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After I responded to Professor Caplan’s post defending an orthodox interpretation of the minimum wage, we had a small conversation on Twitter:

Bryan: My argument is that we should consider all relevant evidence, and most minimum wage researchers don’t.

Ashok: But the evidence is only relevant if std theory applies, and unless one has strong priors that has been ‘refuted’, relevant evidence would be far more valuable w/o Krueger/Card, to the extent one trusts empirics

B: Empirical work “refutes” nothing. All it can do is raise or lower probabilities.

A: Absolutely agree, but then you can’t claim that your argument works for those of us w/o strong priors, as you do.

B: How do you figure? If you have 50/50 prior on employ effect of min wage, why doesn’t totality of evidence sway you?

A: Because of empirics from Krueger. Once my priors change, value of “relevant” empirics diminishes as it begs the question

B: Presenting new info never “begs the question.”

I’m using this blog post to explain more thoroughly the point I was trying to make earlier, and 140 characters won’t suffice. 

Here’s the argument for a standard approach to minimum wage and relevant effects on employment:

But suppose you disagree with me on both counts.  Suppose you have a weak prior about the disemployment effects of the minimum wage.  Suppose further that you think that the best empirical work in economics is very good indeed.  Doesn’t existing evidence then oblige you to admit that the minimum wage has roughly zero effect on employment?

Let’s break this down logically. Let the proposition P be that labor markets operate under orthodox theory and hence wage controls cause unemployment. Everyone has some prior on this proposition. As it happens, Caplan’s beliefs are strong, and mine aren’t. So I update my priors quite a bit more significantly considering Krueger and Card, but this isn’t really important to the debate at hand.

Caplan is arguing that I should change my beliefs based on price controls in general, labor market regulation, and immigration. Here’s why I think his argument is wrong:

  • Caplan is arguing that P is true
  • He is, further, arguing that a plethora of other evidence stand as fair empirics against the Krueger study which clearly shows no disemployment effects on minimum wage (or would at least adjust one’s priors to towards that conclusion).
  • In citing the evidence that the labor demand curve for immigrants is downward sloping and hence suggesting that wage controls cause unemployment, one has to assume that labor markets operate under normal conditions, which is precisely the question at hand.

If wage controls are fundamentally different, as Krueger/Card shows, it really doesn’t matter what the rest of an economy works like. The idea that you can extrapolate how labor markets work from rent controls and agricultural subsidies is irrelevant, because we’ve defined our proposition specifically in the case of a labor market.

I was wrong in suggesting that this “begs the question”, considering the Bayesian nature of this debate. However, one would have to have really strong priors to ignore Krueger/Card and hence extrapolate empirics from other industries onto labor, but he can’t then claim that:

But suppose you disagree with me on both counts.  Suppose you have a weak prior about the disemployment effects of the minimum wage.  Suppose further that you think that the best empirical work in economics is very good indeed.  Doesn’t existing evidence then oblige you to admit that the minimum wage has roughly zero effect on employment?

Further, even in the empirics he cites, there’s a missing dimension in his reasoning: humans are not capital:

If you object, “Evidence on rent control is only relevant for housing markets, not labor markets,” I’ll retort, “In that case, evidence on the minimum wage in New Jersey and Pennsylvania in the 1990s is only relevant for those two states during that decade.”  My point: If you can’t generalize empirical results from one market to another, you can’t generalize empirical results from one state to another, or one era to another.  And if that’s what you think, empirical work is a waste of time.

Even if we establish that it’s okay to generalize empirical results from one market to the other – and, as was my point above, that’s not possible without assuming your conclusion – this seems like a pretty remarkable statement. There is nothing qualitatively different between New Jersey and Pennsylvania, or the 1990s and 1960s. There is something qualitatively different between a human being and a machine. For one, it’s illegal to enslave own one of them.

Because standard economic theory applies in one particular market certainly doesn’t suggest that every single commodity or good (if you can even call labor that) operates under these conditions. In the most comprehensive study conducted on wage controls, we have strong reason to believe that these very conditions are irrelevant.

I cede that if one has strong priors and a distrust of economic empirics, the dominant belief might still be an orthodox interpretation of the minimum wage. But if one has strong enough priors he can believe just about anything. When so much empirical evidence casts doubt on economic theory, I don’t understand the need to study “relevant” data, which is useful only to those with such high priors.

Neil Irwin notes that the “soaring dollar” is sign enough that the American economy is recovering:

In short, the U.S. economy is looking a bit better. And the other world economies are sucking wind. Just today, new data from the European Union showed that  in the 17 countries that use the euro currency, employment fell to its lowest level in seven years in the final months of 2012. In other words, things are even worse for workers in Europe than they were in the immediate aftermath of the 2008 crisis. […]

In other words, as terrible as the economy here may feel, it could be a lot worse. And importantly, while government policies (particularly by central banks) certainly have a lot of power to influence exchange rates, the core reality is this: The value or the dollar or any other currency hinges on the economic outlook for the country that uses it.

Dean Baker begs to differ:

The only serious way to get the trade deficit down is get the dollar down. That will make our exports cheaper to people living in other countries and make imports more expensive for people in the United States. That means more exports and fewer imports, and therefore a smaller trade deficit. (For those folks who were looking to the trade agreements, the idea that these will reduce the trade deficit is just something that the Serious People tell to children.)

Anyhow, it is easy to show there is no direct relationship between the health of the economy and the strength of the dollar. In fact, the recovery in the first half of the Clinton administration was based to a substantial extent on the idea that a lower deficit would lead to a lower valued dollar and therefore more net exports. And, this largely worked as shown below.

Other things equal, for a country that’s not price-inelastic on trade (technically, if the Marshall-Lerner condition is satisfied) I’d support a weaker currency. This generally benefits the disadvantaged who, in theory, would be more employable in traditionally blue-collar jobs like manufacturing and low-end services. It hurts the people who have much wealth in dollars, but that increasingly excludes the poor, and even middle-class.

But, it’s too simplistic to assume that what we need right now is a weaker currency, or that traditional devaluation (err, “depreciation”) will increase exports. Take, for example, this graph of our exports to China:

Image

This graph shows that after the recession ended, both exports to China and the dollar increased with each other. This isn’t to say that there’s a causal relationship, indeed theory would suggest just the opposite. But does indicate that simplistic devaluations need have no effect. So just as Dean says “it is easy to show there is no direct relationship between the health of the economy and the strength of the dollar”, it is easy to show there is no direct relationship between net exports (which haven’t changed much in the past five years) and the dollar.

There’s also a pretty important problem with significantly devaluing the dollar. The world would be very angry with us. The world operates on a dollar-standard and countries pay for the most important import (oil) with the greenback. This means that countries keep dollars so that they can keep their energy sources flowing, and it also means that many nations have much of their wealth in dollars.

We would be ceding a key, global presence if our economy couldn’t survive without a weaker currency (recent job reports and sales show that this just isn’t the case). 

Indeed, a rise in the dollar implies an increased demand for dollar-denominated purchases, i.e. American exports. As several large multinational corporations signal a shift in manufacturing presence back to the United States, while still others plan on starting operations anew, it’s clear the world expects a growing demand for American exports. The value of the dollar is as much about market expectations regarding the American economy, as it is about the American economy itself.

Exchange rates, however, are also limited in the information they provide about an economy. For floating currencies, as the demand for exports increases the currency gains value. Eventually, the increased value results in a decreasing demand for exports. Indeed, between any two freely-trading nations, the exchange rates automatically adjust to create a standard equilibrium. 

Of course, the world is neither that simple nor predictable, but principally the same. Neil also recognizes this, I’ll finish with him:

At times, the tendency to conflate the strength or weakness of a currency with the strength or weakness of the nation is problematic. It can lead to bad policy if, for example, policymakers in a country with a terrible economic situation are unwilling to take steps to help because they fear allowing their currency to decline.

But strip out that emotionalism, and this teaches a fundamental lesson for policymakers: If you take care of your country’s economic prospects, the value of your currency will take care of itself.

So, contra Dean, I don’t believe that a rising dollar is a bad thing, per se. I certainly don’t believe devaluation sends the right message. And, when Dean says:

Anyhow, it is easy to show there is no direct relationship between the health of the economy and the strength of the dollar.

He knows that if the correlation doesn’t hold in the upward-direction, it definitely doesn’t on the way down, either. So if one can’t prescribe policy recommending a stronger dollar citing no correlation, then we certainly can’t recommend a weaker dollar, either. In this case, we let it be, laissez-faire

 

People like to caricature PK as some sort of deficit nut. The crazy professor that runs around screaming “Deficits don’t matter, ever“, or “Keep printing that money“. Or, more recently, that he’s a crude Keynesian.

So, I’m not going to do any analysis here, just post a few quotes from the good doc and you tell me if this is “crude” or, as Jeffrey Sachs and Joe Scarborough put it:

Dick Cheney and Paul Krugman have declared from opposite sides of the ideological divide that deficits don’t matter, but they simply have it wrong. Reasonable liberals and conservatives can disagree on what role the federal government should play yet still believe that government should resume paying its way. It has become part of Keynesian lore in recent years that public debt is essentially free, that we needn’t worry about its buildup and that we should devote all of our attention to short-term concerns since, as John Maynard Keynes wrote, “in the long run, we are all dead.” But that crude interpretation of Keynesian economics is deeply misguided; Keynes himself disagreed with it.

Here’s what Paul Krugman has to say:

I wish I could agree with [the view that deficits never matter, as long as you have your own currency] […] But for the record, it’s just not right.

The key thing to remember is that current conditions […] won’t always prevail […] But this too shall pass, and when it does, things will be very different.

So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation […]

Suppose, now, that we were to find ourselves back in that situation with the government still running deficits [and] that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates. […]

Well, the first month’s financing would increase the monetary base by around 12 percent. [The price level would rise] roughly in proportion to the increase in monetary base. And rising prices would, to a first approximation, raise the deficit in proportion.

So we’re talking about a monetary base that rises […] 400 percent a year. Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk […] can make that point disappear:if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.

[…] But the idea that deficits can never matter, that our possession of an independent national currency makes the whole issue go away, is something I just don’t understand.

Correct me if I’m wrong, but the professor sounds like a Very Serious Person.

James Hamilton asks Brad Delong:

Finally, let me invite you to answer the questions I posed for Krugman and O’Brien: “Do you maintain that U.S. debt could become an arbitrarily large multiple of GDP with no consequences for yields? If you acknowledge that there is a level of debt at which these effects would start to matter for the United States, what is your estimate of that level, and how did you arrive at it?” We give our answers to these questions in our paper. What’s yours?

I’m going to invite myself into this little debate. This question can be interpreted in many different ways that, I think, is the problem with the fear-mongering behind a particular debt-GDP ratio. What do I mean by this?

The R-R paper infamously notes that after debt exceeds 90% of GDP, yields start rising, because investors no longer have confidence that the country in question can service its debt. Even ignoring the fact that this “limit”, if you will, doesn’t apply to countries that borrow in their own currency, the 90% figure is meaningless.

Presumably, investors worried that countries will have to borrow more to pay interest on its bonds which will lead to a snowball effect of debt accumulation. Therefore, it’s hardly the debt that’s important, but the deficit. So it’s not a particularly worthwhile task to wonder the debt-GDP ratio at which a country “tips over”.

Consider an example. You’re told a country has debt levels at a staggering 500% of national income. You’re also told that its debt has been at this level for the past 500 years, and official estimates predict this ratio well into the next 500 years. The market won’t suddenly demand higher yields, because the country has consistently serviced all its interest in the past, and will do so in the future.

Deficits imply that a country has to borrow to service its interest, debt implies nothing. The 90% figure was likely a correlation with a) the fact that the countries in question couldn’t denominate debt in their own currency and b) they had high deficits.

So yes, I believe debt against GDP can become arbitrarily large so long as a country isn’t running deficits. Of course, on the long journey to huge debt levels, a country does run deficits, and it’s entirely possible that investors deem this to be unsustainable, causing a debt crisis in the interim. You can parse this as a one-time promised deficit of whatever level you choose. Say, if, the US buys all the gold in the world to build statues and create a Cult of Obama. As long as it does it only once, services all its interest, and doesn’t run a deficit next year to do so.

But that’s not the question being asked. The question that’s being asked supposes an arbitrary debt to GDP. Position has no meaning without regard to velocity which, itself, has no meaning without regard to acceleration. I would actually argue that so long as an arbitrarily high nth derivative of debt is negative, the countries fiscal position would be stable. Of course, this is beside the point in reality because the level of confidence with which an investor can know debt is greater than he can know deficits, and so forth. The nth derivative becomes, basically, unknowable, at which point the investor plays it safe.

You might think my answer is meaningless, and to some extent it is. But that’s because it’s answering a meaningless question.

 

Edit: Note, I don’t actually thing that our long-term debt is irrelevant. In fact, I depart from Krugman in that I think we had better start talking about rising healthcare costs not just in 20 years, but in 50, 100 today. But, unlike others, I won’t wrongly caricature him as someone who doesn’t care about this, but he definitely seems to discount for the future far more (as in have faith that future politicians aren’t clueless).

In the continuing saga of responses to Noah Smith’s article about the poor and their savings, squarelyrooted chimes in:

Hmmm, I wonder what would happen if everyone started saving as much income as they reasonably could? Where would the high yield investments be with so much capital sloshing around? How would the markets react when aggregate demand plummets even further? – Ethan Gach

 

Snark aside, the key here is that, while it would benefit any individual poor person to save more (assuming, of course, that’s possible given their income and cost-of-living, which is not an assumption I’m eager to make), if every poor person somehow stumbled onto Smith’s article and tried to save more it might generate economic disequlibria that wouldn’t benefit anyone. This is semi-related to the point I’ve made before that aggregate saving is a very different animal than individual saving.

This is just not true. I wish it were true, because it means the poor actually represent a more than insignificant part of our economy. It’s not true for the same reason Noah wrote his article: the poor have no cash savings.

Let’s take a model economy where the top 20% are “rich” and everyone else is “poor”. Let’s be generous and assume the rich control only 80% of the wealth when, in our economy, that figure is far higher. Let’s also stipulate the total value of this economy is a million dollars, and the poor’s aggregate savings grow at 2% per annum against the rich whose grow at 10%. I’ll be conservative and model this with a constant returns on capital across the rich and poor. This obviously isn’t the case, but it doesn’t need to be.

So what we have is 20% of the population controlling $800,000 and the remaining 80% controlling $200,000. At the initial savings rate for the poor, this is what the economy will look like in 10 years:

Year

Poor

Rich

Ratio

1

200000.00

800000.00

0.25

2

214000

920000

0.2326087

3

228980

1058000

0.2164272

4

245009

1216700

0.2013714

5

262159

1399205

0.1873630

6

280510

1609086

0.1743290

7

300146

1850449

0.1622018

8

321156.3

2128016

0.1509182

9

343637.2

2447218

0.1404195

10

367691.8

2814301

0.1306512

11

393430.3

3236446

0.1215624

12

420970.4

3721913

0.1131059

13

450438.3

4280200

0.1052377

14

481969.0

4922230

0.09791680

15

515707

5660565

0.09110519

Now, let’s consider that the poor triple their savings rate to 6%:

 

Year

Poor

Rich

Ratio

1

200000.00

800000.00

0.25

2

222000

920000

0.2413043

3

246420

1058000

0.2329112

4

273526

1216700

0.2248099

5

303614

1399205

0.2169904

6

337012

1609086

0.2094429

7

374083

1850449

0.2021580

8

415232

2128016

0.1951264

9

460908

2447218

0.1883394

10

511607

2814301

0.1817884

11

567884

3236446

0.1754654

12

630351

3721913

0.1693622

13

699690

4280200

0.1634714

14

776656

4922230

0.15778540

15

862088

5660565

0.15229721

I’m not posting a table to vindicate the obvious, but the portion of aggregate savings allocated to the poor will continue to fall until their savings rate is equal to that of the rich, or 10%. This means that it’s highly unlikely that even a significant increase in the savings rate of the bottom 50% (which, in terms of wealth not income, are poor as far as our society is concerned) will cause any “disequilibrium effects”.

Indeed, the ability of the poor to affect our capital markets are even more dispersed in our economy. Because of high levels of risk aversion and poor investment practices, it’s unlikely that they will earn the same rate of return on their savings as the rich. The wealth distribution I assumed is also a lot more equal than what America actually is.

So, contrary to hazy economic thinking, nothing will happen to interest rates and investment markets if we encourage the poor to save. It would be irresponsible to think so because of what Mr. Ethan Gach says. Time to look at the numbers.

Bryan Caplan has a pretty interesting argument for the orthodox interpretation of the minimum wage (that is causes unemployment). It really, almost works – but it doesn’t. Caplan argues that even if data ‘officially about the minimum wage’ doesn’t support his case, all plenty of other highly relevant data does:

1. The literature on the effect of low-skilled immigration on native wages.  A strong consensus finds that large increases in low-skilled immigration have little effect on low-skilled native wages.  […] These results imply a highly elastic demand curve for low-skilled labor, which in turn implies a large disemployment effect of the minimum wage.

2. The literature on the effect of European labor market regulation. Most economists who study European labor markets admit that strict labor market regulations are an important cause of high long-term unemployment […] European governments are afraid to embrace the deregulation they know they need to restore full employment.  To be fair, high minimum wages are only one facet of European labor market regulation.  But if you find that one kind of regulation that raises labor costs reduces employment, the reasonable inference to draw is that any regulation that raises labor costs has similar effects – including, of course, the minimum wage.

3. The literature on the effects of price controls in general.  There are vast empirical literatures studying the effects of price controls of housing (rent control), agriculture (price supports), energy (oil and gas price controls), banking (Regulation Q) etc.

If you object, “Evidence on rent control is only relevant for housing markets, not labor markets,” I’ll retort, “In that case, evidence on the minimum wage in New Jersey and Pennsylvania in the 1990s is only relevant for those two states during that decade.”  My point: If you can’t generalize empirical results from one market to another, you can’t generalize empirical results from one state to another, or one era to another.

4. The literature on Keynesian macroeconomics.  If you’re even mildly Keynesian, you know that downward nominal wage rigidity occasionally leads to lots of involuntary unemployment.  If, like most Keynesians, you think that your view is backed by overwhelming empirical evidence, I have a challenge for you: Explain why market-driven downward nominal wage rigidity leads to unemployment without implying that a government-imposed minimum wage leads to unemployment.  The challenge is tough because the whole point of the minimum wage is to intensify what Keynesians correctly see as the fundamental cause of unemployment: The failure of nominal wages to fall until the market clears.

If the data that actually tests the phenomenon in questionconclusively notes that minimum wage does not have employment effects, it doesn’t make sense to appeal to second-order, but relevant, data. Here’s why this argument begs the question:

  • The null hypothesis was that economic theory is right which implies that wage controls cause unemployment.
  • David Card and Alan Krueger disprove the null, showing that wage controls contradict economic theory.
  • Caplan argues that if theory holds, elsewhere, it must hold for minimum wage as well.

In other words, the original argument against a minimum wage was based on textbook economics, Caplan argues that textbook economics holds elsewhere too, and therefore must be applicable to wage controls.

Caplan further argues that we can extrapolate empirical data in one market to every other market. Is Caplan really suggesting that because the market for apples gives rise to a downward-sloping demand curve wherein price floors cause surpluses that the same must apply for human labor? Why, then, can I not extrapolate the labor market from rice in the Hunan Provence (ostensibly a Giffen good). I would agree with Caplan that we ought to stick with standard economics had the null not been conclusively disproven.

For that “relevant” empirical evidence to mean anything, standard theory has to be true. You can’t explain why standard theory applies to wage controls and simultaneously use evidence which is predicated on standard theory being true.

I’m also curious about the extent to which European regulations increase the unit-cost of labor. I was under the impression that most of the inflexibility in Europe came from unions that made it impossible to fire workers. The argument comparing minimum wage effects to immigration is similarly flawed: immigration has demand-side effects, as well, which make the process worthwhile.

Here are some reasons why human labor is different:

  • Not to sound Marxist or anything, but there is a sense in which the decision to work isn’t really a choice in the classical sense, but a natural force. Those earning at minimum wage are very unlikely to have any wealth to wait for a job, and must accept the most immediate opening to make end’s meet. This is not a choice. In this position, employers clearly have the power considering a captive demand to work. If we’re making market analogies, this is somewhat akin to a central bank increasing capital reserve ratios, thereby creating a captive demand for government debt and hence forcing prices down.
  • Unlike an apple uneaten or machine unused, labor unemployment has external social costs. My point is, it’s better to let a man work and pay him nothing (in an economic sense) to prevent skill atrophy. This thinking may convince employees to work for far less than optimal wages to remain connected with our social fabric.

The point is, for whatever reason, economic theory can’t explain wage controls. Caplan saves his argument by noting his strong priors:

Part of the reason is admittedly my strong prior.  In the absence of any specific empirical evidence, I am 99%+ sure that a randomly selected demand curve will have a negative slope.  I hew to this prior even in cases – like demand for illegal drugs or illegal immigration – where a downward-sloping demand curve is ideologically inconvenient for me.  What makes me so sure?  Every purchase I’ve ever made or considered – and every conversation I’ve had with other people about every purchase they’ve ever made or considered.

But his argument was intended for those of us like me who don’t have strong priors, and don’t deeply distrust empirical data. In that sense, his premises assume his conclusion, and the argument fails to have logical validity.

h/t: Scott Sumner and Tyler Cowen

Niklas Blanchard points me to his solutions for wealth inequality. He makes several good points:

It is clear that in order to deal with poverty through cash transfer, the system is going to have to be designed in a way that, first and foremost, aligns incentives with goals. However, it is important that this program be a program that allows individuals to succeed by imposing self-binding constraints. That is why I advocate what could be termed a “graduated income transfer system”. Under this system, there is a (and small) cash grant, guaranteed income, if prefer. This is given to everyone under a certain threshold regardless of their intentions. However, to move into the more generous system of cash transfers, individuals (or families) will be required to sit down with a DHHS financial planner to create goal thresholds. Payment of subsequent tranches of income support will be contingent upon successful completion of these goals. While there may be some “automatic” goals that make it in the list, the idea is for people to adapt the goals to their personal situation. In this way, we aren’t so much imposing the heavy hand of the nanny state upon people, but rather creating a system whereby people who suffer from hyperbolic discounting can credibly commit to a self-binding strategy. Nearly every successful petro-state has elected to lock up the rewards away from people and politics, so they will not be plundered.

This is the gem that Noah missed in his post earlier today. The gap between education and actual financial planning, as I noted, is vast. My only quibble with Niklas is I would appreciate an option where local firms can provide an alternative to DHHS planners. A centralized bureaucracy won’t adapt to local needs nearly as well as, say, a planner at the local Walmart. 

The tenor of his argument is institution of a strong basic income replacing all other welfare programs:

From the outset I want to make clear; my first-choice “solution” to the issue of addressing the needs of the poor from a income support standpoint is simple cash transfers through a EITC-style tax rebate scheme fully-funded by a progressive consumption tax. For everything. That means no food stamps, no rent control, no housing assistance, no cell phone program, no child care assistance. Nothing but a periodic cash endowment to supplement income. This cash grant would fade over a wide income range, as to minimize marginal tax rates at the low end. Once the cash is dispensed, people can do with it what they will, and post hoc complaints. The outcome of peoples’ actions after the endowment is completely upon them. The end.

And with this, I strongly disagree. First, let me clarify. In my opinion, the argument for a basic income rather than government spending is the efficiency of market forces. If transfers are provided in full liquidity, proponents argue, the market will optimally allocate the needed services, be it Internet, education, healthcare, or food. I’m usually in favor of this approach. For example, I’m not particularly happy about subsidizing the solar energy industry (classical example being Solyndra). I’d rather have the government price carbon including all external costs which would force the market, not a few bureaucrats, to pick the best alternative. Indeed, the market-oriented carbon tax is six times more efficient than Obama’s CAFE standards.

But Niklas also notes that the poor are not very good at spending their money. This sounds paternalistic, but reaches for a sad truth. When families earning under $15,000 spend almost a tenth of their income on lottery tickets, something is deeply wrong. A nonzero portion of the basic income, further, would be directed towards cigarettes, alcohol, and car loans. 

If your goal is to provide a better life for all at this moment, a basic income is smart. However, it will never level the playing field between kids born in poverty and affluence (nothing will, but this won’t even make a dent). Government provision of education, books, technology, and healthcare all have large, external benefits. So, to the end that our goal is a sustainably fair society, a basic income will not help.

The negative income tax also reduces the hours worked, even against our current welfare state. I’m always skeptical of conservative claims that welfare fails to align incentives with desired goals, but the evidence against basic income seems pretty clear to me. Indeed, there’s no reason to believe a basic income would be any simpler than our welfare state. Sure, our transfer system has been gouged by vested interests and lobbyists, but there’s no reason to believe a basic income system won’t be subject to the same decay. In economic debates, our tax code sounds rather simple and progressive, but in reality it’s table of contents is longer than the Bible and our own Treasury Secretary can’t do his own taxes. 

Basic income sounds like a beautiful idea in theory, but fails to align incentives with stated goals. These, of course, may differ. As a market progressive (Miles Kimball might say supply-side liberal), I want widespread access to capital markets, high investment in human capital, and socialization of risk. 

I have yet to be convinced a negative income tax can achieve any of the above.

Noah Smith has an article in The Atlantic about wealth inequality in the United States. A viral video caught the attention of the economics-blogosphere, and Noah is the latest to comment.  The import of Noah’s argument is the importance of thrift:

Today, wealth equality is closely tied to income equality. But in the long run, it’s all about thrift, frugality, and saving — in other words, teaching a consumer nation a lesson in cheapness.

Progressives have a hard time ascribing wealth inequality to savings rate and (predictably, though not incorrectly) blame structural issues like falling wage share of income. As one very popular commentator notes:

This is absurd. The real wealth gap is based in capital gains, not direct income. Teaching Americans to be frugal is not going to address any of the systemic differences that make it easier by orders of magnitude for the already rich to keep making money.

The fact is, poor American’s can save, they just have really bad habits. For example, as Derek Thompson notes, the poor spend a whopping 9% of their income on lottery tickets. So let’s be honest here, the whole diatribe against Noah that the poor can’t save is crap.

If we’re going to talk about wealth inequality, it’s pretty informative to understand its emergence, why it’s fundamentally different from income inequality, and why an “equal” society won’t help. Consider, an island which is functionally equal – you might say socialist. I’m not suggesting this is a plausibly sustainable situation, but it’s an interesting starting point. Let’s also assume that somehow socialism hasn’t eroded work ethic and desire to innovate. In reality, this isn’t a reasonable assumption, but I’m not making an argument about economic ideology.

So, on day one, the Keynesian economist, farmer, laborer, and lawyer each earn $100 a year. The economist is a spendthrift, with a good taste for Portuguese wine and Victorian clothes, and has only $10 left each year. The laborer, saves diligently, and has $50 leftover. Very soon, an island that once had income equality becomes very unequal, both in income and wealth. The wealth inequality comes first, but soon the laborer has more money to invest in his daughter’s education, and to loan to the moderately-thrifty lawyer and farmer to earn a good return.

So wealth inequality comes first. This is especially true if you consider, in our society, income derived from education to be a capital gain (though, legally, it is treated as labor). In the island, wealth and income inequality were both functions of preference.

However, in our society, as wealth inequality isn’t just a function of preferences, but income itself (in the island this isn’t the case because future income inequality is derived from wealth inequality which itself is derived from preferences). But, in a given snapshot, wealth inequality grows as, in some ways, the integral, roughly speaking, of income inequality.

This is because, if preferences are randomly distributed, the savings become a function of income. As income inequality rises (as it has in the past 40 years), the ability to save gets rather more concentrated amongst the rich. This, and not preferences, becomes the key force of wealth inequality. This is further compounded by the fact that, in a very literal sense, wealth begets wealth through capital income.

So my point of all this is I think Noah’s wrong that somehow altering preferences will fix the situation. Noah argues that, for a “return to equality”, the poor need to be nudged and educated:

In addition to “nudging” middle-class and poor Americans to save more, we can help them get a better return on their assets — the second thing that has a huge effect on wealth in the long run. This means helping middle-class people invest in stocks without paying high fees. The first part of this is teaching middle-class people to avoid making frequent changes in their stock portfolios. Studies show that individual investors consistently lose money when they try to buy and sell and buy and sell, mostly because they tend to ignore trading costs. So financial education should teach people to let their stock portfolios just sit there for decades, and ignore the ups and downs.

The second way to get better returns is to avoid actively managed funds. Actively managed mutual funds charge high fees to purchase portfolios of stocks that, statistically, are no better than simply buying a low-cost “index” fund that tracks the overall level of the market. Pension plans like TIAA-CREF tend to charge even higher fees, meaning even worse returns. Financial education can teach middle-class people what a low-cost index fund is, and how to invest in one.

The first point is rather interesting, and Richard Thaler has the best evidence that it might work (Save More Tomorrow – fantastic study, I think everyone should read it). I don’t have much to say about personal finance education, I think it’s important, but I just don’t think it will have a lasting effect on habits in a consumer culture. Education will be artificial and instituted in the context of grades, which will be the only reason people pursue the subject.

But, as I argued, changing preferences will have only an ephemeral effect. What we need are:

  • Robust risk sharing programs (particularly universal healthcare, strong social insurance, and unemployment insurance). This will a) decrease the need for wealth, mitigating the effect of wealth inequality and b) allow the poor to invest most of their income in stocks, so that they can take part in America’s wonderful capital market. Noah mentions China a country that’s poor but manages to save a lot. One of the many reasons for this, I believe, is an underdeveloped insurance market, creating a greater need for wealth.
  • Ban lotteries. This is simple. Sure, states make a lot of money from them, but this is absolutely the most regressive tax in the country. Not only are educated people informed enough to know that the state has an edge, but it’s a very small part of their income.
  • “Nudge” Americans to save through opt-out programs sponsored by an employer.
  • Institute a progressive consumption tax with negative income
  • Fix income inequality.

The integral-relation with income inequality explains why it will always grow as income inequality is constant, but wealth distribution doesn’t need to be as skewed as it is. Preferences will go some way, but the real change needs to come from income distribution (by investing in human capital) and access to capital markets (by pooling risk).

The falling role of labor in our economy will make wealth very important. Acting now is a pretty good idea. But, moving on, let’s remember a few things: demand creates supply, and wealth inequality creates income inequality. Let’s not mistake cause and symptom.

The Washington Post has a message that Democrats need to pay attention to: You won’t have demographic dividends for long. And it’s coming from what you think will help you most (Mexicans).

If someone looked at state-by-state polls, there’s a wonderful positive correlation between the states that went Romney and those with the highest proportion of African-Americans. But wait! Didn’t basically all the African-American vote go to Obama, isn’t it the whites who broke Romney? Yes, but, importantly the state that was most fiercely liberal was Vermont, which, basically, has no blacks.

This article confirms something I’ve always suspected about the Northeast. It’s not less racist and not inherently more egalitarian vis-a-vis illegal immigrants. Randomly selected, liberal, New Englanders who were “treated” by a period of exposure to Spanish-speaking Latinos noted a significant shift to the right on immigration policies and deportation. 

So it’s not that the liberal city of Boston, where this study was conducted, is any more enlightened than Birmingham. It’s just richer, and more isolated. I’ve long argued that the negative effects of immigration (which are certainly outweighed by the positive effects) ought to be borne equally by those near Mexico, and those afar. Indeed, it almost seems easy sitting in Newton to disparage the nativists in Arizona.

I don’t support a regional visa program, because to prevent illegal domestic immigration, we’d need a police state (not like we don’t have the infrastructure, but still). I would argue that some of my argument is diminished by the fact that California, the Midwest, and New England basically fund the South. However, a deeply segregated United States will continue to result in the gridlocked politics that damn us today. Latinos too.

This project would be a shining example of a public-private partnership. While it seems pretty racist for the government to incentivize black and latino migration to the north, corporations have, for a long time, employed affirmative action to diversify their workforce. Affirmative action policies should be lowered in the South and Southwest, with a strong increase elsewhere, including paid relocations for interested workers (given a certain level of productivity, contract to work, etc.)

This might even result in a Red state or two in New England (because, as the Post notes, whites will become more racist), but will free the south from Richard Nixon’s curse.

Edit: Prof Altman corrects me, log purchasing power was used to facilitate interpretation by keeping constant the % changes across different values of the dependent variable. Although, using log scales seems to be valid regardless to account for diminishing returns to the dollar.

Daniel Altman is out with a new white paper, Are international differences in living standards really so hard to explain? It’s not a long paper, and I’d recommend it to anyone curious about the so-called gap between “the west and the rest”. There’s tons of literature (both general and technical) about international development and the best place, by far, to get a thorough exposure to this material is Development Economics @ MRUniversity. Frequently cited factors include:

  • Institutions (extractive vs inclusive)
  • Geography
  • Natural resources

Niall Ferguson cites six “killer apps”:

  1. Competition
  2. The scientific method
  3. Rule of law via democracy
  4. Modern medicine
  5. Consumer society (“the idea that everyone should have a set of clothes”)
  6. A “Protestant Ethic”

Altman’s paper considers the share of national output that doesn’t come from natural resources like oil or gas. This, arguably, captures the essence of a thriving society: i.e. that which it earned through its culture or institutions (by this logic, it might not make sense to include geography, either, but the results are very interesting). Altman considers three least-squares regressions to understand the portion of economic variance that can be attributed to selected factors. Here are the regressions:

Image

A few quick explanations on the methodology. The log per capita income is used (presumably) to account for the diminishing marginal utility of money. Most of the data is from the 2010 World Bank’s World Development Indicators database though, where 2010 figures aren’t available, Altman considers the 2009 report.

The third regression (which considers gender equality – GII – on top of legal frameworks) is the most appropriate. However, it’s also arguably the most subjective. Perhaps Ferguson would do well to look at this data, which might quell his ancient imperial tendencies, because imperial institutions account for only about 5% of the overall variation in living standards.

But the most striking part of the data is what should be “low-hanging fruit” – landlocked countries. That countries are landlocked is an artifice of false political boundaries dictated in London or Paris and these closed borders, unfortunately, stifle trade and commerce between nations. There’s nothing qualitatively different between a landlocked country and the state of Iowa yet, because of political borders, being landlocked is almost as bad as gender inequality. The curse of these borders is even then understated knowing that this is a binary variable that (should be) easy to fix.

Of course, port cities will always be richer, but only because of the trade industry itself. After landlocked nations get access to international (or even continental) trade, surely economic variance should decline as nations previously excluded from trade prosper.

Indeed, Africa (and, to a lesser extent, Latin America) seem to be the last vestiges of a landlocked era. North American countries are large, each with access to the sea. Australia is an Island. Europe has a customs union. Most of Asia doesn’t live in a landlocked country. Africa is moving towards freer markets in pockets with the East African Community etc. Further, it’s probably not smart to move towards fully free markets immediately. Industrial policy is important in a world of capital, particularly so for Africa to be competitive in the future. However, moves towards regional customs unions so that no nation is locked from trade will be a real boon.

Indeed, it would be interesting to consider a regression that considers not a binary access to seaports, but some index that captures the cost of access to international trade from regulations, tariffs, or any other such policies.

Altman notes that countries with the lowest negative residuals (those that performed worse than expected) were, unsurprisingly, locked in generations of civil conflict, extractive dictators, and war. So comes the cost of having a fancy British legal system.

I wasn’t surprised to see the extent to which Arab countries, like Qatar, exceeded their predicted output considering the ridiculous rents on oil, but was surprised to see that even the United States had a very high residual. Altman points out, this residual can be explained completely by a relatively high GII indicating, perhaps, the subjective nature of the index or, perhaps, a culture that thrives despite gender inequality.

This is an empowering report because about 50% of the variation in output can be reduced to eminently solvable problems (I don’t consider draught to be solvable, though it may be in the future). As development economists have noted for a few years now, Africa isn’t intractable. Jeffrey Sachs noted that almost 30% of economic output can be explained by malaria.

It’s time to get that 30% back.