Scalability and inequality

2022-05-152022-05-08 pnrj core principles, inequality, mathematical models, statistics biology, capital, chemistry, DNA, exponential growth, fat tail, growth, inequality, labor, normal distribution, Pareto distribution, PCR, physics, scalability, scale

May 15 JDN 2459715

Why are some molecules (e.g. DNA) billions of times larger than others (e.g. H2O), but all atoms are within a much narrower range of sizes (only a few hundred)?

Why are some animals (e.g. elephants) millions of times as heavy as other (e.g. mice), but their cells are basically the same size?

Why does capital income vary so much more (factors of thousands or millions) than wages (factors of tens or hundreds)?

These three questions turn out to have much the same answer: Scalability.

Atoms are not very scalable: Adding another proton to a nucleus causes interactions with all the other protons, which makes the whole atom unstable after a hundred protons or so. But molecules, particularly organic polymers such as DNA, are tremendously scalable: You can add another piece to one end without affecting anything else in the molecule, and keep on doing that more or less forever.

Cells are not very scalable: Even with the aid of active transport mechanisms and complex cellular machinery, a cell’s functionality is still very much limited by its surface area. But animals are tremendously scalable: The same exponential growth that got you from a zygote to a mouse only needs to continue a couple years longer and it’ll get you all the way to an elephant. (A baby elephant, anyway; an adult will require a dozen or so years—remarkably comparable to humans, in fact.)

Labor income is not very scalable: There are only so many hours in a day, and the more hours you work the less productive you’ll be in each additional hour. But capital income is perfectly scalable: We can add another digit to that brokerage account with nothing more than a few milliseconds of electronic pulses, and keep doing that basically forever (due to the way integer storage works, above 2^63 it would require special coding, but it can be done; and seeing as that’s over 9 quintillion, it’s not likely to be a problem any time soon—though I am vaguely tempted to write a short story about an interplanetary corporation that gets thrown into turmoil by an integer overflow error).

This isn’t just an effect of our accounting either. Capital is scalable in a way that labor is not. When your contribution to production is owning a factory, there’s really nothing to stop you from owning another factory, and then another, and another. But when your contribution is working at a factory, you can only work so hard for so many hours.

When a phenomenon is highly scalable, it can take on a wide range of outcomes—as we see in molecules, animals, and capital income. When it’s not, it will only take on a narrow range of outcomes—as we see in atoms, cells, and labor income.

Exponential growth is also part of the story here: Animals certainly grow exponentially, and so can capital when invested; even some polymers function that way (e.g. under polymerase chain reaction). But I think the scalability is actually more important: Growing rapidly isn’t so useful if you’re going to immediately be blocked by a scalability constraint. (This actually relates to the difference between r- and K- evolutionary strategies, and offers further insight into the differences between mice and elephants.) Conversely, even if you grow slowly, given enough time, you’ll reach whatever constraint you’re up against.

Indeed, we can even say something about the probability distribution we are likely to get from random processes that are scalable or non-scalable.

A non-scalable random process will generally converge toward the familiar normal distribution, a “bell curve”:

[Image from Wikipedia: By Inductiveload – self-made, Mathematica, Inkscape, Public Domain, https://commons.wikimedia.org/w/index.php?curid=3817954]

The normal distribution has most of its weight near the middle; most of the population ends up near there. This is clearly the case for labor income: Most people are middle class, while some are poor and a few are rich.

But a scalable random process will typically converge toward quite a different distribution, a Pareto distribution:

[Image from Wikipedia: By Danvildanvil – Own work, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=31096324]

A Pareto distribution has most of its weight near zero, but covers an extremely wide range. Indeed it is what we call fat tailed, meaning that really extreme events occur often enough to have a meaningful effect on the average. A Pareto distribution has most of the people at the bottom, but the ones at the top are really on top.

And indeed, that’s exactly how capital income works: Most people have little or no capital income (indeed only about half of Americans and only a third(!) of Brits own any stocks at all), while a handful of hectobillionaires make utterly ludicrous amounts of money literally in their sleep.

Indeed, it turns out that income in general is pretty close to distributed normally (or maybe lognormally) for most of the income range, and then becomes very much Pareto at the top—where nearly all the income is capital income.

This fundamental difference in scalability between capital and labor underlies much of what makes income inequality so difficult to fight. Capital is scalable, and begets more capital. Labor is non-scalable, and we only have to much to give.

It would require a radically different system of capital ownership to really eliminate this gap—and, well, that’s been tried, and so far, it hasn’t worked out so well. Our best option is probably to let people continue to own whatever amounts of capital, and then tax the proceeds in order to redistribute the resulting income. That certainly has its own downsides, but they seem to be a lot more manageable than either unfettered anarcho-capitalism or totalitarian communism.

Capitalism can be fair

2021-08-222021-08-15 pnrj core principles, ethics capital, capitalism, fairness, Marxism, profit, socialism, surplus

Aug 22 JDN 2459449

There are certainly extreme right-wing libertarians who seem to think that capitalism is inherently fair, or that “fairness” is meaningless and (some very carefully defined notion of) liberty is the only moral standard. I am not one of them. I agree that many of the actual practices of modern capitalism as we know it are unfair, particularly in the treatment of low-skill workers.

But lately I’ve been seeing a weirdly frequent left-wing take—Marxist take, really—that goes to the opposite extreme, saying that capitalism is inherently unfair, that the mere fact that capital owners ever get any profit on anything is proof that the system is exploitative and unjust and must be eliminated.

So I decided it would be worthwhile to provide a brief illustration of how, at least in the best circumstances, a capitalist system of labor can in fact be fair and just.

The argument that capitalism is inherently unjust seems to be based on the notion that profit means “workers are paid less than their labor is worth”. I think that the reason this argument is so insidious is that it’s true in one sense—but not true in another. Workers are indeed paid less than the total surplus of their actual output—but, crucially, they are not paid less than what the surplus of their output would have been had the capital owner not provided capital and coordination.

Suppose that we are making some sort of product. To make it more concrete, let’s say shirts. You can make a shirt by hand, but it’s a lot of work, and it takes a long time. Suppose that you, working on your own by hand, can make 1 shirt per day. You can sell each shirt for $10, so you get $10 per day.

Then, suppose that someone comes along who owns looms and sewing machines. They gather you and several other shirt-makers and offer to let you use their machines, in exchange for some of the revenue. With the aid of 9 other workers and the machines, you are able to make 30 shirts per day. You can still sell each shirt for $10, so now there is total revenue of $300.

Whether or not this is fair depends on precisely the bargain that was struck with the owner of the machines. Suppose that he asked for 40% of the revenue. Then the 10 workers including yourself would get (0.60)($300) = $180 to split, presumably evenly, and each get $18 per day. This seems fair; you’re clearly better off than you were making shirts by yourself. The capital owner then gets (0.40)($300) = $120, which is more than each of you, but not by a ridiculous amount; and he probably has costs to deal with in maintaining those machines.

But suppose instead the owner had demanded 80% of the revenue; then you would have to split (0.20)($300) = $60 between you, and each would only get $6 per day. The capital owner would then get (0.80)($300) = $240, 40 times as much as each of you.

Or perhaps instead of a revenue-sharing agreement, the owner offers to pay you a wage. If that wage is $18 per day, it seems fair. If it is $6 per day, it seems obviously unfair.

If this owner is the only employer, then he is competing only with working alone. So we would expect him to offer a wage of $10 per day, or maybe slightly more since working with the machines may be harder or more unpleasant than working by hand.

But if there are many employers, then he is now competing with those employers as well. If he offers $10, someone else might offer $12, and a third might offer $15. Competition should drive the system toward an equilibrium where workers are getting paid their marginal value product—in other words, the wage for one hour of work should equal the additional value added by one more hour of work.

In the case that seems fair, where workers are getting more money than they would have on their own, are they getting paid “less than the value of their labor”? In one sense, yes; the total surplus is not going all to the workers, but is being shared with the owner of the machines. But the more important sense is whether they’d be better off quitting and working on their own—and they obviously would not be.

What value does the capital owner provide? Well, the capital, of course. It’s their property and they are letting other people use it. Also, they incur costs to maintain it.

Of course, it matters how the capital owner obtained that capital. If they are an inventor who made it themselves, it seems obviously just that they should own it. If they inherited it or got lucky on the stock market, it isn’t something they deserve in a deep sense, but it’s reasonable to say they are entitled to it. But if the only reason they have the capital is by theft, fraud, or exploitation, then obviously they don’t deserve it. In practice, there are very few of the first category, a huge number of the second, and all too many of the third. Yet this is not inherent to the capitalist work arrangement. Many capital owners don’t deserve what they own; but those who do have a right to make a profit letting other people use their property.

There are of course many additional complexities that arise in the real world, in terms of market power, bargaining, asymmetric information, externalities, and so on. I freely admit that in practice, capitalism is often unfair. But I think it’s worth pointing out that the mere existence of profit from capital ownership is not inherently unjust, and in fact by organizing our economy around it we have managed to achieve unprecedented prosperity.

How much wealth is there in the world?

2019-07-142019-07-07 pnrj inequality capital, GDP, inequality, wealth

July 14 JDN 2458679

How much wealth is there in the world? If we split it all evenly, how much would each of us have?

It’s a surprisingly complicated question: What counts as wealth? Presumably we include financial assets, real estate, commodities—anything that can be sold on a market. But what about natural resources? Shouldn’t we somehow value clean air and water? What about human capital—health, knowledge, skills, and expertise that make us able to work better?

I’m going to stick with tradeable assets for now, because I’m interested in questions of redistribution. If we were to add up all the wealth in the United States, or all the wealth in the world, and split it all evenly, how much would each person get? Even then, there are questions about how to price assets: Do we current market prices, or what was actually paid for them in the past? How much do we depreciate? How do we count debt that was used to buy non-financial assets (such as student loans)?

The Federal Reserve reports an official estimate of the US capital stock at $56.2 trillion (in 2011 dollars). Assuming that a third of income is capital income, that means that of our GDP of $18.9 trillion (in 2012 dollars), this would make the rate of return on capital 11%. That rate of return strikes me as pretty clearly too high. This must be an underestimate of our capital stock.

The 2015 Global Wealth Report estimates total US wealth as $63.5 trillion, and total world wealth as $153.2 trillion. This was for 2014, so using the US GDP growth rate of about 2% and the world GDP growth rate of 3.6%, the current wealth stocks should be about $70 trillion and $183 trillion respectively.

This gives a much more plausible rate of return: One third of the US GDP of $19.6 trillion (in 2014 dollars) is $6.53 trillion, yielding a rate of return of about 9%.

One third of the world GDP of $78 trillion is $26 trillion, yielding a rate of return of about 14%. This seems a bit high, but we’re including a lot of countries with very little capital that we would expect to have very high rates of return, so it might be right.

Credit Suisse releases estimates of total wealth that are supposed to include non-financial assets as well, though these are even more uncertain than financial assets. They estimate total US wealth as $98 trillion and total world wealth as $318 trillion.

There’s a lot of uncertainty around all of these figures, but I think these are close enough to get a sense of what sort of redistribution might be possible.

If the US wealth stock is about $70 trillion and our population is about 330 million, that means that the average wealth of an American is $200,000. If our wealth stock is instead about $98 trillion, the average wealth of an American is about $300,000.

Since the average number of people in a US household is 2.5, this means that average household wealth is somewhere between $500,000 and $750,000. This is actually a bit less than I thought; I would have guessed that the mythical “average American household” is a millionaire. (Of course, even Credit Suisse might be underestimating our wealth stock.)

If the world wealth stock is about $180 trillion and the population is about 7.7 billion, global average wealth per person is about $23,000. If instead the global wealth stock is about $320 trillion, the average wealth of a human being is about $42,000.

Both of these are far above the median wealth, which is much more representative of what a typical person has. Median wealth per adult in the US is about $65,000; worldwide it’s only about $4,200.

This means that if we were to somehow redistribute all wealth in the United States, half the population would gain an average of somewhere between $140,000 and $260,000, or on a percentage basis, the median American would see their wealth increase by 215% to 400%. If we were to instead somehow redistribute all wealth in the world, half the population would gain an average of $19,000 to $38,000; the median individual would see their wealth increase by 450% to 900%.

Of course, we can’t literally redistribute all the wealth in the world. Even if we could somehow organize it logistically—a tall order to be sure—such a program would introduce all sorts of inefficiencies and perverse incentives. That would really be socialism: We would be allocating wealth entirely based on a government policy and not at all by the market.

But suppose instead we decided to redistribute some portion of all this wealth. How about 10%? That seems like a small enough amount to avoid really catastrophic damage to the economy. Yes, there would be some inefficiencies introduced, but this could be done with some form of wealth taxes that wouldn’t require completely upending capitalism.

Suppose we did this just within the US. 10% of US wealth, redistributed among the whole population, would increase median wealth by between $20,000 and $30,000, or between 30% and 45%. That’s already a pretty big deal. And this is definitely feasible; the taxation infrastructure is all already in place. We could essentially buy the poorest half of the population a new car on the dime of the top half.

If instead we tried to do this worldwide, we would need to build the fiscal capacity first; the infrastructure to tax wealth effectively is not in place in most countries. But supposing we could do that, we could increase median wealth worldwide by between $2,000 and $4,000, or between 50% and 100%. Of course, this would mean that many of us in the US would lose a similar amount; but I think it’s still quite remarkable that we could as much as double the wealth of most of the world’s population by redistributing only 10% of the total wealth. That’s how much wealth inequality there is in the world.

Just how rich is rich?

2019-05-262019-05-16 pnrj core principles, ethics, inequality, public policy Ann Arbor, Bill Gates, billionaires, capital, capital gains, capitalism, GiveDirectly, Gordon Gekko, Jeff Bezos, millionaires, Mitt Romney, poor, Queen Elizabeth, rich, Scandinaviaisbetter, socialism, wealth

May 26 JDN 2458630

I think if there is one single thing I would like more people to know about economics, it is the sheer magnitude of global inequality. Most people seem to have no idea just how rich some people are—and how poor so many others are. They have a vision in their head of what “rich” and “poor” are, and their “rich” is a low-level Wall Street trader making $400,000 a year (the kind of people Gordon Gekko mocks in the film), and “poor” is someone who lives under a bridge in New York City. (They’re both New Yorkers, I guess. New Yorkers seem to be the iconic Americans, which is honestly more representative than you might think—80% of Americans live in urban or suburban areas.)

If we take a global perspective, this is not what “rich” and “poor” truly mean.

In next week’s post I’ll talk about what “poor” means. It’s really appallingly bad. We have to leave the First World in order to find it; many people here are poor, but not that poor. It’s so bad that I think once you really understand it, it can’t but change your whole outlook on the world. But I’m saving that for next week.

This week, I’ll talk about what “rich” really means in today’s world. We needn’t leave the United States, for the top 3 and 6 of the top 10 richest people in the world live here. And they are all White men, by the way, though Carlos Slim and Amancio Ortega are at least Latino.

Going down the list of billionaires ranked by wealth, you have to get down to 15th place before encountering a woman, and it’s really worse than that, because Francoise Bettencourt (15), Alice Walton (17), Jacqueline Mars (33), Yang Huiyan (42), Susan Klatton (46), Laurena Powell-Jobs (54), Abigail Johnson (71), and Iris Fontbona (74) are all heirs. The richest living woman who didn’t simply inherit from her father or husband is actually Gina Rinehart, the 75th richest person in the world. (And note that, while also in some sense an heir, Queen Elizabeth is not on that list; in fact, she’s nowhere near the richest people in the world. She’s not in the top 500.)

You have to get to 20th place before encountering someone non-White (Ma Huateng), and all the way down to 65th before encountering someone not White or East Asian (the Hinduja brothers). Not one of the top 100 richest people is Black.

Just how rich are these people? Well, there’s a meme going around saying that Jeff Bezos could afford to buy every homeless person in the world a house at median market price and still, with just what’s left over, be a multi-billionaire among the top 100 richest people in the world.

And that meme is completely correct. The math checks out.

There are about 554,000 homeless people in the US at any given time.

The median sale price of a currently existing house in the US is about $253,000.

Multiply those two numbers together, and you get $140 billion.

And Jeff Bezos has net wealth of $157 billion.

This means that he would still have $17 billion left after buying all those houses. The 100th richest person in the world has $13 billion, so Jeff Bezos would still be higher than that.

Even $17 billion is enough to spend over $2 million every single day—over $20 per second—and never run out of money as long as the dividends keep paying out.

Jeff Bezos in fact made so much in dividends and capital gains this past quarter that he was taking in as much money as the median Amazon employee’s annual salary—which is more than what I make as a grad student, and only slightly less than the median US individual income—every nine seconds. Yes, you read that correctly: Nine (9) seconds. In the time it took you to read this paragraph, Jeff Bezos probably received more in capital gains than you will make this whole year. And if not (because you’re relatively rich or you read quickly), I’m sure he will have in the time it takes you to read this whole post.

When Mitt Romney ran for President, a great deal was made of his net wealth of over $250 million. This is indeed very rich, richer than anyone really needs or probably deserves. But compared to the world’s richest, this is pocket change. Jeff Bezos gets that much in dividends and capital gains every day. Bill Gates could give away that much every day for a year and still not run out of money. (He doesn’t quite give that much, but he does give a lot.)

I grew up in Ann Arbor, Michigan. Ann Arbor is a medium-sized city of about 120,000 people (230th in the US by population), and relatively well-off (median household income about 16% higher than the US median). Nevertheless, if Jeff Bezos wanted to, he could give every single person in Ann Arbor the equivalent of 30 years of their income—over a million dollars each—and still have enough money left to be among the world’s 100 richest people.

Or suppose instead that all the world’s 500 richest people decided to give away all the money they have above $1 billion—so they’d all still be billionaires, but only barely. That $8.7 trillion they have together, minus the $500 billion they’re keeping, would be $8.2 trillion. In fact, let’s say they keep a little more, just to make sure they all have the same ordering: Give each one an extra $1 million for each point they are in the ranking, so that Jeff Bezos would stay on top at $1 B + 500 ($0.001 B) = $1.5 billion, while Bill Gates in second place would have $1 million less, and so on. That would leave us with still over $8 trillion to give away.

How far could that $8 trillion go? Well, suppose we divided it evenly between all 328 million people in the United States. How much would each person receive? Oh, just about $24,000—basically my annual income.

Or suppose instead we spread it out over the entire world: Every single man, woman, and child on the planet Earth gets an equal share. There are 7.7 billion people in the world, so by spreading out $8 trillion between them, each one would get over $1000. For you or I that’s a big enough windfall to feel. For the world’s poorest people, it’s more than they make in several years. It would be life-changing for them. (Actually that’s about what GiveDirectly gives each family—and it is life-changing.)

And let me remind you: This would be leaving them billionaires. They’re just not as much billionaires as before—they only have $1 billion instead of $20 billion or $50 billion or $100 billion. And even $1 billion is obviously enough to live however you want, wherever you want, for the rest of your life, never working another day if you don’t want to. With $1 billion, you can fly in jets (a good one will set you back $20 million), sail in yachts (even a massive 200-footer wouldn’t run much above $200 million), and eat filet mignon at every meal (in fact, at $25 per pound, you can serve it to yourself and a hundred of your friends without breaking a sweat). You can decorate your bedroom with original Jackson Pollock paintings (at $200 million, his most expensive painting is only 20% of your wealth) and bathe in bottles of Dom Perignon (at $400 per liter, a 200-liter bath would cost you about $80,000—even every day that’s only $30 million a year, or maybe half to a third of your capital income). Remember, this is all feasible at just $1 billion—and Jeff Bezos has over a hundred times that. There is no real lifestyle improvement that happens between $1 billion and $157 billion; it’s purely a matter of status and power.

Taking enough to make them mere millionaires would give us another $0.5 trillion to spend (about the GDP of Sweden, one-fourth the GDP of Canada, or 70% of the US military budget).

Do you think maybe these people have too much money?

I’m not saying that we should confiscate all private property. I’m not saying that we should collectivize all industry. I believe in free markets and private enterprise. People should be able to get rich by inventing things and starting businesses.

But should they be able to get that rich? So rich that one man could pay off every mortgage in a whole major city? So rich that the CEO of a company makes what his employees make in a year in less than a minute? So rich that 500 people—enough to fill a large lecture hall—own enough wealth that if it were spread out evenly they could give $1000 to every single person in the world?

If Jeff Bezos had $1.5 million, I’d say he absolutely earned it. Some high-level programmers at Amazon have that much, and they absolutely earned it. If he had $15 million, I’d think maybe he could deserve that, given his contribution to the world. If he had $150 million, I’d find it hard to believe that anyone could really deserve that much, but if it’s part of what we need to make capitalism work, I could live with that.

But Jeff Bezos doesn’t have $1.5 million. He doesn’t have $15 million. He doesn’t have $150 million. He doesn’t have $1.5 billion. He doesn’t even have $15 billion. He has $150 billion. He has over a thousand times the level of wealth at which I was already having to doubt whether any human being could possibly deserve so much money—and once it gets that big, it basically just keeps growing. A stock market crash might drop it down temporarily, but it would come back in a few years.

And it’s not like there’s nothing we could do to spread this wealth around. Some fairly simple changes in how we tax dividends and capital gains would be enough to get a lot of it, and a wealth tax like the one Elizabeth Warren has proposed would help a great deal as well. At the rates people have seriously proposed, these taxes would only really stop their wealth from growing; it wouldn’t meaningfully shrink it.

That could be combined with policy changes about compensation for corporate executives, particularly with regard to stock options, to make it harder to extract such a large proportion of a huge multinational corporation’s wealth into a single individual. We could impose a cap on the ratio between median employee salary (including the entire supply chain!) and total executive compensation (including dividends and capital gains!), say 100 to 1. (Making in 9 seconds what his employees make in a year, Jeff Bezos is currently operating at a ratio of over 3 million to 1.) If you exceed the cap, the remainder is taxed at 100%. This would mean that as a CEO you can still make $100 million a year, but only if your median employee makes $1 million. If your median employee makes $30,000, you’d better keep your own compensation under $3 million, because we’re gonna take the rest.

Is this socialism? I guess maybe it’s democratic socialism, the high-tax, high-spend #ScandinaviaIsBetter welfare state. But it would not be an end to free markets or free enterprise. We’re not collectivizing any industries, let alone putting anyone in guillotines. You could still start a business and make millions or even hundreds of millions of dollars; you’d simply be expected to share that wealth with your employees and our society as a whole, instead of hoarding it all for yourself.

Why “marginal productivity” is no excuse for inequality

2017-05-282017-10-08 pnrj critique of neoclassical economics, development economics, ethics, inequality capital, China, income, India, J.K. Rowling, marginal productivity, Microsoft, productivity, returns to scale, salary, wage

May 28, JDN 2457902

In most neoclassical models, workers are paid according to their marginal productivity—the additional (market) value of goods that a firm is able to produce by hiring that worker. This is often used as an excuse for inequality: If someone can produce more, why shouldn’t they be paid more?

The most extreme example of this is people like Maura Pennington writing for Forbes about how poor people just need to get off their butts and “do something”; but there is a whole literature in mainstream economics, particularly “optimal tax theory”, arguing based on marginal productivity that we should tax the very richest people the least and never tax capital income. The Chamley-Judd Theorem famously “shows” (by making heroic assumptions) that taxing capital just makes everyone worse off because it reduces everyone’s productivity.

The biggest reason this is wrong is that there are many, many reasons why someone would have a higher income without being any more productive. They could inherit wealth from their ancestors and get a return on that wealth; they could have a monopoly or some other form of market power; they could use bribery and corruption to tilt government policy in their favor. Indeed, most of the top 0.01% do literally all of these things.

But even if you assume that pay is related to productivity in competitive markets, the argument is not nearly as strong as it may at first appear. Here I have a simple little model to illustrate this.

Suppose there are 10 firms and 10 workers. Suppose that firm 1 has 1 unit of effective capital (capital adjusted for productivity), firm 2 has 2 units, and so on up to firm 10 which has 10 units. And suppose that worker 1 has 1 unit of so-called “human capital”, representing their overall level of skills and education, worker 2 has 2 units, and so on up to worker 10 with 10 units. Suppose each firm only needs one worker, so this is a matching problem.

Furthermore, suppose that productivity is equal to capital times human capital: That is, if firm 2 hired worker 7, they would make 2*7 = $14 of output.

What will happen in this market if it converges to equilibrium?

Well, first of all, the most productive firm is going to hire the most productive worker—so firm 10 will hire worker 10 and produce $100 of output. What wage will they pay? Well, they need a wage that is high enough to keep worker 10 from trying to go elsewhere. They should therefore pay a wage of $90—the next-highest firm productivity times the worker’s productivity. That’s the highest wage any other firm could credibly offer; so if they pay this wage, worker 10 will not have any reason to leave.

Now the problem has been reduced to matching 9 firms to 9 workers. Firm 9 will hire worker 9, making $81 of output, and paying $72 in wages.

And so on, until worker 1 at firm 1 produces $1 and receives… $0. Because there is no way for worker 1 to threaten to leave, in this model they actually get nothing. If I assume there’s some sort of social welfare system providing say $0.50, then at least worker 1 can get that $0.50 by threatening to leave and go on welfare. (This, by the way, is probably the real reason firms hate social welfare spending; it gives their workers more bargaining power and raises wages.) Or maybe they have to pay that $0.50 just to keep the worker from starving to death.

What does inequality look like in this society?
Well, the most-productive firm only has 10 times as much capital as the least-productive firm, and the most-educated worker only has 10 times as much skill as the least-educated worker, so we might think that incomes would vary only by a factor of 10.

But in fact they vary by a factor of over 100.

The richest worker makes $90, while the poorest worker makes $0.50. That’s a ratio of 180. (Still lower than the ratio of the average CEO to their average employee in the US, by the way.) The worker is 10 times as productive, but they receive 180 times as much income.

The firm profits vary along a more reasonable scale in this case; firm 1 makes a profit of $0.50 while firm 10 makes a profit of $10. Indeed, except for firm 1, firm n always makes a profit of $n. So that’s very nearly a linear scaling in productivity.

Where did this result come from? Why is it so different from the usual assumptions? All I did was change one thing: I allowed for increasing returns to scale.

If you make the usual assumption of constant returns to scale, this result can’t happen. Multiplying all the inputs by 10 should just multiply the output by 10, by assumption—since that is the definition of constant returns to scale.

But if you look at the structure of real-world incomes, it’s pretty obvious that we don’t have constant returns to scale.

If we had constant returns to scale, we should expect that wages for the same person should only vary slightly if that person were to work in different places. In particular, to have a 2-fold increase in wage for the same worker you’d need more than a 2-fold increase in capital.

This is a bit counter-intuitive, so let me explain a bit further. If a 2-fold increase in capital results in a 2-fold increase in wage for a given worker, that’s increasing returns to scale—indeed, it’s precisely the production function I assumed above.
If you had constant returns to scale, a 2-fold increase in wage would require something like an 8-fold increase in capital. This is because you should get a 2-fold increase in total production by doubling everything—capital, labor, human capital, whatever else. So doubling capital by itself should produce a much weaker effect. For technical reasons I’d rather not get into at the moment, usually it’s assumed that production is approximately proportional to capital to the one-third power—so to double production you need to multiply capital by 2^3 = 8.

I wasn’t able to quickly find really good data on wages for the same workers across different countries, but this should at least give a rough idea. In Mumbai, the minimum monthly wage for a full-time worker is about $80. In Shanghai, it is about $250. If you multiply out the US federal minimum wage of $7.25 per hour by 40 hours by 4 weeks, that comes to $1160 per month.

Of course, these are not the same workers. Even an “unskilled” worker in the US has a lot more education and training than a minimum-wage worker in India or China. But it’s not that much more. Maybe if we normalize India to 1, China is 3 and the US is 10.

Likewise, these are not the same jobs. Even a minimum wage job in the US is much more capital-intensive and uses much higher technology than most jobs in India or China. But it’s not that much more. Again let’s say India is 1, China is 3 and the US is 10.

If we had constant returns to scale, what should the wages be? Well, for India at productivity 1, the wage is $80. So for China at productivity 3, the wage should be $240—it’s actually $250, close enough for this rough approximation. But the US wage should be $800—and it is in fact $1160, 45% larger than we would expect by constant returns to scale.

Let’s try comparing within a particular industry, where the differences in skill and technology should be far smaller. The median salary for a software engineer in India is about 430,000 INR, which comes to about $6,700. If that sounds rather low for a software engineer, you’re probably more accustomed to the figure for US software engineers, which is $74,000. That is a factor of 11 to 1. For the same job. Maybe US software engineers are better than Indian software engineers—but are they that much better? Yes, you can adjust for purchasing power and shrink the gap: Prices in the US are about 4 times as high as those in India, so the real gap might be 3 to 1. But these huge price differences themselves need to be explained somehow, and even 3 to 1 for the same job in the same industry is still probably too large to explain by differences in either capital or education, unless you allow for increasing returns to scale.

In most industries, we probably don’t have quite as much increasing returns to scale as I assumed in my simple model. Workers in the US don’t make 100 times as much as workers in India, despite plausibly having both 10 times as much physical capital and 10 times as much human capital.

But in some industries, this model might not even be enough! The most successful authors and filmmakers, for example, make literally thousands of times as much money as the average author or filmmaker in their own country. J.K. Rowling has almost $1 billion from writing the Harry Potter series; this is despite having literally the same amount of physical capital and probably not much more human capital than the average author in the UK who makes only about 11,000 GBP—which is about $14,000. Harry Potter and the Philosopher’s Stone is now almost exactly 20 years old, which means that Rowling made an average of $50 million per year, some 3500 times as much as the average British author. Is she better than the average British author? Sure. Is she three thousand times better? I don’t think so. And we can’t even make the argument that she has more capital and technology to work with, because she doesn’t! They’re typing on the same laptops and using the same printing presses. Either the return on human capital for British authors is astronomical, or something other than marginal productivity is at work here—and either way, we don’t have anything close to constant returns to scale.

What can we take away from this? Well, if we don’t have constant returns to scale, then even if wage rates are proportional to marginal productivity, they aren’t proportional to the component of marginal productivity that you yourself bring. The same software developer makes more at Microsoft than at some Indian software company, the same doctor makes more at a US hospital than a hospital in China, the same college professor makes more at Harvard than at a community college, and J.K. Rowling makes three thousand times as much as the average British author—therefore we can’t speak of marginal productivity as inhering in you as an individual. It is an emergent property of a production process that includes you as a part. So even if you’re entirely being paid according to “your” productivity, it’s not really your productivity—it’s the productivity of the production process you’re involved in. A myriad of other factors had to snap into place to make your productivity what it is, most of which you had no control over. So in what sense, then, can we say you earned your higher pay?

Moreover, this problem becomes most acute precisely when incomes diverge the most. The differential in wages between two welders at the same auto plant may well be largely due to their relative skill at welding. But there’s absolutely no way that the top athletes, authors, filmmakers, CEOs, or hedge fund managers could possibly make the incomes they do by being individually that much more productive.

Sometimes people have to lose their jobs. This isn’t a bad thing.

2016-10-082017-10-08 pnrj ethics, inequality, macroeconomics, public policy active labor market policy, capital, Denmark, education, Eleizer Yudkowsky, employment, employment protection legislation, hires, income, jobs, labor, Less Wrong, Miles Kimball, Parade magazine, productivity, race, rent, robots, separations, technology, unemployment, wealth

Oct 8, JDN 2457670

Eleizer Yudkowsky (founder of the excellent blog forum Less Wrong) has a term he likes to use to distinguish his economic policy views from either liberal, conservative, or even libertarian: “econoliterate”, meaning the sort of economic policy ideas one comes up with when one actually knows a good deal about economics.

In general I think Yudkowsky overestimates this effect; I’ve known some very knowledgeable economists who disagree quite strongly over economic policy, and often following the conventional political lines of liberal versus conservative: Liberal economists want more progressive taxation and more Keynesian monetary and fiscal policy, while conservative economists want to reduce taxes on capital and remove regulations. Theoretically you can want all these things—as Miles Kimball does—but it’s rare. Conservative economists hate minimum wage, and lean on the theory that says it should be harmful to employment; liberal economists are ambivalent about minimum wage, and lean on the empirical data that shows it has almost no effect on employment. Which is more reliable? The empirical data, obviously—and until more economists start thinking that way, economics is never truly going to be a science as it should be.

But there are a few issues where Yudkowsky’s “econoliterate” concept really does seem to make sense, where there is one view held by most people, and another held by economists, regardless of who is liberal or conservative. One such example is free trade, which almost all economists believe in. A recent poll of prominent economists by the University of Chicago found literally zero who agreed with protectionist tariffs.

Another example is my topic for today: People losing their jobs.

Not unemployment, which both economists and almost everyone else agree is bad; but people losing their jobs. The general consensus among the public seems to be that people losing jobs is always bad, while economists generally consider it a sign of an economy that is run smoothly and efficiently.

To be clear, of course losing your job is bad for you; I don’t mean to imply that if you lose your job you shouldn’t be sad or frustrated or anxious about that, particularly not in our current system. Rather, I mean to say that policy which tries to keep people in their jobs is almost always a bad idea.

I think the problem is that most people don’t quite grasp that losing your job and not having a job are not the same thing. People not having jobs who want to have jobs—unemployment—is a bad thing. But losing your job doesn’t mean you have to stay unemployed; it could simply mean you get a new job. And indeed, that is what it should mean, if the economy is running properly.

Check out this graph, from FRED:

The red line shows hires—people getting jobs. The blue line shows separations—people losing jobs or leaving jobs. During a recession (the most recent two are shown on this graph), people don’t actually leave their jobs faster than usual; if anything, slightly less. Instead what happens is that hiring rates drop dramatically. When the economy is doing well (as it is right now, more or less), both hires and separations are at very high rates.

Why is this? Well, think about what a job is, really: It’s something that needs done, that no one wants to do for free, so someone pays someone else to do it. Once that thing gets done, what should happen? The job should end. It’s done. The purpose of the job was not to provide for your standard of living; it was to achieve the task at hand. Once it doesn’t need done, why keep doing it?

We tend to lose sight of this, for a couple of reasons. First, we don’t have a basic income, and our social welfare system is very minimal; so a job usually is the only way people have to provide for their standard of living, and they come to think of this as the purpose of the job. Second, many jobs don’t really “get done” in any clear sense; individual tasks are completed, but new ones always arise. After every email sent is another received; after every patient treated is another who falls ill.

But even that is really only true in the short run. In the long run, almost all jobs do actually get done, in the sense that no one has to do them anymore. The job of cleaning up after horses is done (with rare exceptions). The job of manufacturing vacuum tubes for computers is done. Indeed, the job of being a computer—that used to be a profession, young women toiling away with slide rules—is very much done. There are no court jesters anymore, no town criers, and very few artisans (and even then, they’re really more like hobbyists). There are more writers now than ever, and occasional stenographers, but there are no scribes—no one powerful but illiterate pays others just to write things down, because no one powerful is illiterate (and even few who are not powerful, and fewer all the time).

When a job “gets done” in this long-run sense, we usually say that it is obsolete, and again think of this as somehow a bad thing, like we are somehow losing the ability to do something. No, we are gaining the ability to do something better. Jobs don’t become obsolete because we can’t do them anymore; they become obsolete because we don’t need to do them anymore. Instead of computers being a profession that toils with slide rules, they are thinking machines that fit in our pockets; and there are plenty of jobs now for software engineers, web developers, network administrators, hardware designers, and so on as a result.

Soon, there will be no coal miners, and very few oil drillers—or at least I hope so, for the sake of our planet’s climate. There will be far fewer auto workers (robots have already done most of that already), but far more construction workers who install rail lines. There will be more nuclear engineers, more photovoltaic researchers, even more miners and roofers, because we need to mine uranium and install solar panels on rooftops.

Yet even by saying that I am falling into the trap: I am making it sound like the benefit of new technology is that it opens up more new jobs. Typically it does do that, but that isn’t what it’s for. The purpose of technology is to get things done.

Remember my parable of the dishwasher. The goal of our economy is not to make people work; it is to provide people with goods and services. If we could invent a machine today that would do the job of everyone in the world and thereby put us all out of work, most people think that would be terrible—but in fact it would be wonderful.

Or at least it could be, if we did it right. See, the problem right now is that while poor people think that the purpose of a job is to provide for their needs, rich people think that the purpose of poor people is to do jobs. If there are no jobs to be done, why bother with them? At that point, they’re just in the way! (Think I’m exaggerating? Why else would anyone put a work requirement on TANF and SNAP? To do that, you must literally think that poor people do not deserve to eat or have homes if they aren’t, right now, working for an employer. You can couch that in cold economic jargon as “maximizing work incentives”, but that’s what you’re doing—you’re threatening people with starvation if they can’t or won’t find jobs.)

What would happen if we tried to stop people from losing their jobs? Typically, inefficiency. When you aren’t allowed to lay people off when they are no longer doing useful work, we end up in a situation where a large segment of the population is being paid but isn’t doing useful work—and unlike the situation with a basic income, those people would lose their income, at least temporarily, if they quit and tried to do something more useful. There is still considerable uncertainty within the empirical literature on just how much “employment protection” (laws that make it hard to lay people off) actually creates inefficiency and reduces productivity and employment, so it could be that this effect is small—but even so, likewise it does not seem to have the desired effect of reducing unemployment either. It may be like minimum wage, where the effect just isn’t all that large. But it’s probably not saving people from being unemployed; it may simply be shifting the distribution of unemployment so that people with protected jobs are almost never unemployed and people without it are unemployed much more frequently. (This doesn’t have to be based in law, either; while it is made by custom rather than law, it’s quite clear that tenure for university professors makes tenured professors vastly more secure, but at the cost of making employment tenuous and underpaid for adjuncts.)

There are other policies we could make that are better than employment protection, active labor market policies like those in Denmark that would make it easier to find a good job. Yet even then, we’re assuming that everyone needs jobs–and increasingly, that just isn’t true.

So, when we invent a new technology that replaces workers, workers are laid off from their jobs—and that is as it should be. What happens next is what we do wrong, and it’s not even anybody in particular; this is something our whole society does wrong: All those displaced workers get nothing. The extra profit from the more efficient production goes entirely to the shareholders of the corporation—and those shareholders are almost entirely members of the top 0.01%. So the poor get poorer and the rich get richer.

The real problem here is not that people lose their jobs; it’s that capital ownership is distributed so unequally. And boy, is it ever! Here are some graphs I made of the distribution of net wealth in the US, using from the US Census.

Here are the quintiles of the population as a whole:

And here are the medians by race:

Medians by age:

Medians by education:

And, perhaps most instructively, here are the quintiles of people who own their homes versus renting (The rent is too damn high!)

All that is just within the US, and already they are ranging from the mean net wealth of the lowest quintile of people under 35 (-$45,000, yes negative—student loans) to the mean net wealth of the highest quintile of people with graduate degrees ($3.8 million). All but the top quintile of renters are poorer than all but the bottom quintile of homeowners. And the median Black or Hispanic person has less than one-tenth the wealth of the median White or Asian person.

If we look worldwide, wealth inequality is even starker. Based on UN University figures, 40% of world wealth is owned by the top 1%; 70% by the top 5%; and 80% by the top 10%. There is less total wealth in the bottom 80% than in the 80-90% decile alone. According to Oxfam, the richest 85 individuals own as much net wealth as the poorest 3.7 billion. They are the 0.000,001%.

If we had an equal distribution of capital ownership, people would be happy when their jobs became obsolete, because it would free them up to do other things (either new jobs, or simply leisure time), while not decreasing their income—because they would be the shareholders receiving those extra profits from higher efficiency. People would be excited to hear about new technologies that might displace their work, especially if those technologies would displace the tedious and difficult parts and leave the creative and fun parts. Losing your job could be the best thing that ever happened to you.

The business cycle would still be a problem; we have good reason not to let recessions happen. But stopping the churn of hiring and firing wouldn’t actually make our society better off; it would keep people in jobs where they don’t belong and prevent us from using our time and labor for its best use.

Perhaps the reason most people don’t even think of this solution is precisely because of the extreme inequality of capital distribution—and the fact that it has more or less always been this way since the dawn of civilization. It doesn’t seem to even occur to most people that capital income is a thing that exists, because they are so far removed from actually having any amount of capital sufficient to generate meaningful income. Perhaps when a robot takes their job, on some level they imagine that the robot is getting paid, when of course it’s the shareholders of the corporations that made the robot and the corporations that are using the robot in place of workers. Or perhaps they imagine that those shareholders actually did so much hard work they deserve to get paid that money for all the hours they spent.

Because pay is for work, isn’t it? The reason you get money is because you’ve earned it by your hard work?

No. This is a lie, told to you by the rich and powerful in order to control you. They know full well that income doesn’t just come from wages—most of their income doesn’t come from wages! Yet this is even built into our language; we say “net worth” and “earnings” rather than “net wealth” and “income”. (Parade magazine has a regular segment called “What People Earn”; it should be called “What People Receive”.) Money is not your just reward for your hard work—at least, not always.

The reason you get money is that this is a useful means of allocating resources in our society. (Remember, money was created by governments for the purpose of facilitating economic transactions. It is not something that occurs in nature.) Wages are one way to do that, but they are far from the only way; they are not even the only way currently in use. As technology advances, we should expect a larger proportion of our income to go to capital—but what we’ve been doing wrong is setting it up so that only a handful of people actually own any capital.

Fix that, and maybe people will finally be able to see that losing your job isn’t such a bad thing; it could even be satisfying, the fulfillment of finally getting something done.

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

2015-10-252017-10-08 pnrj core principles, financial fraud, inequality, macroeconomics, public policy Apple, Bernie Sanders, Bill Clinton, capital, capital gains, Center for American Progress, corporate welfare, debt, debt crisis, deficit, externalities, finance, fiscal policy, Henry George, high-frequency trading, income tax, Jon Stewart, Krugman, Marco Rubio, multiplier, Obama, progressive taxation, puppies and rainbows, reform, sales tax, Stiglitz, subsidy, tax expenditure, taxation, Tim Cook, unemployment, VAT, voodoo economics

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?”

What if employees were considered assets?

2015-10-142015-10-12 pnrj core principles, public policy accounting, asset, capital, credit, debit, equity, labor, liability, nonzero-sum, Robert Reich, wealth, zero-sum

JDN 2457308 EDT 15:31

Robert Reich has an interesting proposal to change the way we think about labor and capital:
“First, are workers assets to be developed or are they costs to be cut?” “Employers treat replaceable workers as costs to be cut, not as assets to be developed.”

This ultimately comes down to a fundamental question of how our accounting rules work: Workers are not considered assets, but wages are considered liabilities.

I don’t want to bore you with the details of accounting (accounting is often thought of as similar to economics, but really it’s the opposite of economics: Whereas economics is empirical, interesting, and fundamentally nonzero-sum, accounting is arbitrary, tedious, and zero-sum by construction), but I think it’s worth discussing the difference between how capital and labor are accounted.

By construction, every credit must come with a debit, no matter how arbitrary this may seem.

We start with an equation:

Assets + Expenses = Equity + Liabilities + Income

When purchasing a piece of capital, you credit the equity account with the capital you just bought, increasing it, then debit the expense account, increasing it as well. Because the capital is valued at the price at which you bought it, the increase in equity exactly balances the increase in expenses, and your assets, liabilities, and income do not change.

But when hiring a worker, you still debit the expense account, but now you credit the liabilities account, increasing it as well. So instead of increasing your equity, which is a good thing, you increase your liabilities, which is a bad thing.

This is why corporate executives are always on the lookout for ways to “cut labor costs”; they conceive of wages as simply outgoing money that doesn’t do anything useful, and therefore something to cut in order to increase profits.

Reich is basically suggesting that we start treating workers as equity, the same as we do with capital; and then corporate executives would be thinking in terms of making a “capital gain” by investing in their workers to increase their “value”.

The problem with this scheme is that it would really only make sense if corporations owned their workers—and I think we all know why that is not a good idea. The reason capital can be counted in the equity account is that capital can be sold off as a source of income; you don’t need to think of yourself as making a sort of “capital gain”; you can make, you know, actual capital gains.

I think actually the deeper problem here is that there is something wrong with accounting in general.

By its very nature, accounting is zero-sum. At best, this allows an error-checking mechanism wherein we can see if the two sides of the equation balance. But at worst, it makes us forget the point of economics.

While an individual may buy a capital asset on speculation, hoping to sell it for a higher price later, that isn’t what capital is for. At an aggregate level, speculation and arbitrage cannot increase real wealth; all they can do is move it around.

The reason we want to have capital is that it makes things—that the value of goods produced by a machine can far exceed the cost to produce that machine. It is in this way that capital—and indeed capitalism—creates real wealth.

Likewise, that is why we use labor—to make things. Labor is worthwhile because—and insofar as—the cost of the effort is less than the benefit of the outcome. Whether you are a baker, an author, a neurosurgeon, or an auto worker, the reason your job is worth doing is that the harm to you from doing it is smaller than the benefit to others from having it done. Indeed, the market mechanism is supposed to be structured so that by transferring wealth to you (i.e., paying you money), we make it so that both you and the people who buy your services are better off.

But accounting methods as we know them make no allowance for this; no matter what you do, the figures always balance. If you end up with more, someone else ends up with less. Since a worker is better off with a wage than they were before, we infer that a corporation must be worse off because it paid that wage. Since a corporation makes a profit selling a good, we infer that a consumer must be worse off because they paid for that purchase. We track the price of everything and understand the value of nothing.

There are two ways of pricing a capital asset: The cost to make it, or the value you get from it. Those two prices are only equal if markets are perfectly efficient, and even then they are only equal at the margin—the last factory built is worth what it can make, but every other factory built before that is worth more. It is that difference which creates real wealth—so assuming that they are the same basically defeats the purpose.

I don’t think we can do away with accounting; we need some way to keep track of where money goes, and we want that system to have built-in mechanisms to reduce rates of error and fraud. Double-entry bookkeeping certainly doesn’t make error and fraud disappear, but it at least does provide some protection against them, which we would lose if we removed the requirement that accounts must balance.

But somehow we need to restructure our metrics so that they give some sense of what economics is really about—not moving around a fixed amount of wealth, but making more wealth. Accounting for employees as assets wouldn’t solve that problem—but it might be a start, I guess?

Elasticity and the Law of Supply

2015-09-262015-09-26 pnrj core principles, public policy capital, Denmark, elasticity, housing, investment, land tax, Law of Supply, long-run, nuclear power, oil, property tax, real estate, rent control, short-run, Singapore, solar power, supply

JDN 2457292 EDT 16:16.

Today’s post is kind of a mirror image of the previous post earlier this week; I was talking about demand before, and now I’m talking about supply. (In the next post, I’ll talk about how the two work together to determine the actual price of goods.)

Just as there is an elasticity of demand which describes how rapidly the quantity demanded changes with changes in price, likewise there is an elasticity of supply which describes how much the quantity supplied changes with changes in price.

The elasticity of supply is defined as the proportional change in quantity supplied divided by the proportional change in price; so for example if the number of cars produced increases 10% when the price of cars increases by 5%, the elasticity of supply of cars would be 10%/5% = 2.

Goods that have high elasticity of supply will rapidly flood the market if the price increases even a small amount; goods that have low elasticity of supply will sell at about the same rate as ever even if the price increases dramatically.

Generally, the more initial investment of capital a good requires, the lower its elasticity of supply is going to be.

If most of the cost of production is in the actual marginal cost of producing each new gizmo, then elasticity of supply will be high, because it’s easy to produce more or produce less as the market changes.

But if most of the cost is in building machines or inventing technologies or training employees which already has to be done in order to make any at all, while the cost of each individual gizmo is unimportant, the elasticity of supply will be low, because there’s no sense letting all that capital you invested go to waste.
We can see these differences in action by comparing different sources of electric power.

Photovoltaic solar power has a high elasticity of supply, because building new solar panels is cheap and fast. As the price of solar energy fluctuates, the amount of solar panel produced changes rapidly. Technically this is actually a “fixed capital” cost, but it’s so modular that you can install as little or as much solar power capacity as you like, which makes it behave a lot more like a variable cost than a fixed cost. As a result, a 1% increase in the price paid for solar power increases the amount supplied by a whopping 2.7%, a supply elasticity of 2.7.

Oil has a moderate elasticity of supply, because finding new oil reserves is expensive but feasible. A lot of oil in the US is produced by small wells; 18% of US oil is produced by wells that put out less than 10 barrels per day. Those small wells can be turned on and off as the price of oil changes, and new ones can be built if it becomes profitable. As a result, investment in oil production is very strongly correlated with oil prices. Still, overall production of oil changes only moderate amounts; in the US it had been steadily decreasing since 1970 until very recently when new technologies and weakened regulations resulted in a rapid increase to near-1970s levels. We sort of did hit peak oil; but it’s never quite that simple.

Nuclear fission has a very low elasticity of supply, because building a nuclear reactor is extremely expensive and requires highly advanced expertise. Buil ding a nuclear power plant costs upward of $35 billion. Once a reactor is built, the cost of generating more power is relatively trivial; three-fourths of the cost a nuclear power plant will ever pay is paid simply to build it (or to pay back the debt incurred by doing so). Even if the price of uranium plummets or the price of oil skyrockets, it would take a long time before more nuclear power plants would be built in response.

Elasticity of supply is generally a lot larger in the long run than in the short run. Over a period of a few days or months, many types of production can’t be changed significantly. If you have a corn field, you grow as much corn as you can this season; even if the price rose substantially you couldn’t actually grow any more than your field will allow. But over a period of a year to a few years, most types of production can be changed; continuing with the corn example, you could buy new land to plant corn next season.

The Law of Supply is actually a lot closer to a true law than the Law of Demand. A negative elasticity of supply is almost unheard of; at worst elasticity of supply can sometimes drop close to zero. It really is true that elasticity of supply is almost always positive.

Land has an elasticity near zero; it’s extremely expensive (albeit not impossible; Singapore does it rather frequently) to actually create new land. As a result there’s really no good reason to ever raise the price of land; higher land prices don’t incentivize new production, they just transfer wealth to landowners. That’s why a land tax is such a good idea; it would transfer some of that wealth away from landowners and let us use it for public goods like infrastructure or research, or even just give it to the poor. A few countries actually have tried this; oddly enough, they include Singapore and Denmark, two of the few places in the world where the elasticity of land supply is appreciably above zero!

Real estate in general (which is what most property taxes are imposed on) is much trickier: In the short run it seems to have a very low elasticity, because building new houses or buildings takes a lot of time and money. But in the long run it actually has a high elasticity of supply, because there is a lot of profit to be made in building new structures if you can fund projects 10 or 15 years out. The short-run elasticity is something like 0.2, meaning a 1% increase in price only yields a 0.2% increase in supply; but the long-run elasticity may be as high as 8, meaning that a 1% increase in price yields an 8% increase in supply. This is why property taxes and rent controls seem like a really good idea at the time but actually probably have the effect of making housing more expensive. The economics of real estate has a number of fundamental differences from the economics of most other goods.

Many important policy questions ultimately hinge upon the elasticity of supply: If elasticity is high, then taxing or regulating something is likely to cause large distortions of the economy, while if elasticity is low, taxes and regulations can be used to support public goods or redistribute wealth without significant distortion to the economy. On the other hand, if elasticity is high, markets generally function well on their own, while if elasticity is low, prices can get far out of whack. As a general rule of thumb, government intervention in markets is most useful and most necessary when elasticity is low.

How much should we save?

2015-07-11 pnrj critique of neoclassical economics, macroeconomics, public policy Bridge to Nowhere, capital, consumption, credit constraint, crowding out, Golden Rule, Humane Genome Project, Hungary hyperinflation, interest, interest rate, investment, labor, life-cycle hypothesis, monetary base, monetary policy, money supply, open market operations, paradox of thrift, Paul Allen, Pirate Code, precautionary saving, quantitative easing, Save More Tomorrow, saving, saving-investment identity, self-control, Weimar Germany, zero lower bound, ZImbabwe

JDN 2457215 EDT 15:43.

One of the most basic questions in macroeconomics has oddly enough received very little attention: How much should we save? What is the optimal level of saving?

At the microeconomic level, how much you should save basically depends on what you think your income will be in the future. If you have more income now than you think you’ll have later, you should save now to spend later. If you have less income now than you think you’ll have later, you should spend now and dissave—save negatively, otherwise known as borrowing—and pay it back later. The life-cycle hypothesis says that people save when they are young in order to retire when they are old—in its strongest form, it says that we keep our level of spending constant across our lifetime at a value equal to our average income. The strongest form is utterly ridiculous and disproven by even the most basic empirical evidence, so usually the hypothesis is studied in a weaker form that basically just says that people save when they are young and spend when they are old—and even that runs into some serious problems.

The biggest problem, I think, is that the interest rate you receive on savings is always vastly less than the interest rate you pay on borrowing, which in turn is related to the fact that people are credit-constrained—they generally would like to borrow more than they actually can. It also has a lot to do with the fact that our financial system is an oligopoly; banks make more profits if they can pay savers less and charge borrowers more, and by colluding with each other they can control enough of the market that no major competitors can seriously undercut them. (There is some competition, however, particularly from credit unions—and if you compare these two credit card offers from University of Michigan Credit Union at 8.99%/12.99% and Bank of America at 12.99%/22.99% respectively, you can see the oligopoly in action as the tiny competitor charges you a much fairer price than the oligopoly beast. 9% means doubling in just under eight years, 13% means doubling in a little over five years, and 23% means doubling in three years.) Another very big problem with the life-cycle theory is that human beings are astonishingly bad at predicting the future, and thus our expectations about our future income can vary wildly from the actual future income we end up receiving. People who are wise enough to know that they do not know generally save more than they think they’ll need, which is called precautionary saving. Combine that with our limited capacity for self-control, and I’m honestly not sure the life-cycle hypothesis is doing any work for us at all.

But okay, let’s suppose we had a theory of optimal individual saving. That would still leave open a much larger question, namely optimal aggregate saving. The amount of saving that is best for each individual may not be best for society as a whole, and it becomes a difficult policy challenge to provide incentives to make people save the amount that is best for society.

Or it would be, if we had the faintest idea what the optimal amount of saving for society is. There’s a very simple rule-of-thumb that a lot of economists use, often called the golden rule (not to be confused with the actual Golden Rule, though I guess the idea is that a social optimum is a moral optimum), which is that we should save exactly the same amount as the share of capital in income. If capital receives one third of income (This figure of one third has been called a “law”, but as with most “laws” in economics it’s really more like the Pirate Code; labor’s share of income varies across countries and years. I doubt you’ll be surprised to learn that it is falling around the world, meaning more income is going to capital owners and less is going to workers.), then one third of income should be saved to make more capital for next year.

When you hear that, you should be thinking: “Wait. Saved to make more capital? You mean invested to make more capital.” And this is the great sleight of hand in the neoclassical theory of economic growth: Saving and investment are made to be the same by definition. It’s called the savings-investment identity. As I talked about in an earlier post, the model seems to be that there is only one kind of good in the world, and you either use it up or save it to make more.

But of course that’s not actually how the world works; there are different kinds of goods, and if people stop buying tennis shoes that doesn’t automatically lead to more factories built to make tennis shoes—indeed, quite the opposite.If people reduce their spending, the products they no longer buy will now accumulate on shelves and the businesses that make those products will start downsizing their production. If people increase their spending, the products they now buy will fly off the shelves and the businesses that make them will expand their production to keep up.

In order to make the savings-investment identity true by definition, the definition of investment has to be changed. Inventory accumulation, products building up on shelves, is counted as “investment” when of course it is nothing of the sort. Inventory accumulation is a bad sign for an economy; indeed the time when we see the most inventory accumulation is right at the beginning of a recession.

As a result of this bizarre definition of “investment” and its equation with saving, we get the famous Paradox of Thrift, which does indeed sound paradoxical in its usual formulation: “A global increase in marginal propensity to save can result in a reduction in aggregate saving.” But if you strip out the jargon, it makes a lot more sense: “If people suddenly stop spending money, companies will stop investing, and the economy will grind to a halt.” There’s still a bit of feeling of paradox from the fact that we tried to save more money and ended up with less money, but that isn’t too hard to understand once you consider that if everyone else stops spending, where are you going to get your money from?

So what if something like this happens, we all try to save more and end up having no money? The government could print a bunch of money and give it to people to spend, and then we’d have money, right? Right. Exactly right, in fact. You now understand monetary policy better than most policymakers. Like a basic income, for many people it seems too simple to be true; but in a nutshell, that is Keynesian monetary policy. When spending falls and the economy slows down as a result, the government should respond by expanding the money supply so that people start spending again. In practice they usually expand the money supply by a really bizarre roundabout way, buying and selling bonds in open market operations in order to change the interest rate that banks charge each other for loans of reserves, the Fed funds rate, in the hopes that banks will change their actual lending interest rates and more people will be able to borrow, thus, ultimately, increasing the money supply (because, remember, banks don’t have the money they lend you—they create it).

We could actually just print some money and give it to people (or rather, change a bunch of numbers in an IRS database), but this is very unpopular, particularly among people like Ron Paul and other gold-bug Republicans who don’t understand how monetary policy works. So instead we try to obscure the printing of money behind a bizarre chain of activities, opening many more opportunities for failure: Chiefly, we can hit the zero lower bound where interest rates are zero and can’t go any lower (or can they?), or banks can be too stingy and decide not to lend, or people can be too risk-averse and decide not to borrow; and that’s not even to mention the redistribution of wealth that happens when all the money you print is given to banks. When that happens we turn to “unconventional monetary policy”, which basically just means that we get a little bit more honest about the fact that we’re printing money. (Even then you get articles like this one insisting that quantitative easing isn’t really printing money.)

I don’t know, maybe there’s actually some legitimate reason to do it this way—I do have to admit that when governments start openly printing money it often doesn’t end well. But really the question is why you’re printing money, whom you’re giving it to, and above all how much you are printing. Weimar Germany printed money to pay off odious war debts (because it totally makes sense to force a newly-established democratic government to pay the debts incurred by belligerent actions of the monarchy they replaced; surely one must repay one’s debts). Hungary printed money to pay for rebuilding after the devastation of World War 2. Zimbabwe printed money to pay for a war (I’m sensing a pattern here) and compensate for failed land reform policies. In all three cases the amount of money they printed was literally billions of times their original money supply. Yes, billions. They found their inflation cascading out of control and instead of stopping the printing, they printed even more. The United States has so far printed only about three times our original monetary base, still only about a third of our total money supply. (Monetary base is the part that the Federal reserve controls; the rest is created by banks. Typically 90% of our money is not monetary base.) Moreover, we did it for the right reasons—in response to deflation and depression. That is why, as Matthew O’Brien of The Atlantic put it so well, the US can never be Weimar.

I was supposed to be talking about saving and investment; why am I talking about money supply? Because investment is driven by the money supply. It’s not driven by saving, it’s driven by lending.

Now, part of the underlying theory was that lending and saving are supposed to be tied together, with money lent coming out of money saved; this is true if you assume that things are in a nice tidy equilibrium. But we never are, and frankly I’m not sure we’d want to be. In order to reach that equilibrium, we’d either need to have full-reserve banking, or banks would have to otherwise have their lending constrained by insufficient reserves; either way, we’d need to have a constant money supply. Any dollar that could be lent, would have to be lent, and the whole debt market would have to be entirely constrained by the availability of savings. You wouldn’t get denied for a loan because your credit rating is too low; you’d get denied for a loan because the bank would literally not have enough money available to lend you. Banking would have to be perfectly competitive, so if one bank can’t do it, no bank can. Interest rates would have to precisely match the supply and demand of money in the same way that prices are supposed to precisely match the supply and demand of products (and I think we all know how well that works out). This is why it’s such a big problem that most macroeconomic models literally do not include a financial sector. They simply assume that the financial sector is operating at such perfect efficiency that money in equals money out always and everywhere.

So, recognizing that saving and investment are in fact not equal, we now have two separate questions: What is the optimal rate of saving, and what is the optimal rate of investment? For saving, I think the question is almost meaningless; individuals should save according to their future income (since they’re so bad at predicting it, we might want to encourage people to save extra, as in programs like Save More Tomorrow), but the aggregate level of saving isn’t an important question. The important question is the aggregate level of investment, and for that, I think there are two ways of looking at it.

The first way is to go back to that original neoclassical growth model and realize it makes a lot more sense when the s term we called “saving” actually is a funny way of writing “investment”; in that case, perhaps we should indeed invest the same proportion of income as the income that goes to capital. An interesting, if draconian, way to do so would be to actually require this—all and only capital income may be used for business investment. Labor income must be used for other things, and capital income can’t be used for anything else. The days of yachts bought on stock options would be over forever—though so would the days of striking it rich by putting your paycheck into a tech stock. Due to the extreme restrictions on individual freedom, I don’t think we should actually do such a thing; but it’s an interesting thought that might lead to an actual policy worth considering.

But a second way that might actually be better—since even though the model makes more sense this way, it still has a number of serious flaws—is to think about what we might actually do in order to increase or decrease investment, and then consider the costs and benefits of each of those policies. The simplest case to analyze is if the government invests directly—and since the most important investments like infrastructure, education, and basic research are usually done this way, it’s definitely a useful example. How is the government going to fund this investment in, say, a nuclear fusion project? They have four basic ways: Cut spending somewhere else, raise taxes, print money, or issue debt. If you cut spending, the question is whether the spending you cut is more or less important than the investment you’re making. If you raise taxes, the question is whether the harm done by the tax (which is generally of two flavors; first there’s the direct effect of taking someone’s money so they can’t use it now, and second there’s the distortions created in the market that may make it less efficient) is outweighed by the new project. If you print money or issue debt, it’s a subtler question, since you are no longer pulling from any individual person or project but rather from the economy as a whole. Actually, if your economy has unused capacity as in a depression, you aren’t pulling from anywhere—you’re simply adding new value basically from thin air, which is why deficit spending in depressions is such a good idea. (More precisely, you’re putting resources to use that were otherwise going to lay fallow—to go back to my earlier example, the tennis shoes will no longer rest on the shelves.) But if you do not have sufficient unused capacity, you will get crowding-out; new debt will raise interest rates and make other investments more expensive, while printing money will cause inflation and make everything more expensive. So you need to weigh that cost against the benefit of your new investment and decide whether it’s worth it.

This second way is of course a lot more complicated, a lot messier, a lot more controversial. It would be a lot easier if we could just say: “The target investment rate should be 33% of GDP.” But even then the question would remain as to which investments to fund, and which consumption to pull from. The abstraction of simply dividing the economy into “consumption” versus “investment” leaves out matters of the utmost importance; Paul Allen’s 400-foot yacht and food stamps for children are both “consumption”, but taxing the former to pay for the latter seems not only justified but outright obligatory. The Bridge to Nowhere and the Humane Genome Project are both “investment”, but I think we all know which one had a higher return for human society. The neoclassical model basically assumes that the optimal choices for consumption and investment are decided automatically (automagically?) by the inscrutable churnings of the free market, but clearly that simply isn’t true.

In fact, it’s not always clear what exactly constitutes “consumption” versus “investment”, and the particulars of answering that question may distract us from answering the questions that actually matter. Is a refrigerator investment because it’s a machine you buy that sticks around and does useful things for you? Or is it consumption because consumers buy it and you use it for food? Is a car an investment because it’s vital to getting a job? Or is it consumption because you enjoy driving it? Someone could probably argue that the appreciation on Paul Allen’s yacht makes it an investment, for instance. Feeding children really is an investment, in their so-called “human capital” that will make them more productive for the rest of their lives. Part of the money that went to the Humane Genome Project surely paid some graduate student who then spent part of his paycheck on a keg of beer, which would make it consumption. And so on. The important question really isn’t “is this consumption or investment?” but “Is this worth doing?” And thus, the best answer to the question, “How much should we save?” may be: “Who cares?”

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