financial fraud

Why we need critical thinking

PNRJ cognitive science, core principles, education, financial fraud, politics, public policy, science and academia , , , , , , , , , , , , , , , , ,

Jul 9 JDN 2460135

I can’t find it at the moment, but awhile ago I read a surprisingly compelling post on social media (I think it was Facebook, but it could also have been Reddit) questioning the common notion that we should be teaching more critical thinking in school.

I strongly believe that we should in fact be teaching more critical thinking in school—actually I think we should replace large chunks of the current math curriculum with a combination of statistics, economics and critical thinking—but it made me realize that we haven’t done enough to defend why that is something worth doing. It’s just become a sort of automatic talking point, like, “obviously you would want more critical thinking, why are you even asking?”

So here’s a brief attempt to explain why critical thinking is something that every citizen ought to be good at, and hence why it’s worthwhile to teach it in primary and secondary school.

Critical thinking, above all, allows you to detect lies. It teaches you to look past the surface of what other people are saying and determine whether what they are saying is actually true.

And our world is absolutely full of lies.

We are constantly lied to by advertising. We are constantly lied to by spam emails and scam calls. Day in and day out, people with big smiles promise us the world, if only we will send them five easy payments of $19.99.

We are constantly lied to by politicians. We are constantly lied to by religious leaders (it’s pretty much their whole job actually).

We are often lied to by newspapers—sometimes directly and explicitly, as in fake news, but more often in subtler ways. Most news articles in the mainstream press are true in the explicit facts they state, but are missing important context; and nearly all of them focus on the wrong things—exciting, sensational, rare events rather than what’s actually important and likely to affect your life. If newspapers were an accurate reflection of genuine risk, they’d have more articles on suicide than homicide, and something like one million articles on climate change for every one on some freak accident (like that submarine full of billionaires).

We are even lied to by press releases on science, which likewise focus on new, exciting, sensational findings rather than supported, established, documented knowledge. And don’t tell me everyone already knows it; just stating basic facts about almost any scientific field will shock and impress most of the audience, because they clearly didn’t learn this stuff in school (or, what amounts to the same thing, don’t remember it). This isn’t just true of quantum physics; it’s even true of economics—which directly affects people’s lives.

Critical thinking is how you can tell when a politician has distorted the views of his opponent and you need to spend more time listening to that opponent speak. Critical thinking could probably have saved us from electing Donald Trump President.

Critical thinking is how you tell that a supplement which “has not been evaluated by the FDA” (which is to say, nearly all of them) probably contains something mostly harmless that maybe would benefit you if you were deficient in it, but for most people really won’t matter—and definitely isn’t something you can substitute for medical treatment.

Critical thinking is how you recognize that much of the history you were taught as a child was a sanitized, simplified, nationalist version of what actually happened. But it’s also how you recognize that simply inverting it all and becoming the sort of anti-nationalist who hates your own country is at least as ridiculous. Thomas Jefferson was both a pioneer of democracy and a slaveholder. He was both a hero and a villain. The world is complicated and messy—and nothing will let you see that faster than critical thinking.


Critical thinking tells you that whenever a new “financial innovation” appears—like mortgage-backed securities or cryptocurrency—it will probably make obscene amounts of money for a handful of insiders, but will otherwise be worthless if not disastrous to everyone else. (And maybe if enough people had good critical thinking skills, we could stop the next “innovation” from getting so far!)

More widespread critical thinking could even improve our job market, as interviewers would no longer be taken in by the candidates who are best at overselling themselves, and would instead pay more attention to the more-qualified candidates who are quiet and honest.

In short, critical thinking constitutes a large portion of what is ordinarily called common sense or wisdom; some of that simply comes from life experience, but a great deal of it is actually a learnable skill set.

Of course, even if it can be learned, that still raises the question of how it can be taught. I don’t think we have a sound curriculum for teaching critical thinking, and in my more cynical moments I wonder if many of the powers that be like it that way. Knowing that many—not all, but many—politicians make their careers primarily from deceiving the public, it’s not so hard to see why those same politicians wouldn’t want to support teaching critical thinking in public schools. And it’s almost funny to me watching evangelical Christians try to justify why critical thinking is dangerous—they come so close to admitting that their entire worldview is totally unfounded in logic or evidence.

But at least I hope I’ve convinced you that it is something worthwhile to know, and that the world would be better off if we could teach it to more people.

Cryptocurrency and its failures

PNRJ core principles, current events, ethics, financial advice, financial fraud, futurism, inequality, market failure, politics, public policy , , , , , ,

Jan 30 JDN 2459620

It started out as a neat idea, though very much a solution in search of a problem. Using encryption, could we decentralize currency and eliminate the need for a central bank?

Well, it’s been a few years now, and we have now seen how well that went. Bitcoin recently crashed, but it has always been astonishingly volatile. As a speculative asset, such volatility is often tolerable—for many, even profitable. But as a currency, it is completely unbearable. People need to know that their money will be a store of value and a medium of exchange—and something that changes price one minute to the next is neither.

Some of cryptocurrency’s failures have been hilarious, like the ill-fated island called [yes, really] “Cryptoland”, which crashed and burned when they couldn’t find any investors to help them buy the island.

Others have been darkly comic, but tragic in their human consequences. Chief among these was the failed attempt by El Salvador to make Bitcoin an official currency.

At the time, President Bukele justified it by an economically baffling argument: Total value of all Bitcoin in the world is $680 billion, therefore if even 1% gets invested in El Salvador, GDP will increase by $6.8 billion, which is 25%!

First of all, that would only happen if 1% of all Bitcoin were invested in El Salvador each year—otherwise you’re looking at a one-time injection of money, not an increase in GDP.

But more importantly, this is like saying that the total US dollar supply is $6 trillion, (that’s physically cash; the actual money supply is considerably larger) so maybe by dollarizing your economy you can get 1% of that—$60 billion, baby! No, that’s not how any of this works. Dollarizing could still be a good idea (though it didn’t go all that well in El Salvador), but it won’t give you some kind of share in the US economy. You can’t collect dividends on US GDP.

It’s actually good how El Salvador’s experiment in bitcoin failed: Nobody bought into it in the first place. They couldn’t convince people to buy government assets that were backed by Bitcoin (perhaps because the assets were a strictly worse deal than just, er, buying Bitcoin). So the human cost of this idiotic experiment should be relatively minimal: It’s not like people are losing their homes over this.

That is, unless President Bukele doubles down, which he now appears to be doing. Even people who are big fans of cryptocurrency are unimpressed with El Salvador’s approach to it.

It would be one thing if there were some stable cryptocurrency that one could try pegging one’s national currency to, but there isn’t. Even so-called stablecoins are generally pegged to… regular currencies, typically the US dollar but also sometimes the Euro or a few other currencies. (I’ve seen the Australian Dollar and the Swiss Franc, but oddly enough, not the Pound Sterling.)

Or a country could try issuing its own cryptocurrency, as an all-digital currency instead of one that is partly paper. It’s not totally clear to me what advantages this would have over the current system (in which most of the money supply is bank deposits, i.e. already digital), but it would at least preserve the key advantage of having a central bank that can regulate your money supply.

But no, President Bukele decided to take an already-existing cryptocurrency, backed by nothing but the whims of the market, and make it legal tender. Somehow he missed the fact that a currency which rises and falls by 10% in a single day is generally considered bad.

Why? Is he just an idiot? I mean, maybe, though Bukele’s approval rating is astonishingly high. (And El Salvador is… mostly democratic. Unlike, say, Putin’s, I think these approval ratings are basically real.) But that’s not the only reason. My guess is that he was gripped by the same FOMO that has gripped everyone else who evangelizes for Bitcoin. The allure of easy money is often irresistible.

Consider President Bukele’s position. You’re governing a poor, war-torn country which has had economic problems of various types since its founding. When the national currency collapsed a generation ago, the country was put on the US dollar, but that didn’t solve the problem. So you’re looking for a better solution to the monetary doldrums your country has been in for decades.

You hear about a fancy new monetary technology, “cryptocurrency”, which has all the tech people really excited and seems to be making tons of money. You don’t understand a thing about it—hardly anyone seems to, in fact—but you know that people with a lot of insider knowledge of technology and finance are really invested in it, so it seems like there must be something good here. So, you decide to launch a program that will convert your country’s currency from the US dollar to one of these new cryptocurrencies—and you pick the most famous one, which is also extremely valuable, Bitcoin.

Could cryptocurrencies be the future of money, you wonder? Could this be the way to save your country’s economy?

Despite all the evidence that had already accumulated that cryptocurrency wasn’t working, I can understand why Bukele would be tempted by that dream. Just as we’d all like to get free money without having to work, he wanted to save his country’s economy without having to implement costly and unpopular reforms.

But there is no easy money. Not really. Some people get lucky; but they ultimately benefit from other people’s hard work.

The lesson here is deeper than cryptocurrency. Yes, clearly, it was a dumb idea to try to make Bitcoin a national currency, and it will get even dumber if Bukele really does double down on it. But more than that, we must all resist the lure of easy money. If it sounds too good to be true, it probably is.

Finance is the commodification of trust

PNRJ core principles, ethics, financial fraud, public policy , , , , , , ,

Jul 18 JDN 2459414

What is it about finance?

Why is it that whenever we have an economic crisis, it seems to be triggered by the financial industry? Why has the dramatic rise in income and wealth inequality come in tandem with a rise in finance as a proportion of our economic output? Why are so many major banks implicated in crimes ranging from tax evasion to money laundering for terrorists?

In other words, why are the people who run our financial industry such utter scum? What is it about finance that it seems to attract the very worst people on Earth?

One obvious answer is that it is extremely lucrative: Incomes in the financial industry are higher than almost any other industry. Perhaps people who are particularly unscrupulous are drawn to the industries that make the most money, and don’t care about much else. But other people like making money too, so this is far from a full explanation. Indeed, incomes for physicists are comparable to those of Wall Street brokers, yet physicists rarely seem to be implicated in mass corruption scandals.

I think there is a deeper reason: Finance is the commodification of trust.

Many industries sell products, physical artifacts like shirts or televisions. Others sell services like healthcare or auto repair, which involve the physical movement of objects through space. Information-based industries are a bit different—what a software developer or an economist sells isn’t really a physical object moving through space. But then what they are selling is something more like knowledge—information that can be used to do useful things.

Finance is different. When you make a loan or sell a stock, you aren’t selling a thing—and you aren’t really doing a thing either. You aren’t selling information, either. You’re selling trust. You are making money by making promises.

Most people are generally uncomfortable with the idea of selling promises. It isn’t that we’d never do it—but we’re reluctant to do it. We try to avoid it whenever we can. But if you want to be successful in finance, you can’t have that kind of reluctance. To succeed on Wall Street, you need to be constantly selling trust every hour of every day.

Don’t get me wrong: Certain kinds of finance are tremendously useful, and we’d be much worse off without them. I would never want to get rid of government bonds, auto loans or home mortgages. I’m actually pretty reluctant to even get rid of student loans, despite the large personal benefits I would get if all student loans were suddenly forgiven. (I would be okay with a system like Elizabeth Warren’s proposal, where people with college degrees pay a surtax that supports free tuition. The problem with most proposals for free college is that they make people who never went to college pay for those who did, and that seems unfair and regressive to me.)

But the Medieval suspicion against “usury“—the notion that there is something immoral about making money just from having money and making promises—isn’t entirely unfounded. There really is something deeply problematic about a system in which the best way to get rich is to sell commodified packages of trust, and the best way to make money is to already have it.

Moreover, the more complex finance gets, the more divorced it becomes from genuinely necessary transactions, and the more commodified it becomes. A mortgage deal that you make with a particular banker in your own community isn’t particularly commodified; a mortgage that is sliced and redistributed into mortgage-backed securities that are sold anonymously around the world is about as commodified as anything can be. It’s rather like the difference between buying a bag of apples from your town farmers’ market versus ordering a barrel of apple juice concentrate. (And of course the most commodified version of all is the financial one: buying apple juice concentrate futures.)

Commodified trust is trust that has lost its connection to real human needs. Those bankers who foreclosed on thousands of mortgages (many of them illegally) weren’t thinking about the people they were making homeless—why would they, when for them those people have always been nothing more than numbers on a spreadsheet? Your local banker might be willing to work with you to help you keep your home, because they see you as a person. (They might not for various reasons, but at least they might.) But there’s no reason for HSBC to do so, especially when they know that they are so rich and powerful they can get away with just about anything (have I mentioned money laundering for terrorists?).

I don’t think we can get rid of finance. We will always need some mechanism to let people who need money but don’t have it borrow that money from people who have it but don’t need it, and it makes sense to have interest charges to compensate lenders for the time and risk involved.

Yet there is much of finance we can clearly dispense with. Credit default swaps could simply be banned, and we’d gain much and lose little. Credit default swaps are basically unregulated insurance, and there’s no reason to allow that. If banks need insurance, they can buy the regulated kind like everyone else. Those regulations are there for a reason. We could ban collateralized debt obligations and similar tranche-based securities, again with far more benefit than harm. We probably still need stocks and commodity futures, and perhaps also stock options—but we could regulate their sale considerably more, particularly with regard to short-selling. Banking should be boring.

Some amount of commodification may be inevitable, but clearly much of what we currently have could be eliminated. In particular, the selling of loans should simply be banned. Maybe even your local banker won’t ever really get to know you or care about you—but there’s no reason we have to allow them to sell your loan to some bank in another country that you’ve never even heard of. When you make a deal with a bank, the deal should be between you and that bank—not potentially any bank in the world that decides to buy the contract at any point in the future. Maybe we’ll always be numbers on spreadsheets—but at least we should be able to choose whose spreadsheets.

If banks want more liquidity, they can borrow from other banks—themselves, taking on the risk themselves. A lending relationship is built on trust. You are free to trust whomever you choose; but forcing me to trust someone I’ve never met is something you have no right to do.

In fact, we might actually be able to get rid of banks—credit unions have a far cleaner record than banks, and provide nearly all of the financial services that are genuinely necessary. Indeed, if you’re considering getting an auto loan or a home mortgage, I highly recommend you try a credit union first.

For now, we can’t simply get rid of banks—we’re too dependent on them. But we could at least acknowledge that banks are too powerful, they get away with far too much, and their whole industry is founded upon practices that need to be kept on a very tight leash.

Why is cryptocurrency popular?

PNRJ financial advice, financial fraud, futurism, heuristics and biases, market failure, public policy , , , , , , , , , , , , ,

May 30 JDN 2459365

At the time of writing, the price of most cryptocurrencies has crashed, likely due to a ban on conventional banks using cryptocurrency in China (though perhaps also due to Elon Musk personally refusing to accept Bitcoin at his businesses). But for all I know by the time this post goes live the price will surge again. Or maybe they’ll crash even further. Who knows? The prices of popular cryptocurrencies have been extremely volatile.

This post isn’t really about the fluctuations of cryptocurrency prices. It’s about something a bit deeper: Why are people willing to put money into cryptocurrencies at all?

The comparison is often made to fiat currency: “Bitcoin isn’t backed by anything, but neither is the US dollar.”

But the US dollar is backed by something: It’s backed by the US government. Yes, it’s not tradeable for gold at a fixed price, but so what? You can use it to pay taxes. The government requires it to be legal tender for all debts. There are certain guaranteed exchange rights built into the US dollar, which underpin the value that the dollar takes on in other exchanges. Moreover, the US Federal Reserve carefully manages the supply of US dollars so as to keep their value roughly constant.

Bitcoin does not have this (nor does Dogecoin, or Etherium, or any of the other hundreds of lesser-known cryptocurrencies). There is no central bank. There is no government making them legal tender for any debts at all, let alone all of them. Nobody collects taxes in Bitcoin.

And so, because its value is untethered, Bitcoin’s price rises and falls, often in huge jumps, more or less randomly. If you look all the way back to when it was introduced, Bitcoin does seem to have an overall upward price trend, but this honestly seems like a statistical inevitability: If you start out being worthless, the only way your price can change is upward. While some people have become quite rich by buying into Bitcoin early on, there’s no particular reason to think that it will rise in value from here on out.

Nor does Bitcoin have any intrinsic value. You can’t eat it, or build things out of it, or use it for scientific research. It won’t even entertain you (unless you have a very weird sense of entertainment). Bitcoin doesn’t even have “intrinsic value” the way gold does (which is honestly an abuse of the term, since gold isn’t actually especially useful): It isn’t innately scarce. It was made scarce by its design: Through the blockchain, a clever application of encryption technology, it was made difficult to generate new Bitcoins (called “mining”) in an exponentially increasing way. But the decision of what encryption algorithm to use was utterly arbitrary. Bitcoin mining could just as well have been made a thousand times easier or a thousand times harder. They seem to have hit a sweet spot where they made it just hard enough that it make Bitcoin seem scarce while still making it feel feasible to get.

We could actually make a cryptocurrency that does something useful, by tying its mining to a genuinely valuable pursuit, like analyzing scientific data or proving mathematical theorems. Perhaps I should suggest a partnership with Folding@Home to make FoldCoin, the crypto coin you mine by folding proteins. There are some technical details there that would be a bit tricky, but I think it would probably be feasible. And then at least all this computing power would accomplish something, and the money people make would be to compensate them for their contribution.

But Bitcoin is not useful. No institution exists to stabilize its value. It constantly rises and falls in price. Why do people buy it?

In a word, FOMO. The fear of missing out. People buy Bitcoin because they see that a handful of other people have become rich by buying and selling Bitcoin. Bitcoin symbolizes financial freedom: The chance to become financially secure without having to participate any longer in our (utterly broken) labor market.

In this, volatility is not a bug but a feature: A stable currency won’t change much in value, so you’d only buy into it because you plan on spending it. But an unstable currency, now, there you might manage to get lucky speculating on its value and get rich quick for nothing. Or, more likely, you’ll end up poorer. You really have no way of knowing.

That makes cryptocurrency fundamentally like gambling. A few people make a lot of money playing poker, too; but most people who play poker lose money. Indeed, those people who get rich are only able to get rich because other people lose money. The game is zero-sum—and likewise so is cryptocurrency.

Note that this is not how the stock market works, or at least not how it’s supposed to work (sometimes maybe). When you buy a stock, you are buying a share of the profits of a corporation—a real, actual corporation that produces and sells goods or services. You’re (ostensibly) supplying capital to fund the operations of that corporation, so that they might make and sell more goods in order to earn more profit, which they will then share with you.

Likewise when you buy a bond: You are lending money to an institution (usually a corporation or a government) that intends to use that money to do something—some real actual thing in the world, like building a factory or a bridge. They are willing to pay interest on that debt in order to get the money now rather than having to wait.

Initial Coin Offerings were supposed to be away to turn cryptocurrency into a genuine investment, but at least in their current virtually unregulated form, they are basically indistinguishable from a Ponzi scheme. Unless the value of the coin is somehow tied to actual ownership of the corporation or shares of its profits (the way stocks are), there’s nothing to ensure that the people who buy into the coin will actually receive anything in return for the capital they invest. There’s really very little stopping a startup from running an ICO, receiving a bunch of cash, and then absconding to the Cayman Islands. If they made it really obvious like that, maybe a lawsuit would succeed; but as long as they can create even the appearance of a good-faith investment—or even actually make their business profitable!—there’s nothing forcing them to pay a cent to the owners of their cryptocurrency.

The really frustrating thing for me about all this is that, sometimes, it works. There actually are now thousands of people who made decisions that by any objective standard were irrational and irresponsible, and then came out of it millionaires. It’s much like the lottery: Playing the lottery is clearly and objectively a bad idea, but every once in awhile it will work and make you massively better off.

It’s like I said in a post about a year ago: Glorifying superstars glorifies risk. When a handful of people can massively succeed by making a decision, that makes a lot of other people think that it was a good decision. But quite often, it wasn’t a good decision at all; they just got spectacularly lucky.

I can’t exactly say you shouldn’t buy any cryptocurrency. It probably has better odds than playing poker or blackjack, and it certainly has better odds than playing the lottery. But what I can say is this: It’s about odds. It’s gambling. It may be relatively smart gambling (poker and blackjack are certainly a better idea than roulette or slot machines), with relatively good odds—but it’s still gambling. It’s a zero-sum high-risk exchange of money that makes a few people rich and lots of other people poorer.

With that in mind, don’t put any money into cryptocurrency that you couldn’t afford to lose at a blackjack table. If you’re looking for something to seriously invest your savings in, the answer remains the same: Stocks. All the stocks.

I doubt this particular crash will be the end for cryptocurrency, but I do think it may be the beginning of the end. I think people are finally beginning to realize that cryptocurrencies are really not the spectacular innovation that they were hyped to be, but more like a high-tech iteration of the ancient art of the Ponzi scheme. Maybe blockchain technology will ultimately prove useful for something—hey, maybe we should actually try making FoldCoin. But the future of money remains much as it has been for quite some time: Fiat currency managed by central banks.

What happened with GameStop?

PNRJ critique of neoclassical economics, current events, ethics, financial fraud, inequality, market failure, public policy , , , , , , ,

Feb 7 JDN 2459253

No doubt by now you’ve heard about the recent bubble in GameStop stock that triggered several trading stops, nearly destroyed a hedge fund, and launched a thousand memes. What really strikes me about this whole thing is how ordinary it is: This is basically the sort of thing that happens in our financial markets all the time. So why are so many people suddenly paying so much attention to it?

There are a few important ways this is unusual: Most importantly, the bubble was triggered by a large number of middle-class people investing small amounts, rather than by a handful of billionaires or hedge funds. It’s also more explicitly collusive than usual, with public statements in writing about what stocks are being manipulated rather than hushed whispers between executives at golf courses. Partly as a consequence of these, the response from the government and the financial industry has been quite different as well, trying to halt trading and block transactions in a way that they would never do if the crisis had been caused by large financial institutions.

If you’re interested in the technical details of what happened, what a short squeeze is and how it can make a hedge fund lose enormous amounts of money unexpectedly, I recommend this summary by KQED. But the gist of it is simple enough: Melvin Capital placed huge bets that GameStop stock would fall in price, and a coalition of middle-class traders coordinated on Reddit to screw them over by buying a bunch of GameStop stock and driving up the price. It worked, and now Melvin Capital lost something on the order of $3-5 billion in just a few days.

The particular kind of bet they placed is called a short, and it’s a completely routine practice on Wall Street despite the fact that I could never quite understand why it is a thing that should be allowed.

The essence of a short is quite simple: When you short, you are selling something you don’t own. You “borrow” it (it isn’t really even borrowing), and then sell it to someone else, promising to buy it back and return it to where you borrowed it from at some point in the future. This amounts to a bet that the price will decline, so that the price at which you buy it is lower than the price at which you sold it.

Doesn’t that seem like an odd thing to be allowed to do? Normally you can’t sell something you have merely borrowed. I can’t borrow a car and then sell it; car title in fact exists precisely to prevent this from happening. If I were to borrow your coat and then sell it to a thrift store, I’d have committed larceny. It’s really quite immaterial whether I plan to buy it back afterward; in general we do not allow people to sell things that they do not own.

Now perhaps the problem is that when I borrow your coat or your car, you expect me to return that precise object—not a similar coat or a car of equivalent Blue Book value, but your coat or your car. When I borrow a share of GameStop stock, no one really cares whether it is that specific share which I return—indeed, it would be almost impossible to even know whether it was. So in that way it’s a bit like borrowing money: If I borrow $20 from you, you don’t expect me to pay back that precise $20 bill. Indeed you’d be shocked if I did, since presumably I borrowed it in order to spend it or invest it, so how would I ever get it back?

But you also don’t sell money, generally speaking. Yes, there are currency exchanges and money-market accounts; but these are rather exceptional cases. In general, money is not bought and sold the way coats or cars are.

What about consumable commodities? You probably don’t care too much about any particular banana, sandwich, or gallon of gasoline. Perhaps in some circumstances we might “loan” someone a gallon of gasoline, intending them to repay us at some later time with a different gallon of gasoline. But far more likely, I think, would be simply giving a friend a gallon of gasoline and then not expecting any particular repayment except perhaps a vague offer of providing a similar favor in the future. I have in fact heard someone say the sentence “Can I borrow your sandwich?”, but it felt very odd when I heard it. (Indeed, I responded something like, “No, you can keep it.”)

And in order to actually be shorting gasoline (which is a thing that you, too, can do, perhaps even right now, if you have a margin account on a commodities exchange), it isn’t enough to borrow a gallon with the expectation of repaying a different gallon; you must also sell that gallon you borrowed. And now it seems very odd indeed to say to a friend, “Hey, can I borrow a gallon of gasoline so that I can sell it to someone for a profit?”

The usual arguments for why shorting should be allowed are much like the arguments for exotic financial instruments in general: “Increase liquidity”, “promote efficient markets”. These arguments are so general and so ubiquitous that they essentially amount to the strongest form of laissez-faire: Whatever Wall Street bankers feel like doing is fine and good and part of what makes American capitalism great.

In fact, I was never quite clear why margin accounts are something we decided to allow; margin trading is inherently high-leverage and thus inherently high-risk. Borrowing money in order to arbitrage financial assets doesn’t just seem like a very risky thing to do, it has been one way or another implicated in virtually every financial crisis that has ever occurred. It would be an exaggeration to say that leveraged arbitrage is the one single cause of financial crises, but it would be a shockingly small exaggeration. I think it absolutely is fair to say that if leveraged arbitrage did not exist, financial crises would be far rarer and further between.

Indeed, I am increasingly dubious of the whole idea of allowing arbitrage in general. Some amount of arbitrage may be unavoidable; there may always be people people who see that prices are different for the same item in two different markets, and then exploit that difference before anyone can stop them. But this is a bit like saying that theft is probably inevitable: Yes, every human society that has had a system of property ownership (which is most of them—even communal hunter-gatherers have rules about personal property), has had some amount of theft. That doesn’t mean there is nothing we can do to reduce theft, or that we should simply allow theft wherever it occurs.

The moral argument against arbitrage is straightforward enough: You’re not doing anything. No good is produced; no service is provided. You are making money without actually contributing any real value to anyone. You just make money by having money. This is what people in the Middle Ages found suspicious about lending money at interest; but lending money actually is doing something—sometimes people need more money than they have, and lending it to them is providing a useful service for which you deserve some compensation.

A common argument economists make is that arbitrage will make prices more “efficient”, but when you ask them what they mean by “efficient”, the answer they give is that it removes arbitrage opportunities! So the good thing about arbitrage is that it stops you from doing more arbitrage?

And what if it doesn’t stop you? Many of the ways to exploit price gaps (particularly the simplest ones like “where it’s cheap, buy it; where it’s expensive, sell it”) will automatically close those gaps, but it’s not at all clear to me that all the ways to exploit price gaps will necessarily do so. And even if it’s a small minority of market manipulation strategies that exploit gaps without closing them, those are precisely the strategies that will be most profitable in the long run, because they don’t undermine their own success. Then, left to their own devices, markets will evolve to use such strategies more and more, because those are the strategies that work.

That is, in order for arbitrage to be beneficial, it must always be beneficial; there must be no way to exploit price gaps without inevitably closing those price gaps. If that is not the case, then evolutionary pressure will push more and more of the financial system toward using methods of arbitrage that don’t close gaps—or even exacerbate them. And indeed, when you look at how ludicrously volatile and crisis-prone our financial system has become, it sure looks an awful lot like an evolutionary equilibrium where harmful arbitrage strategies have evolved to dominate.

A world where arbitrage actually led to efficient pricing would be a world where the S&P 500 rises a steady 0.02% per day, each and every day. Maybe you’d see a big move when there was actually a major event, like the start of a war or the invention of a vaccine for a pandemic. You’d probably see a jump up or down of a percentage point or two with each quarterly Fed announcement. But daily moves of even five or six percentage points would be a very rare occurrence—because the real expected long-run aggregate value of the 500 largest publicly-traded corporations in America is what the S&P 500 is supposed to represent, and that is not a number that should change very much very often. The fact that I couldn’t really tell you what that number is without multi-trillion-dollar error bars is so much the worse for anyone who thinks that financial markets can somehow get it exactly right every minute of every day.

Moreover, it’s not hard to imagine how we might close price gaps without simply allowing people to exploit them. There could be a bunch of economists at the Federal Reserve whose job it is to locate markets where there are arbitrage opportunities, and then a bundle of government funds that they can allocate to buying and selling assets in order to close those price gaps. Any profits made are received by the treasury; any losses taken are borne by the treasury. The economists would get paid a comfortable salary, and perhaps get bonuses based on doing a good job in closing large or important price gaps; but there is no need to give them even a substantial fraction of the proceeds, much less all of it. This is already how our money supply is managed, and it works quite well, indeed obviously much better than an alternative with “skin in the game”: Can you imagine the dystopian nightmare we’d live in if the Chair of the Federal Reserve actually received even a 1% share of the US money supply? (Actually I think that’s basically what happened in Zimbabwe: The people who decided how much money to print got to keep a chunk of the money that was printed.)

I don’t actually think this GameStop bubble is all that important in itself. A decade from now, it may be no more memorable than Left Shark or the Macarena. But what is really striking about it is how little it differs from business-as-usual on Wall Street. The fact that a few million Redditors can gather together to buy a stock “for the lulz” or to “stick it to the Man” and thereby bring hedge funds to their knees is not such a big deal in itself, but it is symptomatic of much deeper structural flaws in our financial system.

Several of the world’s largest banks are known to have committed large-scale fraud. Why have we done so little about it?

PNRJ core principles, current events, ethics, financial fraud , , , , , , , , , , , , ,

July 16, JDN 2457951

In 2014, JPMorgan Chase paid a settlement of $614 million for fraudulent mortgage lending contributing to the crisis; but this was spare change compared to the $16.5 billion Bank of America paid in settlements for their fradulent mortgages.

In 2015, Citibank paid $700 million in restitution and $35 million in penalties for fraudulent advertising of “payment protection” services.

In 2016, Wells Fargo paid $190 in settlements for defrauding their customers with fake accounts.

Even PayPal has paid $25 million in settlements over abuses of their “PayPal Credit” system.
In 2016, Goldman Sachs paid $5.1 billion in settlements over their fraudulent sales of mortgage-backed securities.
But the worst offender of course is HSBC, which has paid $2.5 billion in settlements over fraud, as well as $1.9 billion in settlements for laundering money for terrorists. The US Justice Department has kept their money-laundering protections classified because they’re so bad that simply revealing them to the public could result in vast amounts of criminal abuse.
These are some of the world’s largest banks. JPMorgan Chase alone owns 8.0% of all investment banking worldwide; Goldman Sachs owns 6.6%; Citi owns 4.9%; Wells Fargo 2.5%; and HSBC 1.8%. That means that between them, these five corporations—all proven to have engaged in large-scale fraud—own almost one-fourth of all the world’s investment banking assets.

What shocks me the most about this is that hardly anyone seems to care. It’s seen as “normal”, as “business as usual” that a quarter of the world’s investment banking system is owned by white-collar criminals. When the issue is even brought up, often the complaint seems to be that the government is being somehow overzealous. The Economist even went so far as to characterize the prosecution of Wall Street fraud as a “shakedown”. Apparently the idea that our world’s most profitable companies shouldn’t be able to launder money for terrorists is just ridiculous. These are rich people; you expect them to follow rules? What is this, some kind of democracy?

Is this just always how it has been? Has corruption always been so thoroughly infused with finance that we don’t even know how to separate them? Has the oligarchy of the top 0.01% become so strong that we can’t even bring ourselves to challenge them when they commit literal treason? For, in case you’ve forgotten, that is what money-laundering for terrorists is: HSBC gave aid and comfort to the enemies of the free world. Like “freedom” and “terrorism”, the word “treason” has been so overused that we begin to forget its meaning; but one of the groups that HSBC gladly loaned money to is an organization that has financed Hezbollah and Al-Qaeda. These are people that American and British soldiers have died fighting against, and when a British bank was found colluding with them, the penalty was… a few weeks of profits, no personal responsibility, and not a single day of prison time. The settlement was in fact less than the profits gained from the criminal enterprise, so this wasn’t even a fine; it was a tax. Our response to treason was to impose a tax.

And this of course was not the result of some newfound leniency in American government in general. No, we are still the nation that imprisons 700 out of every 100,000 people, the nation with more prisoners than any other nation on Earth. Our police officers still kill young Black men with impunity, including at least three dozen unarmed Black men every year, many of them for no apparent reason at all. (The precise number is still unknown, as the police refuse to keep an official database of all the citizens they kill.) Decades of “law and order” politicians promising to stop the “rising crime” (that is actually falling) have made the United States very close to a police state, especially in poor neighborhoods that are primarily inhabited by Black and Hispanic people. We don’t even have an especially high crime rate, except for gun homicides (and that because we have so many guns, also more than any other nation on Earth). We are, if anything, an especially vindictive society, cruel, unforgiving, and violent towards those we perceive as transgressors.

Except, that is, when the criminals are rich. Even the racial biases seem to go away in such circumstances; there is no reasonable doubt as to the guilt of O.J. Simpson or Bill Cosby, but Simpson only ended up in prison years later on a completely unrelated offense, and after Cosby’s mistrial it’s unclear if he’ll ever see any prison time. I don’t see how either man could have been less punished for his crimes had he been White; but can anyone seriously doubt that both men would be punished more had they not been rich?

I do not think that capitalism is an irredeemable system. I think that, in themselves, free markets are very useful, and we should not remove or restrict them unnecessarily. But capitalism isn’t supposed to be a system where the rich can do whatever they want and the poor have to accept it. Capitalism is supposed to be a system where everyone is free to do as they choose, unless they are harming others—and the rules are supposed to be the same for everyone. A free market is not one where you can buy the right to take away other people’s freedom.

Is this just some utopian idealism? It would surely be utopian to imagine a world where fraud never happens, that much is true. Someone, somewhere, will always be defrauding someone else. But a world where fraud is punished most of the time? Where our most powerful institutions are still subject to the basic rule of law? Is that a pipe dream as well?

What you can do to protect against credit card fraud

PNRJ financial advice, financial fraud, public policy , , , , , , ,

JDN 2457923

This is the second post in my ongoing series on financial fraud, but it’s also some useful personal financial advice. One of the most common forms of fraud, which I have experienced, and most Americans will experience at some point in their lives, is credit card fraud. The US leads the world in credit card fraud, accounting for 47% of all money stolen by this means. In most countries credit card fraud is declining, but not here.

The good news is that there are several things you can do to reduce both the probability of being victimized and the harm you will suffer if you are. I am of course not the first to make such recommendations; similar lists have been made by the Wall Street Journal, Consumer Reports, and even the FTC itself.

1. The first and simplest is to use fewer credit cards.

It is a good idea to have at least one credit card, because you can build a credit history this way which will help you get larger loans such as car loans and home loans later. The best thing to do is to use it for regular purchases and then pay it off as quickly as you can. The higher the interest rate, the more imperative it is to pay it quickly.

More credit cards means that you have more to keep track of, and more that can be stolen; it also generally means that you have larger total credit limits, which is a mixed blessing at best. You have more liquidity that way, to buy things you need; but you also have more temptation to buy things you don’t actually need, and more risk of losing a great deal should any of your cards be stolen.

2. Buy fewer things online, and always from reputable merchants.

This is one I certainly preach more than I practice; I probably buy as much online now as I do in person. It’s hard to beat the combination of higher convenience, wider selection, and lower prices. But buying online is the most likely way to have your credit card stolen (and it is certainly how mine was stolen a few years ago).

The US is unusual among developed countries because we still mainly use magnetic-strip cards, whereas most countries have switched to the EMV system of chip-based cards that provide more security. But this security measure is really quite overrated; it can’t protect against “card not present” fraud, which is by far the most common. Unless and until you can somehow link up the encrypted chips to your laptop in order to use them to pay online, the chips will do little to protect against fraud.

3. Monitor your bank and credit card statements regularly.

This is something you should be doing anyway. Online statements are available from just about every major bank and credit union, and you can check them at any time, any day. Watching these online statements will help you keep track of your spending, manage your budget, and, yes, protect against fraud, because the sooner you see and report a suspicious transaction the more likely you are to recover the money.

4. Use secure passwords, don’t re-use passwords, and use a secure password manager.

Most people still use remarkably insecure passwords for their online accounts. Hacking your online accounts —especially your online retail accounts, like Amazon—typically means being able to steal your credit cards. As we move into the cyberpunk future, personal security will increasingly be coextensive with online security, and until we find something better, that means good passwords.

Passwords should be long, complicated, and not easily tied to anything about you. To remember them, I highly recommend the following technique: Write a sentence of several words, and then convert the words of that sentence into letters and numbers. For example (obviously don’t use this particular example; the whole point is for passwords to be unique), the sentence “Passwords should be long, complicated, and not easily tied to anything about you.” could become the password “Psblcanet2aau”.

Human long-term memory is encoded in something very much like narrative, so you can make a password much more memorable by making it tell a story. (Literally a story if you like: “Once upon a time, in a land far away, there were seven dwarves who lived in a forest.” could form the password “1uatialfatw7dwliaf”.) If you used the whole words, it would be far too long to fit in most password systems; but by condensing it into letters, you keep it memorable while allowing it to fit. The first letters of English words are not quite random—some letters are much more common than others, for example—but as long as the password is long enough this doesn’t make it substantially easier to guess.

If you have any doubts about the security of your password, do the following: Generate a new password by the same method you used to generate that one, and then try the new password—not the old password—in an entropy checking utility such as https://howsecureismypassword.net/. The utility will tell you approximately how long it would take to guess your password by guessing random characters using current technology. This is really an upper limit—computers will get faster, and by knowing things about you, hackers can improve upon random guessing substantially—but a good password should at least be in the thousands or millions of years, while a very bad password (like the word “password” itself) can literally be in the nanoseconds. (Actually if you play around you can generate passwords that can take far longer, even “12 tredecillion years” and the like, but they are generally too long to actually use.) The reason not to use your actual password is that there is a chance, however remote, that it could be intercepted while you were doing the check. But by checking the method, you can ensure that you are generating passwords in an effective way.

After you’ve generated all these passwords, how do you remember them all? It’s unreasonable to expect you to keep them all in your head. Instead, you can just keep a few of the most important ones in your head, including a master password that you then use for a password manager like LastPass or Keeper. Password managers are frequently rated by sites like PC Mag, CNET, Consumer Affairs, and CSO. Get one that is free and top-rated; there’s no reason to pay when the free ones are just as good, and no excuse for getting any less than the best when the best ones are free.

The idea of a password manager makes some people uncomfortable—aren’t you handing your passwords over to someone else?—so let me explain it a little. You aren’t actually handing over your passwords, first of all; a reputable password manager will actually encrypt your passwords locally, and then only transmit encrypted versions of them to the site that operates the password manager. This means that no one—not the company, not even you—can access those passwords without knowing the master password, so definitely make sure you remember that master password.

In theory, it would be better to just remember different 27-character alphanumeric passwords for each site you use online. This is indisputable. Encryption isn’t perfect, and theoretically someone might be able to recover your passwords even from Keeper or LastPass. But that is astronomically unlikely, and what’s far more likely is that if you don’t use a password manager, you will forget your passwords, or re-use them and get them stolen, or else make them too simple and allow them to be guessed. A password manager allows you to maintain dozens of distinct, very complex passwords, and even update them regularly, all while remembering only one or a few. In practice, this is what provides the best security.

5. Above all, report any suspicious activity immediately.

This one I cannot emphasize enough. If you do nothing else, do this. If you ever have any reason to suspect that your credit card might have been compromised, call your bank immediately. Get them to cancel the card, send you a new one, and check any recent transactions.

Do this if you lose your wallet. Do it if you see something weird on your online statement. Do it if you bought something from an online retailer that seemed a little sketchy. Do it if you just have a weird hunch and something doesn’t feel right. The cost of doing this is a minor inconvenience; the benefit could be thousands of dollars.

If you do report a stolen card, in most cases you won’t be held liable for a penny—the credit card company will have to cover any losses. But if you don’t, you could end up making payments on interest on a balance that a thief ran up on your behalf.

If we all do this, credit card fraud could become a thing of the past. Now, about those interest rates…

Financial fraud is everywhere

PNRJ critique of neoclassical economics, ethics, financial fraud, public policy , , , , , , ,

Jun 4, JDN 2457909
When most people think of “crime”, they probably imagine petty thieves, pickpockets, drug dealers, street thugs. In short, we think of crime as something poor people do. And certainly, that kind of crime is more visible, and typically easier to investigate and prosecute. It may be more traumatic to be victimized by it (though I’ll get back to that in a moment).

The statistics on this matter are some of the fuzziest I’ve ever come across, so estimates could be off by as much as an order of magnitude. But there is some reason to believe that, within most highly-developed countries, financial fraud may actually be more common than any other type of crime. It is definitely among the most common, and the only serious contenders for exceeding it are other forms of property crime such as petty theft and robbery.

It also appears that financial fraud is the one type of crime that isn’t falling over time. Violent crime and property crime are both at record lows; the average American’s probability of being victimized by a thief or a robber in any given year has fallen from 35% to 11% in the last 25 years. But the rate of financial fraud appears to be roughly constant, and the rate of high-tech fraud in particular is definitely rising. (This isn’t too surprising, given that the technology required is becoming cheaper and more widely available.)

In the UK, the rate of credit card fraud rose during the Great Recession, fell a little during the recovery, and has been holding steady since 2010; it is estimated that about 5% of people in the UK suffer credit card fraud in any given year.

About 1% of US car loans are estimated to contain fraudulent information (such as overestimated income or assets). As there are over $1 trillion in outstanding US car loans, that amounts to about $5 billion in fraud losses every year.

Using DOJ data, Statistic Brain found that over 12 million Americans suffer credit card fraud any given year; based on the UK data, this is probably an underestimate. They also found that higher household income had only a slight effect of increasing the probability of suffering such fraud.

The Office for Victims of Crime estimates that total US losses due to financial fraud are between $40 billion and $50 billion per year—which is to say, the GDP of Honduras or the military budget of Japan. The National Center for Victims of Crime estimated that over 10% of Americans suffer some form of financial fraud in any given year.

Why is fraud so common? Well, first of all, it’s profitable. Indeed, it appears to be the only type of crime that is. Most drug dealers live near the poverty line. Most bank robberies make off with less than $10,000.

But Bernie Madoff made over $50 billion before he was caught. Of course he was an exceptional case; the median Ponzi scheme only makes off with… $2.1 million. That’s over 200 times the median bank robbery.

Second, I think financial fraud allows the perpetrator a certain psychological distance from their victims. Just as it’s much easier to push a button telling a drone to launch a missile than to stab someone to death, it’s much easier to move some numbers between accounts than to point a gun at someone’s head and demand their wallet. Construal level theory is all about how making something seem psychologically more “distant” can change our attitudes toward it; toward things we perceive as “distant”, we think more abstractly, we accept more risks, and we are more willing to engage in violence to advance a cause. (It also makes us care less about outcomes, which may be a contributing factor in the collective apathy toward climate change.)

Perhaps related to this psychological distance, we also generally have a sense that fraud is not as bad as violent crime. Even judges and juries often act as though white-collar criminals aren’t real criminals. Often the argument seems to be that the behavior involved in committing financial fraud is not so different, after all, from the behavior of for-profit business in general; are we not all out to make an easy buck?

But no, it is not the same. (And if it were, this would be more an indictment of capitalism than it is a justification for fraud. So this sort of argument makes a lot more sense coming from socialists than it does from capitalists.)

One of the central justifications for free markets lies in the assumption that all parties involved are free, autonomous individuals acting under conditions of informed consent. Under those conditions, it is indeed hard to see why we have a right to interfere, as long as no one else is being harmed. Even if I am acting entirely out of my own self-interest, as long as I represent myself honestly, it is hard to see what I could be doing that is morally wrong. But take that away, as fraud does, and the edifice collapses; there is no such thing as a “right to be deceived”. (Indeed, it is quite common for Libertarians to say they allow any activity “except by force or fraud”, never quite seeming to realize that without the force of government we would all be surrounded by unending and unstoppable fraud.)

Indeed, I would like to present to you for consideration the possibility that large-scale financial fraud is worse than most other forms of crime, that someone like Bernie Madoff should be viewed as on a par with a rapist or a murderer. (To its credit, our justice system agrees—Madoff was given the maximum sentence of 150 years in maximum security prison.)

Suppose you were given the following terrible choice: Either you will be physically assaulted and beaten until several bones are broken and you fall unconscious—or you will lose your home and all the money you put into it. If the choice were between death and losing your home, obviously, you’d lose your home. But when it is a question of injury, that decision isn’t so obvious to me. If there is a risk of being permanently disabled in some fashion—particularly mentally disabled, as I find that especially terrifying—then perhaps I accept losing my home. But if it’s just going to hurt a lot and I’ll eventually recover, I think I prefer the beating. (Of course, if you don’t have health insurance, recovering from a concussion and several broken bones might also mean losing your home—so in that case, the dilemma is a no-brainer.) So when someone commits financial fraud on the scale of hundreds of thousands of dollars, we should consider them as having done something morally comparable to beating someone until they have broken bones.

But now let’s scale things up. What if terrorist attacks, or acts of war by a foreign power, had destroyed over one million homes, killed tens of thousands of Americans by one way or another, and cut the wealth of the median American family in half? Would we not count that as one of the greatest acts of violence in our nation’s history? Would we not feel compelled to take some overwhelming response—even be tempted toward acts of brutal vengeance? Yet that is the scale of the damage done by the Great Recession—much, if not all, preventable if our regulatory agencies had not been asleep at the wheel, lulled into a false sense of security by the unending refrain of laissez-faire. Most of the harm was done by actions that weren’t illegal, yes; but some of actually was illegal (20% of direct losses are attributable to fraud), and most of the rest should have been illegal but wasn’t. The repackaging and selling of worthless toxic assets as AAA bonds may not legally have been “fraud”, but morally I don’t see how it was different. With this in mind, the actions of our largest banks are not even comparable to murder—they are comparable to invasion or terrorism. No mere individual shooting here; this is mass murder.

I plan to make this a bit of a continuing series. I hope that by now I’ve at least convinced you that the problem of financial fraud is a large and important one; in later posts I’ll go into more detail about how it is done, who is doing it, and what perhaps can be done to stop them.

How about we listen to the Nobel Laureate when we set our taxes?

PNRJ core principles, financial fraud, inequality, macroeconomics, public policy , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

JDN 2457321 EDT 11:20

I know I’m going out on a limb here, but I think it would generally be a good thing if we based our tax system on the advice of Nobel Laureate economists. Joseph Stiglitz wrote a tax policy paper for the Roosevelt Institution last year that describes in detail how our tax system could be reformed to simultaneously restore economic growth, reduce income inequality, promote environmental sustainability, and in the long run even balance the budget. What’s more, he did the math (I suppose Nobel Laureate economists are known for that), and it looks like his plan would actually work.

The plan is good enough that I think it’s worth going through in some detail.

He opens by reminding us that our “debt crisis” is of our own making, the result of politicians (and voters) who don’t understand economics:

“But we should be clear that these crises – which have resulted in a government shutdown and a near default on the national debt – are not economic but political. The U.S. is not like Greece, unable to borrow to fund its debt and deficit. Indeed, the U.S. has been borrowing at negative real interest rates.”

Stiglitz pulls no punches against bad policies, and isn’t afraid to single out conservatives:

“We also show that some of the so-called reforms that conservatives propose would be counterproductive – they could simultaneously reduce growth and economic welfare and increase unemployment and inequality. It would be better to have no reform than these reforms.”

A lot of the news media keep trying to paint Bernie Sanders as a far-left radical candidate (like this article in Politico calling his hometown the “People’s Republic of Burlington”), because he says things like this: “in recent years, over 99 percent of all new income generated in the economy has gone to the top 1 percent.”

But the following statement was not said by Bernie Sanders, it was said by Joseph Stiglitz, who I will remind you one last time is a world-renowned Nobel Laureate economist:

“The weaknesses in the labor market are reflected in low wages and stagnating incomes. That helps explain why 95 percent of the increase in incomes in the three years after the recovery officially began went to the upper 1 percent. For most Americans, there has been no recovery.”

It was also Stiglitz who said this:

“The American Dream is, in reality, a myth. The U.S. has some of the worst inequality across generations (social mobility) among wealthy nations. The life prospects of a young American are more dependent on the income and education of his parents than in other advanced countries.”

In this country, we have reached the point where policies supported by the analysis of world-renowned economists is considered far-left radicalism, while the “mainstream conservative” view is a system of tax policy that is based on pure fantasy, which has been called “puppies and rainbows” by serious policy analysts and “voodoo economics” by yet another Nobel Laureate economist. A lot of very smart people don’t understand what’s happening in our political system, and want “both sides” to be “equally wrong”, but that is simply not the case: Basic facts of not just social science (e.g. Keynesian monetary policy), but indeed natural science (evolutionary biology, anthropogenic climate change) are now considered “political controversies” because the right wing doesn’t want to believe them.

But let’s get back to the actual tax plan Stiglitz is proposing. He is in favor of raising some taxes and lowering others, spending more on some things and less on other things. His basic strategy is actually quite simple: Raise taxes with low multipliers and cut taxes with high multipliers. Raise spending with high multipliers and cut spending with low multipliers.

“While in general taxes take money out of the system, and therefore have a deflationary bias, some taxes have a larger multiplier than others, i.e. lead to a greater reduction in aggregate demand per dollar of revenue raised. Taxes on the rich and superrich, who save a large fraction of their income, have the least adverse effect on aggregate demand. Taxes on lower income individuals have the most adverse effect on aggregate demand.”

In other words, by making the tax system more progressive, we can directly stimulate economic growth while still increasing the amount of tax revenue we raise. And of course we have plenty of other moral and economic reasons to prefer progressive taxation.

Stiglitz tears apart the “job creator” myth:

“It is important to dispel a misunderstanding that one often hears from advocates of lower taxes for the rich and corporations, which contends that the rich are the job producers, and anything that reduces their income will reduce their ability and incentive to create jobs. First, at the current time, it is not lack of funds that is holding back investment. It is not even a weak and dysfunctional financial sector. America’s large corporations are sitting on more than $2 trillion in cash. What is holding back investment, especially by large corporations, is the lack of demand for their products.”

Stiglitz talks about two principles of taxation to follow:

First is the Generalized Henry George Principle, that we should focus taxes on things that are inelastic, meaning their supply isn’t likely to change much with the introduction of a tax. Henry George favored taxing land, which is quite inelastic indeed. The reason we do this is to reduce the economic distortions created by a tax; the goal is to collect revenue without changing the number of real products that are bought and sold. We need to raise revenue and we want to redistribute income, but we want to do it without creating unnecessary inefficiencies in the rest of the economy.

Second is the Generalized Polluter Pays Principle, that we should tax things that have negative externalities—effects on other people that are harmful. When a transaction causes harm to others who were not party to the transaction, we should tax that transaction in an amount equal to the harm that it would cause, and then use that revenue to offset the damage. In effect, if you hurt someone else, you should have to pay to clean up your own mess. This makes obvious moral sense, but it also makes good economic sense; taxing externalities can improve economic efficiency and actually make everyone better off. The obvious example is again pollution (the original Polluter Pays Principle), but there are plenty of other examples as well.

Stiglitz of course supports taxes on pollution and carbon emissions, which really should be a no-brainer. They aren’t just good for the environment, they would directly increase economic efficiency. The only reason we don’t have comprehensive pollution taxes (or something similar like cap-and-trade) is again the political pressure of right-wing interests.

Stiglitz focuses in particular on the externalities of the financial system, the boom-and-bust cycle of bubble, crisis, crash that has characterized so much of our banking system for generations. With a few exceptions, almost every major economic crisis has been preceded by some sort of breakdown of the financial system (and typically widespread fraud by the way). It is not much exaggeration to say that without Wall Street there would be no depressions. Externalities don’t get a whole lot bigger than that.

Stiglitz proposes a system of financial transaction taxes that are designed to create incentives against the most predatory practices in finance, especially the high-frequency trading in which computer algorithms steal money from the rest of the economy thousands of times per second. Even a 0.01% tax on each financial transaction would probably be enough to eliminate this particular activity.

He also suggests the implementation of “bonus taxes” which disincentivize paying bonuses, which could basically be as simple as removing the deductions placed during the Clinton administration (in a few years are we going to have to say “the first Clinton administration”?) that exempt “performance-based pay” from most forms of income tax. All pay is performance-based, or supposed to be. There should be no special exemption for bonuses and stock options.

Stiglitz also proposes a “bank rescue fund” which would be something like an expansion of the FDIC insurance that banks are already required to have, but designed as catastrophe insurance for the whole macroeconomy. Instead of needing bailed out from general government funds, banks would only be bailed out from a pool of insurance funds they paid in themselves. This could work, but honestly I think I’d rather reduce the moral hazard even more by saying that we will never again bail out banks directly, but instead bail out consumers and real businesses. This would probably save banks anyway (most people don’t default on debts if they can afford to pay them), and if it doesn’t, I don’t see why we should care. The only reason banks exist is to support the real economy; if we can support the real economy without them, they deserve to die. That basic fact seems to have been lost somewhere along the way, and we keep talking about how to save or stabilize the financial system as if it were valuable unto itself.

Stiglitz also proposes much stricter regulations on credit cards, which would require them to charge much lower transaction fees and also pay a portion of their transaction revenue in taxes. I think it’s fair to ask whether we need credit cards at all, or if there’s some alternative banking system that would allow people to make consumer purchases without paying 20% annual interest. (It seems like there ought to be, doesn’t it?)

Next Stiglitz gets to his proposal to reform the corporate income tax. Like many of us, he is sick of corporations like Apple and GE with ten and eleven-figure profits paying little or no taxes by exploiting a variety of loopholes. He points out some of the more egregious ones, like the “step up of basis at death” which allows inherited capital to avoid taxation (personally, I think both morally and economically the optimal inheritance tax rate is 100%!), as well as the various loopholes on offshore accounting which allow corporations to design and sell their products in the US, even manufacture them here, and pay taxes as if all their work were done in the Cayman Islands. He also points out that the argument that corporate taxes disincentivize investment is ridiculous, because most investment is financed by corporate bonds which are tax-deductible.

Stiglitz departs from most other economists in that he actually proposes raising the corporate tax rate itself. Most economists favor cutting the rate on paper, then closing the loopholes to ensure that the new rate is actually paid. Stiglitz says this is not enough, and we must both close the loopholes and increase the rate.

I’m actually not sure I agree with him on this; the incidence of corporate taxes is not very well-understood, and I think there’s a legitimate worry that taxing Apple will make iPhones more expensive without actually taking any money from Tim Cook. I think it would be better to get rid of the corporate tax entirely and then dramatically raise the marginal rates on personal income, including not only labor income but also all forms of capital income. Instead of taxing Apple hoping it will pass through to Tim Cook, I say we just tax Tim Cook. Directly tax his $4 million salary and $70 million in stock options.

Stiglitz does have an interesting proposal to introduce “rent-seeking” taxes that specifically apply to corporations which exercise monopoly or oligopoly power. If you can actually get this to work, it’s very clever; you could actually create a market incentive for corporations to support their own competition—and not in the sense of collusion but in the sense of actually trying to seek out more competitive markets in order to avoid the monopoly tax. Unfortunately, Stiglitz is a little vague on how we’d actually pull that off.

One thing I do agree with Stiglitz on is the use of refundable tax credits to support real investment. Instead of this weird business about not taxing dividends and capital gains in the hope that maybe somehow this will support real investment, we actually give tax credits specifically to companies that build factories or hire more workers.

Stiglitz also does a good job of elucidating the concept of “corporate welfare”, officially called “tax expenditures”, in which subsidies for corporations are basically hidden in the tax code as rebates or deductions. This is actually what Obama was talking about when he said “spending in the tax code”, (he did not invent the concept of tax expenditures), but since he didn’t explain himself well even Jon Stewart accused him of Orwellian Newspeak. Economically a refundable tax rebate of $10,000 is exactly the same thing as a subsidy of $10,000. There are some practical and psychological differences, but there are no real economic differences. If you’re still confused about tax expenditures, the Center for American Progress has a good policy memo on the subject.

Stiglitz also has some changes to make to the personal income tax, all of which I think are spot-on. First we increase the marginal rates, particularly at the very top. Next we equalize rates on all forms of income, including capital income. Next, we remove most, if not all, of the deductions that allow people to avoid paying the rate it says on paper. Finally, we dramatically simplify the tax code so that the majority of people can file a simplified return which basically just says, “This is my income. This is the tax rate for that income. This is what I owe.” You wouldn’t have to worry about itemizing your student loans or mortgage payments or whatever else; just tally up your income and look up your rate. As he points out, this would save a lot of people a lot of stress and also remove a lot of economic distortions.

He talks about how we can phase out the mortgage-interest deduction in particular, because it’s clearly inefficient and regressive but it’s politically popular and dropping it suddenly could lead to another crisis in housing prices.

Stiglitz has a deorbit for anyone who thinks capital income should not be taxed:

“There is, moreover, no justification for taxing those who work hard to earn a living at a higher rate than those who derive their income from speculation.”

By equalizing rates on labor and capital income, he estimates we could raise an additional $130 billion per year—just shy of what it would take to end world hunger. (Actually some estimates say it would be more than enough, others that it would be about half what we need. It’s definitely in the ballpark, however.)

Stiglitz actually proposes making a full deduction of gross household income at $100,000, meaning that the vast majority of Americans would pay no income tax at all. This is where he begins to lose me, because it necessarily means we aren’t going to raise enough revenue by income taxes alone.

He proposes to make up the shortfall by introducing a value-added tax, a VAT. I have to admit a lot of countries have these (including most of Europe) and seem to do all right with them; but I never understood why they are so popular among economists. They are basically sales taxes, and it’s very hard to make any kind of sales tax meaningfully progressive. In fact, they are typically regressive, because rich people spend a smaller proportion of their income than poor people do. Unless we specifically want to disincentivize buying things (and a depression is not the time to do that!), I don’t see why we would want to switch to a sales tax.

At the end of the paper Stiglitz talks about the vital difference between short-term spending cuts and long-term fiscal sustainability:

“Thus, policies that promote output and employment today also contribute to future growth – particularly if they lead to more investment. Thus, austerity measures that take the form of cutbacks in spending on infrastructure, technology, or education not only weaken the economy today, but weaken it in the future, both directly (through the obvious impacts, for example, on the capital stock) but also indirectly, through the diminution in human capital that arises out of employment or educational experience. […] Mindless “deficit fetishism” is likely to be counterproductive. It will weaken the economy and prove counterproductive to raising revenues because the main reason that we are in our current fiscal position is the weak economy.”

It amazes me how many people fail to grasp this. No one would say that paying for college is fiscally irresponsible, because we know that all that student debt will be repaid by your increased productivity and income later on; yet somehow people still think that government subsidies for education are fiscally irresponsible. No one would say that it is a waste of money for a research lab to buy new equipment in order to have a better chance at making new discoveries, yet somehow people still think it is a waste of money for the government to fund research. The most legitimate form of this argument is “crowding-out”, the notion that the increased government spending will be matched by an equal or greater decrease in private spending; but the evidence shows that many public goods—like education, research, and infrastructure—are currently underfunded, and if there is any crowding-out, it is much smaller than the gain produced by the government investment. Crowding-out is theoretically possible but empirically rare.

Above all, now is not the time to fret about deficits. Now is the time to fret about unemployment. We need to get more people working; we need to create jobs for those who are already seeking them, better jobs for those who have them but want more, and opportunities for people who have given up searching for work to keep trying. To do that, we need spending, and we will probably need deficits. That’s all right; once the economy is restored to full capacity then we can adjust our spending to balance the budget (or we may not even need to, if we devise taxes correctly).

Of course, I fear that most of these policies will fall upon deaf ears; but Stiglitz calls us to action:

“We can reform our tax system in ways that will strengthen the economy today, address current economic and social problems, and strengthen our economy for the future. The economic agenda is clear. The question is, will the vested interests which have played such a large role in creating the current distorted system continue to prevail? Do we have the political will to create a tax system that is fair and serves the interests of all Americans?”