Month: December 2014

Why we give gifts

PNRJ core principles, critique of neoclassical economics , , , , ,

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!

PNRJ core principles, critique of neoclassical economics, heuristics and biases , , , , , , , , , , , , , , , , , ,

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

PNRJ public policy , , , , , , , , , , ,

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

PNRJ critique of neoclassical economics, public policy , , , , , , , , , , , , , , , , , , ,

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.