saving

The right (and wrong) way to buy stocks

pnrj financial advice, heuristics and biases , , , , , , , , , , , , , , , , , , ,

July 9, JDN 2457944

Most people don’t buy stocks at all. Stock equity is the quintessential form of financial wealth, and 42% of financial net wealth in the United States is held by the top 1%, while the bottom 80% owns essentially none.

Half of American households do not have any private retirement savings at all, and are depending either on employee pensions or Social Security for their retirement plans.

This is not necessarily irrational. In order to save for retirement, one must first have sufficient income to live on. Indeed, I got very annoyed at a “financial planning seminar” for grad students I attended recently, trying to scare us about the fact that almost none of us had any meaningful retirement savings. No, we shouldn’t have meaningful retirement savings, because our income is currently much lower than what we can expect to get once we graduate and enter our professions. It doesn’t make sense for someone scraping by on a $20,000 per year graduate student stipend to be saving up for retirement, when they can quite reasonably expect to be making $70,000-$100,000 per year once they finally get that PhD and become a professional economist (or sociologist, or psychologist or physicist or statistician or political scientist or material, mechanical, chemical, or aerospace engineer, or college professor in general, etc.). Even social workers, historians, and archaeologists make a lot more money than grad students. If you are already in the workforce and only expect to be getting small raises in the future, maybe you should start saving for retirement in your 20s. If you’re a grad student, don’t bother. It’ll be a lot easier to save once your income triples after graduation. (Personally, I keep about $700 in stocks mostly to get a feel for what it is like owning and trading stocks that I will apply later, not out of any serious expectation to support a retirement fund. Even at Warren Buffet-level returns I wouldn’t make more than $200 a year this way.)

Total US retirement savings are over $25 trillion, which… does actually sound low to me. In a country with a GDP now over $19 trillion, that means we’ve only saved a year and change of total income. If we had a rapidly growing population this might be fine, but we don’t; our population is fairly stable. People seem to be relying on economic growth to provide for their retirement, and since we are almost certainly at steady-state capital stock and fairly near full employment, that means waiting for technological advancement.

So basically people are hoping that we get to the Wall-E future where the robots will provide for us. And hey, maybe we will; but assuming that we haven’t abandoned capitalism by then (as they certainly haven’t in Wall-E), maybe you should try to make sure you own some assets to pay for robots with?

But okay, let’s set all that aside, and say you do actually want to save for retirement. How should you go about doing it?

Stocks are clearly the way to go. A certain proportion of government bonds also makes sense as a hedge against risk, and maybe you should even throw in the occasional commodity future. I wouldn’t recommend oil or coal at this point—either we do something about climate change and those prices plummet, or we don’t and we’ve got bigger problems—but it’s hard to go wrong with corn or steel, and for this one purpose it also can make sense to buy gold as well. Gold is not a magical panacea or the foundation of all wealth, but its price does tend to correlate negatively with stock returns, so it’s not a bad risk hedge.

Don’t buy exotic derivatives unless you really know what you’re doing—they can make a lot of money, but they can lose it just as fast—and never buy non-portfolio assets as a financial investment. If your goal is to buy something to make money, make it something you can trade at the click of a button. Buy a house because you want to live in that house. Buy wine because you like drinking wine. Don’t buy a house in the hopes of making a financial return—you’ll have leveraged your entire portfolio 10 to 1 while leaving it completely undiversified. And the problem with investing in wine, ironically, is its lack of liquidity.

The core of your investment portfolio should definitely be stocks. The biggest reason for this is the equity premium; equities—that is, stocks—get returns so much higher than other assets that it’s actually baffling to most economists. Bond returns are currently terrible, while stock returns are currently fantastic. The former is currently near 0% in inflation-adjusted terms, while the latter is closer to 16%. If this continues for the next 10 years, that means that $1000 put in bonds would be worth… $1000, while $1000 put in stocks would be worth $4400. So, do you want to keep the same amount of money, or quadruple your money? It’s up to you.

Higher risk is generally associated with higher return, because rational investors will only accept additional risk when they get some additional benefit from it; and stocks are indeed riskier than most other assets, but not that much riskier. For this to be rational, people would need to be extremely risk-averse, to the point where they should never drive a car or eat a cheeseburger. (Of course, human beings are terrible at assessing risk, so what I really think is going on is that people wildly underestimate the risk of driving a car and wildly overestimate the risk of buying stocks.)

Next, you may be asking: How does one buy stocks? This doesn’t seem to be something people teach in school.

You will need a brokerage of some sort. There are many such brokerages, but they are basically all equivalent except for the fees they charge. Some of them will try to offer you various bells and whistles to justify whatever additional cut they get of your trades, but they are almost never worth it. You should choose one that has a low a trade fee as possible, because even a few dollars here and there can add up surprisingly quickly.

Fortunately, there is now at least one well-established reliable stock brokerage available to almost anyone that has a standard trade fee of zero. They are called Robinhood, and I highly recommend them. If they have any downside, it is ironically that they make trading too easy, so you can be tempted to do it too often. Learn to resist that urge, and they will serve you well and cost you nothing.

Now, which stocks should you buy? There are a lot of them out there. The answer I’m going to give may sound strange: All of them. You should buy all the stocks.

All of them? How can you buy all of them? Wouldn’t that be ludicrously expensive?

No, it’s quite affordable in fact. In my little $700 portfolio, I own every single stock in the S&P 500 and the NASDAQ. If I get a little extra money to save, I may expand to own every stock in Europe and China as well.

How? A clever little arrangement called an exchange-traded fund, or ETF for short. An ETF is actually a form of mutual fund, where the fund purchases shares in a huge array of stocks, and adjusts what they own to precisely track the behavior of an entire stock market (such as the S&P 500). Then what you can buy is shares in that mutual fund, which are usually priced somewhere between $100 and $300 each. As the price of stocks in the market rises, the price of shares in the mutual fund rises to match, and you can reap the same capital gains they do.

A major advantage of this arrangement, especially for a typical person who isn’t well-versed in stock markets, is that it requires almost no attention at your end. You can buy into a few ETFs and then leave your money to sit there, knowing that it will grow as long as the overall stock market grows.

But there is an even more important advantage, which is that it maximizes your diversification. I said earlier that you shouldn’t buy a house as an investment, because it’s not at all diversified. What I mean by this is that the price of that house depends only on one thing—that house itself. If the price of that house changes, the full change is reflected immediately in the value of your asset. In fact, if you have 10% down on a mortgage, the full change is reflected ten times over in your net wealth, because you are leveraged 10 to 1.

An ETF is basically the opposite of that. Instead of its price depending on only one thing, it depends on a vast array of things, averaging over the prices of literally hundreds or thousands of different corporations. When some fall, others will rise. On average, as long as the economy continues to grow, they will rise.

The result is that you can get the same average return you would from owning stocks, while dramatically reducing the risk you bear.

To see how this works, consider the past year’s performance of Apple (AAPL), which has done very well, versus Fitbit (FIT), which has done very poorly, compared with the NASDAQ as a whole, of which they are both part.

AAPL has grown over 50% (40 log points) in the last year; so if you’d bought $1000 of their stock a year ago it would be worth $1500. FIT has fallen over 60% (84 log points) in the same time, so if you’d bought $1000 of their stock instead, it would be worth only $400. That’s the risk you’re taking by buying individual stocks.

Whereas, if you had simply bought a NASDAQ ETF a year ago, your return would be 35%, so that $1000 would be worth $1350.

Of course, that does mean you don’t get as high a return as you would if you had managed to choose the highest-performing stock on that index. But you’re unlikely to be able to do that, as even professional financial forecasters are worse than random chance. So, would you rather take a 50-50 shot between gaining $500 and losing $600, or would you prefer a guaranteed $350?

If higher return is not your only goal, and you want to be socially responsible in your investments, there are ETFs for that too. Instead of buying the whole stock market, these funds buy only a section of the market that is associated with some social benefit, such as lower carbon emissions or better representation of women in management. On average, you can expect a slightly lower return this way; but you are also helping to make a better world. And still your average return is generally going to be better than it would be if you tried to pick individual stocks yourself. In fact, certain classes of socially-responsible funds—particularly green tech and women’s representation—actually perform better than conventional ETFs, probably because most investors undervalue renewable energy and, well, also undervalue women. Women CEOs perform better at lower prices; why would you not want to buy their companies?

In fact ETFs are not literally guaranteed—the market as a whole does move up and down, so it is possible to lose money even by buying ETFs. But because the risk is so much lower, your odds of losing money are considerably reduced. And on average, an ETF will, by construction, perform exactly as well as the average performance of a randomly-chosen stock from that market.

Indeed, I am quite convinced that most people don’t take enough risk on their investment portfolios, because they confuse two very different types of risk.

The kind you should be worried about is idiosyncratic risk, which is risk tied to a particular investment—the risk of having chosen the Fitbit instead of Apple. But a lot of the time people seem to be avoiding market risk, which is the risk tied to changes in the market as a whole. Avoiding market risk does reduce your chances of losing money, but it does so at the cost of reducing your chances of making money even more.

Idiosyncratic risk is basically all downside. Yeah, you could get lucky; but you could just as well get unlucky. Far better if you could somehow average over that risk and get the average return. But with diversification, that is exactly what you can do. Then you are left only with market risk, which is the kind of risk that is directly tied to higher average returns.

Young people should especially be willing to take more risk in their portfolios. As you get closer to retirement, it becomes important to have more certainty about how much money will really be available to you once you retire. But if retirement is still 30 years away, the thing you should care most about is maximizing your average return. That means taking on a lot of market risk, which is then less risky overall if you diversify away the idiosyncratic risk.

I hope now that I have convinced you to avoid buying individual stocks. For most people most of the time, this is the advice you need to hear. Don’t try to forecast the market, don’t try to outperform the indexes; just buy and hold some ETFs and leave your money alone to grow.

But if you really must buy individual stocks, either because you think you are savvy enough to beat the forecasters or because you enjoy the gamble, here’s some additional advice I have for you.

My first piece of advice is that you should still buy ETFs. Even if you’re willing to risk some of your wealth on greater gambles, don’t risk all of it that way.

My second piece of advice is to buy primarily large, well-established companies (like Apple or Microsoft or Ford or General Electric). Their stocks certainly do rise and fall, but they are unlikely to completely crash and burn the way that young companies like Fitbit can.

My third piece of advice is to watch the price-earnings ratio (P/E for short). Roughly speaking, this is the number of years it would take for the profits of this corporation to pay off the value of its stock. If they pay most of their profits in dividends, it is approximately how many years you’d need to hold the stock in order to get as much in dividends as you paid for the shares.

Do you want P/E to be large or small? You want it to be small. This is called value investing, but it really should just be called “investing”. The alternatives to value investing are actually not investment but speculation and arbitrage. If you are actually investing, you are buying into companies that are currently undervalued; you want them to be cheap.

Of course, it is not always easy to tell whether a company is undervalued. A common rule-of-thumb is that you should aim for a P/E around 20 (20 years to pay off means about 5% return in dividends); if the P/E is below 10, it’s a fantastic deal, and if it is above 30, it might not be worth the price. But reality is of course more complicated than this. You don’t actually care about current earnings, you care about future earnings, and it could be that a company which is earning very little now will earn more later, or vice-versa. The more you can learn about a company, the better judgment you can make about their future profitability; this is another reason why it makes sense to buy large, well-known companies rather than tiny startups.

My final piece of advice is not to trade too frequently. Especially with something like Robinhood where trades are instant and free, it can be tempting to try to ride every little ripple in the market. Up 0.5%? Sell! Down 0.3%? Buy! And yes, in principle, if you could perfectly forecast every such fluctuation, this would be optimal—and make you an almost obscene amount of money. But you can’t. We know you can’t. You need to remember that you can’t. You should only trade if one of two things happens: Either your situation changes, or the company’s situation changes. If you need the money, sell, to get the money. If you have extra savings, buy, to give those savings a good return. If something bad happened to the company and their profits are going to fall, sell. If something good happened to the company and their profits are going to rise, buy. Otherwise, hold. In the long run, those who hold stocks longer are better off.

How much should we save?

pnrj critique of neoclassical economics, macroeconomics, public policy , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

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?”

Why the Republican candidates like flat income tax—and we really, really don’t

pnrj critique of neoclassical economics, public policy , , , , , , , , , , , , , , , , , , , , , , , , ,

JDN 2456160 EDT 13:55.

The Republican Party is scrambling to find viable Presidential candidates for next year’s election. The Democrats only have two major contenders: Hillary Clinton looks like the front-runner (and will obviously have the most funding), but Bernie Sanders is doing surprisingly well, and is particularly refreshing because he is running purely on his principles and ideas. He has no significant connections, no family dynasty (unlike Jeb Bush and, again, Hillary Clinton) and not a huge amount of wealth (Bernie’s net wealth is about $500,000, making him comfortably upper-middle class; compare to Hillary’s $21.5 million and her husband’s $80 million); but he has ideas that resonate with people. Bernie Sanders is what politics is supposed to be. Clinton’s campaign will certainly raise more than his; but he has already raised over $4 million, and if he makes it to about $10 million studies suggest that additional spending above that point is largely negligible. He actually has a decent chance of winning, and if he did it would be a very good sign for the future of America.

But the Republican field is a good deal more contentious, and the 19 candidates currently running have been scrambling to prove that they are the most right-wing in order to impress far-right primary voters. (When the general election comes around, whoever wins will of course pivot back toward the center, changing from, say, outright fascism to something more like reactionism or neo-feudalism. If you were hoping they’d pivot so far back as to actually be sensible center-right capitalists, think again; Hillary Clinton is the only one who will take that role, and they’ll go out of their way to disagree with her in every way they possibly can, much as they’ve done with Obama.) One of the ways that Republicans are hoping to prove their right-wing credentials is by proposing a flat income tax and eliminating the IRS.

Unlike most of their proposals, I can see why many people think this actually sounds like a good idea. It would certainly dramatically reduce bureaucracy, and that’s obviously worthwhile since excess bureaucracy is pure deadweight loss. (A surprising number of economists seem to forget that government does other things besides create excess bureaucracy, but I must admit it does in fact create excess bureaucracy.)

Though if they actually made the flat tax rate 20% or even—I can’t believe this is seriously being proposed—10%, there is no way the federal government would have enough revenue. The only options would be (1) massive increases in national debt (2) total collapse of government services—including their beloved military, mind you, or (3) directly linking the Federal Reserve quantitative easing program to fiscal policy and funding the deficit with printed money. Of these, 3 might not actually be that bad (it would probably trigger some inflation, but actually we could use that right now), but it’s extremely unlikely to happen, particularly under Republicans. In reality, after getting a taste of 2, we’d clearly end up with 1. And then they’d be complaining about the debt and clamor for more spending cuts, more spending cuts, ever more spending cuts, but there would simply be no way to run a functioning government on 10% of GDP in anything like our current system. Maybe you could do it on 20%—maybe—but we currently spend more like 35%, and that’s already a very low amount of spending for a First World country. The UK is more typical at 47%, while Germany is a bit low at 44%; Sweden spends 52% and France spends a whopping 57%. Anyone who suggests we cut government spending from 35% to 20% needs to explain which 3/7 of government services are going to immediately disappear—not to mention which 3/7 of government employees are going to be immediately laid off.

And then they want to add investment deductions; in general investment deductions are a good thing, as long as you tie them to actual investments in genuinely useful things like factories and computer servers. (Or better yet, schools, research labs, or maglev lines, but private companies almost never invest in that sort of thing, so the deduction wouldn’t apply.) The kernel of truth in the otherwise ridiculous argument that we should never tax capital is that taxing real investment would definitely be harmful in the long run. As I discussed with Miles Kimball (a cognitive economist at Michigan and fellow econ-blogger I hope to work with at some point), we could minimize the distortionary effects of corporate taxes by establishing a strong deduction for real investment, and this would allow us to redistribute some of this enormous wealth inequality without dramatically harming economic growth.

But if you deduct things that aren’t actually investments—like stock speculation and derivatives arbitrage—then you reduce your revenue dramatically and don’t actually incentivize genuinely useful investments. This is the problem with our current system, in which GE can pay no corporate income tax on $108 billion in annual profit—and you know they weren’t using all that for genuinely productive investment activities. But then, if you create a strong enforcement system for ensuring it is real investment, you need bureaucracy—which is exactly what the flat tax was claimed to remove. At the very least, the idea of eliminating the IRS remains ridiculous if you have any significant deductions.

Thus, the benefits of a flat income tax are minimal if not outright illusory; and the costs, oh, the costs are horrible. In order to have remotely reasonable amounts of revenue, you’d need to dramatically raise taxes on the majority of people, while significantly lowering them on the rich. You would create a direct transfer of wealth from the poor to the rich, increasing our already enormous income inequality and driving millions of people into poverty.

Thus, it would be difficult to more clearly demonstrate that you care only about the interests of the top 1% than to propose a flat income tax. I guess Mitt Romney’s 47% rant actually takes the cake on that one though (Yes, all those freeloading… soldiers… and children… and old people?).

Many Republicans are insisting that a flat tax would create a surge of economic growth, but that’s simply not how macroeconomics works. If you steeply raise taxes on the majority of people while cutting them on the rich, you’ll see consumer spending plummet and the entire economy will be driven into recession. Rich people simply don’t spend their money in the same way as the rest of us, and the functioning of the economy depends upon a continuous flow of spending. There is a standard neoclassical economic argument about how reducing spending and increasing saving would lead to increased investment and greater prosperity—but that model basically assumes that we have a fixed amount of stuff we’re either using up or making more stuff with, which is simply not how money works; as James Kroeger cogently explains on his blog “Nontrivial Pursuits”, money is created as it is needed; investment isn’t determined by people saving what they don’t spend. Indeed, increased consumption generally leads to increased investment, because our economy is currently limited by demand, not supply. We could build a lot more stuff, if only people could afford to buy it.

And that’s not even considering the labor incentives; as I already talked about in my previous post on progressive taxation, there are two incentives involved when you increase someone’s hourly wage. On the one hand, they get paid more for each hour, which is a reason to work; that’s the substitution effect. But on the other hand, they have more money in general, which is a reason they don’t need to work; that’s the income effect. Broadly speaking, the substitution effect dominates at low incomes (about $20,000 or less), the income effect dominates at high incomes (about $100,000 or more), and the two effects cancel out at moderate incomes. Since a tax on your income hits you in much the same way as a reduction in your wage, this means that raising taxes on the poor makes them work less, while raising taxes on the rich makes them work more. But if you go from our currently slightly-progressive system to a flat system, you raise taxes on the poor and cut them on the rich, which would mean that the poor would work less, and the rich would also work less! This would reduce economic output even further. If you want to maximize the incentive to work, you want progressive taxes, not flat taxes.

Flat taxes sound appealing because they are so simple; even the basic formula for our current tax rates is complicated, and we combine it with hundreds of pages of deductions and credits—not to mention tens of thousands of pages of case law!—making it a huge morass of bureaucracy that barely anyone really understands and corporate lawyers can easily exploit. I’m all in favor of getting rid of that; but you don’t need a flat tax to do that. You can fit the formula for a progressive tax on a single page—indeed, on a single line: r = 1 – I^-p

That’s it. It’s simple enough to be plugged into any calculator that is capable of exponents, not to mention efficiently implemented in Microsoft Excel (more efficiently than our current system in fact).

Combined with that simple formula, you could list all of the sensible deductions on a couple of additional pages (business investments and educational expenses, mostly—poverty should be addressed by a basic income, not by tax deductions on things like heating and housing, which are actually indirect corporate subsidies), along with a land tax (one line: $3000 per hectare), a basic income (one more line: $8,000 per adult and $4,000 per child), and some additional excise taxes on goods with negative externalities (like alcohol, tobacco, oil, coal, and lead), with a line for each; then you can provide a supplementary manual of maybe 50 pages explaining the detailed rules for applying each of those deductions in unusual cases. The entire tax code should be readable by an ordinary person in a single sitting no longer than a few hours. That means no more than 100 pages and no more than a 7th-grade reading level.

Why do I say this? Isn’t that a ridiculous standard? No, it is a Constitutional imperative. It is a fundamental violation of your liberty to tax you according to rules you cannot reasonably understand—indeed, bordering on Kafkaesque. While this isn’t taxation without representation—we do vote for representatives, after all—it is something very much like it; what good is the ability to change rules if you don’t even understand the rules in the first place? Nor would it be all that difficult: You first deduct these things from your income, then plug the result into this formula.

So yes, I absolutely agree with the basic principle of tax reform. The tax code should be scrapped and recreated from scratch, and the final product should be a primary form of only a few pages combined with a supplementary manual of no more than 100 pages. But you don’t need a flat tax to do that, and indeed for many other reasons a flat tax is a terrible idea, particularly if the suggested rate is 10% or 15%, less than half what we actually spend. The real question is why so many Republican candidates think that this will appeal to their voter base—and why they could actually be right about that.

Part of it is the entirely justified outrage at the complexity of our current tax system, and the appealing simplicity of a flat tax. Part of it is the long history of American hatred of taxes; we were founded upon resisting taxes, and we’ve been resisting taxes ever since. In some ways this is healthy; taxes per se are not a good thing, they are a bad thing, a necessary evil.

But those two things alone cannot explain why anyone would advocate raising taxes on the poorest half of the population while dramatically cutting them on the top 1%. If you are opposed to taxes in general, you’d cut them on everyone; and if you recognize the necessity of taxation, you’d be trying to find ways to minimize the harm while ensuring sufficient tax revenue, which in general means progressive taxation.

To understand why they would be pushing so hard for flat taxes, I think we need to say that many Republicans, particularly those in positions of power, honestly do think that rich people are better than poor people and we should always give more to the rich and less to the poor. (Maybe it’s partly halo effect, in which good begets good and bad begets bad? Or maybe just world theory, the ingrained belief that the world is as it ought to be?)

Romney’s 47% rant wasn’t an exception; it was what he honestly believes, what he says when he doesn’t know he’s on camera. He thinks that he earned every penny of his $250 million net wealth; yes, even the part he got from marrying his wife and the part he got from abusing tax laws, arbitraging assets and liquidating companies. He thinks that people who live on $4,000 or even $400 a year are simply lazy freeloaders, who could easily work harder, perhaps do some arbitrage and liquidation of their own (check out these alleged “rags to riches” stories including the line “tried his hand at mortgage brokering”), but choose not to, and as a result deserve what they get. (It’s important to realize just how bizarre this moral attitude truly is; even if I thought you were the laziest person on Earth, I wouldn’t let you starve to death.) He thinks that the social welfare programs which have reduced poverty but never managed to eliminate it are too generous—if he even thinks they should exist at all. And in thinking these things, he is not some bizarre aberration; he is representing an entire class of people, nearly all of whom vote Republican.

The good news is, these people are still in the minority. They hold significant sway over the Republican primary, but will not have nearly as much impact in the general election. And right now, the Republican candidates are so numerous and so awful that I have trouble seeing how the Democrats could possibly lose. (But please, don’t take that as a challenge, you guys.)

Why we give gifts

pnrj core principles, critique of neoclassical economics , , , , ,

JDN 2457020 EST 18:28.

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

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

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

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

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

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

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

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

Fear not the deficit

pnrj public policy , , , , , , , , , , , , , , , , , ,

JDN 2456984 PST 12:20.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

S = (W + G – T) – C

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

S = (W – C) + (G – T)

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

S – I = (W – C – I) + (G – T)

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

P = C + I – W + (X – M)

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

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

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

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

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

S – I + P = (G – T) + (X – M)

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

Y = C + I + G + (X – M)

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

Y = C + P + S + T

So those two things must be the same:

C + S + T + P = C + I + G + (X – M)

Canceling and rearranging we get:

(S – I) + P = (G – T) + (X – M)

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

From the profit equation:

W = C + I + (X – M) – P

Put that back into our GDP equation:

Y = W + P + G

GDP is wages plus profits plus government spending.

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

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

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

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