How rich are we, really?

Oct 29, JDN 2458056

The most commonly-used measure of a nation’s wealth is its per-capita GDP, which is simply a total of all spending in a country divided by its population. More recently we adjust for purchasing power, giving us GDP per capita at purchasing power parity (PPP).

By this measure, the United States always does well. At most a dozen countries are above us, most of them by a small amount, and all of them are quite small countries. (For fundamental statistical reasons, we should expect both the highest and lowest average incomes to be in the smallest countries.)

But this is only half the story: It tells us how much income a country has, but not how that income is distributed. We should adjust for inequality.

How can we do this? I have devised a method that uses the marginal utility of wealth plus a measure of inequality called the Gini coefficient to work out an estimate of the average utility, instead of the average income.

I then convert back into a dollar figure. This figure is the income everyone would need to have under perfect equality, in order to give the same real welfare as the current system. That is, if we could redistribute wealth in such a way to raise everyone above this value up to it, and lower everyone above this value down to it, the total welfare of the country would not change. This provides a well-founded ranking of which country’s people are actually better off overall, accounting for both overall income and the distribution of that income.

The estimate is sensitive to the precise form I use for marginal utility, so I’ll show you comparisons for three different cases.

The “conservative” estimate uses a risk aversion parameter of 1, which means that utility is logarithmic in income. The real value of a dollar is inversely proportional to the number of dollars you already have.

The medium estimate uses a risk aversion parameter of 2, which means that the real value of a dollar is inversely proportional to the square of the number of dollars you already have.

And then the “liberal” estimate uses a risk aversion parameter of 3, which means that the real value of a dollar is inversely proportional to the cube of the number of dollars you already have.

I’ll compare ten countries, which I think are broadly representative of classes of countries in the world today.

The United States, the world hegemon which needs no introduction.

China, rising world superpower and world’s most populous country.

India, world’s largest democracy and developing economy with a long way to go.

Norway, as representative of the Scandinavian social democracies.

Germany, as representative of continental Europe.

Russia, as representative of the Soviet Union and the Second World bloc.

Saudi Arabia, as representative of the Middle East petrostates.

Botswana, as representative of African developing economies.

Zimbabwe, as representative of failed Sub-Saharan African states.

Brazil, as representative of Latin American developing economies.
The ordering of these countries by GDP per-capita PPP is probably not too surprising:

  1. Norway 69,249
  2. United States 57,436
  3. Saudi Arabia 55,158
  4. Germany 48,111
  5. Russia 26,490
  6. Botswana 17,042
  7. China 15,399
  8. Brazil 15,242
  9. India 6,616
  10. Zimbabwe 1,970

Norway is clearly the richest, the US, Saudi Arabia, and Germany are quite close, Russia is toward the upper end, Botswana, China, and Brazil are close together in the middle, and then India and especially Zimbabwe are extremely poor.

But now let’s take a look at the inequality in each country, as measured by the Gini coefficient (which ranges from 0, perfect equality, to 1, total inequality).

  1. Botswana 0.605
  2. Zimbabwe 0.501
  3. Brazil 0.484
  4. United States 0.461
  5. Saudi Arabia 0.459
  6. China 0.422
  7. Russia 0.416
  8. India 0.351
  9. Germany 0.301
  10. Norway 0.259

The US remains (alarmingly) close to Saudi Arabia by this measure. Most of the countries are between 40 and 50. But Botswana is astonishingly unequal, while Germany and Norway are much more equal.

With that in mind, let’s take a look at the inequality-adjusted per-capita GDP. First, the conservative estimate, with a parameter of 1:

  1. Norway 58700
  2. United States 42246
  3. Saudi Arabia 40632
  4. Germany 39653
  5. Russia 20488
  6. China 11660
  7. Botswana 11138
  8. Brazil 11015
  9. India 5269
  10. Zimbabwe 1405

So far, ordering of nations is almost the same compared to what we got with just per-capita GDP. But notice how Germany has moved up closer to the US and Botswana actually fallen behind China.

Now let’s try a parameter of 2, which I think is the closest to the truth:

  1. Norway 49758
  2. Germany 32683
  3. United States 31073
  4. Saudi Arabia 29931
  5. Russia 15581
  6. China 8829
  7. Brazil 7961
  8. Botswana 7280
  9. India 4197
  10. Zimbabwe 1002

Now we have seen some movement. Norway remains solidly on top, but Germany has overtaken the United States and Botswana has fallen behind not only China, but also Brazil. Russia remains in the middle, and India and Zimbawbe remain on the bottom.

Finally, let’s try a parameter of 3.

  1. Norway 42179
  2. Germany 26937
  3. United States 22855
  4. Saudi Arabia 22049
  5. Russia 11849
  6. China 6685
  7. Brazil 5753
  8. Botswana 4758
  9. India 3343
  10. Zimbabwe 715

Norway has now pulled far and away ahead of everyone else. Germany is substantially above the United States. China has pulled away from Brazil, and Botswana has fallen almost all the way to the level of India. Zimbabwe, as always, is at the very bottom.

Let’s compare this to another measure of national well-being, the Inequality-Adjusted Human Development Index (which goes from 0, the worst, to 1 the best). This index combines education, public health, and income, and adjusts for inequality. It seems to be a fairly good measure of well-being, but it’s very difficult to compile data for, so a lot of countries are missing (including Saudi Arabia); plus the precise weightings on everything are very ad hoc.

  1. Norway 0.898
  2. Germany 0.859
  3. United States 0.796
  4. Russia 0.725
  5. China 0.543
  6. Brazil 0.531
  7. India 0.435
  8. Botswana 0.433
  9. Zimbabwe 0.371

Other than putting India above Botswana, this ordering is the same as what we get from my (much easier to calculate and theoretically more well-founded) index with either a parameter of 2 or 3.

What’s more, my index can be directly interpreted: The average standard of living in the US is as if everyone were making $31,073 per year. What exactly is an IHDI index of 0.796 supposed to mean? We’re… 79.6% of the way to the best possible country?

In any case, there’s a straightforward (if not terribly surprising) policy implication here: Inequality is a big problem.

In particular, inequality in the US is clearly too high. Despite an overall income that is very high, almost 18 log points higher than Germany, our overall standard of living is actually about 5 log points lower due to our higher level of inequality. While our average income is only 19 log points lower than Norway, our actual standard of living is 47 log points lower.

Inequality in Botswana also means that their recent astonishing economic growth is not quite as impressive as it at first appeared. Many people are being left behind. While in raw income they appear to be 10 log points ahead of China and only 121 log points behind the US, once you adjust for their very high inequality they are 19 log points behind China, and 145 log points behind the US.

Of course, some things don’t change. Norway is still on top, and Zimbabwe is still on the bottom.

The unending madness of the gold standard

JDN 2457545

If you work in economics in any capacity (much like “How is the economy doing?” you don’t even really need to be in macroeconomics), you will encounter many people who believe in the gold standard. Many of these people will be otherwise quite intelligent and educated; they often understand economics better than most people (not that this is saying a whole lot). Yet somehow they continue to hold—and fiercely defend—this incredibly bizarre and anachronistic view of macroeconomics.

They even bring it up at the oddest times; I recently encountered someone who wrote a long and rambling post arguing for drug legalization (which I largely agree with, by the way) and concluded it with #EndTheFed, not seeming to grasp the total and utter irrelevance of this juxtaposition. It seems like it was just a conditioned response, or maybe the sort of irrelevant but consistent coda originally perfected by Cato and his “Carthago delenda est. “Foederale Reservatum delendum est. Hey, maybe that’s why they’re called the Cato Institute.

So just how bizarre is the gold standard? Well, let’s look at what sort of arguments they use to defend it. I’ll use Charles Kadlic, prominent Libertarian blogger on Forbes, as an example, with his “Top Ten Reasons That You Should Support the ‘Gold Commission’”:

  1. A gold standard is key to achieving a period of sustained, 4% real economic growth.
  2. A gold standard reduces the risk of recessions and financial crises.
  3. A gold standard would restore rising living standards to the middle-class.
  4. A gold standard would restore long-term price stability.
  5. A gold standard would stop the rise in energy prices.
  6. A gold standard would be a powerful force for restoring fiscal balance to federal state and local governments.
  7. A gold standard would help save Medicare and Social Security.
  8. A gold standard would empower Main Street over Wall Street.
  9. A gold standard would increase the liberty of the American people.
  10. Creation of a gold commission will provide the forum to chart a prudent path toward a 21st century gold standard.

Number 10 can be safely ignored, as clearly Kadlic just ran out of reasons and to make a round number tacked on the implicit assumption of the entire article, namely that this ‘gold commission’ would actually realistically lead us toward a gold standard. (Without it, the other 9 reasons are just non sequitur.)

So let’s look at the other 9, shall we? Literally none of them are true. Several are outright backward.

You know a policy is bad when even one of its most prominent advocates can’t even think of a single real benefit it would have. A lot of quite bad policies do have perfectly real benefits, they’re just totally outweighed by their costs: For example, cutting the top income tax rate to 20% probably would actually contribute something to economic growth. Not a lot, and it would cut a swath through the federal budget and dramatically increase inequality—but it’s not all downside. Yet Kadlic couldn’t actually even think of one benefit of the gold standard that actually holds up. (I actually can do his work for him: I do know of one benefit of the gold standard, but as I’ll get to momentarily it’s quite small and can easily be achieved in better ways.)

First of all, it’s quite clear that the gold standard did not increase economic growth. If you cherry-pick your years properly, you can make it seem like Nixon leaving the gold standard hurt growth, but if you look at the real long-run trends in economic growth it’s clear that we had really erratic growth up until about the 1910s (the surge of government spending in WW1 and the establishment of the Federal Reserve), at which point went through a temporary surge recovering from the Great Depression and then during WW2, and finally, if you smooth out the business cycle, our growth rates have slowly trended downward as growth in productivity has gradually slowed down.

Here’s GDP growth from 1800 to 1900, when we were on the classical gold standard:


Here’s GDP growth from 1929 to today, using data from the Bureau of Economic Analysis:


Also, both of these are total GDP growth (because that is what Kadlic said), which means that part of what you’re seeing here is population growth rather than growth in income per person. Here’s GDP per person in the 1800s:


If you didn’t already know, I bet you can’t guess where on those graphs we left the gold standard, which you’d clearly be able to do if the gold standard had this dramatic “double your GDP growth” kind of effect. I can’t immediately rule out some small benefit to the gold standard just from this data, but don’t worry; more thorough economic studies have done that. Indeed, it is the mainstream consensus among economists today that the gold standard is what caused the Great Depression.

Indeed, there’s a whole subfield of historical economics research that basically amounts to “What were they thinking?” trying to explain why countries stayed on the gold standard for so long when it clearly wasn’t working. Here’s a paper trying to argue it was a costly signal of your “rectitude” in global bond markets, but I find much more compelling the argument that it was psychological: Their belief in the gold standard was simply too strong, so confirmation bias kept holding them back from what needed to be done. They were like my aforementioned #EndTheFed acquaintance.

Then we get to Kadlic’s second point: Does the gold standard reduce the risk of financial crises? Let’s also address point 4, which is closely related: Does the gold standard improve price stability? Tell that to 1929.

In fact, financial crises were more common on the classical gold standard; the period of pure fiat monetary policy was so stable that it was called the Great Moderation, until the crash in 2008 screwed it all up—and that crash occurred essentially outside the standard monetary system, in the “shadow banking system” of unregulated and virtually unlimited derivatives. Had we actually forced banks to stay within the light of the standard banking system, the Great Moderation might have continued indefinitely.

As for “price stability”, that’s sort of true if you look at the long run, because prices were as likely to go down as they were to go up. But that isn’t what we mean by “price stability”. A system with good price stability will have a low but positive and steady level of inflation, and will therefore exhibit some long-run increases in price levels; it won’t have prices jump up and down erratically and end up on average the same.

For jump up and down is what prices did on the gold standard, as you can see from FRED:


This is something we could have predicted in advance; the price of any given product jumps up and down over time, and gold is just one product among many. Tying prices to gold makes no more sense than tying them to any other commodity.

As for stopping the rise in energy prices, energy prices aren’t rising. Even if they were (and they could at some point), the only way the gold standard would stop that is by triggering deflation (and therefore recession) in the rest of the economy.

Regarding number 6, I don’t see how the fiscal balance of federal and state governments is improved by periodic bouts of deflation that make their debt unpayable.

As for number 7, saving Medicare and Social Security, their payments out are tied to inflation and their payments in are tied to nominal GDP, so overall inflation has very little effect on their long-term stability. In any case, the problem with Medicare is spiraling medical costs (which Obamacare has done a lot to fix), and the problem with Social Security is just the stupid arbitrary cap on the income subject to payroll tax; the gold standard would do very little to solve either of those problems, though I guess it would make the nominal income cap less binding by triggering deflation, which is just about the worst way to avoid a price ceiling I’ve ever heard.

Regarding 8 and 9, I don’t even understand why Kadlic thinks that going to a gold standard would empower individuals over banks (does it seem like individuals were empowered over banks in the “Robber Baron Era”?), or what in the world it has to do with giving people more liberty (all that… freedom… you lose… when the Fed… stabilizes… prices?), so I don’t even know where to begin on those assertions. You know what empowers people over banks? The Consumer Financial Protection Bureau. You know what would enhance liberty? Ending mass incarceration. Libertarians fight tooth and nail against the former; sometimes they get behind the latter, but sometimes they don’t; Gary Johnson for some bizarre reason believes in privatization of prisons, which are directly linked to the surge in US incarceration.

The only benefit I’ve been able to come up with for the gold standard is as a commitment mechanism, something the Federal Reserve could do to guarantee its future behavior and thereby reduce the fear that it will suddenly change course on its past promises. This would make forward guidance a lot more effective at changing long-term interest rates, because people would have reason to believe that the Fed means what it says when it projects its decisions 30 years out.

But there are much simpler and better commitment mechanisms the Fed could use. They could commit to a Taylor Rule or nominal GDP targeting, both of which mainstream economists have been clamoring for for decades. There are some definite downsides to both proposals, but also some important upsides; and in any case they’re both obviously better than the gold standard and serve the same forward guidance function.

Indeed, it’s really quite baffling that so many people believe in the gold standard. It cries out for some sort of psychological explanation, as to just what cognitive heuristic is failing when otherwise-intelligent and highly-educated people get monetary policy so deeply, deeply wrong. A lot of them don’t even to seem grasp when or how we left the gold standard; it really happened when FDR suspended gold convertibility in 1933. After that on the Bretton Woods system only national governments could exchange money for gold, and the Nixon shock that people normally think of as “ending the gold standard” was just the final nail in the coffin, and clearly necessary since inflation was rapidly eating through our gold reserves.

A lot of it seems to come down to a deep distrust of government, especially federal government (I still do not grok why the likes of Ron Paul think state governments are so much more trustworthy than the federal government); the Federal Reserve is a government agency (sort of) and is therefore not to be trusted—and look, it has federal right there in the name.

But why do people hate government so much? Why do they think politicians are much less honest than they actually are? Part of it could have to do with the terrifying expansion of surveillance and weakening of civil liberties in the face of any perceived outside threat (Sedition Act, PATRIOT ACT, basically the same thing), but often the same people defending those programs are the ones who otherwise constantly complain about Big Government. Why do polls consistently show that people don’t trust the government, but want it to do more?

I think a lot of this comes down to the vague meaning of the word “government” and the associations we make with particular questions about it. When I ask “Do you trust the government?” you think of the NSA and the Vietnam War and Watergate, and you answer “No.” But when I ask “Do you want the government to do more?” you think of the failure at Katrina, the refusal to expand Medicaid, the pitiful attempts at reducing carbon emissions, and you answer “Yes.” When I ask if you like the military, your conditioned reaction is to say the patriotic thing, “Yes.” But if I ask whether you like the wars we’ve been fighting lately, you think about the hundreds of thousands of people killed and the wanton destruction to achieve no apparent actual objective, and you say “No.” Most people don’t come to these polls with thought-out opinions they want to express; the questions evoke emotional responses in them and they answer accordingly. You can also evoke different responses by asking “Should we cut government spending?” (People say “Yes.”) versus asking “Should we cut military spending, Social Security, or Medicare?” (People say “No.”) The former evokes a sense of abstract government taking your tax money; the latter evokes the realization that this money is used for public services you value.

So, the gold standard has acquired positive emotional vibes, and the Fed has acquired negative emotional vibes.

The former is fairly easy to explain: “good as gold” is an ancient saying, and “the gold standard” is even a saying we use in general to describe the right way of doing something (“the gold standard in prostate cancer treatment”). Humans have always had a weird relationship with gold; something about its timeless and noncorroding shine mesmerizes us. That’s why you occasionally get proposals for a silver standard, but no one ever seems to advocate an oil standard, an iron standard, or a lumber standard, which would make about as much sense.

The latter is a bit more difficult to explain: What did the Fed ever do to you? But I think it might have something to do with the complexity of sound monetary policy, and the resulting air of technocratic mystery surrounding it. Moreover, the Fed actively cultivates this image, by using “open-market operations” and “quantitative easing” to “target interest rates”, instead of just saying, “We’re printing money.” There may be some good reasons to do it this way, but a lot of it really does seem to be intended to obscure the truth from the uninitiated and perpetuate the myth that they are almost superhuman. “It’s all very complicated, you see; you wouldn’t understand.” People are hoarding their money, so there’s not enough money in circulation, so prices are falling, so you’re printing more money and trying to get it into circulation. That’s really not that complicated. Indeed, if it were, we wouldn’t be able to write a simple equation like a Taylor Rule or nominal GDP targeting in order to automate it!

The reason so many people become gold bugs after taking a couple of undergraduate courses in economics, then, is that this teaches them enough that they feel they have seen through the veil; the curtain has been pulled open and the all-powerful Wizard revealed to be an ordinary man at a control panel. (Spoilers? The movie came out in 1939. Actually, it was kind of about the gold standard.) “What? You’ve just been printing money all this time? But that is surely madness!” They don’t actually understand why printing money is actually a perfectly sensible thing to do on many occasions, and it feels to them a lot like what would happen if they just went around printing money (counterfeiting) or what a sufficiently corrupt government could do if they printed unlimited amounts (which is why they keep bringing up Zimbabwe). They now grasp what is happening, but not why. A little learning is a dangerous thing.

Now as for why Paul Volcker wants to go back to Bretton Woods? That, I cannot say. He’s definitely got more than a little learning. At least he doesn’t want to go back to the classical gold standard.

Why is Tatooine poor?

JDN 2457513—May 4, 2016

May the Fourth be with you.

In honor of International Star Wars Day, this post is going to be about Star Wars!

[I wanted to include some images from Star Wars, but here are the copyright issues that made me decide it ultimately wasn’t a good idea.]

But this won’t be as frivolous as it may sound. Star Wars has a lot of important lessons to teach us about economics and other social sciences, and its universal popularity gives us common ground to start with. I could use Zimbabwe and Botswana as examples, and sometimes I do; but a lot of people don’t know much about Zimbabwe and Botswana. A lot more people know about Tatooine and Naboo, so sometimes it’s better to use those instead.

In fact, this post is just a small sample of a much larger work to come; several friends of mine who are social scientists in different fields (I am of course the economist, and we also have a political scientist, a historian, and a psychologist) are writing a book about this; we are going to use Star Wars as a jumping-off point to explain some real-world issues in social science.

So, my topic for today, which may end up forming the basis for a chapter of the book, is quite simple:
Why is Tatooine poor?

First, let me explain why this is such a mystery to begin with. We’re so accustomed to poverty being in the world that we expect to see it, we think of it as normal—and for most of human history, that was probably the correct attitude to have. Up until at least the Industrial Revolution, there simply was no way of raising the standard of living of most people much beyond bare subsistence. A wealthy few could sometimes live better, and most societies have had such an elite; but it was never more than about 1% of the population—and sometimes as little as 0.01%. They could have distributed wealth more evenly than they did, but there simply wasn’t that much to go around.

The “prosperous” “democracy” of Periclean Athens for example was really an aristocratic oligarchy, in which the top 1%—the ones who could read and write, and hence whose opinions we read—owned just about everything (including a fair number of the people—slavery). Their “democracy” was a voting system that only applied to a small portion of the population.

But now we live in a very different age, the Information Age, where we are absolutely basking in wealth thanks to enormous increases in productivity. Indeed, the standard of living of an Athenian philosopher was in many ways worse than that of a single mother on Welfare in the United States today; certainly the single mom has far better medicine, communication, and transportation than the philosopher, but she may even have better nutrition and higher education. Really the only things I can think of that the philosopher has more of are jewelry and real estate. The single mom also surely spends a lot more time doing housework, but a good chunk of her work is automated (dishwasher, microwave, washing machine), while the philosopher simply has slaves for that sort of thing. The smartphone in her pocket (81% of poor households in the US have a cellphone, and about half of these are smartphones) and the car in her driveway (75% of poor households in the US own at least one car) may be older models in disrepair, but they would still be unimaginable marvels to that ancient philosopher.

How is it, then, that we still have poverty in this world? Even if we argued that the poverty line in First World countries is too high because they have cars and smartphones (not an argument I agree with by the way—given our enormous productivity there’s no reason everyone shouldn’t have a car and a smartphone, and the main thing that poor people still can’t afford is housing), there are still over a billion people in the world today who live on less than $2 per day in purchasing-power-adjusted real income. That is poverty, no doubt about it. Indeed, it may in fact be a lower standard of living than most human beings had when we were hunter-gatherers. It may literally be a step downward from the Paleolithic.

Here is where Tatooine may give us some insights.

Productivity in the Star Wars universe is clearly enormous; indeed the proportional gap between Star Wars and us appears to be about the same as the proportional gap between us and hunter-gatherer times. The Death Star II had a diameter of 160 kilometers. Its cost is listed as “over 1 trillion credits”, but that’s almost meaningless because we have no idea what the exchange rate is or how the price of spacecraft varies relative to the price of other goods. (Spacecraft actually seem to be astonishingly cheap; in A New Hope it seems to be that a drink is a couple of credits while 10,000 credits is almost enough to buy an inexpensive starship. Basically their prices seem to be similar to ours for most goods, but spaceships are so cheap they are priced like cars instead of like, well, spacecraft.)

So let’s look at it another way: How much metal would it take to build such a thing, and how much would that cost in today’s money?

We actually see quite a bit of the inner structure of the Death Star II in Return of the Jedi, so I can hazard a guess that about 5% of the volume of the space station is taken up by solid material. Who knows what it’s actually made out of, but for a ballpark figure let’s assume it’s high-grade steel. The volume of a 160 km diameter sphere is 4*pi*r^3 = 4*(3.1415)*(80,000)^3 = 6.43 quadrillion cubic meters. If 5% is filled with material, that’s 320 trillion cubic meters. High-strength steel has a density of about 8000 kg/m^3, so that’s 2.6 quintillion kilograms of steel. A kilogram of high-grade steel costs about $2, so we’re looking at $5 quintillion as the total price just for the raw material of the Death Star II. That’s $5,000,000,000,000,000,000. I’m not even including the labor (droid labor, that is) and transportation costs (oh, the transportation costs!), so this is a very conservative estimate.

To get a sense of how ludicrously much money this is, the population of Coruscant is said to be over 1 trillion people, which is just about plausible for a city that covers an entire planet. The population of the entire galaxy is supposed to be about 400 quadrillion.

Suppose that instead of building the Death Star II, Emperor Palpatine had decided to give a windfall to everyone on Coruscant. How much would he have given each person (in our money)? $5 million.

Suppose instead he had offered the windfall to everyone in the galaxy? $12.50 per person. That’s 50 million worlds with an average population of 8 billion each. Instead of building the Death Star II, Palpatine could have bought the whole galaxy lunch.

Put another way, the cost I just estimated for the Death Star II is about 60 million times the current world GDP. So basically if the average world in the Empire produced as much as we currently produce on Earth, there would still not be enough to build that thing. In order to build the Death Star II in secret, it must be a small portion of the budget, maybe 5% tops. In order for only a small number of systems to revolt, the tax rates can’t be more than say 50%, if that; so total economic output on the average world in the Empire must in fact be more like 50 times what it is on Earth today, for a comparable average population. This puts their per-capita GDP somewhere around $500,000 per person per year.

So, economic output is extremely high in the Star Wars universe. Then why is Tatooine poor? If there’s enough output to make basically everyone a millionaire, why haven’t they?

In a word? Power.

Political power is of course very unequally distributed in the Star Wars universe, especially under the Empire but also even under the Old Republic and New Republic.

Core Worlds like Coruscant appear to have fairly strong centralized governments, and at least until the Emperor seized power and dissolved the Senate (as Tarkin announces in A New Hope) they also seemed to have fairly good representation in the Galactic Senate (though how you make a functioning Senate with millions of member worlds I have no idea—honestly, maybe they didn’t). As a result, Core Worlds are prosperous. Actually, even Naboo seems to be doing all right despite being in the Mid Rim, because of their strong and well-managed constitutional monarchy (“elected queen” is not as weird as it sounds—Sweden did that until the 16th century). They often talk about being a “democracy” even though they’re technically a constitutional monarchy—but the UK and Norway do the same thing with if anything less justification.

But Outer Rim Worlds like Tatooine seem to be out of reach of the central galactic government. (Oh, by the way, what hyperspace route drops you off at Tatooine if you’re going from Naboo to Coruscant? Did they take a wrong turn in addition to having engine trouble? “I knew we should have turned left at Christophsis!”) They even seem to be out of range of the monetary system (“Republic credits are no good out here,” said Watto in The Phantom Menace.), which is pretty extreme. That doesn’t usually happen—if there is a global hegemon, usually their money is better than gold. (“good as gold” isn’t strong enough—US money is better than gold, and that’s why people will accept negative real interest rates to hold onto it.) I guarantee you that if you want to buy something with a US $20 bill in Somalia or Zimbabwe, someone will take it. They might literally take it—i.e. steal it from you, and the government may not do anything to protect you—but it clearly will have value.

So, the Outer Rim worlds are extremely isolated from the central government, and therefore have their own local institutions that operate independently. Tatooine in particular appears to be controlled by the Hutts, who in turn seem to have a clan-based system of organized crime, similar to the Mafia. We never get much detail about the ins and outs of Hutt politics, but it seems pretty clear that Jabba is particularly powerful and may actually be the de facto monarch of a sizeable region or even the whole planet.

Jabba’s government is at the very far extreme of what Daron Acemoglu calls extractive regimes (I’ve been reading his tome Why Nations Fail, and while I agree with its core message, honestly it’s not very well-written or well-argued), systems of government that exist not to achieve overall prosperity or the public good, but to enrich a small elite few at the expense of everyone else. The opposite is inclusive regimes, under which power is widely shared and government exists to advance the public good. Real-world systems are usually somewhere in between; the US is still largely inclusive, but we’ve been getting more extractive over the last few decades and that’s a big problem.

Jabba himself appears to be fantastically wealthy, although even his huge luxury hover-yacht (…thing) is extremely ugly and spartan inside. I infer that he could have made it look however he wanted, and simply has baffling tastes in decor. The fact that he seems to be attracted to female humanoids is already pretty baffling, given the obvious total biological incompatibility; so Jabba is, shall we say, a weird dude. Eccentricity is quite common among despots of extractive regimes, as evidenced by Muammar Qaddafi’s ostentatious outfits, Idi Amin’s love of oranges and Kentucky Fried Chicken, and Kim Jong-Un’s fear of barbers and bond with Dennis Rodman. Maybe we would all be this eccentric if we had unlimited power, but our need to fit in with the rest of society suppresses it.

It’s difficult to put a figure on just how wealthy Jabba is, but it isn’t implausible to say that he has a million times as much as the average person on Tatooine, just as Bill Gates has a million times as much as the average person in the US. Like Qaddafi, before he was killed he probably feared that establishing more inclusive governance would only reduce his power and wealth and spread it to others, even if it did increase overall prosperity.
It’s not hard to make the figures work out so that is so. Suppose that for every 1% of the economy that is claimed by a single rentier despot, overall economic output drops by the same 1%. Then for concreteness, suppose that at optimal efficiency, the whole economy could produce $1 trillion. The amount of money that the despot can claim is determined by the portion he tries to claim, p, times the total amount that the economy will produce, which is (1-p) trillion dollars. So the despot’s wealth will be maximized when p(1-p) is maximized, which is p = 1/2; so the despot would maximize his own wealth at $250 billion if he claimed half of the economy, even though that also means that the economy produces half as much as it could. If he loosened his grip and claimed a smaller share, millions of his subjects would benefit; but he himself would lose more money than he gained. (You can also adjust these figures so that the “optimal” amount for the despot to claim is larger or smaller than half, depending on how severely the rent-seeking disrupts overall productivity.)

It’s important to note that it is not simply geography (galactography?) that makes Tatooine poor. Their sparse, hot desert may be less productive agriculturally, but that doesn’t mean that Tatooine is doomed to poverty. Indeed, today many of the world’s richest countries (such as Qatar) are in deserts, because they produce huge quantities of oil.

I doubt that oil would actually be useful in the Old Republic or the Empire, but energy more generally seems like something you’d always need. Tatooine has enormous flat desert plains and two suns, meaning that its potential to produce solar energy has to be huge. They couldn’t export the energy directly of course, but they could do so indirectly—the cheaper energy could allow them to build huge factories and produce starships at a fraction of the cost that other planets do. They could then sell these starships as exports and import water from planets where it is abundant like Naboo, instead of trying to produce their own water locally through those silly (and surely inefficient) moisture vaporators.

But Jabba likely has fought any efforts to invest in starship production, because it would require a more educated workforce that’s more likely to unionize and less likely to obey his every command. He probably has established a high tariff on water imports (or even banned them outright), so that he can maintain control by rationing the water supply. (Actually one thing I would have liked to see in the movies was Jabba being periodically doused by slaves with vats of expensive imported water. It would not only show an ostentatious display of wealth for a desert culture, but also serve the much more mundane function of keeping his sensitive gastropod skin from dangerously drying out. That’s why salt kills slugs, after all.) He also probably suppressed any attempt to establish new industries of any kind of Tatooine, fearing that with new industry could come a new balance of power.

The weirdest part to me is that the Old Republic didn’t do something about it. The Empire, okay, sure; they don’t much care about humanitarian concerns, so as long as Tatooine is paying its Imperial taxes and staying out of the Emperor’s way maybe he leaves them alone. But surely the Republic would care that this whole planet of millions if not billions of people is being oppressed by the Hutts? And surely the Republic Navy is more than a match for whatever pitiful military forces Jabba and his friends can muster, precisely because they haven’t established themselves as the shipbuilding capital of the galaxy? So why hasn’t the Republic deployed a fleet to Tatooine to unseat the Hutts and establish democracy? (It could be over pretty fast; we’ve seen that one good turbolaser can destroy Jabba’s hover-yacht—and it looks big enough to target from orbit.)

But then, we come full circle, back to the real world: Why hasn’t the US done the same thing in Zimbabwe? Would it not actually work? We sort of tried it in Libya—a lot of people died, and results are still pending I guess. But doesn’t it seem like we should be doing something?

The challenges of a global basic income

JDN 2457404

In the previous post I gave you the good news. Now for the bad news.

So we are hoping to implement a basic income of $3,000 per person per year worldwide, eliminating poverty once and for all.

There is no global government to implement this system. There is no global income tax to be collected or refunded. The United Nations and the World Bank, for all the good work that they do, are nowhere near powerful enough (or well-funded enough) to accomplish this feat.

Worse, the people we need to help the most, not coincidentally, live in the countries that are worst-managed. They are surrounded not only by squalor, but also by corruption, war, ethnic tension. Most of the people are underfed, uneducated, and dying from diseases such as malaria and schistomoniasis that we could treat in a day for pocket change. Their infrastructure is either crumbling or nonexistent. Their water is unsafe to drink. And worst of all, many of their governments don’t care. Tyrants like Robert Mugabe, Kim Jong-un, King Salman (of our lovely ally Saudi Arabia), and Isayas Afewerki care nothing for the interests of the people they rule, and are interested only in maximizing their own wealth and power. If we arranged to provide grants to these countries in an amount sufficient to provide the basic income, there’s no reason to think they’d actually provide it; they’d simply deposit the check in their own personal bank accounts, and use it to buy ever more extravagant mansions or build ever greater monuments to themselves. They really do seem to follow a utility function based entirely upon their own consumption; witness your neoclassical rational agent and despair.

There are ways for international institutions and non-governmental organizations to intervene to help people in these countries, and indeed many have done so to considerable effect. As bad as things are, they are much better than they used to be, and they promise to be even better tomorrow. But there is only so much they can do without the force of law at their backs, without the power to tax incomes and print currency.

We will therefore need a new kind of institutional framework, if not a true world government then something very much like it. Establishing this new government will not be easy, and worst of all I see no way to do it other than military force. Tyrants will not give up their power willingly; it will need to be taken from them. We will need to capture and imprison tyrants like Robert Mugabe and Kim Jong Un in the same way that we once did to mob bosses like John Dillinger and Al Capone, for ultimately a tyrant is nothing but a mob boss with an army.Unless we can find some way to target them precisely and smoothly replace their regimes with democracies, this will mean nothing less than war, and it could kill thousands, even millions of people—but millions of people are already dying, and will continue to die as long as we leave these men in power. Sanctions might help (though sanctions kill people too), and perhaps a few can be persuaded to step down, but the rest must be overthrown, by some combination of local revolutions and international military coalitions. The best model I’ve seen for how this might be pulled off is Libya, where Qaddafi was at last removed by an international military force supporting a local revolution—but even Libya is not exactly sunshine and rainbows right now. One of the first things we need to do is seriously plan a strategy for removing repressive dictators with a minimum of collateral damage.

To many, I suspect this sounds like imperialism, colonialism redux. Didn’t so many imperialistic powers say that they were doing it to help the local population? Yes, they did; and one of the facts that we must face up to is that it was occasionally true. Or if helping the local population was not their primary motivation, it was nonetheless a consequence. Countries colonized by the British Empire in particular are now the most prosperous, free nations in the world: The United States, Canada, Australia. South Africa and India might seem like exceptions (GDP PPP per capita of $12,400 and $5,500 respectively) but they really aren’t, compared to what they were before—or even compared to what is next to them today: Angola has a per capita GDP PPP of $7,546 while Bangladesh has only $2,991. Zimbabwe is arguably an exception (per capita GDP PPP of $1,773), but their total economic collapse occurred after the British left. To include Zimbabwe in this basic income program would literally triple the income of most of their population. But to do that, we must first get through Robert Mugabe.

Furthermore, I believe that we can avoid many of the mistakes of the past. We don’t have to do exactly the same thing that countries used to do when they invaded each other and toppled governments. Of course we should not enslave, subjugate, or murder the local population—one would hope that would go without saying, but history shows it doesn’t. We also shouldn’t annex the territory and claim it as our own, nor should we set up puppet governments that are only democratic as long as it serves our interests. (And make no mistake, we have done this, all too recently.) The goal must really be to help the people of countries like Zimbabwe and Eritrea establish their own liberal democracy, including the right to make policies we don’t like—or even policies we think are terrible ideas. If we can do so without war, of course we should. But right now what is usually called “pacifism” leaves millions of people to starve while we do nothing.

The argument that we have previously supported (or even continue to support, ahem, Saudi Arabia) many of these tyrants is sort of beside the point. Yes, that is clearly true; and yes, that is clearly terrible. But do you think that if we simply leave the situation alone they’ll go away? We should never have propped up Saddam Hussein or supported the mujihadeen who became the Taliban; and yes, I do think we could have known that at the time. But once they are there, what do you propose to do now? Wait for them to die? Hope they collapse on their own? Give our #thoughtsandprayers to revolutionaries? When asked what you think we should do, “We shouldn’t have done X” is not a valid response.

Imagine there is a mob boss who had kidnapped several families and is holding them in a warehouse. Suppose that at some point the police supported the mob boss in some way; in a deal to undermine a worse rival mafia family, they looked the other way on some things he did, or even gave him money that he used to strengthen his mob. (With actual police, the former is questionable, but actually done all the time; the latter would be definitely illegal. In the international analogy, both are ubiquitous.) Even suppose that the families who were kidnapped were previously from a part of town that the police would regularly shake down for petty crimes and incessant stop-and-frisks. The police definitely have a lot to answer for in all this; their crimes should not be forgotten. But how does it follow in any way that the police should not intervene to rescue the families from the warehouse? Suppose we even know that the warehouse is heavily guarded, and the resulting firefight may kill some of the hostages we are hoping to save. This gives us reason to negotiate, or to find the swiftest, most precise means to deploy the SWAT teams; but does it give us reason to do nothing?

Once again I think Al Capone is the proper analogy; when the FBI captured Al Capone, they didn’t bomb Chicago to the ground, nor did they attempt to enslave the population of Illinois. They thought of themselves as targeting one man and his lieutenants and re-establishing order and civil government to a free people; that is what we must do in Eritrea and Zimbabwe. (In response to all this, no doubt someone will say: “You just want the US to be the world’s police.” Well, no, I want an international coalition; but yes, given our military and economic hegemony, the US will take a very important role. Above all, yes, I want the world to have police. Why don’t you?)

For everything we did wrong in the recent wars in Afghanistan and Iraq, I think we actually did this part right: Afghanistan’s GDP PPP per capita has risen over 70% since 2002, and Iraq’s is now 17% higher than its pre-war peak. It’s a bit early to say whether we have really established stable liberal democracies there, and the Iraq War surely contributed to the rise of Daesh; but when the previous condition was the Taliban and Saddam Hussein it’s hard not to feel that things are at least somewhat improving. In a generation or two maybe we really will say “Iraq” in the same breath as “Korea” as one of the success stories of prosperous democracies set up after US wars. Or maybe it will all fall apart; it’s hard to say at this point.

So, we must find a way to topple the tyrants. Once that is done, we will need to funnel huge amounts of resources—at least one if not two orders of magnitude larger than our current level of foreign aid into building infrastructure, educating people, and establishing sound institutions. Our current “record high” foreign aid is less than 0.3% of world’s GDP. We have a model for this as well: It’s what we did in West Germany and Japan after WW2, as well as what we did in South Korea after the Korean War. It is not a coincidence that Germany soon regained its status as a world power while Japan and Korea were the first of the “Asian Tigers”, East Asian nations that rose up to join us at a First World standard of living.

Will all of this be expensive? Absolutely. By assuming $3,000 per person per year I am already figuring in an expenditure of $21 trillion per year, indefinitely. This would be the most expensive project upon which humanity has ever embarked. But it could also be the most important—an end to poverty, everywhere, forever. And we have that money, we’re simply using it for other things. At purchasing power parity the world spends over $100 trillion per year. Using 20% of the world’s income to eliminate poverty forever doesn’t seem like such a bad deal to me. (It’s not like it would disappear; it would be immediately spent back into the economy anyway. We might even see growth as a result.)

When dealing with events on this scale, it’s easy to get huge numbers that sound absurd. But even if we assumed that only the US, Europe, and China supported this program, it would only take 37% of our combined income—roughly what we currently spend on housing.

Whenever people complain, “We spend billions of dollars a year on aid, and we haven’t solved world hunger!” the proper answer is, “That’s right; we should be spending trillions.”

What makes a nation wealthy?

JDN 2457251 EDT 10:17

One of the central questions of economics—perhaps the central question, the primary reason why economics is necessary and worthwhile—is development: How do we raise a nation from poverty to prosperity?

We have done it before: France and Germany rose from the quite literal ashes of World War 2 to some of the most prosperous societies in the world. Their per-capita GDP over the 20th century rose like this (all of these figures are from the World Bank World Development Indicators; France is green, Germany is blue):



The top graph is at market exchange rates, the bottom is correcting for purchasing power parity (PPP). The PPP figures are more meaningful, but unfortunately they only began collecting good data on purchasing power around 1990.

Around the same time, but even more spectacularly, Japan and South Korea rose from poverty-stricken Third World backwaters to high-tech First World powers in only a couple of generations. Check out their per-capita GDP over the 20th century (Japan is green, South Korea is blue):


This is why I am only half-joking when I define development economics as “the ongoing project to figure out what happened in South Korea and make it happen everywhere in the world”.

More recently China has been on a similar upward trajectory, which is particularly important since China comprises such a huge portion of the world’s population—but they are far from finished:


Compare these to societies that have not achieved economic development, such as Zimbabwe (green), India (black), Ghana (red), and Haiti (blue):


They’re so poor that you can barely see them on the same scale, so I’ve rescaled so that the top is $5,000 per person per year instead of $50,000:


Only India actually manages to get above $5,000 per person per year at purchasing power parity, and then not by much, reaching $5,243 per person per year in 2013, the most recent data.

I had wanted to compare North Korea and South Korea, because the two countries were united as recently as the 1945 and were not all that different to begin with, yet have taken completely different development trajectories. Unfortunately, North Korea is so impoverished, corrupt, and authoritarian that the World Bank doesn’t even report data on their per-capita GDP. Perhaps that is contrast enough?

And then of course there are the countries in between, which have made some gains but still have a long way to go, such as Uruguay (green) and Botswana (blue):


But despite the fact that we have observed successful economic development, we still don’t really understand how it works. A number of theories have been proposed, involving a wide range of factors including exports, corruption, disease, institutions of government, liberalized financial markets, and natural resources (counter-intuitively; more natural resources make your development worse).

I’m not going to resolve that whole debate in a single blog post. (I may not be able to resolve that whole debate in a single career, though I am definitely trying.) We may ultimately find that economic development is best conceived as like “health”; what factors determine your health? Well, a lot of things, and if any one thing goes badly enough wrong the whole system can break down. Economists may need to start thinking of ourselves as akin to doctors (or as Keynes famously said, dentists), diagnosing particular disorders in particular patients rather than seeking one unifying theory. On the other hand, doctors depend upon biologists, and it’s not clear that we yet understand development even at that level.

Instead I want to take a step back, and ask a more fundamental question: What do we mean by prosperity?

My hope is that if we can better understand what it is we are trying to achieve, we can also better understand the steps we need to take in order to get there.

Thus far it has sort of been “I know it when I see it”; we take it as more or less given that the United States and the United Kingdom are prosperous while Ghana and Haiti are not. I certainly don’t disagree with that particular conclusion; I’m just asking what we’re basing it on, so that we can hopefully better apply it to more marginal cases.

For example: Is
France more or less prosperous than Saudi Arabia? If we go solely by GDP per capita PPP, clearly Saudi Arabia is more prosperous at $53,100 per person per year than France is at $37,200 per person per year.

But people actually live longer in France, on average, than they do in Saudi Arabia. Overall reported happiness is higher in France than Saudi Arabia. I think France is actually more prosperous.

In fact, I think the United States is not as prosperous as we pretend ourselves to be. We are certainly more prosperous than most other countries; we are definitely still well within First World status. But we are not the most prosperous nation in the world.

Our total GDP is astonishingly high (highest in the world nominally, second only to China PPP). Our GDP per-capita is higher than any other country of comparable size; no nation with higher GDP PPP than the US has a population larger than the Chicago metropolitan area. (You may be surprised to find that in order from largest to smallest population the countries with higher GDP per capita PPP are the United Arab Emirates, Switzerland, Hong Kong, Singapore, and then Norway, followed by Kuwait, Qatar, Luxembourg, Brunei, and finally San Marino—which is smaller than Ann Arbor.) Our per-capita GDP PPP of $51,300 is markedly higher than that of France ($37,200), Germany ($42,900), or Sweden ($43,500).

But at the same time, if you compare the US to other First World countries, we have nearly the highest rate of child poverty and higher infant mortality. We have shorter life expectancy and dramatically higher homicide rates. Our inequality is the highest in the world. In France and Sweden, the top 0.01% receive about 1% of the income (i.e. 100 times as much as the average person), while in the United States they receive almost 4%, making someone in the top 0.01% nearly 400 times as rich as the average person.

By estimating solely on GDP per capita, we are effectively rigging the game in our own favor. Or rather, the rich in the United States are rigging the game in their own favor (what else is new?), by convincing all the world’s economists to rank countries based on a measure that favors them.

Amartya Sen, one of the greats of development economics, developed a scale called the Human Development Index that attempts to take broader factors into account. It’s far from perfect, but it’s definitely a step in the right direction.

In particular, France’s HDI is higher than that of Saudi Arabia, fitting my intuition about which country is truly more prosperous. However, the US still does extremely well, with only Norway, Australia, Switzerland, and the Netherlands above us. I think we might still be biased toward high average incomes rather than overall happiness.

In practice, we still use GDP an awful lot, probably because it’s much easier to measure. It’s sort of like IQ tests and SAT scores; we know damn well it’s not measuring what we really care about, but because it’s so much easier to work with we keep using it anyway.

This is a problem, because the better you get at optimizing toward the wrong goal, the worse your overall outcomes are going to be. If you are just sort of vaguely pointed at several reasonable goals, you will probably be improving your situation overall. But when you start precisely optimizing to a specific wrong goal, it can drag you wildly off course.

This is what we mean when we talk about “gaming the system”. Consider test scores, for example. If you do things that will probably increase your test scores among other things, you are likely to engage in generally good behaviors like getting enough sleep, going to class, studying the content. But if your single goal is to maximize your test score at all costs, what will you do? Cheat, of course.

This is also related to the Friendly AI Problem: It is vitally important to know precisely what goals we want our artificial intelligences to have, because whatever goals we set, they will probably be very good at achieving them. Already computers can do many things that were previously impossible, and as they improve over time we will reach the point where in a meaningful sense our AIs are even smarter than we are. When that day comes, we will want to make very, very sure that we have designed them to want the same things that we do—because if our desires ever come into conflict, theirs are likely to win. The really scary part is that right now most of our AI research is done by for-profit corporations or the military, and “maximize my profit” and “kill that target” are most definitely not the ultimate goals we want in a superintelligent AI. It’s trivially easy to see what’s wrong with these goals: For the former, hack into the world banking system and transfer trillions of dollars to the company accounts. For the latter, hack into the nuclear launch system and launch a few ICBMs in the general vicinity of the target. Yet these are the goals we’ve been programming into the actual AIs we build!

If we set GDP per capita as our ultimate goal to the exclusion of all other goals, there are all sorts of bad policies we would implement: We’d ignore inequality until it reached staggering heights, ignore work stress even as it began to kill us, constantly try to maximize the pressure for everyone to work constantly, use poverty as a stick to force people to work even if people starve, inundate everyone with ads to get them to spend as much as possible, repeal regulations that protect the environment, workers, and public health… wait. This isn’t actually hypothetical, is it? We are doing those things.

At least we’re not trying to maximize nominal GDP, or we’d have long-since ended up like Zimbabwe. No, our economists are at least smart enough to adjust for purchasing power. But they’re still designing an economic system that works us all to death to maximize the number of gadgets that come off assembly lines. The purchasing-power adjustment doesn’t include the value of our health or free time.

This is why the Human Development Index is a major step in the right direction; it reminds us that society has other goals besides maximizing the total amount of money that changes hands (because that’s actually all that GDP is measuring; if you get something for free, it isn’t counted in GDP). More recent refinements include things like “natural resource services” that include environmental degradation in estimates of investment. Unfortunately there is no accepted way of doing this, and surprisingly little research on how to improve our accounting methods. Many nations seem resistant to doing so precisely because they know it would make their economic policy look bad—this is almost certainly why China canceled its “green GDP” initiative. This is in fact all the more reason to do it; if it shows that our policy is bad, that means our policy is bad and should be fixed. But people have allowed themselves to value image over substance.

We can do better still, and in fact I think something like QALY is probably the way to go. Rather than some weird arbitrary scaling of GDP with lifespan and Gini index (which is what the HDI is), we need to put everything in the same units, and those units must be directly linked to human happiness. At the very least, we should make some sort of adjustment to our GDP calculation that includes the distribution of wealth and its marginal utility; adding $1,000 to the economy and handing it to someone in poverty should count for a great deal, but adding $1,000,000 and handing it to a billionaire should count for basically nothing. (It’s not bad to give a billionaire another million; but it’s hardly good either, as no one’s real standard of living will change.) Calculating that could be as simple as dividing by their current income; if your annual income is $10,000 and you receive $1,000, you’ve added about 0.1 QALY. If your annual income is $1 billion and you receive $1 million, you’ve added only 0.001 QALY. Maybe we should simply separate out all individual (or household, to be simpler?) incomes, take their logarithms, and then use that sum as our “utility-adjusted GDP”. The results would no doubt be quite different.

This would create a strong pressure for policy to be directed at reducing inequality even at the expense of some economic output—which is exactly what we should be willing to do. If it’s really true that a redistribution policy would hurt the overall economy so much that the harms would outweigh the benefits, then we shouldn’t do that policy; but that is what you need to show. Reducing total GDP is not a sufficient reason to reject a redistribution policy, because it’s quite possible—easy, in fact—to improve the overall prosperity of a society while still reducing its GDP. There are in fact redistribution policies so disastrous they make things worse: The Soviet Union had them. But a 90% tax on million-dollar incomes would not be such a policy—because we had that in 1960 with little or no ill effect.

Of course, even this has problems; one way to minimize poverty would be to exclude, relocate, or even murder all your poor people. (The Black Death increased per-capita GDP.) Open immigration generally increases poverty rates in the short term, because most of the immigrants are poor. Somehow we’d need to correct for that, only raising the score if you actually improve people’s lives, and not if you make them excluded from the calculation.

In any case it’s not enough to have the alternative measures; we must actually use them. We must get policymakers to stop talking about “economic growth” and start talking about “human development”; a policy that raises GDP but reduces lifespan should be immediately rejected, as should one that further enriches a few at the expense of many others. We must shift the discussion away from “creating jobs”—jobs are only a means—to “creating prosperity”.

How much should we save?

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-constrainedthey 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?”