s a whole lot of unnecessary risk.

As Josh acknowledges, that doesn’t mean you shouldn’t own a house; it just means you shouldn’t fool yourself into thinking it’s a wise investment.

But Dan McLaughlin at the Federalist isn’t satisfied:

Economists … should never make the mistake of ignoring consumer behavior they regard as irrational…What Barro should have asked himself (as any real economist should) before declaring that vast numbers of homebuyers and homeowners have been acting irrationally for millenia in buying their own homes is: what are they getting out of it that my analysis is missing?

I enthusiastically endorse the sentiment that when we observe “inexplicable” behavior, our first instinct should be to ask “What am I missing?”. But Barro at least tried to do that — he pointed to “a sense of security” and the desire to customize one’s residence. I agree with McLaughlin’s assessment that these are pretty weak answers, but unfortunately McLaughlin’s own “answers” are even weaker. According to McLaughlin, we own houses because we don’t like to move, and he elaborates at length on the reasons why —- moving is expensive, it means adjusting to new neighborhoods, uprooting your family, etc. etc.

The thing is, though, none of this is a reason to own rather than rent. You could accomplish all of the above with a 99-year lease (binding for the landlord but not for the tenant) which would give you all the residential stability of home ownership while transferring the risk to a professional landlord with diversified holdings.

So why do people buy houses? Offhand, I can think of three answers:

Continue reading ‘Housing Problems’

Social Accounting

We’ve had a very long recent thread about the social costs and benefits of high frequency trading, where I’ve apparently managed to confuse a number of readers by switching back and forth, according to the convenience of the moment, between two different, but perfectly legitimate, social accounting systems.

To clarify matters, let’s forget for the moment about high frequency trading and look at something simpler — innovation in the IT industry, where it’s clear that profit-maximization can easily lead to too much innovation. I’ll do the accounting both ways to make it clear that both ways are right.

First, the assumptions:

Alice has developed a word processor, which she sells online. It costs her $5000 a year to maintain a server, where you can download a copy for $1000. She sells 100 copies a year, and therefore collects $100,000 in revenue. Most of the consuemrs who buy those copies value them at more than their price. In fact, the total value of those 100 copies to the consumers is $200,000.

Bob has an idea for a word processor that’s a little better than Alice’s, so that each consumer would be willing to pay $10 more for Bob’s than for Alice’s.

If Bob develops his word processor, how much can Alice charge for hers? Because her word processor is inferior to Bob’s, she’s got to undercut his price by $10 in order to maintain any customers at all. So if Bob charges $600, Alice charges $590. But then Bob can steal all of Alice’s customers by lowering his price to $599.99, whereupon Alice must lower her price to $589.99, whereupon Bob steals all her customers by lowering his price another penny….and the race to the bottom is on. But Alice’s price cannot fall below $50, because then she wouldn’t earn enough to cover her server costs. So Alice, who is smart enough to foresee all this, gives up and cedes the market to Bob.

Once Bob has the market to himself, he doesn’t have to worry about re-entry by Alice, because they both know perfectly well that the instant she renews her server contract, the race to the bottom will be back on and she’ll have spent $5000 for nothing.

Now if Bob sells his word processor for $1000, it’s he instead of Alice who earns $100,000 a year in revenue and therefore (after subtracting the server cost) $95,000 in profit. He weighs this against the $80,000 cost of developing his word processor and takes the plunge.

I claim that Bob’s decision is privately wise (i.e. wise from Bob’s point of view) and socially foolish (i.e. it reduces social welfare, defined as the total dollar value of all the gains to consumers and producers). We can calculate the costs and benefits of Bob’s decision in either of two equally legitimate ways. Because they are equally legitimate, they lead to the same bottom line: Bob’s private benefit exceeds his private cost by $15,000 (which is why he plunges ahead), while the social cost exceeds the social benefit by $79,000 (which is why we wish he wouldn’t).

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High Frequency Rentseeking

Spread Networks recently spent $300 million to build a fiberoptic cable that will let Wall Street traders shave .003 seconds off their execution times.

What’s the social value of that cable? If you can shave .003 seconds off the time it takes to execute a trade, how much good have you done the world?

Clearly, the full value of the cable resides in its ability to get things done faster. So start with a vast overestimate: Suppose the entire economy is on hold waiting for that trade to be completed. Then, thanks to the cable, we can all get on with our lives .003 seconds sooner and produce an extra .003 seconds worth of output.

In a $15-trillion-a-year economy, that comes to about $1500.

If we assume, more realistically, that just 1/1000 of the economy is hanging fire waiting for this one trade, the social contribution of a .003-second speedup is roughly $1.50. I’m confident it’s even more realistic to replace that 1/1000 with 1/1,000,000 . That gets us down to about an eighth of a cent.

But chances are you’d be willing to pay a hell of a lot more than an eighth of a cent for that extra speed, which is why Spread Networks is willing to pour $300 million into this thing, and why, quite generally, we should expect there to be more invested in such projects than they return in social value.

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Krugman Versus Keynes

Remember Paul Krugman? You know, the guy who thinks we’re so deep in a liquidity trap that pretty much all spending is good spending, even if it’s socially wasteful?

Well, here’s something odd. That very same Paul Krugman is outraged to the core by expenditures on fiberoptic cables to support high frequency trading — expenditures that I happen to agree represent a giant social waste.

“We’re giving huge sums to the financial industry for little or nothing in return”, gripes the very same Krugman who thought it was a swell idea to stimulate the economy through hundreds of billions in government spending, whether or not we got anything in return.

It’s true that Keynesian economists have reasons to believe that wasteful spending is sometimes good. But honest Keynesian economists tend to acknowledge that those reasons apply equally well to both private and public spending.

Krugman’s view, apparently, is that, at least in the current climate, wasteful spending is good as long as you’re spending taxpayer’s money, but bad if you’re spending your own money. That’s not Keynesianism. It’s just crankiness.

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Homer Nods

Well, nobody’s perfect.

When it comes to skewering bad reasoning — and making the right arguments crystal clear — Don Boudreaux is usually about as close to perfect as anyone gets. But this time I believe he’s committed a gaffe of his own.

In a column on the minimum wage, Don writes:

Suppose that I invent and use a machine to steal $15,000 every year from each of 500,000 poor Americans, with the $7.5 billion being transferred into my Swiss bank account. After skimming off a few hundred million bucks to cover processing and handling expenses, I share the bulk of these proceeds with about 16.5 million friends…Am I acting immorally? Most people would answer “yes”…

By way of context, a CBO study forecasts that raising the minimum wage to $10.10 per hour will cause 500,000 workers to lose their $15,000-a-year jobs, while raising the pay of 16.5 million others.

But Don’s analogy fails, because taking someone’s $15,000-a-year job is not the same thing as taking someone’s $15,000. I think it’s a fair guess that most minimum wage workers dislike their jobs. So losing one of those jobs has an upside, which has to be weighed against the downside of not getting paid. On balance, losing that $15,000-a-year job might be no more painful than losing, say, $5000 a year.

The right version of Don’s analogy, then, goes more like this:

Continue reading ‘Homer Nods’

The Arithmetic of Wage Gaps

Mark Perry and Andrew Biggs argue in the Wall Street Journal that

These gender-disparity claims [the claims that women are paid 23% less than men for the same work] are also economically illogical. If women were paid 77 cents on the dollar, a profit-oriented firm could dramatically cut labor costs by replacing male employees with females. Progressives assume that businesses nickel-and-dime suppliers, customers, consultants, anyone with whom they come into contact — yet ignore a great opportunity to reduce wages by 23% [by hiring women instead of men].

Well, first of all, even if we take the gender disparity claims at face value, this doesn’t add up to an opportunity to reduce wages by 23%. Only about half the work force is female, so the average firm, if it replaced all of its men with women earning 23% less, would reduce its wage bill by only about 11.5%.

Beyond that, the Perry/Biggs argument appears to founder on the observation that lazy and incompetent managers do in fact manage to ignore profit opportunities all the time. Why, then, is it so hard to imagine that they’re ignoring this one?

Fortunately, I’m here to fill the gap —- by figuring out just how big a profit opportunity we’re talking about.

Continue reading ‘The Arithmetic of Wage Gaps’

Style Versus Content

Paul Krugman pauses to wonder why he’s been characterized as immoderate when — according to him — “there’s not a lot of air between my views and those of, say, staff economists at the Fed.” His conclusion: “What was radical, if you like, was my style, not my content.”

Bingo. Krugman’s detachment from mainstream economics is indeed a matter more of style than of content. But one symptom of that detachment is his failure to recognize that style is all that matters. Economics is most valuable not as a repository of received truths, but as a way of thinking — a way of thinking that has proved itself extraordinarily valuable as a bulwark against nonsense and claptrap. It’s that way of thinking — the style of economics — that Krugman so often and so depressingly abandons.

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Walter Oi, 1929 – 2013

A long time ago, when I had just started teaching at the University of Rochester, a blind man marched into my office, adopted a commanding stance, and announced in a booming voice that “it takes 150 condoms to prevent one birth in India”. Then he turned on his heels and marched out, leaving me to wonder what he had divided into what to get that number.

That’s what it was like working with Walter Oi, who died peacefully in his sleep on Christmas Eve after a long illness. Walter loved odd facts, and he loved to share them. It was Walter who told me that when all frozen pies had 12 inch diameters, apple was the most popular flavor — but when 7 inch pies came on the market, apple immediately fell to something like fifth place. His explanation: When you’re buying a 12 inch pie, the whole family has to agree on a flavor, and apple wins because it’s everyone’s second choice. With 7 inch pies, family members each get their pick, and almost nobody chooses apple.

Walter loved facts so much that he sometimes invented new ones, because the world could always use more. One day he walked into the department coffee room and announced that “A one hundred pound man and a three hundred pound man have exactly the same quantity of blood.” When this was met with considerable skepticism, Walter responded as he always responded to skepticism — by repeating himself more forcefully: “A one hundred pound man and a three hundred pound man have EXACTLY the same quantity of blood”.

In those pre-Internet days, some of us owned a device called an “encyclopedia”, which was sort of like a hardcopy printout of Wikipedia, but with fewer Simpsons references. A couple of my more enterprising colleagues went home and checked their encyclopedias that night, and came back the next morning to report that according to authoritative sources, a man’s blood volume is roughly proportional to his body weight. Walter’s response: “Nope. A one hundred pound man and a three hundred pound man have EXACTLY the same quantity of blood.”

If you watched carefully and didn’t blink, you might have caught him suppressing a smile.

Continue reading ‘Walter Oi, 1929 – 2013′