Why we give gifts

JDN 2457020 EST 18:28.

You’ll notice it’s Sunday, not Saturday; I apologize for not actually posting on time this week. Due to the holiday season I was whisked away to family activities in Cleveland, and could not find wifi that was both free and reliable.

But since it is the Christmas season—Christmas Day was last Thursday—the time during which most Americans spend more than we can probably afford buying gifts (the highest rate of consumer spending all year long, much of it on credit cards, a significant boost for the economy in these times of depression), I thought it would be worthwhile to talk about why gifts are so important to us.

As I’ve already mentioned a few posts ago, neoclassical economists are typically baffled by gift-giving, and several have written research papers and books about why Christmas gifts are economically inefficient and should be stopped. Oddly it never seems to occur to them that if this is true, then there is widespread irrational consumer behavior that has nothing to do with government intervention or perverse incentives—which already means neoclassical economic theory is in serious trouble. Nobody forces you to buy gifts, so if it’s such a bad idea but we do it anyway, we must not be rational agents.

But in fact it’s not such a bad idea, and it’s “inefficient” only in a very narrow-minded sense that takes no account of relationships or human emotions. Gifts only make us not “rational agents” in that we are not infinite identical psychopaths. There is in fact nothing irrational about gifts.

Gift-giving is a human universal; it has been with us far longer than money or markets or indeed civilization itself. Everyone from tribal hunter-gatherers to neoclassical economists gives gifts, and in fact most people who descend from populations that lived in higher latitudes (that is, “White people”, though perhaps in a later post I’ll explain why our “race” categories are genetically absurd) actually celebrate some sort of gift-giving ceremony around the time of the Winter Solstice. Many of our Christmas traditions actually come from the Germanic holiday Yule, which is why we say things like “Yuletide greetings” even though that has absolutely nothing to do with Jesus. We celebrate around the Solstice because it was such a momentous season for us, the darkest night of the year; as if the darkness and cold weren’t bad enough by themselves they are the harbinger of the dreaded winter that prevents our crops from growing and may not allow us all to survive. We reaffirm our family ties and promise to help each other through this dangerous time. Music, gifts, and feasting are simply the way that humans organize our celebrations—again this is universal.

What do gifts accomplish that a simple transfer of cash would not? I can think of three things:

      1. Convey closeness: First of all there is of course the fact that by buying someone a gift at all, you are expressing the fact that you care about them and want to be close to them. But the choice of the gift also matters. Your closest friends always buy you the best gifts, because they know you the best. Thus the sort of gift you receive from someone is a measure of how well they know you. Many of us give each other lists of ideas to buy, but I always include more on the list than I expect to receive and encourage people to buy things that are not on the list that they think I might enjoy. A computer program can buy things off a list; the point is that we express our relationships by choosing things we know people want without them having to ask. We trust people to know us well enough to get it right most of the time; they’ll probably make mistakes (most people think they know others better than they actually do), but the mistakes are made up for by the successes. The disappointment in getting something you didn’t want isn’t even so much in the thing as it is in the fear that your loved ones don’t know you as well as you thought they did; this is why I consider it important to express—gently and tactfully of course—when you really don’t like a gift you received; you want them to know you better and do better next time, not keep giving you things you hate while you brood behind fake smiles. What you choose to buy conveys what you know and how you feel; this is why the best gift is one you love to have but didn’t ask for. That’s why I’m honestly more excited about my new travel pillow and copy of Randall Monroe’s What If? than I am about my new Bluetooth headset; of course the headset is more expensive and more useful, but I specifically asked for it. My sister and my mother knew me well enough that the book and the travel pillow I didn’t have to ask for.
      2. Grant permission to indulge: This is particularly important in the United States, because our society has Puritanical roots that make us suspicious of any activity that isn’t directly linked to productive efficiency. Honestly when those economists criticize Christmas as “inefficient” they are not so much making a serious economic argument as they are expressing in terms familiar to them the centuries-old Puritanical norm. It is considered unseemly to buy things for yourself that are purely for fun, particularly if they are expensive. You are expected to buy only the minimum you need, because any more is greedy; the notion seems to be that there is only so much stuff to go around, and if you take more others will have less. (This could scarcely be further from the truth; your frivolous consumer purchases can save children from starvation by giving their parents jobs in factories.) Neoclassical economists often think they are immune to this sort of norm, but aside from their discomfort with Christmas, the sense of righteousness they often have around “raising the savings rate” says otherwise. The link from savings to investment is tenuous at best, but one thing saving definitely does do is prevent you from spending indulgently. But since buying things that make us happy is actually kind of the entire point of having an economy in the first place, it is necessary to find workarounds for this oppressive ethic. One solution is gifts; to give someone else an indulgent gift allows them to engage in indulgent activities, while preserving their own status as someone who wouldn’t normally waste money in that way, and since you are not the one indulging you can hardly be accused of frivolity either. This is also what gift cards accomplish; in economic terms gift cards seem weird, because they are at best as good as cash, and often far worse. But gift cards are typically for retail stores where it is hard to buy something that’s not indulgent, thus offering permission to indulge. This is why a gift card for GameStop or Dick’s Sporting Goods makes sense, but a gift card to Walmart or Kroger seems odd. This is also why receiving cash or an Amazon gift card doesn’t feel as good; since you can buy just about anything, the social norm toward spending responsibly returns. (Never buy anyone a VISA gift card; it’s basically the same as cash except you’re giving some of the money to VISA.)
      3. Conveys your own status: By buying expensive things for other people, you raise your own reputation as an individual. This one is easy to become cynical about, so it’s important to be clear what it actually means. Conveying your own status doesn’t necessarily mean arrogantly domineering over other people. It certainly can mean that, which is why if your cousin has $20 million and buys everyone in the family a new car every year, you’d honestly not be that thrilled about it; yeah, it’s nice getting a new car, but your cousin is clearly showboating his superior wealth and trying to make everyone else look cheap and/or poor. But there is a way to elevate your own status without downgrading everyone else’s, and truly generous gifts are a way of doing that. If the things you buy are really things your loved ones truly need, then you express your generosity and love for them by buying more than you can easily afford. Philanthropy is also a means of conveying status, and again comes in both forms. When Carnegie built buildings and named them after himself, he was being arrogant and domineering. When Bill Gates established a foundation to combat malaria and poverty in Africa, he was being genuinely generous. This kind of status is always a bit paradoxical: The best way to earn a reputation as a good person is to honestly try to help people and have little concern for your own reputation; people who try too hard to improve their own reputations just end up seeming arrogant and narcissistic. In order to deserve status, it is necessary not to directly seek it. The clearest example here is Jonas Salk: He invented a vaccine that saved the lives of thousands of children, making him more deserving of a billion dollars than anyone else I can think of. And he had a chance at a billion dollars, but he specifically gave it up, because in order to get it he would have had to enforce a patent that would raise the price of the vaccine and allow children to needlessly suffer and die. It was the very character that made him deserve the wealth that caused him to refuse it. The only way to hit the target is to aim much higher.

If you really want to insist, yes, there’s also some sort of net transfer of wealth involved in gift-giving, because it is expected that the richer you are the more you’ll spend on gifts. But that’s a very small part; even in hunter-gather societies that have negligible levels of inequality human beings still give each other gifts. Gifts are a part of us; they are written in the language of life itself upon the ancient thread that binds us to our ancestors and makes us who we are—by which I mean, of course, DNA. We could probably no more stop giving gifts than we could stop feeling love.

The World Development Report is on cognitive economics this year!

JDN 2457013 EST 21:01.

On a personal note, I can now proudly report that I have successfully defended my thesis “Corruption, ‘the Inequality Trap’, and ‘the 1% of the 1%’ “, and I now have completed a master’s degree in economics. I’m back home in Michigan for the holidays (hence my use of Eastern Standard Time), and then, well… I’m not entirely sure. I have a gap of about six months before PhD programs start. I have a number of job applications out, but unless I get a really good offer (such as the position at the International Food Policy Research Institute in DC) I think I may just stay in Michigan for awhile and work on my own projects, particularly publishing two of my books (my nonfiction magnum opus, The Mathematics of Tears and Joy, and my first novel, First Contact) and making some progress on a couple of research papers—ideally publishing one of them as well. But the future for me right now is quite uncertain, and that is now my major source of stress. Ironically I’d probably be less stressed if I were working full-time, because I would have a clear direction and sense of purpose. If I could have any job in the world, it would be a hard choice between a professorship at UC Berkeley or a research position at the World Bank.

Which brings me to the topic of today’s post: The people who do my dream job have just released a report showing that they basically agree with me on how it should be done.

If you have some extra time, please take a look at the World Bank World Development Report. They put one out each year, and it provides a rigorous and thorough (236 pages) but quite readable summary of the most important issues in the world economy today. It’s not exactly light summer reading, but nor is it the usual morass of arcane jargon. If you like my blog, you can probably follow most of the World Development Report. If you don’t have time to read the whole thing, you can at least skim through all the sidebars and figures to get a general sense of what it’s all about. Much of the report is written in the form of personal vignettes that make the general principles more vivid; but these are not mere anecdotes, for the report rigorously cites an enormous volume of empirical research.

The title of the 2015 report? “Mind, Society, and Behavior”. In other words, cognitive economics. The world’s foremost international economic institution has just endorsed cognitive economics and rejected neoclassical economics, and their report on the subject provides a brilliant introduction to the subject replete with direct applications to international development.

For someone like me who lives and breathes cognitive economics, the report is pure joy. It’s all there, from anchoring heuristic to social proof, corruption to discrimination. The report is broadly divided into three parts.

Part 1 explains the theory and evidence of cognitive economics, subdivided into “thinking automatically” (heuristics), “thinking socially” (social cognition), and “thinking with mental models” (bounded rationality). (If I wrote it I’d also include sections on the tribal paradigm and narrative, but of course I’ll have to publish that stuff in the actual research literature first.) Anyway the report is so amazing as it is I really can’t complain. It includes some truly brilliant deorbits on neoclassical economics, such as this one from page 47: ” In other words, the canonical model of human behavior is not supported in any society that has been studied.”

Part 2 uses cognitive economic theory to analyze and improve policy. This is the core of the report, with chapters on poverty, childhood, finance, productivity, ethnography, health, and climate change. So many different policies are analyzed I’m not sure I can summarize them with any justice, but a few particularly stuck out: First, the high cognitive demands of poverty can basically explain the whole observed difference in IQ between rich and poor people—so contrary to the right-wing belief that people are poor because they are stupid, in fact people seem stupid because they are poor. Simplifying the procedures for participation in social welfare programs (which is desperately needed, I say with a stack of incomplete Medicaid paperwork on my table—even I find these packets confusing, and I have a master’s degree in economics) not only increases their uptake but also makes people more satisfied with them—and of course a basic income could simplify social welfare programs enormously. “Are you a US citizen? Is it the first of the month? Congratulations, here’s $670.” Another finding that I found particularly noteworthy is that productivity is in many cases enhanced by unconditional gifts more than it is by incentives that are conditional on behavior—which goes against the very core of neoclassical economic theory. (It also gives us yet another item on the enormous list of benefits of a basic income: Far from reducing work incentives by the income effect, an unconditional basic income, as a shared gift from your society, may well motivate you even more than the same payment as a wage.)

Part 3 is a particularly bold addition: It turns the tables and applies cognitive economics to economists themselves, showing that human irrationality is by no means limited to idiots or even to poor people (as the report discusses in chapter 4, there are certain biases that poor people exhibit more—but there are also some they exhibit less.); all human beings are limited by the same basic constraints, and economists are human beings. We like to think of ourselves as infallibly rational, but we are nothing of the sort. Even after years of studying cognitive economics I still sometimes catch myself making mistakes based on heuristics, particularly when I’m stressed or tired. As a long-term example, I have a number of vague notions of entrepreneurial projects I’d like to do, but none for which I have been able to muster the effort and confidence to actually seek loans or investors. Rationally, I should either commit or abandon them, yet cannot quite bring myself to do either. And then of course I’ve never met anyone who didn’t procrastinate to some extent, and actually those of us who are especially smart often seem especially prone—though we often adopt the strategy of “active procrastination”, in which you end up doing something else useful when procrastinating (my apartment becomes cleanest when I have an important project to work on), or purposefully choose to work under pressure because we are more effective that way.

And the World Bank pulled no punches here, showing experiments on World Bank economists clearly demonstrating confirmation bias, sunk-cost fallacy, and what the report calls “home team advantage”, more commonly called ingroup-outgroup bias—which is basically a form of the much more general principle that I call the tribal paradigm.

If there is one flaw in the report, it’s that it’s quite long and fairly exhausting to read, which means that many people won’t even try and many who do won’t make it all the way through. (The fact that it doesn’t seem to be available in hard copy makes it worse; it’s exhausting to read lengthy texts online.) We only have so much attention and processing power to devote to a task, after all—which is kind of the whole point, really.

The terrible, horrible, no-good very-bad budget bill

JDN 2457005 PST 11:52.

I would have preferred to write about something a bit cheerier (like the fact that by the time I write my next post I expect to be finished with my master’s degree!), but this is obviously the big news in economic policy today. The new House budget bill was unveiled Tuesday, and then passed in the House on Thursday by a narrow vote. It has stalled in the Senate thanks in part to fierce—and entirely justified—opposition by Elizabeth Warren, and so today it has been delayed in the Senate. Obama has actually urged his fellow Democrats to pass it, in order to avoid another government shutdown. Here’s why Warren is right and Obama is wrong.

You know the saying “You can’t negotiate with terrorists!”? Well, in practice that’s not actually true—we negotiate with terrorists all the time; the FBI has special hostage negotiators for this purpose, because sometimes it really is the best option. But the saying has an underlying kernel of truth, which is that once someone is willing to hold hostages and commit murder, they have crossed a line, a Rubicon from which it is impossible to return; negotiations with them can never again be good-faith honest argumentation, but must always be a strategic action to minimize collateral damage. Everyone knows that if you had the chance you’d just as soon put bullets through all their heads—because everyone knows they’d do the same to you.

Well, right now, the Republicans are acting like terrorists. Emotionally a fair comparison would be with two-year-olds throwing tantrums, but two-year-olds do not control policy on which thousands of lives hang in the balance. This budget bill is designed—quite intentionally, I’m sure—in order to ensure that Democrats are left with only two options: Give up on every major policy issue and abandon all the principles they stand for, or fail to pass a budget and allow the government to shut down, canceling vital services and costing billions of dollars. They are holding the American people hostage.

But here is why you must not give in: They’re going to shoot the hostages anyway. This so-called “compromise” would not only add $479 million in spending on fighter jets that don’t work and the Pentagon hasn’t even asked for, not only cut $93 million from WIC, a 3.5% budget cut adjusted for inflation—literally denying food to starving mothers and children—and dramatically increase the amount of money that can be given by individuals in campaign donations (because apparently the unlimited corporate money of Citizens United wasn’t enough!), but would also remove two of the central provisions of Dodd-Frank financial regulation that are the only thing that stands between us and a full reprise of the Great Recession. And even if the Democrats in the Senate cave to the demands just as the spineless cowards in the House already did, there is nothing to stop Republicans from using the same scorched-earth tactics next year.

I wouldn’t literally say we should put bullets through their heads, but we definitely need to get these Republicans out of office immediately at the next election—and that means that all the left-wing people who insist they don’t vote “on principle” need to grow some spines of their own and vote. Vote Green if you want—the benefits of having a substantial Green coalition in Congress would be enormous, because the Greens favor three really good things in particular: Stricter regulation of carbon emissions, nationalization of the financial system, and a basic income. Or vote for some other obscure party that you like even better. But for the love of all that is good in the world, vote.

The two most obscure—and yet most important—measures in the bill are the elimination of the swaps pushout rule and the margin requirements on derivatives. Compared to these, the cuts in WIC are small potatoes (literally, they include a stupid provision about potatoes). They also really aren’t that complicated, once you boil them down to their core principles. This is however something Wall Street desperately wants you to never, ever do, for otherwise their global crime syndicate will be exposed.

The swaps pushout rule says quite simply that if you’re going to place bets on the failure of other companies—these are called credit default swaps, but they are really quite literally a bet that a given company will go bankrupt—you can’t do so with deposits that are insured by the FDIC. This is the absolute bare minimum regulatory standard that any reasonable economist (or for that matter sane human being!) would demand. Honestly I think credit default swaps should be banned outright. If you want insurance, you should have to buy insurance—and yes, deal with the regulations involved in buying insurance, because those regulations are there for a reason. There’s a reason you can’t buy fire insurance on other people’s houses, and that exact same reason applies a thousandfold for why you shouldn’t be able to buy credit default swaps on other people’s companies. Most people are not psychopaths who would burn down their neighbor’s house for the insurance money—but even when their executives aren’t psychopaths (as many are), most companies are specifically structured so as to behave as if they were psychopaths, as if no interests in the world mattered but their own profit.

But the swaps pushout rule does not by any means ban credit default swaps. Honestly, it doesn’t even really regulate them in any real sense. All it does is require that these bets have to be made with the banks’ own money and not with everyone else’s. You see, bank deposits—the regular kind, “commercial banking”, where you have your checking and savings accounts—are secured by government funds in the event a bank should fail. This makes sense, at least insofar as it makes sense to have private banks in the first place (if we’re going to insure with government funds, why not just use government funds?). But if you allow banks to place whatever bets they feel like using that money, they have basically no downside; heads they win, tails we lose. That’s why the swaps pushout rule is absolutely indispensable; without it, you are allowing banks to gamble with other people’s money.

What about margin requirements? This one is even worse. Margin requirements are literally the only thing that keeps banks from printing unlimited money. If there was one single cause of the Great Recession, it was the fact that there were no margin requirements on over-the-counter derivatives. Because there were no margin requirements, there was no limit to how much money banks could print, and so print they did; the result was a still mind-blowing quadrillion dollars in nominal value of outstanding derivatives. Not million, not billion, not even trillion; quadrillion. $1e15. $1,000,000,000,000,000. That’s how much money they printed. The total world money supply is about $70 trillion, which is 1/14 of that. (If you read that blog post, he makes a rather telling statement: “They demonstrate quite clearly that those who have been lending the money that we owe can’t possibly have had the money they lent.” No, of course they didn’t! They created it by lending it. That is what our system allows them to do.)

And yes, at its core, it was printing money. A lot of economists will tell you otherwise, about how that’s not really what’s happening, because it’s only “nominal” value, and nobody ever expects to cash them in—yeah, but what if they do? (These are largely the same people who will tell you that quantitative easing isn’t printing money, because, uh… er… squirrel!) A tiny fraction of these derivatives were cashed in in 2007, and I think you know what happened next. They printed this money and now they are holding onto it; but woe betide us all if they ever decide to spend it. Honestly we should invalidate all of these derivatives and force them to start over with strict margin requirements, but short of that we must at least, again at the bare minimum, have margin requirements.

Why are margin requirements so important? There’s actually a very simple equation that explains it. If the margin requirement is m, meaning that you must retain a portion m between 0 and 1 of the loans you make as reserves, the total amount of money supply that can be created from the current amount of money M is just M/m. So if margin requirements were 100%—full-reserve banking—then the total money supply is M, and therefore in full control of the central bank. This is how it should be, in my opinion. But usually m is set around 10%, so the total money supply is 10M, meaning that 90% of the money in the system was created by banks. But if you ever let that margin requirement go to zero, you end up dividing by zero—and the total amount of money that can be created is infinite.

To see how this works, suppose we start with $1000 and put it in bank A. Bank A then creates a loan; how big they can make the loan depends on the margin requirement. Let’s say it’s 10%. They can make a loan of $900, because they must keep $100 (10% of $1000) in reserve. So they do that, and then it gets placed in bank B. Then bank B can make a loan of $810, keeping $90. The $810 gets deposited in bank C, which can make a loan of $729, and so on. The total amount of money in the system is the sum of all these: $1000 in bank A (remember, that deposit doesn’t disappear when it’s loaned out!), plus the $900 in bank B, plus $810 in bank C, plus $729 in bank D. After 4 steps we are at $3,439. As we go through more and more steps, the money supply gets larger at an exponentially decaying rate and we converge toward the maximum at $10,000.

The original amount is M, and then we add M(1-m), M(1-m)^2, M(1-m)^3, and so on. That produces the following sum up to n terms (below is LaTeX, which I can’t render for you without a plugin, which requires me to pay for a WordPress subscription I cannot presently afford; you can copy-paste and render it yourself here):

\sum_{k=0}^{n} M (1-m)^k = M \frac{1 – (1-m)^{n+1}}{m}

And then as you let the number of terms grow arbitrarily large, it converges toward a limit at infinity:

\sum_{k=0}^{\infty} M (1-m)^k = \frac{M}{m}

To be fair, we never actually go through infinitely many steps, so even with a margin requirement of zero we don’t literally end up with infinite money. Instead, we just end up with n M, the number of steps times the initial money supply. Start with $1000 and go through 4 steps: $4000. Go through 10 steps: $10,000. Go through 100 steps: $100,000. It just keeps getting bigger and bigger, until that money has nowhere to go and the whole house of cards falls down.

Honestly, I’m not even sure why Wall Street banks would want to get rid of margin requirements. It’s basically putting your entire economy on the counterfeiting standard. Fiat money is often accused of this, but the government has both (a) the legitimate authority empowered by the electorate and (b) incentives to maintain macroeconomic stability, neither of which private banks have. There is no reason other than altruism (and we all know how much altruism Citibank and HSBC have—it is approximately equal to the margin requirement they are trying to get passed—and yes, they wrote the bill) that would prevent them from simply printing as much money as they possibly can, thus maximizing their profits; and they can even excuse the behavior by saying that everyone else is doing it, so it’s not like they could prevent the collapse all by themselves. But by lobbying for a regulation to specifically allow this, they no longer have that excuse; no, everyone won’t be doing it, not unless you pass this law to let them. Despite the global economic collapse that was just caused by this sort of behavior only seven years ago, they now want to return to doing it. At this point I’m beginning to wonder if calling them an international crime syndicate is actually unfair to international crime syndicates. These guys are so totally evil it actually goes beyond the bounds of rational behavior; they’re turning into cartoon supervillains. I would honestly not be that surprised if there were a video of one of these CEOs caught on camera cackling maniacally, “Muahahahaha! The world shall burn!” (Then again, I was pleasantly surprised to see the CEO of Goldman Sachs talking about the harms of income inequality, though it’s not clear he appreciated his own contribution to that inequality.)

And that is why Democrats must not give in. The Senate should vote it down. Failing that, Obama should veto. I wish he still had the line-item veto so he could just remove the egregious riders without allowing a government shutdown, but no, the Senate blocked it. And honestly their reasoning makes sense; there is supposed to be a balance of power between Congress and the President. I just wish we had a Congress that would use its power responsibly, instead of holding the American people hostage to the villainous whims of Wall Street banks.

No, capital taxes should not be zero

JDN 2456998 PST 11:38.

It’s an astonishingly common notion among neoclassical economists that we should never tax capital gains, and all taxes should fall upon labor income. Here Scott Sumner writing for The Economist has the audacity to declare this a ‘basic principle of economics’. Many of the arguments are based on rather esoteric theorems like the Atkinson-Stiglitz Theorem (I thought you were better than that, Stiglitz!) and the Chamley-Judd Theorem.

All of these theorems rest upon two very important assumptions, which many economists take for granted—yet which are utterly and totally untrue. For once it’s not assumed that we are infinite identical psychopaths; actually psychopaths might not give wealth to their children in inheritance, which would undermine the argument in a different way, by making each individual have a finite time horizon. No, the assumptions are that saving is the source of investment, and investment is the source of capital income.

Investment is the source of capital, that’s definitely true—the total amount of wealth in society is determined by investment. You do have to account for the fact that real investment isn’t just factories and machines, it’s also education, healthcare, infrastructure. With that in mind, yes, absolutely, the total amount of wealth is a function of the investment rate.

But that doesn’t mean that investment is the source of capital income—because in our present system the distribution of capital income is in no way determined by real investment or the actual production of goods. Virtually all capital income comes from financial markets, which are rife with corruption—they are indeed the main source of corruption that remains in First World nations—and driven primarily by arbitrage and speculation, not real investment. Contrary to popular belief and economic theory, the stock market does not fund corporations; corporations fund the stock market. It’s this bizarre game our society plays, in which a certain portion of the real output of our productive industries is siphoned off so that people who are already rich can gamble over it. Any theory of capital income which fails to take these facts into account is going to be fundamentally distorted.

The other assumption is that investment is savings, that the way capital increases is by labor income that isn’t spent on consumption. This isn’t even close to true, and I never understood why so many economists think it is. The notion seems to be that there is a certain amount of money in the world, and what you don’t spend on consumption goods you can instead spend on investment. But this is just flatly not true; the money supply is dynamically flexible, and the primary means by which money is created is through banks creating loans for the purpose of investment. It’s that I term I talked about in my post on the deficit; it seems to come out of nowhere, because that’s literally what happens.

On the reasoning that savings is just labor income that you don’t spend on consumption, then if you compute the figure W – C , wages and salaries minus consumption, that figure should be savings, and it should be equal to investment. Well, that figure is negative—for reasons I gave in that post. Total employee compensation in the US in 2014 is $9.2 trillion, while total personal consumption expenditure is $11.4 trillion. The reason we are able to save at all is because of government transfers, which account for $2.5 trillion. To fill up our GDP to its total of $16.8 trillion, you need to add capital income: proprietor income ($1.4 trillion) and receipts on assets ($2.1 trillion); then you need to add in the part of government spending that isn’t transfers ($1.4 trillion).

If you start with the fanciful assumption that the way capital increases is by people being “thrifty” and choosing to save a larger proportion of their income, then it makes some sense not to tax capital income. (Scott Sumner makes exactly that argument, having us compare two brothers with equal income, one of whom chooses to save more.) But this is so fundamentally removed from how capital—and for that matter capitalism—actually operates that I have difficulty understanding why anyone could think that it is true.

The best I can come up with is something like this: They model the world by imagining that there is only one good, peanuts, and everyone starts with the same number of peanuts, and everyone has a choice to either eat their peanuts or save and replant them. Then, the total production of peanuts in the future will be due to the proportion of peanuts that were replanted today, and the amount of peanuts each person has will be due to their past decisions to save rather than consume. Therefore savings will be equal to investment and investment will be the source of capital income.

I bet you can already see the problem even in this simple model, if we just relax the assumption of equal wealth endowments: Some people have a lot more peanuts than others. Why do some people eat all their peanuts? Well it probably has something to do with the fact they’d starve if they didn’t. Reducing your consumption below the level at which you can survive isn’t “thrifty”, it’s suicidal. (And if you think this is a strawman, the IMF has literally told Third World countries that their problem is they need to save more. Here they are arguing that in Ghana.) In fact, economic growth leads to saving, not the other way around. Most Americans aren’t starving, and could probably stand to save more than we do, but honestly it might not be good if we did—everyone trying to save more can lead to the Paradox of Thrift and cause a recession.

Even worse, in that model world, there is only capital income. There is no such thing as labor income, only the number of peanuts you grow from last year’s planting. If we now add in labor income, what happens? Well, peanuts don’t work anymore… let’s try robots. You have a certain number of robots, and you can either use the robots to do things you need (including somehow feeding you, I guess), or you can use them to build more robots to use later. You can also build more robots yourself. Then the “zero capital tax” argument amounts to saying that the government should take some of your robots for public use if you made them yourself, but not if they were made by other robots you already had.

In order for that argument to carry through, you need to say that there was no such thing as an initial capital endowment; all robots that exist were either made by their owners or saved from previous construction. If there is anyone who simply happened to be born with more robots, or has more because they stole them from someone else (or, more likely, both, they inherited from someone who stole), the argument falls apart.

And even then you need to think about the incentives: If capital income is really all from savings, then taxing capital income provides an incentive to spend. Is that a bad thing? I feel like it isn’t; the economy needs spending. In the robot toy model, we’re giving people a reason to use their robots to do actual stuff, instead of just leaving them to make more robots. That actually seems like it might be a good thing, doesn’t it? More stuff gets done that helps people, instead of just having vast warehouses full of robots building other robots in the hopes that someday we can finally use them for something. Whereas, taxing labor income may give people an incentive not to work, which is definitely going to reduce economic output. More precisely, higher taxes on labor would give low-wage workers an incentive to work less, and give high-wage workers an incentive to work more, which is a major part of the justification of progressive income taxes. A lot of the models intended to illustrate the Chamley-Judd Theorem assume that taxes have an effect on capital but no effect on labor, which is kind of begging the question.

Another thought that occurred to me is: What if the robots in the warehouse are all destroyed by a war or an earthquake? And indeed the possibility of sudden capital destruction would be a good reason not to put everything into investment. This is generally modeled as “uninsurable depreciation risk”, but come on; of course it’s uninsurable. All real risk is uninsurable in the aggregate. Insurance redistributes resources from those who have them but don’t need them to those who suddenly find they need them but don’t have them. This actually does reduce the real risk in utility, but it certainly doesn’t reduce the real risk in terms of goods. Stephen Colbert made this point very well: “Obamacare needs the premiums of healthier people to cover the costs of sicker people. It’s a devious con that can only be described as—insurance.” (This suggests that Stephen Colbert understands insurance better than many economists.) Someone has to make that new car that you bought using your insurance when you totaled the last one. Insurance companies cannot create cars or houses—or robots—out of thin air. And as Piketty and Saez point out, uninsurable risk undermines the Chamley-Judd Theorem. Unlike all these other economists, Piketty and Saez actually understand capital and inequality.
Sumner hand-waves that point away by saying we should just institute a one-time transfer of wealth to equalized the initial distribution, as though this were somehow a practically (not to mention politically) feasible alternative. Ultimately, yes, I’d like to see something like that happen; restore the balance and then begin anew with a just system. But that’s exceedingly difficult to do, while raising the tax rate on capital gains is very easy—and furthermore if we leave the current stock market and derivatives market in place, we will not have a just system by any stretch of the imagination. Perhaps if we can actually create a system where new wealth is really due to your own efforts, where there is no such thing as inheritance of riches (say a 100% estate tax above $1 million), no such thing as poverty (a basic income), no speculation or arbitrage, and financial markets that actually have a single real interest rate and offer all the credit that everyone needs, maybe then you can say that we should not tax capital income.

Until then, we should tax capital income, probably at least as much as we tax labor income.

Yes, but what about the next 5000 years?

JDN 2456991 PST 1:34.

This week’s post will be a bit different: I have a book to review. It’s called Debt: The First 5000 Years, by David Graeber. The book is long (about 400 pages plus endnotes), but such a compelling read that the hours melt away. “The First 5000 Years” is an incredibly ambitious subtitle, but Graeber actually manages to live up to it quite well; he really does tell us a story that is more or less continuous from 3000 BC to the present.

So who is this David Graeber fellow, anyway? None will be surprised that he is a founding member of Occupy Wall Street—he was in fact the man who coined “We are the 99%”. (As I’ve studied inequality more, I’ve learned he made a mistake; it really should be “We are the 99.99%”.) I had expected him to be a historian, or an economist; but in fact he is an anthropologist. He is looking at debt and its surrounding institutions in terms of a cultural ethnography—he takes a step outside our own cultural assumptions and tries to see them as he might if he were encountering them in a foreign society. This is what gives the book its freshest parts; Graeber recognizes, as few others seem willing to, that our institutions are not the inevitable product of impersonal deterministic forces, but decisions made by human beings.

(On a related note, I was pleasantly surprised to see in one of my economics textbooks yesterday a neoclassical economist acknowledging that the best explanation we have for why Botswana is doing so well—low corruption, low poverty by African standards, high growth—really has to come down to good leadership and good policy. For once they couldn’t remove all human agency and mark it down to grand impersonal ‘market forces’. It’s odd how strong the pressure is to do that, though; I even feel it in myself: Saying that civil rights progressed so much because Martin Luther King was a great leader isn’t very scientific, is it? Well, if that’s what the evidence points to… why not? At what point did ‘scientific’ come to mean ‘human beings are helplessly at the mercy of grand impersonal forces’? Honestly, doesn’t the link between science and technology make matters quite the opposite?)

Graeber provides a new perspective on many things we take for granted: in the introduction there is one particularly compelling passage where he starts talking—with a fellow left-wing activist—about the damage that has been done to the Third World by IMF policy, and she immediately interjects: “But surely one has to pay one’s debts.” The rest of the book is essentially an elaboration on why we say that—and why it is absolutely untrue.

Graeber has also made me think quite a bit differently about Medieval society and in particular Medieval Islam; this was certainly the society in which the writings of Socrates were preserved and algebra was invented, so it couldn’t have been all bad. But in fact, assuming that Graeber’s account is accurate, Muslim societies in the 14th century actually had something approaching the idyllic fair and free market to which all neoclassicists aspire. They did so, however, by rejecting one of the core assumptions of neoclassical economics, and you can probably guess which one: the assumption that human beings are infinite identical psychopaths. Instead, merchants in Medieval Muslim society were held to high moral standards, and their livelihood was largely based upon the reputation they could maintain as upstanding good citizens. Theoretically they couldn’t even lend at interest, though in practice they had workarounds (like payment in installments that total slightly higher than the original price) that amounted to low rates of interest. They did not, however, have anything approaching the levels of interest that we have today in credit cards at 29% or (it still makes me shudder every time I think about it) payday loans at 400%. Paying on installments to a Muslim merchant would make you end up paying about a 2% to 4% rate of interest—which sounds to me almost exactly what it should be, maybe even a bit low because we’re not taking inflation into account. In any case, the moral standards of society kept people from getting too poor or too greedy, and as a result there was little need for enforcement by the state. In spite of myself I have to admit that may not have been possible without the theological enforcement provided by Islam.
Graeber also avoids one of the most common failings of anthropologists, the cultural relativism that makes them unwilling to criticize any cultural practice as immoral even when it obviously is (except usually making exceptions for modern Western capitalist imperialism). While at times I can see he was tempted to go that way, he generally avoids it; several times he goes out of his way to point out how women were sold into slavery in hunter-gatherer tribes and how that contributed to the institutions of chattel slavery that developed once Western powers invaded.

Anthropologists have another common failing that I don’t think he avoids as well, which is a primitivist bent in which anthropologists speak of ancient societies as idyllic and modern societies as horrific. That’s part of why I said ‘if Graber’s account is accurate,’ because I’m honestly not sure it is. I’ll need to look more into the history of Medieval Islam to be sure. Graeber spends a great deal of time talking about how our current monetary system is fundamentally based on threats of violence—but I can tell you that I have honestly never been threatened with violence over money in my entire life. Not by the state, not by individuals, not by corporations. I haven’t even been mugged—and that’s the sort of the thing the state exists to prevent. (Not that I’ve never been threatened with violence—but so far it’s always been either something personal, or, more often, bigotry against LGBT people.) If violence is the foundation of our monetary system, then it’s hiding itself extraordinarily well. Granted, the violence probably pops up more if you’re near the very bottom, but I think I speak for most of the American middle class when I say that I’ve been through a lot of financial troubles, but none of them have involved any guns pointed at my head. And you can’t counter this by saying that we theoretically have laws on the books that allow you to be arrested for financial insolvency—because that’s always been true, in fact it’s less true now than any other point in history, and Graeber himself freely admits this. The important question is how many people actually get violence enforced upon them, and at least within the United States that number seems to be quite small.

Graeber describes the true story of the emergence of money historically, as the result of military conquest—a way to pay soldiers and buy supplies when in an occupied territory where nobody trusts you. He demolishes the (always fishy) argument that money emerged as a way of mediating a barter system: If I catch fish and he makes shoes and I want some shoes but he doesn’t want fish right now, why not just make a deal to pay later? This is of course exactly what they did. Indeed Graeber uses the intentionally provocative word communism to describe the way that resources are typically distributed within families and small villages—because it basically is “from each according to his ability, to each according to his need”. (I would probably use the less-charged word “community”, but I have to admit that those come from the same Latin root.) He also describes something I’ve tried to explain many times to neoclassical economists to no avail: There is equally a communism of the rich, a solidarity of deal-making and collusion that undermines the competitive market that is supposed to keep the rich in check. Graeber points out that wine, women and feasting have been common parts of deals between villages throughout history—and yet are still common parts of top-level business deals in modern capitalism. Even as we claim to be atomistic rational agents we still fall back on the community norms that guided our ancestors.

Another one of my favorite lines in the book is on this very subject: “Why, if I took a free-market economic theorist out to an expensive dinner, would that economist feel somewhat diminished—uncomfortably in my debt—until he had been able to return the favor? Why, if he were feeling competitive with me, would he be inclined to take me someplace even more expensive?” That doesn’t make any sense at all under the theory of neoclassical rational agents (an infinite identical psychopath would just enjoy the dinner—free dinner!—and might never speak to you again), but it makes perfect sense under the cultural norms of community in which gifts form bonds and generosity is a measure of moral character. I also got thinking about how introducing money directly into such exchanges can change them dramatically: For instance, suppose I took my professor out to a nice dinner with drinks in order to thank him for writing me recommendation letters. This seems entirely appropriate, right? But now suppose I just paid him $30 for writing the letters. All the sudden it seems downright corrupt. But the dinner check said $30 on it! My bank account debit is the same! He might go out and buy a dinner with it! What’s the difference? I think the difference is that the dinner forms a relationship that ties the two of us together as individuals, while the cash creates a market transaction between two interchangeable economic agents. By giving my professor cash I would effectively be saying that we are infinite identical psychopaths.

While Graeber doesn’t get into it, a similar argument also applies to gift-giving on holidays and birthdays. There seriously is—I kid you not—a neoclassical economist who argues that Christmas is economically inefficient and should be abolished in favor of cash transfers. He wrote a book about it. He literally does not understand the concept of gift-giving as a way of sharing experiences and solidifying relationships. This man must be such a joy to have around! I can imagine it now: “Will you play catch with me, Daddy?” “Daddy has to work, but don’t worry dear, I hired a minor league catcher to play with you. Won’t that be much more efficient?”

This sort of thing is what makes Debt such a compelling read, and Graeber does make some good points and presents a wealth of historical information. So now it’s time to talk about what’s wrong with the book, the things Graeber gets wrong.

First of all, he’s clearly quite ignorant about the state-of-the-art in economics, and I’m not even talking about the sort of cutting-edge cognitive economics experiments I want to be doing. (When I read what Molly Crockett has been working on lately in the neuroscience of moral judgments, I began to wonder if I should apply to University College London after all.)

No, I mean Graeber is ignorant of really basic stuff, like the nature of government debt—almost nothing of what I said in that post is controversial among serious economists; the equations certainly aren’t, though some of the interpretation and application might be. (One particularly likely sticking point called “Ricardian equivalence” is something I hope to get into in a future post. You already know the refrain: Ricardian equivalence only happens if you live in a world of infinite identical psychopaths.) Graeber has internalized the Republican talking points about how this is money our grandchildren will owe to China; it’s nothing of the sort, and most of it we “owe” to ourselves. In a particularly baffling passage Graeber talks about how there are no protections for creditors of the US government, when creditors of the US government have literally never suffered a single late payment in the last 200 years. There are literally no creditors in the world who are more protected from default—and only a few others that reach the same level, such as creditors to the Bank of England.

In an equally-bizarre aside he also says in one endnote that “mainstream economists” favor the use of the gold standard and are suspicious of fiat money; exactly the opposite is the case. Mainstream economists—even the neoclassicists with whom I have my quarrels—are in almost total agreement that a fiat monetary system managed by a central bank is the only way to have a stable money supply. The gold standard is the pet project of a bunch of cranks and quacks like Peter Schiff. Like most quacks, the are quite vocal; but they are by no means supported by academic research or respected by top policymakers. (I suppose the latter could change if enough Tea Party Republicans get into office, but so far even that hasn’t happened and Janet Yellen continues to manage our fiat money supply.) In fact, it’s basically a consensus among economists that the gold standard caused the Great Depression—that in addition to some triggering event (my money is on Minsky-style debt deflation—and so is Krugman’s), the inability of the money supply to adjust was the reason why the world economy remained in such terrible shape for such a long period. The gold standard has not been a mainstream position among economists since roughly the mid-1980s—before I was born.

He makes this really bizarre argument about how because Korea, Japan, Taiwan, and West Germany are major holders of US Treasury bonds and became so under US occupation—which is indisputably true—that means that their development was really just some kind of smokescreen to sell more Treasury bonds. First of all, we’ve never had trouble selling Treasury bonds; people are literally accepting negative interest rates in order to have them right now. More importantly, Korea, Japan, Taiwan, and West Germany—those exact four countries, in that order—are the greatest economic success stories in the history of the human race. West Germany was rebuilt literally from rubble to become once again a world power. The Asian Tigers were even more impressive, raised from the most abject Third World poverty to full First World high-tech economy status in a few generations. If this is what happens when you buy Treasury bonds, we should all buy as many Treasury bonds as we possibly can. And while that seems intuitively ridiculous, I have to admit, China’s meteoric rise also came with an enormous investment in Treasury bonds. Maybe the secret to economic development isn’t physical capital or exports or institutions; nope, it’s buying Treasury bonds. (I don’t actually believe this, but the correlation is there, and it totally undermines Graeber’s argument that buying Treasury bonds makes you some kind of debt peon.)

Speaking of correlations, Graeber is absolutely terrible at econometrics; he doesn’t even seem to grasp the most basic concepts. On page 366 he shows this graph of the US defense budget and the US federal debt side by side in order to argue that the military is the primary reason for our national debt. First of all, he doesn’t even correct for inflation—so most of the exponential rise in the two curves is simply the purchasing power of the dollar declining over time. Second, he doesn’t account for GDP growth, which is most of what’s left after you account for inflation. He has two nonstationary time-series with obvious exponential trends and doesn’t even formally correlate them, let alone actually perform the proper econometrics to show that they are cointegrated. I actually think they probably are cointegrated, and that a large portion of national debt is driven by military spending, but Graeber’s graph doesn’t even begin to make that argument. You could just as well graph the number of murders and the number of cheesecakes sold, each on an annual basis; both of them would rise exponentially with population, thus proving that cheesecakes cause murder (or murders cause cheesecakes?).

And then where Graeber really loses me is when he develops his theory of how modern capitalism and the monetary and debt system that go with it are fundamentally corrupt to the core and must be abolished and replaced with something totally new. First of all, he never tells us what that new thing is supposed to be. You’d think in 400 pages he could at least give us some idea, but no; nothing. He apparently wants us to do “not capitalism”, which is an infinite space of possible systems, some of which might well be better, but none of which can actually be implemented without more specific ideas. Many have declared that Occupy has failed—I am convinced that those who say this appreciate neither how long it takes social movements to make change, nor how effective Occupy has already been at changing our discourse, so that Capital in the Twenty-First Century can be a bestseller and the President of the United States can mention income inequality and economic mobility in his speeches—but insofar as Occupy has failed to achieve its goals, it seems to me that this is because it was never clear just what Occupy’s goals were to begin with. Now that I’ve read Graeber’s work, I understand why: He wanted it that way. He didn’t want to go through the hard work (which is also risky: you could be wrong) of actually specifying what this new economic system would look like; instead he’d prefer to find flaws in the current system and then wait for someone else to figure out how to fix them. That has always been the easy part; any human system comes with flaws. The hard part is actually coming up with a better system—and Graeber doesn’t seem willing to even try.

I don’t know exactly how accurate Graeber’s historical account is, but it seems to check out, and even make sense of some things that were otherwise baffling about the sketchy account of the past I had previously learned. Why were African tribes so willing to sell their people into slavery? Well, because they didn’t think of it as their people—they were selling captives from other tribes taken in war, which is something they had done since time immemorial in the form of slaves for slaves rather than slaves for goods. Indeed, it appears that trade itself emerged originally as what Graeber calls a “human economy”, in which human beings are literally traded as a fungible commodity—but always humans for humans. When money was introduced, people continued selling other people, but now it was for goods—and apparently most of the people sold were young women. So much of the Bible makes more sense that way: Why would Job be all right with getting new kids after losing his old ones? Kids are fungible! Why would people sell their daughters for goats? We always sell women! How quickly do we flirt with the unconscionable, when first we say that all is fungible.

One of Graeber’s central points is that debt came long before money—you owed people apples or hours of labor long before you ever paid anybody in gold. Money only emerged when debt became impossible to enforce, usually because trade was occurring between soldiers and the villages they had just conquered, so nobody was going to trust anyone to pay anyone back. Immediate spot trades were the only way to ensure that trades were fair in the absence of trust or community. In other words, the first use of gold as money was really using it as collateral. All of this makes a good deal of sense, and I’m willing to believe that’s where money originally came from.

But then Graeber tries to use this horrific and violent origin of money—in war, rape, and slavery, literally some of the worst things human beings have ever done to one another—as an argument for why money itself is somehow corrupt and capitalism with it. This is nothing short of a genetic fallacy: I could agree completely that money had this terrible origin, and yet still say that money is a good thing and worth preserving. (Indeed, I’m rather strongly inclined to say exactly that.) The fact that it was born of violence does not mean that it is violence; we too were born of violence, literally millions of years of rape and murder. It is astronomically unlikely that any one of us does not have a murderer somewhere in our ancestry. (Supposedly I’m descended from Julius Caesar, hence my last name Julius—not sure I really believe that—but if so, there you go, a murderer and tyrant.) Are we therefore all irredeemably corrupt? No. Where you come from does not decide what you are or where you are going.

In fact, I could even turn the argument around: Perhaps money was born of violence because it is the only alternative to violence; without money we’d still be trading our daughters away because we had no other way of trading. I don’t think I believe that either; but it should show you how fragile an argument from origin really is.

This is why the whole book gives this strange feeling of non sequitur; all this history is very interesting and enlightening, but what does it have to do with our modern problems? Oh. Nothing, that’s what. The connection you saw doesn’t make any sense, so maybe there’s just no connection at all. Well all right then. This was an interesting little experience.

This is a shame, because I do think there are important things to be said about the nature of money culturally, philosophically, morally—but Graeber never gets around to saying them, seeming to think that merely pointing out money’s violent origins is a sufficient indictment. It’s worth talking about the fact that money is something we made, something we can redistribute or unmake if we choose. I had such high expectations after I read that little interchange about the IMF: Yes! Finally, someone gets it! No, you don’t have to repay debts if that means millions of people will suffer! But then he never really goes back to that. The closest he veers toward an actual policy recommendation is at the very end of the book, a short section entitled “Perhaps the world really does owe you a living” in which he very briefly suggests—doesn’t even argue for, just suggests—that perhaps people do deserve a certain basic standard of living even if they aren’t working. He could have filled 50 pages arguing the ins and outs of a basic income with graphs and charts and citations of experimental data—but no, he just spends a few paragraphs proposing the idea and then ends the book. (I guess I’ll have to write that chapter myself; I think it would go well in The End of Economics, which I hope to get back to writing in a few months—while I also hope to finally publish my already-written book The Mathematics of Tears and Joy.)

If you want to learn about the history of money and debt over the last 5000 years, this is a good book to do so—and that is, after all, what the title said it would be. But if you’re looking for advice on how to improve our current economic system for the benefit of all humanity, you’ll need to look elsewhere.

And so in the grand economic tradition of reducing complex systems into a single numeric utility value, I rate Debt: The First 5000 Years a 3 out of 5.

Fear not the deficit

JDN 2456984 PST 12:20.

The deficit! It’s big and scary! And our national debt is rising by the second, says a “debt clock” that is literally just linearly extrapolating the trend. You don’t actually think that there are economists marking down every single dollar the government spends and uploading it immediately, do you? We’ve got better things to do. Conservatives will froth at the mouth over how Obama is the “biggest government spender in world history“, which is true if you just look at the dollar amounts, but of course it is; Obama is the president of the richest country in world history. If the government continues to tax at the same rate and spend what it taxes, government spending will be a constant proportion of GDP (which isn’t quite true, but it’s pretty close; there are ups and downs but for the last 40 years or so federal spending is generally in the range 30% to 35% of GDP), and the GDP of the United States is huge, and far beyond that of any other nation not only today, but ever. This is particularly true if you use nominal dollars, but it’s even true if you use inflation-adjusted real GDP. No other nation even gets close to US GDP, which is about to reach $17 trillion a year (unless you count the whole European Union as a nation, in which case it’s a dead heat).

China recently passed us if you use purchasing-power-parity, but that really doesn’t mean much, because purchasing-power-parity, or PPP, is a measure of standard of living, not a measure of a nation’s total economic power. If you want to know how well people in a country live, you use GDP per capita (that is, per person) PPP. But if you want to know a country’s capacity to influence the world economy, what matters is so-called real GDP, which is adjusted for inflation and international exchange rates. The difference is that PPP will tell you how many apples a person can buy, but real GDP will tell you how many aircraft carriers a government can build. The US is still doing quite well in that department, thank you; we have 10 of the world’s 20 active aircraft carriers, which is to say as many as everyone else combined. The US has 4% of the world’s population and 24% of the world’s economic output.

In particular, GDP in the US has been growing rather steadily since the Great Recession, and we are now almost recovered from the Second Depression and back to our equilibrium level of unemployment and economic growth. As the economy grows, government spending grows alongside it. Obama has actually presided over a decrease in the proportion of government spending relative to GDP, largely because of all this political pressure to reduce the deficit and stop the growth of the national debt. Under Obama the deficit has dropped dramatically.

But what is the deficit, anyway? And how can the deficit be decreasing if the debt clock keeps ticking up?

The government deficit is simply the difference between total government spending and total government revenue. If the government spends $3.90 trillion and takes in $3.30 trillion, the deficit is going to be $0.60 trillion, or $600 billion. In the rare case that you take in more than you spend, the deficit would be negative; we call that a surplus instead. (This almost never happens.)

Because of the way the US government is financed, the deficit corresponds directly to the national debt, which is the sum of all outstanding loans to the government. Every time the government spends more than it takes in, it makes up the difference by taking out a loan, in the form of a Treasury bond. As long as the deficit is larger than zero, the debt will increase. Think of the debt as where you are, and the deficit as how fast you’re going; you can be slowing down, but you’ll continue to move forward as long as you have some forward momentum.

Who is giving us these loans? You can look at the distribution of bondholders here. About a third of the debt is owned by the federal government itself, which makes it a very bizarre notion of “debt” indeed. Of the rest, 21% is owned by states or the Federal Reserve, so that’s also a pretty weird kind of debt. Only 55% of the total debt is owned by the public, and of those 39% are people and corporations within the United States. That means that only 33% of the national debt is actually owned by foreign people, corporations, or governments. What we actually owe to China is about $1.4 trillion. That’s a lot of money (it’s literally enough to make an endowment that would end world hunger forever), but our total debt is almost $18 trillion, so that’s only 8%.

When most people see these huge figures they panic: “Oh my god, we owe $18 trillion! How will we ever repay that!” Well, first of all, our GDP is $17 trillion, so we only owe a little over one year of income. (I wish I only owed one year of income in student loans….)

But in fact we don’t really owe it at all, and we don’t need to ever repay it. Chop off everything that’s owned by US government institutions (including the Federal Reserve, which is only “quasi-governmental”), and the figure drops down to $9.9 trillion. If by we you mean American individuals and corporations, then obviously we don’t owe back the debt that’s owned by ourselves, so take that off; now you’re looking at $6 trillion. That’s only about 4 months of total US economic output, or less than two years of government revenue.

And it gets better! The government doesn’t need to somehow come up with that money; they don’t even have to raise it in taxes. They can print that money, because the US government has a sovereign currency and the authority to print as much as we want. Really, we have the sovereign currency, because the US dollar is the international reserve currency, the currency that other nations hold in order to make exchanges in foreign markets. Other countries buy our money because it’s a better store of value than their own. Much better, in fact; the US has the most stable inflation rate in the world, and has literally never undergone hyperinflation. Better yet, the last time we had prolonged deflation was the Great Depression. This system is self-perpetuating, because being the international reserve currency also stabilizes the value of your money.

This is why it’s so aggravating to me when people say things like “the government can’t afford that” or “the government is broke” or “that money needs to come from somewhere”. No, the government can’t be broke! No, the money doesn’t have to come from somewhere! The US government is the somewhere from which the world’s money comes. If there is one institution in the world that can never, ever be broke, it is the US government. This gives our government an incredible amount of power—combine that with our aforementioned enormous GDP and fleet of aircraft carriers, and you begin to see why the US is considered a global hegemon.

To be clear: I’m not suggesting we eliminate all taxes and just start printing money to pay for everything. Taxes are useful, and we should continue to have them—ideally we would make them more progressive than they presently are. But it’s important to understand why taxes are useful; it’s really not that they are “paying for” government services. It’s actually more that they are controlling the money supply. The government creates money by spending, then removes money by taxing; in this way we maintain a stable growth of the money supply that allows us to keep the economy running smoothly and maintain inflation at a comfortable level. Taxes also allow the government to redistribute income from those who have it and save it to those who need it and will spend it—which is all the more reason for them to be progressive. But in theory we could eliminate all taxes without eliminating government services; it’s just that this would cause a surge in inflation. It’s a bad idea, but by no means impossible.

When we have a deficit, the national debt increases. This is not a bad thing. This is a fundamental misconception that I hope to disabuse you of: Government debt is not like household debt or corporate debt. When people say things like “we need to stop spending outside our means” or “we shouldn’t put wars on the credit card”, they are displaying a fundamental misunderstanding of what government debt is. The government simply does not operate under the same kind of credit constraints as you and I.

First, the government controls its own interest rates, and they are always very low—typically the lowest in the entire economy. That already gives it a lot more power over its debt than you or I have over our own.

Second, the government has no reason to default, because they can always print more money. That’s probably why bondholders tolerate the fact that the government sets its own interest rates; sure, it only pays 0.5%, but it definitely pays that 0.5%.

Third, government debt plays a role in the functioning of global markets; one of the reasons why China is buying up so much of our debt is so that they can keep the dollar high in value and thus maintain their trade surplus. (This is why whenever someone says something like, “The government needs to stop going further into debt, just like how I tightened my belt and paid off my mortgage!” I generally reply, “So when was the last time someone bought your debt in order to prop up your currency?”) This is also why we can’t get rid of our trade deficit and maintain a “strong dollar” at the same time; anyone who wants to do that may feel patriotic, but they are literally talking nonsense. The stronger the dollar, the higher the trade deficit.

Fourth, as I already hinted at above, the government doesn’t actually need debt at all. Government debt, like taxation, is not actually a source of funding; it is a tool of monetary policy. (If you’re going to quote one sentence from this post, it should be the previous; that basically sums up what I’m saying.) Even without raising taxes or cutting spending, the government could choose not to issue bonds, and instead print cash. You could make a sophisticated economic argument for how this is really somehow “issuing debt with indefinite maturity at 0% interest”; okay, fine. But it’s not what most people think of when they think of debt. (In fact, sophisticated economic arguments can go quite the opposite way: there’s a professor at Harvard I may end up working with—if I get into Harvard for my PhD of course—who argues that the federal debt and deficit are literally meaningless because they can be set arbitrarily by policy. I think he goes too far, but I see his point.) This is why many economists were suggesting that in order to get around ridiculous debt-ceiling intransigence Obama could simply Mint the Coin.

Government bonds aren’t really for the benefit of the government, they’re for the benefit of society. They allow the government to ensure that there is always a perfectly safe investment that people can buy into which will anchor interest rates for the rest of the economy. If we ever did actually pay off all the Treasury bonds, the consequences could be disastrous.

Fifth, the government does not have a credit limit; they can always issue more debt (unless Congress is filled with idiots who won’t raise the debt ceiling!). The US government is the closest example in the world to what neoclassical economists call a perfect credit market. A perfect credit market is like an ideal rational agent; these sort of things only exist in an imaginary world of infinite identical psychopaths. A perfect credit market would have perfect information, zero transaction cost, zero default risk, and an unlimited quantity of debt; with no effort at all you could take out as much debt as you want and everyone would know that you are always guaranteed to pay it back. This is in most cases an utterly absurd notion—but in the case of the US government it’s actually pretty close.

Okay, now that I’ve deluged you with reasons why the national debt is fundamentally different from a household mortgage or corporate bond, let’s get back to talking about the deficit. As I mentioned earlier, the deficit is almost always positive; the government is almost always spending more money than it takes in. Most people think that is a bad thing; it is not.

It would be bad for a corporation to always run a deficit, because then it would never make a profit. But the government is not a for-profit corporation. It would be bad for an individual to always run a deficit, because eventually they would go bankrupt. But the government is not an individual.

In fact, the government running a deficit is necessary for both corporations to make profits and individuals to gain net wealth! The government is the reason why our monetary system is nonzero-sum.

This is actually so easy to see that most people who learn about it react with shock, assuming that it can’t be right. There can’t be some simple and uncontroversial equation that shows that government deficits are necessary for profits and savings. Actually, there is; and the fact that we don’t talk about this more should tell you something about the level of sophistication in our economic discourse.

Individuals do work, get paid wages W. (This also includes salaries and bonuses; it’s all forms of labor income.) They also get paid by government spending, G, and pay taxes, T. Let’s pretend that all taxing and spending goes to people and not corporations. This is pretty close to true, especially since corporations as big as Boeing frequently pay nothing in taxes. Corporate subsidies, while ridiculous, are also a small portion of spending—no credible estimate is above $300 billion a year, or less than 10% of the budget. (Without that assumption the equation has a couple more terms, but the basic argument doesn’t change.) People use their money to buy consumption goods, C. What they don’t spend they save, S.

S = (W + G – T) – C

I’m going to rearrange this for reasons that will soon become clear:

S = (W – C) + (G – T)

I’ll also subtract investment I from both sides, again for reasons that will become clear:

S – I = (W – C – I) + (G – T)

Corporations hire workers and pay them W. They make consumption goods which are then sold for C. They also sell to foreign companies and buy from foreign companies, exporting X and importing M. Since we have a trade deficit, this means that X < M. Finally, they receive investment I that comes in the form of banks creating money through loans (yes, banks can create money). Most of our monetary policy is in the form of trying to get banks to create more money by changing interest rates. Only when desperate do we actually create the money directly (I’m not sure why we do it this way). In any case, this yields a total net profit P.

P = C + I – W + (X – M)

Now, if the economy is functioning well, we want profits and savings to both be positive—both people and corporations will have more money on average next year then they had this year. This means that S > 0 and P > 0. We also don’t want the banks loaning out more money than people save—otherwise people go ever further into debt—so we actually want S > I, or S – I > 0. If S – I > 0, people are paying down their debts and gaining net wealth. If S – I < 0, people are going further into debt and losing net wealth. In a well-functioning economy we want people to be gaining net wealth.

In order to have P > 0, because X – M < 0 we need to have C + I > W. People have to spend more on consumption and investment than they are paid in wages—have to, absolutely have to, as a mathematical law—in order for corporations to make a profit.

But then if C + I > W, W – C – I < 0, which means that the first term of the savings equation is negative. In order for savings to be positive, it must be—again as a mathematical law—that G – T > 0, which means that government spending exceeds taxes. In order for both corporations to profit and individuals to save at the same time, the government must run a deficit.

There is one other way, actually, and that’s for X – M to be positive, meaning you run a trade surplus. But right now we don’t, and moreover, the world as a whole necessarily cannot. For the world as a whole, X = M. This will remain true at least until we colonize other planets. This means that in order for both corporate profits and individual savings to be positive worldwide, overall governments worldwide must spend more than they take in. It has to be that way, otherwise the equations simply don’t balance.

You can also look at it another way by adding the equations for S – I and P:

S – I + P = (G – T) + (X – M)

Finally, you can also derive this a third way. This is your total GDP which we usually call Y (“yield”, I think?); it’s equal to consumption plus investment plus government spending, plus net exports:

Y = C + I + G + (X – M)

It’s also equal to consumption plus profit plus saving plus taxes:

Y = C + P + S + T

So those two things must be the same:

C + S + T + P = C + I + G + (X – M)

Canceling and rearranging we get:

(S – I) + P = (G – T) + (X – M)

The sum of saving minus investment (which we can sort of think of as “net saving”) plus profit is equal to the sum of the government deficit and the trade surplus. (Usually you don’t see P in this sectoral balances equation because no distinction is made between consumers and corporations and P is absorbed into S.)

From the profit equation:

W = C + I + (X – M) – P

Put that back into our GDP equation:

Y = W + P + G

GDP is wages plus profits plus government spending.

That’s a lot of equations; simple equations, but yes, equations. Lots of people are scared by equations. So here, let me try to boil it down to a verbal argument. When people save and corporations make profits, money gets taken out of circulation. If no new money is added, the money supply will decrease as a result; this shrinks the economy (mathematically it must absolutely shrink it in nominal terms; theoretically it could cause deflation and not reduce real output, but in practice real output always goes down because deflation causes its own set of problems). New money can be created by banks, but the mechanism of creation requires that people go further into debt. This is unstable, and eventually people can’t borrow anymore and the whole financial system comes crashing down. The better way, then, is for the government to create new money. Yes, as we currently do things, this means the government will go further into debt; but that’s all right, because the government can continue to increase its debt indefinitely without having to worry about hitting a ceiling and making everything fall apart. We could also just print money instead, and in fact I think in many cases this is what we should do—but for whatever reason people always freak out when you suggest such a thing, invariably mentioning Zimbabwe. (And yes, Zimbabwe is in awful shape; but they didn’t just print money to cover a reasonable amount of deficit spending. They printed money to line their own pockets, and it was thousands of times more than what I’m suggesting. Also Zimbabwe has a much smaller economy; $1 trillion is 5% of US GDP, but it’s 8,000% of Zimbabwe’s. I’m suggesting we print maybe 4% of GDP; at the peak of the hyperinflation they printed something more like 100,000%.)

One last thing before I go. If investment suddenly drops, net saving will go up. If the government deficit and trade deficit remain constant, profits must go down. This drives firms into bankruptcy, driving wages down as well. This makes GDP fall—and you get a recession. A similar effect would occur if consumption suddenly drops. In both cases people will be trying to increase their net wealth, but in fact they won’t be able to—this is what’s called the paradox of thrift. You actually want to increase the government deficit under these circumstances, because then you will both add to GDP directly and allow profits and wages to go back up and raise GDP even further. Because GDP has gone down, tax income will go down, so if you insist on balancing the budget, you’ll cut spending and only make things worse.

Raising the government deficit generally increases economic growth. From these simple equations it looks like you could raise GDP indefinitely, but these are nominal figures—actual dollar amounts—so after a certain point all you’d be doing is creating inflation. Where exactly that point is depends on how your economy is performing relative to its potential capacity. In a recession you are far below capacity, so that’s just the time to spend. You’d only want a budget surplus if you actually thought you were above long-run capacity, because you’re depleting natural resources or causing too much inflation or something like that. And indeed, we hardly ever see budget surpluses.

So that, my dear reader, is why we don’t need to fear the deficit. Government debt is nothing like other forms of debt; profits and savings depend upon the government spending more than it takes in; deficits are highly beneficial during recessions; and the US government is actually in a unique position to never worry about defaulting on its debt.

Why immigration is good

JDN 2456977 PST 12:31.

The big topic in policy news today is immigration. After years of getting nothing done on the issue, Obama has finally decided to bypass Congress and reform our immigration system by executive order. Republicans are threatening to impeach him if he does. His decision to go forward without Congressional approval may have something to do with the fact that Republicans just took control of both houses of Congress. Naturally, Fox News is predicting economic disaster due to the expansion of the welfare state. (When is that not true?) A more legitimate critique comes from the New York Times, who point out how this sudden shift demonstrates a number of serious problems in our political system and how it is financed.

So let’s talk about immigration, and why it is almost always a good thing for a society and its economy. There are a couple of downsides, but they are far outweighed by the upsides.

I’ll start with the obvious: Immigration is good for the immigrants. That’s why they’re doing it. Uprooting yourself from your home and moving thousands of miles isn’t easy under the best circumstances (like I when I moved from Michigan to California for grad school); now imagine doing it when you are in crushing poverty and you have to learn a whole new language and culture once you arrive. People are only willing to do this when the stakes are high. The most extreme example is of course the children refugees from Latin America, who are finally getting some of the asylum they so greatly deserve, but even the “ordinary” immigrants coming from Mexico are leaving a society racked with poverty, endemic with corruption, and bathed in violence—most recently erupting in riots that have set fire to government buildings. These people are desperate; they are crossing our border despite the fences and guns because they feel they have no other choice. As a fundamental question of human rights, it is not clear to me that we even have the right to turn these people away. Forget the effect on our economy; forget the rate of assimilation; what right do we have to say to these people that their suffering should go on because they were born on the wrong side of an arbitrary line?

There are wealthier immigrants—many of them here, in fact, for grad schoolwhose circumstances are not so desperate; but hardly anyone even considers turning them away, because we want their money and their skills in our society. Americans who fear brain drain have it all backwards; the United States is where the brains drain to. This trend may be reversing more recently as our right-wing economic policy pulls funding away from education and science, but it would likely only reach the point where we export as many intelligent people as we import; we’re not talking about creating a deficit here, only reducing our world-dominating surplus. And anyway I’m not so concerned about those people; yes, the world needs them, but they don’t need much help from the world.

My concern is for our tired, our poor, our huddled masses yearning to breathe free. These are the people we are thinking about turning away—and these are the people who most desperately need us to take them in. That alone should be enough reason to open our borders, but apparently it isn’t for most people, so let’s talk about some of the ways that America stands to gain from such a decision.

First of all, immigration increases economic growth. Immigrants don’t just take in money; they also spend it back out, which further increases output and creates jobs. Immigrants are more likely than native citizens to be entrepreneurs, perhaps because taking the chance to start a business isn’t so scary after you’ve already taken the chance to travel thousands of miles to a new country. Our farming system is highly dependent upon cheap immigrant labor (that’s a little disturbing, but if as far as the US economy, we get cheap food by hiring immigrants on farms). On average, immigrants are younger than our current population, so they are more likely to work and less likely to retire, which has helped save the US from the economic malaise that afflicts nations like Japan where the aging population is straining the retirement system. More open immigration wouldn’t just increase the number of immigrants coming here to do these things; it would also make the immigrants who are already here more productive by opening up opportunities for education and entrepreneurship. Immigration could speed the recovery from the Second Depression and maybe even revitalize our dying Rust Belt cities.

Now, what about the downsides? By increasing the supply of labor faster than they increase the demand for labor, immigrants could reduce wages. There is some evidence that immigrants reduce wages, particularly for low-skill workers. This effect is rather small, however; in many studies it’s not even statistically significant (PDF link). A 10% increase in low-skill immigrants leads to about a 3% decrease in low-skill wages (PDF link). The total economy grows, but wages decrease at the bottom, so there is a net redistribution of wealth upward.

Immigration is one of the ways that globalization increases within-nation inequality even as it decreases between-nation inequality; you move the poor people to rich countries, and they become less poor than they were, but still poorer than most of the people in those rich countries, which increases the inequality there. On average the world becomes better off, but it can seem bad for the rich countries, especially the people in rich countries who were already relatively poor. Because they distribute wealth by birthright, national borders actually create something analogous to the privilege of feudal lords, albeit to a much larger segment of the population. (Much larger: Here’s a right-wing site trying to argue that the median American is in the top 1% of income by world standards; neat trick, because Americans comprise 4% of the world population—so our top half makes up 2% of the world’s population by themselves. Yet somehow apparently that 2% of the population is the top 1%? Also, the US isn’t the only rich country; have you heard of, say, Europe?)

There’s also a lot of variation in the literature as to the size—or even direction—of the effect of immigration on low-skill wages. But since the theory makes sense and the preponderance of the evidence is toward a moderate reduction in wages for low-skill native workers, let’s assume that this is indeed the case.

First of all I have to go back to my original point: These immigrants are getting higher wages than they would have in the countries they left. (That part is usually even true of the high-skill immigrants.) So if you’re worried about low wages for low-skill workers, why are you only worried about that for workers who were born on this side of the fence? There’s something deeply nationalistic—if not outright racist—inherent in the complaint that Americans will have lower pay or lose their jobs when Mexicans come here. Don’t Mexicans also deserve jobs and higher pay?

Aside from that, do we really want to preserve higher wages at the cost of economic efficiency? Are high wages an end in themselves? It seems to me that what we’re really concerned about is welfare—we want the people of our society to live better lives. High wages are one way to do that, but not the only way; a basic income could reverse that upward redistribution of wealth, taking the economic benefits of the immigration that normally accrue toward the top and giving them to the bottom. As I already talked about in an earlier post, a basic income is a lot more efficient than trying to mess around with wages. Markets are very powerful; we shouldn’t always accept what they do, but we should also be careful when we interfere with them. If the market is trying to drive certain wages down, that means that there is more desire to do that kind of work then there is work of that kind that needs done. The wage change creates a market incentive for people to switch to more productive kinds of work. We should also be working to create opportunities to make that switch—funding free education, for instance—because an incentive without an opportunity is a bit like pointing a gun at someone’s head and ordering them to give birth to a unicorn.

So on the one hand we have the increase in local inequality and the potential reduction in low-skill wages; those are basically the only downsides. On the other hand, we have increases in short-term and long-term economic growth, lower global inequality, more spending, more jobs, a younger population with less strain on the retirement system, more entrepreneurship, and above all, the enormous lifelong benefits to the immigrants themselves that motivated them to move in the first place. It seems pretty obvious to me: we can enact policies to reduce the downsides, but above all we must open our borders.

What just happened in that election?

JDN 2456970 PST 11:12.

My head is still spinning from the election results on Tuesday. Republicans gained a net of 12 seats to secure their majority in the House. Even worse, Republicans gained at least 7 seats in the Senate (note that each Senate seat should count for 4.35 House seats because there are 100 Senators and 435 Representatives) and may gain two more depending on how runoffs go. This gives them a majority in both houses of Congress. So people like Republicans then? Maybe they’re fed up with Obama and dissatisfied with his handling of the economy (even though it has actually been spectacular given what he had to work with).
But then when we look at actual ballot proposals, the ones that passed were mostly liberal issues. California passed proposition 47, which will reduce sentences for minor drug and theft crimes and substantially reduce our incidence of incarceration. (There’s no sign of releasing current prisoners, unfortunately; but at least we won’t be adding as many new ones.) Marijuana was legalized—fully legalized, for all purposes—in Alaska, Oregon, and DC, further reducing incarceration. At last, the US may finally stop being the incarceration capitol of the world! We currently hold the title in both per-capita and total incarceration, so there can be no dispute. (Technically the Seychelles has a higher per-capita rate, but come on, they don’t count as a real country; they have a population smaller than Ann Arbor—or for that matter the annual throughput of Riker’s Island.)

The proposals to allow wolf hunting in Michigan failed, for which many wolves would thank you if they could. Minimum wages were raised in five states, four of which are Republican-leaning states. The most extreme minimum wage hike was in San Francisco, where the minimum wage is going to be raised as high as $18 over the next four years. So people basically agree with Democrats on policy, but decided to hand the Senate over to Republicans.

I think the best explanation for what happened is the voting demographics. When we have a Senate election, we aren’t sampling randomly from the American population; we’re pulling from specific states, and specific populations within those states. Geography played a huge role in these election results. So did age; the voting population was much older on average than the general population, because most young people simply didn’t vote. I know some of these young people, who tell me things like “I’m not voting because I won’t be part of that system!” Apparently their level of understanding of social change approaches that of the Lonely Island song “I Threw it on the Ground”. Not voting isn’t rebellion, it’s surrender. (I’m not sure who said that first, but it’s clearly right.) Rebellion would be voting for a radical third-party candidate, or running as one yourself. Rebellion would be leading rallies to gather support—that is, votes—for that candidate. Alternatively, you could say that rebellion is too risky and simply aim for reform, in which case you’d vote for Democrats as I did.

Your failure to vote did not help change that system. On the contrary, it was because of your surrender that we got two houses of Congress controlled by Republicans who have veered so far to the right they are bordering on fascism and feudalism. It is strange living in a society where the “mainstream” has become so extremist. You end up feeling like a radical far-left Marxist when in fact you agree—as I do—with the core policies of FDR or even Eisenhower. You have been told that the right is capitalism and the left is socialism; this is wrong. The left is capitalism; the right is feudalism. When I tell you I want a basic income funded by a progressive income tax, I am agreeing with Milton Friedman.

This must be how it feels to be a secularist in an Islamist theocracy like Iran. Now that Colorado has elected a state legislator who is so extreme that he literally has performed exorcisms to make people not gay or transgender (his name is apparently Gordon Klingenschmitt), I fear we’re dangerously on the verge of a theocracy of our own.

Of course, I shouldn’t just blame the people who didn’t vote; I should also blame the people who did vote, and voted for candidates who are completely insane. Even though it’s just a state legislature, tens of thousands of people voted for that guy in Colorado; tens of thousands of Americans were okay with the fact that he thinks gay and transgender people have demons inside us that need to be removed by exorcism. Even in Iran theocracy is astonishingly popular. People are voting for these candidates, and we must find out why and change their minds. We must show them that the people they are voting for are not going to make good decisions that benefit America, they are going to make selfish decisions that benefit themselves or their corporate cronies, or even just outright bad decisions that hurt everyone. As an example of the latter (which is arguably worse), there is literally no benefit to discrimination against women or racial minorities or LGBT people. It’s just absolute pure deadweight loss that causes massive harm without any benefit at all. It’s deeply, deeply irrational, and one of the central projects of cognitive economics must be figuring out what makes people discriminate and figuring out how to make them stop.

To be fair, some of the candidates that were elected are not so extreme. Tom Cotton of Arkansas (whose name is almost offensively down-homey rural American; I don’t think I could name a character that in a novel without people thinking it was satire) supported the state minimum wage increase and is sponsoring a bill that would ban abortions after 20 weeks, which is actually pretty reasonable, rather than at conception, which is absurd.

Thom Tillis of North Carolina is your standard old rich White male corporate stooge, but I don’t see anything in his platform that is particularly terrifying. David Perdue of Georgia is the same; he’s one of those business owners who thinks he knows how to run the economy because he can own a business while it makes money. (Even if he did have something to do with the profitability of the business—which is not entirely clear—that’s still like a fighter pilot saying he’s a great aerospace engineer.) Cory Gardner is similar (not old, but rich White male corporate stooge), but he’s scary simply because he came from the Colorado state legislature, where they just installed that exorcist guy.

Thad Cochran of Mississippi was re-elected, so he was already there; he generally votes along whatever lines the Republican leadership asks him to, so he is not so much a villain as a henchman. Shelley Moore Capito of West Virginia also seems to basically vote whatever the party says.

Joni Ernst of Iowa is an interesting character; despite being a woman, she basically agrees with all the standard Republican positions, including those that are obviously oppressive of women. She voted for an abortion ban at conception, which is totally different from what Cotton wants. She even takes the bizarre confederalist view of Paul Ryan that a federal minimum wage is “big government” but a state minimum wage is just fine. The one exception is that she supports reform of sexual harassment policy in the military, probably because she experienced it herself.

But I’m supposed to be an economist, so what do I think is going to happen to the economy? (Of course, don’t forget, the economy is made of people. One of the best things that can ever happen to an economy is the empowerment of women, racial minorities, and LGBT people, all of which are now in jeopardy under a Republican Congress.)

The best-case scenario is “not much”; the obstructionism continues, and despite an utterly useless government the market repairs itself as it will always do eventually. Job growth will continue at its slow but steady pace, GDP will get back to potential trend. Inequality will continue to increase as it has been doing for about 30 years now. In a couple years there will be another election and hopefully Republicans will lose their majority.

The worst-case scenario is “Republicans get what they want”. The budget will finally be balanced—by cutting education, infrastructure, and social services. Then they’ll unbalance it again by cutting taxes on the rich and starting a couple more wars, because that kind of government spending doesn’t count. (They are weaponized Keynesians all.) They’ll restrict immigration even though immigration is what the First World needs right now (not to mention the fact that the people coming here need it even more). They’ll impose draconian regulations on abortion, they’ll stop or reverse the legalization of marijuana and same-sex marriage.

Democrats must not cave in to demands for “compromise” and “bipartisanship”. If the Republicans truly believed in those things, they wouldn’t have cost the economy $24 billion and downgraded the credit rating of the US government by their ridiculous ploy to shut down the government. They wouldn’t have refused to deal until the sequester forced nonsensical budget cuts. They wouldn’t make it a central part of their platform to undermine or repeal the universal healthcare system that they invented just so that Democrats can’t take credit for it. They have become so committed to winning political arguments at any cost that they are willing to do real harm to America and its people in order to do it. They are overcome by the tribal paradigm, and we all suffer for it.

No, the Republicans in Congress today are like 3-year-olds who throw a tantrum when they don’t get everything exactly their way. You can’t negotiate with these people, you can’t compromise with them. I wish you could, I really do. I’ve heard of days long gone when Congress actually accomplished things, but I have only vague recollections, for I was young in the Clinton era. (I do remember times under Bush II when Congress did things, but they were mostly bad things.) Maybe if we’re firm enough or persuasive enough some of them will even come around. But the worst thing Democrats could do right now is start caving to Republican demands thinking that it will restore unity to our government—because that unity would come only at the price of destroying people’s lives.

Unfortunately I fear that Democrats will appease Republicans in this way, because they’ve been doing that so far. In the campaign, hardly any of the Democrats mentioned Obama’s astonishing economic record or the numerous benefits of Obamacare—which by the way is quite popular among its users, at least more so than getting rid of it entirely (most people want to fix it, not eliminate it). Most of the Democratic candidates barely ran a campaign deserving of the name.

To be clear: Do not succumb to the tribal paradigm yourself. Do not think that everyone who votes Republican is a bad person—the vast majority are good people who were misled. Do not even assume that every Republican politician is evil; a few obviously are (see also Dick Cheney), but most are actually not so much evil as blinded by the ideology of their tribe. I believe that Paul Ryan and Rand Paul think that what they do is in the best interests of America; the problem is not their intentions but their results and their unwillingness to learn from those results. We do need to find ways to overcome partisanship and restore unity and compromise—but we must not simply bow to their demands in order to do that.

Democrats: Do not give in. Stand up for your principles. Every time you give in to their obstructionism, you are incentivizing that obstructionism. And maybe next election you could actually talk about the good things your party does for people—or the bad things their party does—instead of running away from your own party and apologizing for everything?

Is marginal productivity fair?

JDN 2456963 PDT 11:11.

The standard economic equilibrium that is the goal of any neoclassical analysis is based on margins, rather than totals; what matters is not how much you have in all, but how much you get from each new one. This may be easier to understand with specific examples: The price of a product isn’t set by the total utility that you get from using that product; it’s set by the marginal utility that you get from each new unit. The wage of a worker isn’t set by their total value to the company; it’s set by the marginal value they provide with each additional hour of work. Formally, it’s not the value of the function f(x), it’s the derivative of the function, f'(x). (If you don’t know calculus, don’t worry about that last part; it isn’t that important to understand the basic concept.)

This is the standard modern explanation for Adam Smith’s “diamond-water paradox“: Why are diamonds so much more expensive than water, even though water is much more useful? Well, we have plenty of water, so the marginal utility of water isn’t very high; what are you really going to do with that extra liter? But we don’t have a lot of diamonds, so even though diamonds in general aren’t that useful, getting an extra diamond has a lot of benefit. (The units are a bit weird, as George Stigler once used to argue that Smith’s paradox is “meaningless”; but that’s silly. Let’s fix the units at “per kilogram”; a kilogram of diamonds is far, far more expensive than a kilogram of water.)

This explanation is obviously totally wrong, by the way; that’s not why diamonds are expensive. The marginal-utility argument makes sense for cars (or at least ordinary Fords and Toyotas, for reasons you’ll see in a minute), but it doesn’t explain diamonds. Diamonds are expensive for two reasons: First, the absolutely insane monopoly power of the De Beers cartel; as you might imagine, water would be really expensive too if it were also controlled by a single cartel with the power to fix prices and crush competitors. (For awhile De Beers executives had a standing warrant for their arrest in the United States; recently they pled guilty and paid fines—because, as we all know, rich people never go to prison.) And you can clearly see how diamond prices plummeted when the cartel was weakened in the 1980s. But Smith was writing long before DeBeers, and even now that De Beers only controls 40% of the market so we have an oligopoly instead of a monopoly (it’s a step in the right direction I guess), diamonds are still far more expensive than water. The real reason why diamonds are expensive is that diamonds are a Veblen good; you don’t buy diamonds because you actually want to use diamonds (maybe once in awhile, if you want to make a diamond saw or something). You buy diamonds in order to show off how rich you are. And if your goal is to show how rich you are, higher prices are good; you want it to be really expensive, you’re more likely to buy it if it’s really expensive. That’s why the marginal utility argument doesn’t work for Porsches and Ferraris; they’re Veblen goods too. If the price of a Ferrari suddenly dropped to $10,000, people would realize pretty quickly that they are hard to maintain, have very poor suspensions, and get awful gas mileage. It’s not like you can actually drive at 150 mph without getting some serious speeding tickets. (I guess they look nice?) But if the price of a Prius dropped to $10,000, everyone would buy one. For some people diamonds are also a speculation good; they hope to buy them at one price and sell them at a higher price. This is also how most trading in the stock market works, which is why I’m dubious of how well the stock market actually supports real investment. When we’re talking about Veblen goods and speculation goods, the sky is the limit; any price that someone can pay is a price they might sell at.

But all of that is a bit tangential. It’s worth thinking about all the ways that neoclassical theory doesn’t comport with reality, all the cases where price and marginal value become unhinged. But for today I’m going to give the neoclassicists the benefit of the doubt: Suppose it were true. Suppose that markets really were perfectly efficient and everything were priced at its marginal value. Would that even be a good thing?

I tend to focus most of my arguments on why a given part of our economic system deviates from optimal efficiency, because once you can convince economists of that they are immediately willing to try to fix it. But what if we had optimal efficiency? Most economists would say that we’re done, we’ve succeeded, everything is good now. (I am suddenly reminded of the Lego song, “Everything is Awesome.”) This notion is dangerously wrong.

A system could be perfectly efficient and still be horrifically unfair. This is particularly important when we’re talking about labor markets. A diamond or a bottle of water doesn’t have feelings; it doesn’t care what price you sell it at. More importantly it doesn’t have rights. People have feelings; people have rights. (And once again I’m back to Citizens United; a rat is more of a person than any corporation. We should stop calling them “rats” and “fat cats”, for this is an insult to the rodent and feline communities. No, only a human psychopath could ever be quite so corrupt.)

Of course when you sell a product, the person selling it cares how much you pay, but that will either trace back to someone’s labor—and labor markets are still the issue—or it won’t, in which case as far as I’m concerned it really doesn’t matter. If you make money simply by owning things, our society is giving you an enormous gift simply by allowing that capital income to exist; press the issue much more and we’d be well within our rights to confiscate every dime. Unless and until capital ownership is shared across the entire population and we can use it to create a post-scarcity society, capital income will be a necessary evil at best.

So let’s talk about labor markets. If you’ve taken any economics, you have probably seen a great many diagrams like this:

supply_demand2

The red line is labor supply, the blue line is labor demand. At the intersection is our glorious efficient market equilibrium, in this case at 7.5 hours of work per day (the x-axis) and $12.50 an hour (the y-axis). The green line is the wage, $12.50 per hour. But let’s stop and think for a moment about what this diagram really means.

What decides that red labor supply line? Do people just arbitrarily decide that they’re going to work 4 hours a day if they get paid $9 an hour, but 8 hours a day if they get paid $13 an hour? No, this line is meant to represent the marginal real cost of working. It’s the monetized value of your work effort and the opportunity cost of what else you could have been doing with your time. It rises because the more hours you work, the more stress it causes you and the more of your life it takes up. Working 4 hours a day, you probably had that time available anyway. Working 8 hours a day, you can fit it in. Working 12 hours a day, now you have no leisure at all. Working 16 hours a day, now you’re having trouble fitting in basic needs like food and sleep. Working 20 hours a day, you eat at work, you don’t get enough sleep, and you’re going to burn yourself out in no time. Why is it a straight line? Because we assume linear relationships to make the math easier. (No, really; that is literally the only reason. We call them “supply and demand curves” but almost always draw and calculate them as straight lines.)

Now let’s consider the blue labor demand line. Is this how much the “job creators” see fit to bestow upon you? No, it’s the marginal value of productivity. The first hour you work each day, you are focused and comfortable, and you can produce a lot of output. The second hour you’re just a little bit fatigued, so you can produce a bit less. By the time you get to hour 8, you’re exhausted, and producing noticeably less output. And if they pushed you past 16 hours, you’d barely produce anything at all. They multiply the amount of products you produce by the price at which they can sell those products, and that’s their demand for your labor. And once again we assume it’s a straight line just to make the math easier.

From this diagram you can calculate what is called employer surplus and worker surplus. Employer surplus is basically the same thing as profit. (It’s not exactly the same for some wonky technical reasons, but for our purposes they may as well be the same.) Worker surplus is a subtler concept; it’s the amount of money you receive minus the monetized value of your cost of working. So if that first hour of work was really easy and you were willing to do it for anything over $5, we take that $5 as your monetized cost of working (your “marginal willingness-to-accept“). Then if you are being paid $12.50 an hour, we infer that you must have gained $7.50 worth of utility from that exchange. (“$7.50 of utility” is a very weird concept, for reasons I’ll get into more in a later post; but it is actually the standard means of estimating utility in neoclassical economics. That’s one of the things I hope to change, actually.)

When you add these up for all the hours worked, the result becomes an integral, which is a formal mathematical way of saying “the area between those two lines”. In this case they are triangles of equal size, so we can just use the old standby A = 1/2*b*h. The area of each triangle is 1/2*7.5*7.5 = $28.13. From each day you work, you make $28.13 in consumer surplus and your employer makes $28.13 in profit.

And that seems fair, doesn’t it? You split it right down the middle. Both of you are better off than you were, and the economic benefits are shared equally. If this were really how labor markets work, that seems like how things ought to be.

But nothing in the laws of economics says that the two areas need to be equal. We tend to draw them that way out of an aesthetic desire for symmetry. But in general they are not, and in some cases they can be vastly unequal.

This happens if we have wildly different elasticities, which is a formal term for the relative rates of change of two things. An elasticity of labor supply of 1 would mean that for a 1% increase in wage you’re willing to work 1% more hours, while an elasticity of 10 would mean that for a 1% increase in wage you’re willing to work 10% more hours. Elasticities can also be negative; a labor demand elasticity of -1 would mean that for a 1% increase in wage your employer is willing to hire you for 1% fewer hours. In the graph above, the elasticity of labor supply is exactly 1. The elasticity of labor demand varies along the curve, but at the equilibrium it is about -1.6. The fact that the profits are shared equally is related to the fact that these two elasticities are close in magnitude but opposite in sign.

But now consider this equilibrium, in which I’ve raised the labor elasticity to 10. Notice that the wage and number of hours haven’t change; it’s still 7.5 hours at $12.50 per hour. But now the profits are shared quite unequally indeed; while the employer still gets $28.13, the value for the worker is only 1/2*7.5*0.75 = $2.81. In real terms this means we’ve switched from a job that starts off easy but quickly gets harder to a job that is hard to start with but never gets much harder than that.

elastic_supply

On the other hand what if the supply elasticity is only 0.1? Now the worker surplus isn’t even a triangle; it’s a trapezoid. The area of this trapezoid is 6*12.5+1/2*1.5*12.5 = $84.38. This job starts off easy and fun—so much so that you’d do it for free—but then after 6 hours a day it quickly becomes exhausting and you need to stop.

inelastic_supply

If we had to guess what these jobs are, my suggestion is that maybe the first one is a research assistant, the second one is a garbage collector, and the third one is a video game tester. And thus, even though they are paid about the same (I think that’s true in real life? They all make about $15 an hour or $30k a year), we all agree that the video game tester job is better than the research assistant job which is better than the garbage collector job—which is exactly what the worker surplus figures are saying.

What about the demand side? Here’s where it gets really unfair. Going back to our research assistant with a supply elasticity of 1, suppose they’re not really that good a researcher. Their output isn’t wrong, but it’s also not very interesting. They can do the basic statistics, but they aren’t very creative and they don’t have a deep intuition for the subject. This might produce a demand elasticity 10 times larger. The worker surplus remains the same, but the employer surplus is much lower. The triangle has an area 1/2*7.5*0.75 = $2.81.

elastic_demand

Now suppose that they are the best research assistant ever; let’s say we have a young Einstein. Everything he touches turns to gold, but even Einstein needs his beauty sleep (he actually did sleep about 10 hours a day, which is something I’ve always been delighted to have in common with him), so the total number of work hours still caps out at 7.5. It is entirely possible for the wage equilibrium to be exactly the same as it was for the lousy researcher, making the graph look like this:

inelastic_demand

You can’t even see the top of the triangle on this scale; it’s literally off the chart. The worker had a lower bound at zero, but there’s no comparable upper bound. (I suppose you could argue the lower bound shouldn’t be there either, since there are kinds of work you’d be willing to do even if you had to pay to do them—like, well, testing video games.) The top of the triangle is actually at about $90, as it turns out, so the area of employer surplus is 1/2*(90-12.5)*7.5 = $290.63. For every day he works, the company gets almost $300, but Einstein himself only gets $28.13 after you include what it costs him to work. (His gross pay is just wage*hours of course, so that’s $93.75.) The total surplus produced is $318.76. Einstein himself only gets a measly 8.9% of that.

So here we have three research assistants, who have very different levels of productivity, getting the same pay. But isn’t pay supposed to reflect productivity? Sort of; it’s supposed to reflect marginal productivity. Because Einstein gets worn out and produces at the same level as the mediocre researcher after 7.5 hours of work, since that’s where the equilibrium is that’s what they both get paid.

Now maybe Einstein should hold back; he could exercise some monopolistic power over his amazing brain. By only offering to work 4 hours a day, he can force the company to pay him at his marginal productivity for 4 hours a day, which turns out to be $49 an hour. Now he makes a gross pay of $196, with a worker surplus of $171.

monopoly_power

This diagram is a bit harder to read, so let me walk you through it. The light red and blue lines are the same as before. The darker blue line is the marginal revenue per hour for Einstein, once he factors in the fact that working more hours will mean accepting a lower wage. The optimum for him is when that marginal revenue curve crosses his marginal cost curve, which is the red supply curve. That decides how many hours he will work, namely 4. But that’s not the wage he gets; to find that, we move up vertically along the dark red line until we get the company’s demand curve. That tells us what wage the company is willing to pay for the level of marginal productivity Einstein has at 4 hours per day of work—which is the $49 wage he ends up making shown by the dark green line. The lighter lines show what happens if we have a competitive labor market, while the darker lines show what happens if Einstein exercises monopoly power.

The company still does pretty well on this deal; they now make an employer surplus of $82. Now, of the total $253 of economic surplus being made, Einstein takes 69%. It’s his brain, so him taking most of the benefit seems fair.

But you should notice something: This result is inefficient! There’s a whole triangle between 4 and 7.5 hours that nobody is getting; it’s called the deadweight loss. In this case it is $65.76, the difference between the total surplus in the efficient equilibrium and the inefficient equilibrium. In real terms, this means that research doesn’t get done because Einstein held back in order to demand a higher wage. That’s research that should be done—its benefit exceeds its cost—but nobody is doing it. Well now, maybe that doesn’t seem so fair after all. It seems selfish of him to not do research that needs done just so he can get paid more for what he does.

If Einstein has monopoly power, he gets a fair share but the market is inefficient. Removing Einstein’s monopoly power by some sort of regulation would bring us back to efficiency, but it would give most of his share to the company instead. Neither way seems right.

How do we solve this problem? I’m honestly not sure. First of all, we rarely know the actual supply and demand elasticities, and when we do it’s generally after painstaking statistical work to determine the aggregate elasticities, which aren’t even what we’re talking about here. These are individual workers.

Notice that the problem isn’t due to imperfect information; the company knows full well that Einstein is a golden goose, but they aren’t going to pay him any more than they have to.

We could just accept it, I suppose. As long as the productive work gets done, we could shrug our shoulders and not worry about the fact that corporations are capturing most of the value from the hard work of our engineers and scientists. That seems to be the default response, perhaps because it’s the easiest. But it sure doesn’t seem fair to me.

One solution might be for the company to voluntarily pay Einstein more, or offer him some sort of performance bonus. I wouldn’t rule out this possibility entirely, but this would require the company to be unusually magnanimous. This won’t happen at most corporations. It might happen for researchers at a university, where the administrators are fellow academics. Or it might happen to a corporate executive because other corporate executives feel solidarity for their fellow corporate executives.

That sort of solidarity is most likely why competition hasn’t driven down executive salaries. Theoretically shareholders would have an incentive to choose boards of directors who are willing to work for $20 an hour and elect CEOs who are willing to work for $30 an hour; but in practice old rich White guys feel solidarity with other old rich White guys, and even if there isn’t any direct quid pro quo there is still a general sense that because we are “the same kind of people” we should all look out for each other—and that’s how you get $50 million salaries. And then of course there’s the fact that even publicly-traded companies often have a handful of shareholders who control enough of the shares to win any vote.

In some industries, we don’t need to worry about this too much because productivity probably doesn’t really vary that much; just how good can a fry cook truly be? But this is definitely an issue for a lot of scientists and engineers, particularly at entry-level positions. Some scientists are an awful lot better than other scientists, but they still get paid the same.

Much more common however is the case where the costs of working vary. Some people may have few alternatives, so their opportunity cost is low, driving their wage down; but that doesn’t mean they actually deserve a lower wage. Or they may be disabled, making it harder to work long hours; but even though they work so much harder their pay is the same, so their net benefit is much smaller. Even though they aren’t any more productive, it still seems like they should be paid more to compensate them for that extra cost of working. At the other end are people who start in a position of wealth and power; they have a high opportunity cost because they have so many other options, so it may take very high pay to attract them; but why do they deserve to be paid more just because they have more to start with?

Another option would be some sort of redistribution plan, where we tax the people who are getting a larger share and give it to those who are getting a smaller share. The problem here arises in how exactly you arrange the tax. A theoretical “lump sum tax” where we just figure out the right amount of money and say “Person A: Give $217 to person B! No, we won’t tell you why!” would be optimally efficient because there’s no way it can distort markets if nobody sees it coming; but this is not something we can actually do in the real world. (It also seems a bit draconian; the government doesn’t even tax activities, they just demand arbitrary sums of money?) We’d have to tax profits, or sales, or income; and all of these could potentially introduce distortions and make the market less efficient.

We could offer some sort of publicly-funded performance bonus, and for scientists actually we do; it’s called the Nobel Prize. If you are truly the best of the best of the best as Einstein was, you may have a chance at winning the Nobel and getting $1.5 million. But of course that has to be funded somehow, and it only works for the very very top; it doesn’t make much difference to Jane Engineer who is 20% more productive than her colleagues.

I don’t find any of these solutions satisfying. This time I really can’t offer a good solution. But I think it’s important to keep the problem in mind. It’s important to always remember that “efficient” does not mean “fair”, and being paid at marginal productivity isn’t the same as being paid for overall productivity.

 Who are the job creators?

JDN 2456956 PDT 11:30.

For about 20 years now, conservatives have opposed any economic measures that might redistribute wealth from the rich as hurting “job creators” and thereby damaging the economy. This has become so common that the phrase “job creator” has become a euphemism for “rich person”; indeed, when Paul Ryan was asked to define “rich” he stumbled over himself and ended up with “job creators”. A few years ago, John Boehner gave a speech saying that ‘the job creators are on strike’. During his presidential campaign, Mitt Romney said Obama was ‘waging war on job creators’.

If you get the impression that the “job creator” narrative is used more often now than ever, you’re not imagining things; the term was used almost as many times in a single month of Obama’s presidency than it was in George W. Bush’s entire second term.

This narrative is not just wrong; it’s utterly ludicrous. The vision seems to be something like this: Out there somewhere, beyond the view of ordinary mortals, there lives a race of beings known as Job Creators. Ours is not to judge them, not to influence them; ours is only to appease them so that they might look upon us with favor and bestow upon us our much-needed Jobs. Without these Jobs, we will surely die, and so all other concerns are secondary: We must appease the Job Creators.

Businesses don’t create jobs because they feel like it, or because they love us, or because we have gone through the appropriate appeasement rituals. They don’t create jobs because their taxes are low or because they have extra money lying around. They create jobs because they see profit in it. They create jobs because the marginal revenue of hiring an additional worker exceeds the marginal cost.

And of course they’ll gladly destroy jobs for the exact same reasons; if they think the marginal cost exceeds the marginal revenue, out come the pink slips. If demand for the product has fallen, if the raw materials have become more expensive, or if new technology has allowed some of the labor to be cheaply automated, workers will be laid off in the interests of the company. In fact, sometimes it won’t even be in the interests of the company; corporate executives are lately in the habit of using layoffs and stock buybacks to artificially boost the value of their stock options so they can exercise them, pocket the money, and run away as the company comes crashing to the ground. Because of market deregulation and the ridiculous theory of “shareholder value” (as though shareholders are the only ones who matter!), our stock market has changed from a system of value creation to a system of value extraction.

What actually creates jobs? Demand. If the demand for their product exceeds the company’s capacity to produce it, they will hire more people in order to produce more of the product. The marginal revenue has to go up, or companies will have no reason to hire new workers. (The marginal cost could also go down, but then you get low-paying jobs, which isn’t really what we’re aiming for.) They will continue hiring more people up until the point at which it costs more to hire someone than they’d make from selling the products that person could make for them.

What if they don’t have enough money? They’ll borrow it. As long as they know they are going to make a profit from that worker, they will gladly borrow money in order to hire them. Indeed, corporations do this sort of thing all the time. If banks stop lending, that’s a big problem—it’s called a credit crunchand it’s a major part of just about any financial crisis. But that isn’t because rich people don’t have enough money, it’s because our banking system is fundamentally defective and corrupt. Yes, fixing the banking system would create jobs in a number of different ways. (The biggest three I can think of: There would be more credit for real businesses to fund investment, more credit for individuals to increase demand, and labor effort that is currently wasted on useless financial speculation would be once again returned to real production.) But that’s not what Paul Ryan and his ilk are talking about—indeed, Paul Ryan seems to think that we should undo the meager reforms we’ve already made. Unless we fundamentally change the financial system, the way to create jobs would be to create demand.

And what decides demand? Well, a lot of things I suppose; preferences, technologies, cultural norms, fads, advertising, and so on. But when you’re looking at short-run changes like the business cycle, the driving factor in most cases is actually quite simple: How much money does the middle class have to spend? The middle class is where most of the consumer spending comes from, and if the middle class has money to spend we will buy products. If we don’t have money to spend—we’re out of work, or we have too much debt to pay—then we won’t buy products. It’s not that we suddenly stopped wanting products; the utility value of those products to us is unchanged. The problem is that we simply can’t afford them anymore. This is what happens in a recession: After some sort of shock to the economy, the middle class stops being able to spend, which reduces demand. That causes corporations to lay off workers, which creates unemployment, which reduces demand even further. To correct for the lost demand, prices are supposed to go down (deflation); but this doesn’t actually work, for two reasons.

First, people absolutely hate seeing their wages go down; even if there is a legitimate economic reason, people still have a sense that they are being exploited by their employers (and sometimes they are). This is called downward nominal wage rigidity.

Second, when prices go down, the real value of debt doesn’t go down; it goes up. Your loans are denominated in dollars, not apples; so reducing the price of apples means that you actually owe more apples than you did before. Since debt is usually one of the big things holding back spending by the middle class in the first place, deflation doesn’t correct the imbalance; it makes it worse. This is called debt deflation. Maybe we shouldn’t call it that, since the problem isn’t the prices, it’s the debt. In 2008, the first thing that happened wasn’t that prices in general went down, which is what we normally mean by “deflation”; it was that housing prices went down, and so suddenly people owed vastly more on their mortgages than they had before, and many of them couldn’t afford to pay. It wasn’t a drop in prices so much as a rise in the real value of debt. (I actually think one of the reasons there is no successful comprehensive theory of the cause of business cycles is that there isn’t a single comprehensive cause of business cycles. It’s usually some form of financial crisis followed by debt deflation—and these are the ones to be worried about, 1929 and 2008—but that isn’t always what happens. In 2001, we actually had an unanticipated negative real economic shock—the 9/11 attacks. In 1973 we had a different kind of real economic shock when OPEC raised oil prices at the same time as the US hit peak oil. We should probably be distinguishing between financial recession and real recession.)

Notice how in this entire discussion of what drives aggregate demand, I have never mentioned rich people getting free money; I haven’t even mentioned tax rates. If you have the simplistic view “taxes are bad” (or the totally insane, yet still common, view “taxation is slavery”), then you’re going to look for excuses to lower taxes whenever you can. If you specifically love rich people more than poor people, you’re going to look for excuses to lower taxes on the rich and raise them on the poor (and there is really no other way to interpret Mitt Romney’s infamous “47%” comments). But none of this has anything to do with aggregate demand and job creation. It is pure ideology and has no basis in economics.

Indeed, there’s little reason to think that a tax on corporate profits or capital income would change hiring decisions at all. When we talk about the potential distortions of income taxes, we really have to be talking about labor income, because labor can actually be disincentivized. Say you’re making $15 an hour and not paying any taxes, but your tax rate is suddenly raised to 40%. You can see that after taxes your real wage is now only $9, and maybe you’ll decide that it’s just not worth it to work those hours. This is because you pay a real cost to work—it’s hard, it’s stressful, it’s frustrating, it takes up time.

Capital income can’t be disincentivized. You can have relative incentives, if you tax certain kinds of capital more than others. But if you tax all capital income at the same rate, the incentives remain exactly as they were before: Seek the highest return on investment. Your only costs were financial, and your only benefits are financial. Yes, you’ll be unhappy that your after-tax return on investment has gone down; but it won’t change your investment decisions. If you previously had the choice between investment A yielding 5% return and investment B yielding a 10% return, you’d choose B. Now you pay a 40% tax on capital income; you now have a choice between a 3% real return on A and a 6% real return on B—you’re still going to choose B. That’s probably why high marginal tax rates on income don’t reduce job growth—because most high incomes are capital incomes of one form or another; even when a CEO reports ordinary income it’s really a due to profits and stock options, it’s not like he was paid a wage for work he did.

To be fair, it does get more complicated when you include borrowing and interest rates (now you have the option of lending your money at interest or borrowing more from someone else, which may be taxed differently), and because it’s so easy to move money across borders you can have a relative incentive even when tax rates within a given nation are all the same. Don’t take this literally as saying that you can do whatever you want with taxes on capital income. But in fact you can do quite a lot, because you can change the real rate of return and have no incentive effect as long as you don’t change the relative rate of return. That’s different from wages, for which the real value of the wage can have a direct effect on employers and employees. (The only way to have the same effect on workers would be to somehow lower the real cost of working—make working easier or more fun—which actually sounds like a great idea if you can do it.) The people who are constantly telling us that workers need to tighten their belts but we mustn’t dare tax the “job creators” have the whole situation exactly backwards.

There’s something else I should bring up as well. In everything I’ve said above, I have taken as given the assumption that we need jobs. For many people, probably most Americans in fact, this is an unquestioned assumption, seemingly so obvious as to be self-evident; of course we need jobs, right? But no, actually, we don’t; what we need is production and distribution of wealth. We need to make food and clothing and houses—those are truly basic needs. We could even say we “need” (or at least want) to make televisions and computers and cars. As individuals and as a society we benefit from having these goods. And in our present capitalist economy, the way that we produce and distribute goods is through a system of jobs—you are paid to make goods, and then you can use that money to buy other goods. Don’t get me wrong; this system works pretty well, and for the most part I want to make small adjustments and reforms around the edges rather than throw the whole thing out. Thus far, other systems have not worked as well; when we have attempted to centrally plan production and distribution, the best-case scenario has been inefficiency and the worst-case scenario has been mass starvation.

But we should also be open to the possibility of other systems that are better than capitalism. We should be open to the possibility of a culture like, well, The Culture (and if you haven’t read any Iain Banks novels you should; I’d probably start with Player of Games), in which artificial intelligence and automation allows central planning to finally achieve efficient production and distribution. We should be open to the possibility of a culture like the Federation (and don’t tell me you haven’t seen Star Trek!), in which resources are so plentiful that anyone can have whatever they want, and people work not because they have to, but because they want to—it gives them meaning and purpose in their lives. Fanciful? Perhaps. But lightspeed worldwide communication and landing robots on other planets would have seemed pretty fanciful a century ago.
Capitalism is really an Industrial Era system. It was designed in, and for, a world in which the most important determinants of production are machines, raw materials, and labor hours. But we don’t live in that world anymore. The most important determinants of production are now ideas; software, research, patents, copyrights. Microsoft, Google, and Amazon don’t make things at all, they make ideas; Sony, IBM, Apple, and Toshiba make things, but those things are primarily for the production and dissemination of ideas. Ideas are just as valuable as things—if not more so—but they obey different rules.

Capitalism was designed for a world of rival, excludable goods with increasing marginal cost. Rival, meaning that if one person has it, someone else can’t have it anymore. We speak of piracy as “stealing”, but that’s totally wrong; if you steal something I have, I don’t have it anymore. If you pirate something I have, I still have it. If I gave you my computer, I wouldn’t have it anymore; but I can give you the ideas in this blog post and then we’ll both have them. Excludable, meaning that there is a way to prevent someone else from getting it if you don’t want them to. And increasing marginal cost, meaning that the more you make, the more it costs to make each one. Under these conditions, you get a very nice equilibrium that is efficient under competition.

But ideas are nonrival, they have nearly zero marginal cost, and we are increasingly finding that they aren’t even very excludable; DRM is astonishingly ineffective. Under these conditions, your nice efficient equilibrium completely evaporates. There can be many different equilibria, or no equilibrium at all; and the results are almost always inefficient. We have shoehorned capitalism onto an economy that it was not designed to deal with. Capitalism was designed for the Industrial Era; but we are now in the Information Era.

Indeed, you can see this in all our neoclassical growth models: K is physical capital—machines—and L is labor, and sometimes it is augmented with N—natural resources. But these typically only explain about 50% of the variation in economic output, so we add an extra term, A, which goes by many names: “productivity”, “efficiency”, “technology”; I think the most informative one is actually “the Solow residual”. It’s the residual; it’s the part we can’t explain, dare I say, the part capitalism isn’t designed to explain. It is, in short, made of ideas. One of my thesis papers is actually about this “total factor productivity”, and how a major component of it is made up of one class of ideas in particular: Corruption. Corruption isn’t a thing, some object in space. It’s a cultural norm, a systemic idea that permeates the thoughts and actions of the whole society. It affects what we do, whom we trust, how the rules are made, and how well we follow those rules. You can even think of capitalism as an idea, a system, a culture—and a good part of “productivity” can be accounted for by “market orientation”, which is to say how capitalist a nation is. I would like to see someday a new model that actually includes these factors as terms in the equation, instead of throwing them all together in the mysterious A that we don’t understand.

With this in mind, we should be asking ourselves whether we need jobs at all, because jobs are a system designed for the production of physical goods in the Industrial Era. Now that we live in the Information Era and most of our production is in the form of ideas, do we still need jobs? Does everyone need a job? If you’re trying to make cars for a million people, it may not take a million people to do it, but it’s going to take thousands. But if you’re trying to design a car for a million people, or make a computer game about cars for a million people to play, that can be done with a lot fewer people. Ideas can be made by a few and then disseminated to the world. General Motors has 200,000 employees (and used to have about twice as many in the 1970s); Blizzard Entertainment has less than 5,000. It’s not because they produce for fewer people; GM sells about 3 million cars a year, and Starcraft sold over 11 million copies. Starcraft came out in 1998, so I added up how many cars GM sold in the US since 1998: 61 million. That’s still 3.28 employees per thousand cars sold, but only 0.45 employees per thousand computer games sold.

Still, I don’t have a detailed account of what this new jobless economic system might look like. For now, it’s probably best if people have jobs. But if we really want to create jobs, we need to increase aggregate demand. That most likely means either reducing debt or giving more money to consumers. It certainly doesn’t have anything to do with tax cuts for the rich.

And really, this is pretty obvious; if you stop and think for a minute about why businesses create jobs, you realize that it has to do with demand for products, not how nice the government treats them or how much extra cash they have laying around. I actually have trouble believing that the people who say “job creators” unironically actually believe the words they are saying. Do they honestly think that rich people create jobs out of sheer brilliance and benevolence, but are constrained by how much money they have and “go on strike” if the government doesn’t kowtow to them?

The only way I can see that they could actually believe this sort of thing would be if they read so much Ayn Rand that it totally infested their brains and rendered them incapable of thinking outside that framework. Perhaps Krugman is right, and Rand Paul really does believe that he is John Galt. Maybe they really do honestly believe that this is how economics works—in which case it’s no wonder that our economy is in trouble. Indeed, the marvel is that it works at all.