How not to do financial transaction tax

JDN 2457520

I strongly support the implementation of a financial transaction tax; like a basic income, it’s one of those economic policy ideas that are so brilliantly simple it’s honestly a little hard to believe how incredibly effective they are at making the world a better place. You mean we might be able to end stock market crashes just by implementing this little tax that most people will never even notice, and it will raise enough revenue to pay for food stamps? Yes, a financial transaction tax is that good.

So, keep that in mind when I say this:

TruthOut’s proposal for a financial transaction tax is somewhere between completely economically illiterate and outright insane.

They propose a 10% transaction tax on stocks and a 1% transaction tax on notional value of derivatives, then offer a “compromise” of 5% on stocks and 0.5% on derivatives. They make a bunch of revenue projections based on these that clearly amount to nothing but multiplying the current amount of transactions by the tax rate, which is so completely wrong we now officially have a left-wing counterpart to trickle-down voodoo economics.

Their argument is basically like this (I’m paraphrasing): “If we have to pay 5% sales tax on groceries, why shouldn’t you have to pay 5% on stocks?”

But that’s not how any of this works.

Demand for most groceries is very inelastic, especially in the aggregate. While you might change which groceries you’ll buy depending on their respective prices, and you may buy in bulk or wait for sales, over a reasonably long period (say a year) across a large population (say all of Michigan or all of the US), total amount of spending on groceries is extremely stable. People only need a certain amount of food, and they generally buy that amount and then stop.

So, if you implement a 5% sales tax that applies to groceries (actually sales tax in most states doesn’t apply to most groceries, but honestly it probably should—offset the regressiveness by providing more social services), people would just… spend about 5% more on groceries. Probably a bit less than that, actually, since suppliers would absorb some of the tax; but demand is much less elastic for groceries than supply, so buyers would bear most of the incidence of the tax. (It does not matter how the tax is collected; see my tax incidence series for further explanation of why.)

Other goods like clothing and electronics are a bit more elastic, so you’d get some deadweight loss from the sales tax; but at a typical 5% to 10% in the US this is pretty minimal, and even the hefty 20% or 30% VATs in some European countries only have a moderate effect. (Denmark’s 180% sales tax on cars seems a bit excessive to me, but it is Pigovian to disincentivize driving, so it also has very little deadweight loss.)

But what would happen if you implemented a 5% transaction tax on stocks? The entire stock market would immediately collapse.

A typical return on stocks is between 5% and 15% per year. As a rule of thumb, let’s say about 10%.

If you pay 5% sales tax and trade once per year, tax just cut your return in half.

If you pay 5% sales tax and trade twice per year, tax destroyed your return completely.

Even if you only trade once every five years, a 5% sales tax means that instead of your stocks being worth 61% more after those 5 years they are only worth 53% more. Your annual return has been reduced from 10% to 8.9%.

But in fact there are many perfectly legitimate reasons to trade as often as monthly, and a 5% tax would make monthly trading completely unviable.

Even if you could somehow stop everyone from pulling out all their money just before the tax takes effect, you would still completely dry up the stock market as a source of funding for all but the most long-term projects. Corporations would either need to finance their entire operations out of cash or bonds, or collapse and trigger a global depression.

Derivatives are even more extreme. The notional value of derivatives is often ludicrously huge; we currently have over a quadrillion dollars in notional value of outstanding derivatives. Assume that say 10% of those are traded every year, and we’re talking $100 trillion in notional value of transactions. At 0.5% you’re trying to take in a tax of $500 billion. That sounds fantastic—so much money!—but in fact what you should be thinking about is that’s a really strong avoidance incentive. You don’t think banks will find a way to restructure their trading practices—or stop trading altogether—to avoid this tax?

Honestly, maybe a total end to derivatives trading would be tolerable. I certainly think we need to dramatically reduce the amount of derivatives trading, and much of what is being traded—credit default swaps, collateralized debt obligations, synthetic collateralized debt obligations, etc.—really should not exist and serves no real function except to obscure fraud and speculation. (Credit default swaps are basically insurance you can buy on other people’s companies. There’s a reason you’re not allowed to buy insurance on other people’s stuff!) Interest rate swaps aren’t terrible (when they’re not being used to perpetrate the largest white-collar crime in history), but they also aren’t necessary. You might be able to convince me that commodity futures and stock options are genuinely useful, though even these are clearly overrated. (Fun fact: Futures markets have been causing financial crises since at least Classical Rome.) Exchange-traded funds are technically derivatives, and they’re just fine (actually ETFs are very low-risk, because they are inherently diversified—which is why you should probably be buying them); but actually their returns are more like stocks, so the 0.5% might not be insanely high in that case.

But stocks? We kind of need those. Equity financing has been the foundation of capitalism since the very beginning. Maybe we could conceivably go to a fully debt-financed system, but it would be a radical overhaul of our entire financial system and is certainly not something to be done lightly.

Indeed, TruthOut even seems to think we could apply the same sales tax rate to bonds, which means that debt financing would also collapse, and now we’re definitely talking about global depression. How exactly is anyone supposed to finance new investments, if they can’t sell stock or bonds? And a 5% tax on the face value of stock or bonds, for all practical purposes, is saying that you can’t sell stock or bonds. It would make no one want to buy them.

Wealthy investors buying of stocks and bonds is essentially no different than average folks buying food, clothing or other real “goods and services.”

Yes it is. It is fundamentally different.

People buy goods to use them. People buy stocks to make money selling them.

This seems perfectly obvious, but it is a vital distinction that seems to be lost on TruthOut.

When you buy an apple or a shoe or a phone or a car, you care how much it costs relative to how useful it is to you; if we make it a bit more expensive, that will make you a bit less likely to buy it—but probably not even one-to-one so that a 5% tax would reduce purchases by 5%; it would probably be more like a 2% reduction. Demand for goods is inelastic. Taxing them will raise a lot of revenue and not reduce the quantity purchased very much.

But when you buy a stock or a bond or an interest rate swap, you care how much it costs relative to what you will be able to sell it for—you care about not its utility but its return. So a 5% tax will reduce the amount of buying and selling by substantially more than 5%—it could well be 50% or even 100%. Demand for financial assets is elastic. Taxing them will not raise much revenue but will substantially reduce the quantity purchased.

Now, for some financial assets, we want to reduce the quantity purchased—the derivatives market is clearly too big, and high-frequency trading that trades thousands of times per second can do nothing but destabilize the financial system. Joseph Stiglitz supports a small financial transaction tax precisely because it would substantially reduce high-frequency trading, and he’s a Nobel Laureate as you may recall. Naturally, he was excluded from the SEC hearings on the subject, because reasons. But the figures Stiglitz is talking about (and I agree with) are on the order of 0.1% for stocks and 0.01% for derivatives—50 times smaller than what TruthOut is advocating.

At the end, they offer another “compromise”:

Okay, half it again, to a 2.5 percent tax on stocks and bonds and a 0.25 percent on derivative trades. That certainly won’t discourage stock and bond trading by the rich (not that that is an all bad idea either).

Yes it will. By a lot. That’s the whole point.

A financial transaction tax is a great idea whose time has come; let’s not ruin its reputation by setting it at a preposterous value. Just as a $15 minimum wage is probably a good idea but a $250 minimum wage is definitely a terrible idea, a 0.1% financial transaction tax could be very beneficial but a 5% financial transaction tax would clearly be disastrous.

Tax incidence revisited, part 2: How taxes affect prices

JDN 2457341

One of the most important aspects of taxation is also one of the most counter-intuitive and (relatedly) least-understood: Taxes are not externally applied to pre-existing exchanges of money. Taxes endogenously interact with the system of prices, changing what the prices will be and then taking a portion of the money exchanged.

The price of something “before taxes” is not actually the price you would pay for it if there had been no taxes on it. Your “pre-tax income” is not actually the income you would have had if there were no income or payroll taxes.

The most obvious case to consider is that of government employees: If there were no taxes, public school teachers could not exist, so the “pre-tax income” of a public school teacher is a meaningless quantity. You don’t “take taxes out” of a government salary; you decide how much money the government employee will actually receive, and then at the same time allocate a certain amount into other budgets based on the tax code—a certain amount into the state general fund, a certain amount into the Social Security Trust Fund, and so on. These two actions could in principle be done completely separately; instead of saying that a teacher has a “pre-tax salary” of $50,000 and is taxed 20%, you could simply say that the teacher receives $40,000 and pay $10,000 into the appropriate other budgets.

In fact, when there is a conflict of international jurisdiction this is sometimes literally what we do. Employees of the World Bank are given immunity from all income and payroll taxes (effectively, diplomatic immunity, though this is not usually how we use the term) based on international law, except for US citizens, who have their taxes paid for them by the World Bank. As a result, all World Bank salaries are quoted “after-tax”, that is, the actual amount of money employees will receive in their paychecks. As a result, a $120,000 salary at the World Bank is considerably higher than a $120,000 salary at Goldman Sachs; the latter would only (“only”) pay about $96,000 in real terms.

For private-sector salaries, it’s not as obvious, but it’s still true. There is actually someone who pays that “before-tax” salary—namely, the employer. “Pre-tax” salaries are actually a measure of labor expenditure (sometimes erroneously called “labor costs”, even by economists—but a true labor cost is the amount of effort, discomfort, stress, and opportunity cost involved in doing labor; it’s an amount of utility, not an amount of money). The salary “before tax” is the amount of money that the employer has to come up with in order to pay their payroll. It is a real amount of money being exchanged, divided between the employee and the government.

The key thing to realize is that salaries are not set in a vacuum. There are various economic (and political) pressures which drive employers to set different salaries. In the real world, there are all sorts of pressures that affect salaries: labor unions, regulations, racist and sexist biases, nepotism, psychological heuristics, employees with different levels of bargaining skill, employers with different concepts of fairness or levels of generosity, corporate boards concerned about public relations, shareholder activism, and so on.

But even if we abstract away from all that for a moment and just look at the fundamental economics, assuming that salaries are set at the price the market will bear, that price depends upon the tax system.

This is because taxes effectively drive a wedge between supply and demand.

Indeed, on a graph, it actually looks like a wedge, as you’ll see in a moment.

Let’s pretend that we’re in a perfectly competitive market. Everyone is completely rational, we all have perfect information, and nobody has any power to manipulate the market. We’ll even assume that we are dealing with hourly wages and we can freely choose the number of hours worked. (This is silly, of course; but removing this complexity helps to clarify the concept and doesn’t change the basic result that prices depend upon taxes.)

We’ll have a supply curve, which is a graph of the minimum price the worker is willing to accept for each hour in order to work a given number of hours. We generally assume that the supply curve slopes upward, meaning that people are willing to work more hours if you offer them a higher wage for each hour. The idea is that it gets progressively harder to find the time—it eats into more and more important alternative activities. (This is in fact a gross oversimplification, but it’ll do for now. In the real world, labor is the one thing for which the supply curve frequently bends backward.)

supply_curve

We’ll also have a demand curve, which is a graph of the maximum price the employer is willing to pay for each hour, if the employee works that many hours. We generally assume that the demand curve slopes downward, meaning that the employer is willing to pay less for each hour if the employee works more hours. The reason is that most activities have diminishing marginal returns, so each extra hour of work generally produces less output than the previous hour, and is therefore not worth paying as much for. (This too is an oversimplification, as I discussed previously in my post on the Law of Demand.)

demand_curve

Put these two together, and in a competitive market the price will be set at the point at which supply is equal to demand, so that the very last hour of work was worth exactly what the employer paid for it. That last hour is just barely worth it to the employer, and just barely worth it to the worker; any additional time would either be too expensive for the employer or not lucrative enough for the worker. But for all the previous hours, the value to the employer is higher than the wage, and the cost to the worker is lower than the wage. As a result, both the employer and the worker benefit.

equilibrium_notax

But now, suppose we implement a tax. For concreteness, suppose the previous market-clearing wage was $20 per hour, the worker was working 40 hours, and the tax is 20%. If the employer still offers a wage of $20 for 40 hours of work, the worker is no longer going to accept it, because they will only receive $16 per hour after taxes, and $16 isn’t enough for them to be willing to work 40 hours. The worker could ask for a pre-tax wage of $25 so that the after-tax wage would be $20, but then the employer will balk, because $25 per hour is too expensive for 40 hours of work.

In order to restore the balance (and when we say “equilibrium”, that’s really all we mean—balance), the employer will need to offer a higher pre-tax wage, which means they will demand fewer hours of work. The worker will then be willing to accept a lower after-tax wage for those reduced hours.

In effect, there are now two prices at work: A supply price, the after-tax wage that the worker receives, which must be at or above the supply curve; and a demand price, the pre-tax wage that the employer pays, which must be at or below the demand curve. The difference between those two prices is the tax.

equilibrium_tax

In this case, I’ve set it up so that the pre-tax wage is $22.50, the after-tax wage is $18, and the amount of the tax is $4.50 or 20% of $22.50. In order for both the employer and the worker to accept those prices, the amount of hours worked has been reduced to 35.

As a result of the tax, the wage that we’ve been calling “pre-tax” is actually higher than the wage that the worker would have received if the tax had not existed. This is a general phenomenon; it’s almost always true that your “pre-tax” wage or salary overestimates what you would have actually gotten if the tax had not existed. In one extreme case, it might actually be the same; in another extreme case, your after-tax wage is what you would have received and the “pre-tax” wage rises high enough to account for the entirety of the tax revenue. It’s not really “pre-tax” at all; it’s the after-tax demand price.

Because of this, it’s fundamentally wrongheaded for people to complain that taxes are “taking your hard-earned money”. In all but the most exceptional cases, that “pre-tax” salary that’s being deducted from would never have existed. It’s more of an accounting construct than anything else, or like I said before a measure of labor expenditure. It is generally true that your after-tax salary is lower than the salary you would have gotten without the tax, but the difference is generally much smaller than the amount of the tax that you see deducted. In this case, the worker would see $4.50 per hour deducted from their wage, but in fact they are only down $2 per hour from where they would have been without the tax. And of course, none of this includes the benefits of the tax, which in many cases actually far exceed the costs; if we extended the example, it wouldn’t be hard to devise a scenario in which the worker who had their wage income reduced received an even larger benefit in the form of some public good such as national defense or infrastructure.

The scissors of supply and demand

JDN 2457299 EDT 17:03

In recent posts I talked about demand and then I talked about supply. Now it’s time to talk about both at once–which is where the real magic happens. Alfred Marshall famously compared supply and demand to the lower and upper blades of a pair of scissors:

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.

~Alfred Marshall, Principles of Economics

Before Marshall, it was actually rather common to debate whether prices are determined by supply or by demand. Actually there seems to be a certain branch of Marxists today who insist upon the “labor theory of value” that seems to rest upon a similar sort of confusion, basically saying that the real value of something is entirely determined by its cost of supply. If the value of something were strictly determined by the labor put into making it, there would be literally no reason to ever make anything. If the value you get from a good is precisely equal to the labor put into it, there is no net benefit to ever making any goods. At most, embodying labor in a product might allow you to transfer labor from one person to another; but there would be no such thing as real economic growth. In order to have real economic growth, products must end up being worth more than what it cost to make them—that is, their value of demand must exceed their cost of supply.

Toward the other end of the political spectrum, we have “Say’s Law”, which says that “supply creates its own demand”; that is, that there is never any such thing as too much or too little overall demand in an economy, because supplying a good automatically makes that good available to trade for something else. I hate to even call it a “law” because isn’t even like the Pirate Code; it’s not even useful as a guideline, it’s just flat wrong. There is absolutely no reason that making something would make someone else want to buy it from you. You can make all sorts of things that nobody wants to buy; the possibilities are endless, really. Balls of lint dusted with powdered sugar, broken ballpoint pens dipped in motor oil, burnt-out lightbulbs covered in melted Swiss cheese. It’s possible that someone might want to buy such bizarre items (call them “postmodernist found art” or something), but there clearly isn’t a large market for such goods, even if you should decide to manufacture thousands of them. Even in an aggregate sense, there’s also no particular reason to think that we can’t have an economy where millions of products pile up on shelves because no one can afford to buy them; indeed, that’s basically what happens in a recession.

In fact, the converse, “demand creates its own supply”, is considerably closer to true. It’s still not strictly true—centuries of searching for the elixir of immortality have failed to produce it, though modern genetic engineering just might finally succeed where all else has failed. (After all, every new technology is impossible… until it isn’t.) But in the long run, this converse law (it doesn’t have a name so far as I know) does contain an important grain of truth: If people want something badly enough, they will spend enormous resources in order to find a way to get it. If you know that a lot of people want something that no one is supplying, it behooves you to find a way to provide it—it might just make you a billionaire. Over centuries of technological advancement, humanity has found ways to provide many goods and services that were previously thought impossible, and one of the central benefits of a capitalist economy is that it provides powerful economic incentives for entrepreneurs to innovate and find ways to provide goods that people have always wanted but never had. Yet, even so, it isn’t true that demand creates its own supply—certainly not in the short run.

Neither supply or demand on its own does much of anything. You can have insatiable demand for something nobody can supply (the aforementioned elixir of immortality), and it still won’t be sold. You can have endless supply of something nobody demands (vacuum?), and it will remain worthless. It’s only when you have both supply and demand that a market becomes possible.

One of the central insights of modern economics is that prices and quantities in a capitalist market are determined simultaneously by supply and demand. In general, both supply and demand are constantly changing in response to events in the world, and thus the prices and quantities of goods shift from one equilibrium to another. In order to predict exactly how they will shift, we would need to know how both supply and demand have changed.

As Marshall alludes to in the above quotation, in some cases we can take either supply or demand as fixed and then the other one is what matters; but these are only special cases. In general, both supply and demand are subject to the winds of changing markets, and we need to keep track of both at once. If that sounds really difficult, that’s because it is—most of what economists do in the real world ultimately amounts to finding ways to distinguish supply effects from demand effects in various situations. Even most statistical methods in econometrics were basically designed as means of separating out demand-related causes from supply-related causes.

A lot of policy questions ultimately depend upon whether supply or demand is the dominant factor: If the business cycle is primarily driven by changes in demand, it makes sense to use monetary and fiscal policy to stabilize the economy (short version: it is, and it does). If it were instead driven by supply (“supply-side economics”), it would instead be better to make structural changes that reduce costs of production. (Why is this obviously wrong? Because there weren’t sudden increases in production costs in 2008—but there was a sudden collapse of consumer buying power. Maybe the 1973 recession can be explained by a sudden increase in oil prices, but there was no such supply shock in 2008.) If the labor market is primarily driven by demand, we need to find ways to get business to hire more people; but if it’s primarily driven by supply, we need to find ways to get people to get off their butts and try to find work. (Again, I think it’s pretty obvious that the former is true, not the latter—since at least 2000 there have never been as many job openings in the US as there were unemployed people.)

In the above policy questions the liberal view is the demand-side and the conservative view is the supply-side, but that need not be the case. Regarding renewable energy, for example, the more liberal view is that lots of people would want to buy electric cars and solar panels, if they were made available, but they aren’t—we are supply-constrained. The more conservative view is that the reason they aren’t selling more is that nobody particularly wants them and trying to force them on us is a fool’s errand—we are demand-constrained. Likewise when it comes to banking, liberals generally think that the reason there isn’t more credit is that banks refuse to supply loans, while conservatives (particularly from the banks themselves) usually argue that it’s because people aren’t willing to take the risk of taking out more loans.

The point, however, is that a lot of policy debates ultimately hinge upon the question of whether demand or supply is more important in driving a particular market—and since sometimes they are both important, sometimes the policy solution requires a combination of different approaches. One of the advantages of quantitative economic analysis is that we can determine exactly how much the costs and benefits of each policy option will be, and thereby choose the one that is most cost-effective.

In this way, “supply or demand?” is a lot like “nature or nurture?”; the answer is always “both”, but there are times when one factor or the other is more important for the policy question at hand.

Elasticity and the Law of Demand

JDN 2457289 EDT 21:04

This will be the second post in my new bite-size format, the first one that’s in the middle of the week.

I’ve alluded previously to the subject of demand elasticity, but I think it’s worth explaining in a little more detail. The basic concept is fairly straightforward: Demand is more elastic when the amount that people want to buy changes a large amount for a small change in price. The opposite is inelastic.

Apples are a relatively elastic good. If the price of apples goes up, people buy fewer apples. Maybe they buy other fruit instead, such as oranges or bananas; or maybe they give up on fruit and eat something else, like rice.

Salt is an extremely inelastic good. No matter what the price of salt is, at least within the range it has been for the last few centuries, people are going to continue to buy pretty much the same amount of salt. (In ancient times salt was actually expensive enough that people couldn’t afford enough of it, which was particularly harmful in desert regions. Mark Kulansky’s book Salt on this subject is surprisingly compelling, given the topic.)
Specifically, the elasticity is equal to the proportional change in quantity demanded, divided by the proportional change in price.

For example, if the price of gas rises from $2 per gallon to $3 per gallon, that’s a 50% increase. If the quantity of gas purchase then falls from 100 billion gallons to 90 billion gallons, that’s a 10% decrease. If increasing the price by 50% decreased the quantity demanded by 10%, that would be a demand elasticity of -10%/50% = -1/5 = -0.2

In practice, measuring elasticity is more complicated than that, because supply and demand are both changing at the same time; so when we see a price change and a quantity change, it isn’t always clear how much of each change is due to supply and how much is due to demand. Sophisticated econometric techniques have been developed to try to separate these two effects (in future posts I plan to explain the basics of some of these techniques), but it’s difficult and not always successful.

In general, markets function better when supply and demand are more elastic. When shifts in price trigger large shifts in quantity, this creates pressure on the price to remain at a fixed level rather than jumping up and down. This in turn means that the market will generally be predictable and stable.

It’s also much harder to make monopoly profits in a market with elastic demand; even if you do have a monopoly, if demand is highly elastic then raising the price won’t make you any money, because whatever you gain in selling each gizmo for more, you’ll lose in selling fewer gizmos. In fact, the profit margin for a monopoly is inversely proportional to the elasticity of demand.

Markets do not function well when supply and demand are highly inelastic. Monopolies can become very powerful and result in very large losses of human welfare. A particularly vivid example of this was in the news recently, when a company named Turing purchased the rights to a drug called Daraprim used primarily by AIDS patients, then hiked the price from $13.50 to $750. This made enough people mad that the CEO has since promised to bring it back down, though he hasn’t said how far.

That price change was only possible because Daraprim has highly inelastic demand—if you’ve got AIDS, you’re going to take AIDS medicine, as much as prescribed, provided only that it doesn’t drive you completely bankrupt. (Not an unreasonable fear, as medical costs are the leading cause of bankruptcy in the United States.) This raised price probably would bankrupt a few people, but for the most part it wouldn’t affect the amount of drug sold; it would just funnel a huge amount of money from AIDS patients to the company. This is probably part of why it made people so mad; that and there would probably be a few people who died because they couldn’t afford this new expensive medication.

Imagine if a company had tried to pull the same stunt for a more elastic good, like apples. “CEO buys up all apple farms, raises price of apples from $2 per pound to $100 per pound.” What’s going to happen then? People are not going to buy any apples. Perhaps a handful of the most die-hard apple lovers still would, but the rest of us are going to meet our fruit needs elsewhere.

For most goods most of the time, elasticity of demand is negative, meaning that as price increases, quantity demanded decreases. This is in fact called the Law of Demand; but as I’ve said, “laws” in economics are like the Pirate Code: They’re really more what you’d call “guidelines”.
There are three major exceptions to the Law of Demand. The first one is the one most economists talk about, and it almost never happens. The second one is talked about occasionally, and it’s quite common. The third one is almost never talked about, and yet it is by far the most common and one of the central driving forces in modern capitalism.
The exception that we usually talk about in economics is called the Giffen Effect. A Giffen good is a good that’s so cheap and such a bare necessity that when it becomes more expensive, you won’t be able to buy less of it; instead you’ll buy more of it, and buy less of other things with your reduced income.

It’s very hard to come up with empirical examples of Giffen goods, but it’s an easy theoretical argument to make. Suppose you’re buying grapes for a party, and you know you need 4 bags of grapes. You have $10 to spend. Suppose there are green grapes selling for $1 per bag and red grapes selling for $4 per bag, and suppose you like red grapes better. With your $10, you can buy 2 bags of green grapes and 2 bags of red grapes, and that’s the 4 bags you need. But now suppose that the price of green grapes rises to $2 per bag. In order to afford 4 bags of grapes, you now need to buy 3 bags of green grapes and only 1 bag of red grapes. Even though it was the price of green grapes that rose, you ended up buying more green grapes. In this scenario, green grapes are a Giffen good.

The exception that is talked about occasionally and occurs a lot in real life is the Veblen Effect. Whereas a Giffen good is a very cheap bare necessity, a Veblen good is a very expensive pure luxury.

The whole point of buying a Veblen good is to prove that you can. You don’t buy a Ferrari because a Ferrari is a particularly nice automobile (a Prius is probably better, and a Tesla certainly is); you buy a Ferrari to show off that you’re so rich you can buy a Ferrari.

On my previous post, jenszorn asked: “Much of consumer behavior is irrational by your standards. But people often like to spend money just for the sake of spending and for showing off. Why else does a Rolex carry a price tag for $10,000 for a Rolex watch when a $100 Seiko keeps better time and requires far less maintenance?” Veblen goods! It’s not strictly true that Veblen goods are irrational; it can be in any particular individual’s best interest is served by buying Veblen goods in order to signal their status and reap the benefits of that higher status. However, it’s definitely true that Veblen goods are inefficient; because ostentatious displays of wealth are a zero-sum game (it’s not about what you have, it’s about what you have that others don’t), any resources spent on rich people proving how rich they are are resources that society could otherwise have used, say, feeding the poor, curing diseases, building infrastructure, or colonizing other planets.

Veblen goods can also result in a violation of the Law of Demand, because raising the price of a Veblen good like Ferraris or Rolexes can make them even better at showing off how rich you are, and therefore more appealing to the kind of person who buys them. Conversely, lowering the price might not result in any more being purchased, because they wouldn’t seem as impressive anymore. Currently a Ferrari costs about $250,000; if they reduced that figure to $100,000, there aren’t a lot of people who would suddenly find it affordable, but many people who currently buy Ferraris might switch to Bugattis or Lamborghinis instead. There are limits to this, of course: If the price of a Ferrari dropped to $2,000, people wouldn’t buy them to show off anymore; but the far larger effect would be the millions of people buying them because you can now get a perfectly good car for $2,000. Yes, I would sell my dear little Smart if it meant I could buy a Ferrari instead and save $8,000 at the same time.

But the third major exception to the Law of Demand is actually the most important one, yet it’s the one that economists hardly ever talk about: Speculation.

The most common reason why people would buy more of something that has gotten more expensive is that they expect it to continue getting more expensive, and then they will be able to sell what they bought at an even higher price and make a profit.

When the price of Apple stock goes up, do people stop buying Apple stock? On the contrary, they almost certainly start buying more—and then the price goes up even further still. If rising prices get self-fulfilling enough, you get an asset bubble; it grows and grows until one day it can’t, and then the bubble bursts and prices collapse again. This has happened hundreds of times in history, from the Tulip Mania to the Beanie Baby Bubble to the Dotcom Boom to the US Housing Crisis.

It isn’t necessarily irrational to participate in a bubble; some people must be irrational, but most people can buy above what they would be willing to pay by accurately predicting that they’ll find someone else who is willing to pay an even higher price later. It’s called Greater Fool Theory: The price I paid may be foolish, but I’ll find someone who is even more foolish to take it off my hands. But like Veblen goods, speculation goods are most definitely inefficient; nothing good comes from prices that rise and fall wildly out of sync with the real value of goods.

Speculation goods are all around us, from stocks to gold to real estate. Most speculation goods also serve some other function (though some, like gold, are really mostly just Veblen goods otherwise; actual useful applications of gold are extremely rare), but their speculative function often controls their price in a way that dominates all other considerations. There’s no real limit to how high or low the price can go for a speculation good; no longer tied to the real value of the good, it simply becomes a question of how much people decide to pay.

Indeed, speculation bubbles are one of the fundamental problems with capitalism as we know it; they are one of the chief causes of the boom-and-bust business cycle that has cost the world trillions of dollars and thousands of lives. Most of our financial industry is now dedicated to the trading of speculation goods, and finance is taking over a larger and larger section of our economy all the time. Many of the world’s best and brightest are being funneled into finance instead of genuinely productive industries; 15% of Harvard grads take a job in finance, and almost half did just before the crash. The vast majority of what goes on in our financial system is simply elaborations on speculation; very little real productivity ever enters into the equation.

In fact, as a general rule I think when we see a violation of the Law of Demand, we know that something is wrong in the economy. If there are Giffen goods, some people are too poor to buy what they really need. If there are Veblen goods, inequality is too large and people are wasting resources competing for status. And since there are always speculation goods, the history of capitalism has been a history of market instability.

Fortunately, elasticity of demand is usually negative: As the price goes up, people want to buy less. How much less is the elasticity.

Is marginal productivity fair?

JDN 2456963 PDT 11:11.

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

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

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

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

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

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

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

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

supply_demand2

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

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

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

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

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

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

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

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

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

elastic_supply

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

inelastic_supply

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

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

elastic_demand

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

inelastic_demand

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

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

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

monopoly_power

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 Who are the job creators?

JDN 2456956 PDT 11:30.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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