Showing posts with label Inequality. Show all posts
Showing posts with label Inequality. Show all posts

26 October 2015

Economic Growth

An essay. It's an overview of what a growth-oriented policy program might look like. Regulation, finance, health, energy and environment, taxes, debt social security and medicare, social programs, labor law, immigration, education, and more. There is a more permanent version here and pdf version here. This version shows on blogger, but if your reader mangles it, the version on my blog or one of the above will work better.

I wrote it the Focusing the presidential debates initiative. The freedom of authors in that initiative to disagree is clear.

Economic Growth

Growth is central


Sclerotic growth is the overriding economic issue of our time. From 1950 to 2000 the US economy grew at an average rate of 3.5% per year. Since 2000, it has grown at half that rate, 1.7%. From the bottom of the great recession in 2009, usually a time of super-fast catch-up growth, it has only grown at two percent per year.2 Two percent, or less, is starting to look like the new normal.

Small percentages hide a large reality. The average American is more than three times better off than his or her counterpart in 1950. Real GDP per person has risen from $16,000 in 1952 to over $50,000 today, both measured in 2009 dollars. Many pundits seem to remember the 1950s fondly, but $16,000 per person is a lot less than $50,000!

If the US economy had grown at 2% rather than 3.5% since 1950, income per person by 2000 would have been $23,000 not $50,000. That’s a huge difference. Nowhere in economic policy are we even talking about events that will double, or halve, the average American’s living standards in the next generation.

Even these large numbers understate reality.

GDP per capita does not capture the increase in lifespan — nearly 10 years — in health, in environmental quality, security and quality of life that we have experienced. The average American today lives far better than a 1950s American would if he or she had three rather than one 1950s cars, TVs, telephones, encyclopedias (in place of internet), or three annual visits to a 1950s doctor.

But even these less quantified benefits flow from economic growth. Only wealthy countries can afford environmental protection and advanced health care. We can afford to worry about global warming. India worries about 600 people per toilet, emphysema from burning cow patties, and easily treatable parasitic infections. Our ability to defend freedom around the world — even if we are wise enough to do it sensibly — depends on robust economic growth. If GDP had grown at 2%, not 3.5%, we would only be able to afford half the military we have today. The immense improvements in the quality of goods and many services we have today are part of the engine of economic growth.

Looking forward, solving almost all our problems hinges on reestablishing robust economic growth. Tax revenue equals tax rate times income, and growth determines how much income there will be. The amount of tax revenue our government has available to pay off debt and to pay the ballooning social security and health care expenses depends almost entirely on economic growth. Larger tax rates can’t come close to raising that much money.

For example, the Congressional Budget Office, making its regular gloomy analysis of the US long-run budget outlook, assumes 2.2% growth from now until 2040.3 But if GDP grew by 3.5% instead, even with no structural reforms at all, GDP in 2040 would be 38% higher, tax revenues would be 38% higher, and a lot of the problem would go away on its own. A 38% increase in Federal Revenue by higher tax rates or a 38% cut in spending are unlikely. Conversely, if GDP only grows 1%, GDP and tax revenues will be 26% lower than the CBO forecasts, which will force a fiscal crisis.

38% more income — or 26% less income — drives just about any agenda one could wish for, from strong defense, to environmental protection, to the affordability of social programs, to the welfare of any segment of the population, to public investments, health, and fundamental research.

And 3.5% is only a return to the post-WWII norm. Pre-2000 economic policies were not ideal. If we achieve 4% or more growth, even greater benefits occur.

The source of growth


Over long periods of time, economic growth comes from one source: productivity, the value of goods and services each worker can produce in a unit of time.

In turn, productivity comes from new ways of doing things. New ideas, at heart; new inventions, new products, new processes, new technology; new ways of organizing companies; new and better skills among workers. Southwest Airlines figuring out how to turn a plane around in 20 minutes, and Walmart mastering supply logistics, are as much productivity growth as installing scanners or ATMs. Workers who know how to use computers rather than shovels produce a lot more per hour.

Higher productivity typically comes from new companies, which displace old companies — and displace the profits of their owners, and the healthy pay and settled lives of their managers and workers. Southwest enters and either displaces the legacy carriers — Pan Am and TWA — or forces wrenching changes for survivors such as American and United. A&P displaced mom and pop stores. Walmart displaced A&P. Amazon may displace Walmart. Nobody likes the process. Everyone needs the results.

Nothing other than productivity matters in the long run. A factor of three increase in income in 50 years, and the much larger rise in income and health since the dawn of the industrial age, dwarfs what unions bargaining for better wages, progressive taxes or redistribution, monetary, fiscal or other stimulus programs, minimum wage laws or other Federal regulation of labor markets, price caps and supports, subsidies, or much of anything else the government can do.

More people working, and working longer hours, can improve income a bit, but soon runs in to an upper limit. Our grandparents worked long hours, but were much worse off than we are.

Saving, investment and capital formation can improve income a bit, but its benefit is limited as well. A 1950 worker working with twice as many 1950 machines produces much less than a modern worker using current technology. Only new ideas, new products, new technologies, new organizations, and new skills produce such huge increases in prosperity.

In this context, the decline of US GDP growth coincides with more worrying changes. Productivity growth is declining. New business formation is sharply down. Mobility of people from job to job has declined.

Restoring growth: a general strategy


A debate rages among economists why America’s growth has slowed. Most commentators advocate one side of that debate, and advocate strong policies according to their favorite theory. Lots of new ideas and grand policy programs are being dreamed up. Someone putting together a policy program might feel they have to choose a side in that debate, or they might wish to let that debate settle, to identify the most important policies.

Either approach is, I think, a mistake, given the urgency and magnitude of the problem, and given the likelihood that such a highly politicized economic debate will come to useful resolution anytime soon.

Let us instead work on the simple, common-sense things that everyone knows are broken, everyone understands are retarding growth, and that when fixed can increase growth. As opposed to looking for big magic bullets, new and clever theories, and ignoring the simple problems staring us in the face.

Will this approach restore 3.5% growth? Will it bring us to 4% or more growth? Well, really, it doesn't matter. When we have a big problem, and we know simple steps will help that problem, we should take those steps. We should do so, especially, because most of these simple steps can be taken at no fundamental economic or other cost.

Our economy is like a garden, but the garden is choked with weeds. Rather than look for some great new fertilizer to throw on it, why don’t we get down on our knees and pull up the weeds? At least we know weeding works! For another metaphor, our economy has become like a hoarder’s house. For a while he could get through the passages and keep life going, but now the junk is closing in. Well, rather than read the architectural magazines about just what the perfect house will look like, let’s get to work cleaning up the mess.

Politics


Alas, such a common-sense, weed-the-garden program has little attraction to many ambitious politicians. Many politicians want a big new program, big new laws and initiatives — a New Deal, a Fair Deal, a Great Society. They don’t see cleaning up the mess left behind by their predecessors as the way to getting one’s face carved on Mt. Rushmore, let alone to win an election. Economists like big new ideas and programs too. Nobody got a Nobel prize for saying, let’s take Adam Smith’s 250 year old classics to heart.

But it is a big idea, a big program, and one that needs and will reward the courageous leadership of great politicians. Everybody has to give up their little deal, protection, tax break and subsidy; everyone has to allow their businesses or profession to be open to competition. Each person must understand that the small loss that he or she will experience directly will be more than made up by everyone else giving up theirs. Politically, rather than fall back on “I’ll support your little deal, you support mine,” everyone has to become part of the coalition that supports reform — “no, I’m not getting mine, so I’m not going to support you getting yours.”

Forming such a coalition and keeping it together is hard. It is the essence of what great politicians can achieve.

Cleaning out the weeds also needs a large effort of simple governance. The President has to revisit and rewrite the mass of executive orders and memos. The Congress has to get serious and pass laws that are actually laws, not thousand page instructions for agencies to figure things out. It has to get around to repealing laws everyone understands are bad — the Jones act restricting shipping, the ban on oil exports, and so on — and reforming laws that everyone understands need to be reformed. It needs to actually follow its own budget law. The heads of agencies will have to renew the staff and reorient them to growth-oriented policy, and undertake a sweeping house-cleaning of regulations and procedures. They will have to implement managerial techniques such as pervasive cost-benefit analysis, regular retrospective review, and sunsets.

All of this is hard too. But it is the basic work of competent, growth-oriented government.

It is tempting to cast the question before us as growth vs. redistribution, or growth vs. inequality, as the rhetoric of redistribution and inequality pervades the arguments from those who want to continue the policies that are strangling growth.

But giving in to that rhetoric is a mistake. The US, in fact, has one of the most progressive tax systems in the world. And the relatively minor costs of government assistance to truly poor, needy, mentally ill or disabled people are not major impediments to growth. The weeds choking the economy represent cronyist redistribution to wealthy people, well-connected industries, and other powerful groups such as public employee unions, and large transfers among middle income people (social security and medicare). They are not, by and large, the result of genuine and effective redistribution from rich to needy poor.

When the average person (voter) expresses concern over inequality, what they really mean is that they are concerned that average people are not getting ahead economically. If the average person were getting ahead, whether some big shot CEOs fly on private jets or not would make little difference. Conversely, the average voter, if not the average left-wing pundit, does not support equality of misery. If the average person continues to do poorly, it would bring them little solace for the government to tax away the lifestyles of the rich and famous.

Long-term robust economic growth is the only way to deliver sustained improvements in the lot of average Americans, and the less fortunate in particular. Redistributing Marie-Antoinette’s jewelry did little for the average French farmer.

The golden rule of economic policy is: Do not transfer incomes by distorting prices or slowing competition and innovation. The golden rule of political economics seems to be: Transfer incomes by distorting prices and regulating away competition. Doing so attracts a lot less attention than on-budget transfers or subsidies. It takes great political leadership to force the political process to obey the economic rule.

Regulation


The vast expansion in regulation is the most obvious change in public policy accompanying America’s growth slowdown. Most recently, under the Dodd-Frank act and the ACA or Obamacare, these two large segments of the economy have seen radical increases in regulatory intervention. But environmental, labor, product, and energy regulation have all increased dramatically as well.4

Sometimes, regulation slows growth in return for public benefits, such as environmental protection or transportation safety. One can argue whether it does so efficiently, but there is a purpose.

Most economic regulation, however, is specifically designed to slow growth. The purpose of most economic regulation is to transfer money to a specific group of people, companies, or industry. It does so by slowing down new entrants, impeding competition, mandating uneconomic actions or cross-subsidies, slowing innovation, turning off price signals, distorting incentives, and encouraging waste. These are the tools of economic regulation, and they all impede economic growth.

People often complain that there are too many rules and regulations, or that the cost of filling out forms is too high, that there is too much red tape, that there are too many lobbyists, or that the direct measurable costs on industry are too large. The economic impact of regulation goes far beyond these standard complaints. The overwhelming cost of regulation is the economic dislocation: companies not started, products not produced, innovations not innovated, people not hired, costs not slashed, prices too high. And growth too slow. Just because it’s harder to measure these costs does not mean that these are not the overwhelmingly more important costs, and the costs that we need to address.

Economic regulation has left behind the rule-of-law framework that many Americans suppose governs their affairs. In the popular imagination, regulation is about rules, and there are just too many of them. In many areas, however, the regulations are so vast, so complex, self-contradictory and so vague, that they basically give the regulators free rein to do what they want. In many cases, there is not a set of rules that you can read and comply with. You need to ask for preemptive permission from a regulator, who determines if your project can go ahead. Delay in getting needed approval is as good as denial in many cases. Projects that cost millions cannot bear years or often decades of delay in getting approvals.

In other cases, vague and expansive laws and regulations give regulators ammunition to pursue a few selected victims, to extort big settlements or send a few examples to jail. And by doing so to frighten the others into following the regulators’ commandments. In many areas just about everyone is in technical violation of some law or regulation.

We are used to the right to see evidence against us, challenge witness testimony, and appeal decisions to an independent and higher court. These rights often do not apply to regulations, where the agency is prosecutor, police, judge, jury, and executioner all wrapped in one. The methods for determining an “abusive” practice or “discriminatory” outcome are not revealed ahead of time so that people could structure their actions in accordance with the rules.

Much of this state of affairs is Congress’ fault, for writing long vague bills which devolve legal power to the agencies. But in an increasing trend, regulatory agencies are going far beyond even the clear limits of their statutory authority and writing rules or commanding outcomes clearly far beyond the plain language of the law. The EPAs expansion of carbon regulation and the definition of wetland are good cases in point.

The popular debate is about “more” vs. “less” regulation. Regulation is not more or less, regulation is effective or ineffective, smarter or dumber, full of unintended consequences or well-designed, captured by industry or effective, based on rules or based on regulator whim, accountable or arbitrary, evaluated by rigorous cost benefit standards or by political winds, distorting economic activity or supporting it, and so forth.

So “de-regulation” is also an inappropriate slogan. “Smart regulation,” or “growth-oriented regulation” are much better descriptors of what needs to be done.

Finance


Financial regulation, even more transparently than other regulation, is just about who gives money and who gets money.

Under the Dodd-Frank act, a highly regulated industry has become suffocatingly regulated. The Federal Reserve embeds hundreds of employees at each major bank, who pass judgment on every decision. The justice department and SEC routinely pursue banks and other financial institutions for multibillion dollar settlements, and now will pursue individuals with criminal charges. The fixed costs of running a compliance department are so high that it is nearly impossible to start a new financial company in the US. Just one new bank has been chartered since the passage of Dodd-Frank.

The parts of the financial system that failed and were bailed out in 2008 — Fannie and Freddie, commercial banks — were already among the most highly regulated businesses in America. Regulation did not fail for being absent. Regulation failed for being ineffective.

Alas, the basic structure of the Dodd-Frank act simply doubles down on the same basic design that has failed again and again: The government guarantees a wide swath of debt, by promise (deposit insurance) and by ex-post bailout. An army of regulators tries to keep banks and other financial institutions from exploiting the guarantee and taking too much risk, and clairvoyantly to forecast panics and take action to stop them. That’s like sending your brother in law to Las Vegas with your credit card, but asking his kids to keep an eye on him.

Like much else in America, our government works to cross purposes. It subsidizes debt with tax deductibility, deposit insurance, too big to fail guarantees, regulatory preference for holding short-term assets, liquidity rules, credit guarantees, Fannie and Freddie, the home mortgage interest deduction, community reinvestment act, student loan programs and so forth. And then it tries to regulate against using debt with bank asset regulation, stress tests, consumer financial protection, macro-prudential policy, and so on.

The alternative is clearly laid out in many sources: Risky investments must be largely financed by issuing equity, not by borrowing very short term money. When that happens, the mass of regulation is simply not needed in order to stop financial crises. Then we will “only” face the task of removing needless regulations whose main purpose is to create subsidies and protections for various clienteles.

Health


The ACA, thousands of pages of law, tens of thousands of pages of regulations, and even more decision-making power by newly empowered regulators, such as the thousands of waivers given to individual companies, represents an enormous increase in Federal intervention in the market for health care and health insurance. Like finance, health was already highly regulated. And like finance, most of the ACA simply doubled down on the same basic regulatory structure that had caused so many pathologies before.

The central problem of preexisting conditions was an artifact of regulation. In the ideal form of health insurance, you buy cheap catastrophic insurance when young, but the insurance policy can follow you as you age, change jobs, and move from state to state, and does not radically increase premiums if you get sick.

Why don’t we have that ideal insurance? Because previous rounds of regulation outlawed it. In the 1940s the US government allowed tax deductions for employer-provided group insurance, but not employer contributions to individual insurance or individuals’ contributions to such insurance. By laws, insurance is not portable across state lines. Thus, there is no reason for anyone who might get a job or move to buy long-term individual insurance that protects against the emergence of pre-existing conditions. In response to the preexisting conditions problem, the ACA forces community rating — everyone pays the same price—tries to mandate healthy people to buy insurance, and steps up pressure on employer provided group plans, which are the source of the problem.

Similarly, once insurance was tax deductible, there was an incentive to salt it up. You would not buy car insurance that “paid for” oil changes — especially if you had to deal with insurance paperwork each time. But with a tax deduction it’s worth buying health insurance that “pays for” routine small expenses. Then the government (state and local too) instituted mandates that insurance must “pay for” — and, of course, charge premiums to cover — all sorts of additional procedures, which makes insurance too expensive.

We need to allow simple, portable, largely catastrophic, lifelong, guaranteed-renewable health insurance to emerge. Right now it’s illegal. To the extent that the government wishes to subsidize health insurance — and it should — then it should give straightforward vouchers, which people can use to buy insurance, or to fund health savings accounts. Such vouchers should take the place of Obamacare, Medicaid, and Medicare.

Health care and insurance is not just distorted from the demand side — too many people paying with someone else’s money. The supply side is ossifyingly restricted as well. New hospitals, new clinics that specialize in cheaply providing one service well, new doctors, new nurses, new insurance companies, all find a wall of laws, regulations, and officials blocking their path. For a reason: To maintain the profits of and cross-subsidies provided by the existing incumbents. Non-profit status itself blocks efficiency: you can’t take over an inefficient non-profit, and non-profits can’t issue equity to make important investments. In reducing the cost and improving the quality of health care, efficiency is far more important than trying to avoid a competitive rate of return to owners.

Energy and Environment


There are few places in the American government where one can witness inefficiency and growth-sapping regulatory bungling on the scale seen in our energy and much (not all) environmental regulation.

Like much else in America, our government pursues conflicting aims. It tries to subsidize and drive down the price of energy. And then it tries simultaneously to regulate against our using energy in a hundred different ham-handed ways, from mileage standards for cars, energy efficiency standards for windows and appliances, special parking places for electric vehicles,

$7,500 tax credits to subsidize $100,000 Tesla cars bought by silicon valley zillionaires, hundreds of annually extended tax credits for various energy boondoggles, and so forth.

The poster child for inefficiency may well be the mandate for gasoline producers to use ethanol. Corn ethanol, it turns out, does nothing to help the environment: It takes nearly as much petroleum energy to produce it as it contains, in the form of fertilizer, transport fuel and so on; it uses up valuable land, which directly emits greenhouse gases, and contributes to erosion and runoff; it drives up the price of food. The only thing sillier was the mandate to include cellulosic ethanol, because the government mandated a technology that simply did not work.

If you were wondering why we do this, it should come as no surprise that corn is produced by big companies in Iowa. If you need more evidence, note that the US also has heavy restrictions on the importation of sugar cane ethanol — as we restrict all sugar cane imports — which actually might be of some environmental benefit. The planet, of course, does not care whether corn is grown in Iowa or sugar cane in Brazil. Corn growers and sugar producers do care.

A litmus test for a presidential candidate ought to be the willingness to stand up in Iowa and say, “Ladies and Gentlemen, a huge government subsidy for corn ethanol is a rotten idea.”

Similarly, if you thought that subsidized production of photovoltaics and the various subsidies to putting solar cells on your roof, including the requirement that your fellow citizens buy electricity back from you at retail prices, are about the environment, you will be puzzled by our government’s heavy import restrictions on cheap Chinese made solar cells. Obviously, mother nature cares not where the cells are produced. Mother politics does.

Energy and transportation policy seem to indulge flights of magical thinking. California, facing a drought, and not having built water projects in decades, is going to spend well over $60 billion dollars on a high-speed rail line. This is advanced in the cause of carbon emission reduction. And quite literally, the case has been made that by building the rail line, we will lower global temperatures, and increase rainfall. If on a dollars per ton of carbon saved the rail line fails elementary cost-benefit analysis, on dollars per drop of water created, it fails the magic vs. reality test.

As this example makes clear, the Federal government is not alone. State and even local regulation is partly to blame as well.

Strong zoning laws forbid people from building houses near where they work, and forbid them from building workplaces near where people live, and from building shops near either. An electric car driving 60 miles is much less energy efficient than living in a high-rise apartment, in a mixed residential/commercial neighborhood, and walking!

A growth-oriented, and anti-cronyist energy policy is pretty simple. To the extent that the government wishes to reduce carbon emissions, impose a simple and straightforward carbon tax. In return, eliminate all the detailed mandates, subsidies, quantity regulations, and boondoggle unprofitable projects. If energy costs more, people will quickly figure out on their own what makes sense.

Energy is an economic paradox, as it is so highly regulated, with so much government picking of technologies, but simultaneously has such a flat long-run supply curve and there are so many technological alternatives. A large price of polluting energy is the most efficient way to induce clean energy innovation; far more efficient than massive amounts of federally subsidized research and development to financially unprofitable businesses and bureaucrats picking technologies. And price-induced behavior changes can reduce usage much more easily than mandating fancier technologies. Paying some attention to turning off the lights when you leave the room is more efficient than mandating LED bulbs and leaving the lights on.

If you are serious about carbon, let the words “nuclear power” pass your lips. We have sitting before us a technology that can easily supply our electricity and many transport needs, with zero carbon or methane emissions. New designs, if only they could pass the immense regulatory hurdle, would be much safer than the 1950s Soviet technology that failed at Chernobyl or the 1960s technology that failed at Fukushima. We are now operating antiques. And even with this rate of accident, nuclear power has caused orders of magnitude less human or environmental suffering than any other fuel.

Similarly, the most environmentally friendly way for people to live is in tightly packed cities, fed by genetically modified foods which yield more per acre of farmland and require fewer fertilizers and pesticides, from laser-leveled fields run efficiently by large corporations in the highest productivity locations. Federal policies to the contrary are not just anti-growth, they’re anti-environment too. When Federal policy can say these things in public, it will have a bit more standing to invoke the name of “science.”

Environmental policy at a minimum needs a far more frequent application of cost-benefit analysis!

As important as carbon may be, our environmental policy has become obsessed with this one danger. But slow warming and sea level rise in 100 years are not the only, or possibly the main, environmental danger we face.

Most of the large species going extinct — elephants, rhinos, lions, and so forth, to say nothing of the more numerous and less photogenic — will go extinct from human predation, poaching, and loss of habitat long before climate has any effect on them. Most of the world faces environmental problems far more pressing than climate. And by focusing on climate, our government is spending far too little time, research and money on small but catastrophic dangers such as global pandemics, crop failures, animal diseases, and so on. As in finance, the unexpected and swift dangers are more likely to cause a crisis than the slow moving widely anticipated ones.

Taxes


Perhaps one economic issue just about every corner of the political spectrum can agree on is that our tax code is a massively complex and broken mess, needing reform.

Practically everyone agrees on the basic structure of a growth-oriented tax reform: Lower marginal rates — the extra amount of taxes you pay on an extra dollar of income determines the disincentive to earning that income. To raise revenue at lower marginal rates, broaden the base, i.e. remove exemptions and loopholes. And massively simplify the code.

Admittedly, not everyone agrees that tax reform should be oriented to growth. The voices for higher taxes argue for redistribution or decapitation — removal of high incomes, even without benefit to lower-income people — freely admitting the growth consequences of high taxes are at least not positive. They just view distributional goals as more important than growth.

Often, however, tax reform proposals sacrifice too quickly the principles of what a good tax system should be with perceived political accommodations to powerful interest groups. Economists should not play politician. We should always start with “in a perfect world, here is what the tax code should look like,” and accommodate political constraints only when asked to. Political constraints change quickly. Economic fundamentals do not.

Herewith, then, a brief reminder of basic principles:

The right corporate tax rate is zero. Corporations never pay taxes. Every dollar of taxes that a corporation pays comes from higher prices of their products, lower wages to their workers, or lower returns to their owners.

Which one, depends on who can get out of the way. While it is politically tempting to suppose that wealthy stockholders bear the burden of corporate taxation, they are in fact the most likely to be able to avoid taxation. While imposing a corporate tax may hurts existing stockholders, by lowering the value of the stock, there is no reason new investors will give the corporation money unless they can get the same after-tax return they can get elsewhere, and in particular abroad. Thus, new investment dries up until the company can pay the same after-tax return to its investors — by raising prices, lowering wages, or reducing scale to generate greater before-tax profits. In addition, these days the owners and investors of corporations are as much your and my pension fund as they are rich individuals.

For all these reasons, eliminating the corporate tax is as likely to be more rather than less progressive. The higher prices a corporation charges hurt everyone. The lower wages corporations pay hurt workers. The income it passes along to its owners is subject to our highly progressive tax system.

A growth-oriented tax system taxes consumption, not income. When we tax income that is saved, or the investment income that results from past saving, we reduce the incentive to save, invest, start companies and build them, vs. enjoy consumption immediately. One of the first theorems you learn in an economics class on taxation is that the right tax on rates of return is zero.

A person-based consumption tax can be progressive. It is useful to collect the basic tax as a VAT. Then people in higher brackets can declare income and receive credit for investments.

The estate tax is a particularly distorting tax on saving and investment. One may sympathize with the the moral judgment that rich kids don’t “deserve” inherited wealth. But the point is on the incentives of the giver. The tax code should not give strong incentives to middle-age people to stop building their businesses, investing their money, spend their money on round the world cruises and their time with tax lawyers. Nor should it force the breakup of privately held businesses to pay taxes. Maybe the kids don’t deserve it, but if people cannot provide better lives for their children, we remove one of the strongest and oldest human incentives for economic activity.

Taxing corporations rather than people and taxing income rather than consumption is behind many complexities of the tax code. For example, right now the corporate and individual tax rates must be at roughly the same level. If we tax corporate income less, then people rush to incorporate themselves. If we tax personal income less, the opposite. But if we tax consumption and not income, then there is no tax benefit to incorporating yourself. As another example, we only need special health savings accounts and college savings accounts because we tax income. If we taxed consumption we would just save for health, college, and retirement as we do everything else.

In partial recognition of the distortions caused by taxing rates of return, our tax code includes an absurdly complex web of ways of getting around capital income taxes, from IRAs, Roth IRAs, 527(b), 401(k), special tax treatment of pension funds and life insurance, lower rates for long-term capital gains, and the various trust shenanigans of the estate tax. Removing the attempt to tax investment income would make all of these complex structures irrelevant. Then they can be removed, greatly simplifying the code.

The economic distortions of the tax system result from the overall marginal tax rate, not each tax alone. The economic distortion due to taxation does not care that there are separate federal, state and local taxes. The economic distortion is the sum of all these. Start by producing one dollar more of value for your employer. Now subtract the corporate income tax, the payroll tax (social security, medicare, etc.), your federal, state, and local income taxes; the investment taxes, capital gains taxes or estate taxes paid between earning and consuming, and the sales taxes, excise taxes, property taxes, gas taxes and so forth that you pay when you buy something, to see how much of value you actually get in return for the dollar of value you provided to your employer. That’s the overall marginal tax rate.

Far too much tax discussion considers federal income taxes alone as if the others did not exist. They do exist. I only half-jokingly suggested an alternative maximum tax.5 Add up all the taxes you pay, including all the taxes companies whose stock you own pay, to any level of government. If it’s above some high number — say, 70% — you’re done and have to pay no more.

When we say broaden the base by removing deductions and credits, we should be serious about that. Thus, even the holy trinity of mortgage interest deduction, charitable donation deduction, and employer provided health insurance deduction should be scrapped. The extra revenue could finance a large reduction in marginal rates.

Why? Consider the mortgage interest deduction. Imagine that in the absence of the deduction, Congress proposes to send a check to each homeowner, in proportion to the interest he or she pays on money borrowed against the value of the house. Furthermore, rich people, people who buy more expensive houses, people who borrow lots of money, and people who refinance often to take cash out get bigger checks than poor people, people who buy smaller houses, people who save up and pay cash, or people who pay down their mortgages. A rich person buying a huge house in Palo Alto, who pays 40% marginal income tax rate, gets a check for 40% of his huge mortgage. A poor person buying a small house in Fresno, who pays a 10% income tax, gets a check for 10% of his much smaller mortgage. There would be riots in the streets before this bill would pass. Yet this is exactly what the mortgage interest deduction accomplishes.

Charitable donations follow the same logic. Suppose Congress proposed to match private charitable donations with federal dollars. Rich people get 40% match, but poor people only get 10%. Not only would that cause riots, but then there would be a much closer eye on just what “charities” mean in today’s America if they received direct checks from the Treasury. We may moan at the complexities of federal expenditures, but there is at least some oversight. Charities spend tax money largely in the dark. The shenanigans of the Clinton foundation are only the most recent visible example of how “nonprofits” are often the latest scam in the American legal system. Notice how every sports star or celebrity has a charitable foundation? They are great ways to escape estate taxes and investment taxes as well as campaign finance laws. Your kids can serve as the executives of the foundation.

Yes, universities (such as my employer) may suffer. Well, I started this essay with the idea that everyone must give up their little subsidy so that the rest will give up theirs. So too must academics.

Americans remain generous. Even without a tax incentive, Americans will give to worthy causes, as they give now to political campaigns. Worthy charities, such as my employer, may even gain by substitution away from tax and political scams.

In sum, the ideal tax system taxes people, it taxes consumption not investment income, and it taxes at a very low rate with a very large base.

The political debate on taxes


Why is this so hard? Because our political debate mixes different goals.

The central goal of a growth-oriented tax system is to raise the revenue needed to fund necessary government spending at minimal distortion to the economy, and in particular minimizing the sorts of distortions that impede the growth process.

A first objection comes from those who want to pair reform of the code with substantial rises in overall revenue. This has been the main stumbling block to tax reform under the Obama Administration.

Second, our tax code mixes raising revenue with a host of special provisions designed to encourage specific activities and transfer income to specific groups or businesses. Objections come from those who what to preserve one or another subsidy, deduction, or exemption.

Third, our tax code mixes raising revenue with efforts to redistribute resources across income and various demographic classes.

The result is paralysis. The answer lies in separating the arguments. One could go so far as to separate the actual legislation.

First, we should discuss the structure of the tax code separately from the proper level of revenues. Let us agree that we will eliminate deductions and exemptions and have three brackets. Start with a revenue-neutral code. But agree that we can separately and much more frequently adjust the rates, which adjust the overall level of revenues.

Second, we should separate the tax code from the subsidy and redistribution code. Let us agree, the tax code serves to raise revenue at minimal distortion. All other economic policy goes into the subsidy code. And subsidies should be on-budget and explicit. So, you want a subsidy for home mortgage interest payments? Sure, let’s talk about it. But it will be an on-budget expense — we will send checks to home buyers if we do it. You want to give $7,500 to each purchaser of electric cars? Sure, let’s talk about it. But it will be an on-budget expense. We will send $7,500 checks electric car purchasers if we do it.

Yes, advocates will object. Congress is not at all likely to appropriate money in this way! Tax credits and deductions are very useful for hiding things like this. But again, honest political leadership should say, if we have to hide what we’re doing from the American people, then we shouldn’t be doing it. Or, we should structure it in a way that is acceptable.

This discussion reflects another reality: The size of the US government is vastly greater than we think. It looks like Federal spending is only about 20% of GDP. But each deduction and mandate is the same thing as a tax and a subsidy. By bringing each deduction and tax credit on budget, we can correctly see exactly the size of our government, and more wisely vote on that size.

Even if my dream of putting all subsidies on budget fails, they should at least be conceptually separate parts of the tax code, and debated separately. The key is to keep the basic tax code focused on raising revenue at smallest possible economic distortion, and to argue separately about subsidies.

The art of politics is, of course, bundling things in a way to get deals done. But it is clear that the current bundling is producing paralysis. Those on the left that wish to raise revenue suspect that those who wish to reform the tax code will not later allow a discussion on revenue, so they must hold reform hostage. Likewise with those who want subsidies. Rather than produce another bundled mess, a great politician should be able to promise an honest hearing on revenue and unpalatable subsidies to get a clean growth-oriented reform.

Redistribution by our federal government fails because of its similarly chaotic approach. Discussions of progressivity consider redistribution through the federal income tax code forgetting about the smorgasbord of social programs and other taxes. Social security, medicaid, food stamps, unemployment insurance, and so on and so on all overlap to an incoherent mess. These should be condensed into one coherent approach to helping lower-income Americans. You can redistribute, if desired, by checks as well as by differing tax rates.

The central problem is again the tension between economics and politics. When a growth-oriented economist writes about taxes, the most important question is the distortion. What economic decision is distorted by taxes? If you produce $2 for your employer but only receive $1 in value, does that distort your decision to work, to take a job, or to invest in the skills needed for the job? Who gets how much money is really not that important to growth.

When the political system discusses taxes, the only question is who gets how much money, subdivided into minute income, geographic, racial and industry categories. Nobody pays attention to the distortions. But the distortions lower growth, and it is the job of wise political leadership to move the public discussion in that direction.

The current tax discussion understates, I think, the importance of simplicity in the tax code. A simple code makes its incentives transparent. A simple code vastly reduces compliance costs. And most of all, a simple code is much more clearly fair. Americans now look at the tax code and suspect — often rightly — that rich smart people with clever lawyers are getting away with things. Our voluntary tax code depends vitally on removing this suspicion. The Greek equilibrium in which each person cheats because he knows everyone else is cheating, corrosive far beyond its effect on revenue, can break out here too.

Tax lawyers and economists often come up with complex schemes to achieve parts of the principles I advocate, without doing much violence to the current code. I think this is a mistake. People who look forward to late March and early April each year as a time to show their hard-won expertise should remember how much the rest of the country hates the experience.

For example, rather than eliminate the corporate tax, some economists advocate having corporations notify each stockholder how much tax is paid on his or her behalf, and then the stockholder can deduct the corporate tax payments from his or her individual taxes. That achieves the same economic result, if the costs of filling out forms are zero.

But that setup is disastrous for commitment and simplicity. The corporate tax remains, and arguments about just what corporations can and can’t deduct, which income where they pay taxes on remain firmly in place. With the corporate tax system still in place, we are a sneeze away from limiting or removing the pass-through. And one cannot ask for a way that smacks more of a handout to “the rich,” hiding its effect of lowering product prices or raising wages. The code is only simplified if the corporate tax is eliminated. (And, if the government wants to subsidize R&D, energy investments, or other activities, do so with on-budget subsidies, just like for people.)

As another example, it seems politically easier to leave in place cherished deductions like health insurance, home mortgage interest, and charity, but limit the total amount of deductions any one person can take. That achieves the economic purpose.

But this setup leaves intact a perpetual argument. Next year, let’s renegotiate a higher limit. Or let’s exempt my favorite deduction from the limit. As long as each deduction remains in place, so does the constituency in its favor, and so do all the thousands of pages of tax code each entails.

Zero is zero. If you don’t kill a tax completely, it keeps coming back like zombies in a science fiction movie. If you don’t kill a tax completely, you do nothing to simplification of the tax code.

Eliminating whole sections of the tax code, rather than nullifying them with clever schemes, has another important advantage. A growth-oriented tax code operates by incentives, but people have to understand the incentives. Tax economists tend to be ultra-rational, and figure that people will react to the actual financial incentive even if it is quite hidden. Of course, the point of hiding it — of offering corporate tax rebates, say, rather than eliminating the corporate tax, or sharply limiting deductions rather than eliminating them — is precisely to fool people politically into thinking the provisions are still there. Well, people so fooled may not see the economic incentive either. Behavioral economists who argue that only very clear, simple, provisions have the appropriate incentives have a point. And their point argues for a simple code full of zeros rather than a complex code that has the same set of economic incentives once an expert combs through it.

Debt and deficits; social security and medicare


Debt and deficits are a looming threat to growth. Read any one of the nonpartisan Congressional Budget Offices’ long-term budget outlooks.

Our central problem is straightforward: promises to pay social security benefits, medicare and other health care will soon overwhelm the US budget. Hidden mountains of unfunded pension liabilities, state debts, student loan debts, and debts the US will incur if another financial crisis, recession, or war face us, add to the risks.

Growth-oriented policy will do a lot to solve the debt and budget problem. Economic growth raises tax revenues without raising tax rates. Stagnant growth will make all these problems much worse.

Conversely, a looming debt crisis or the extreme taxes that would be needed to pay for an unreformed system will be strong drags on economic growth. So, setting long-run spending in order now is both necessary, and much easier than doing it later.

Indexing social security to price inflation rather than wage inflation takes care of much of the social security problem. Indexing it to the prices of things that old people actually buy helps even more. Changing the nature of health care support to vouchers, and enacting the other health care reforms mentioned above will give both better help to people in need and solve that budget problem. Both of these steps are much easier the sooner they are taken, so that nobody has to receive an actual cut in benefits.

An economist should emphasize the distortions to economic decisions embodied by these programs, not the cost per se. Programs are bad when they require taxes so large that the taxes kill growth, or when the incentives of the programs sap people’s incentive to work, save, and invest. Social security should be converted to private accounts, not so much to save the government money as to ensure that each person knows that an extra hour of work, or extra effort made to learn a new skill or start a company, results eventually in greater resources for him or her, not just greater taxes.

Social programs


From a growth perspective, the most important characteristic of social programs is also not so much their cost, as it is their disincentives and their ineffectiveness.

Most of our social programs phase out as income rises, often with hard steps at which if you earn one extra dollar you lose a large benefit. If you earn an extra dollar, you can lose health care subsidies, food stamps, social security, medicare, disability payments, and a host of smaller subsidies from home heating oil subsidies, child care subsidies, transportation subsidies and even (in my home town) parking permit subsidies.

As usual in our weed-pulling exercise, there are so many programs and they interact in so many ways, that adding them all up is hard. The broad picture though is that for many Americans there is close to a one for one tax rate from zero up to $60,000 per year in the form of reduced benefits.

The answer is not necessarily to be stingier. The answer, as elsewhere, is to design programs with more attention paid to marginal disincentives, and to design programs that fit together rather than assume each one acts in isolation.

One good way to eliminate marginal disincentives is more frequently to condition support on time rather than income. Unemployment benefits work to some extent this way. Yes, you lose unemployment benefits if you get a job, which provides a disincentive. But you can only earn unemployment benefits for a certain period of time.

It is surprising, in fact, that a society as fluid as ours conditions so much of its government activity on income, as if income were a permanent and innate characteristic. Income changes rapidly through time and over the life cycle.

Social programs are so expensive because most of them are middle class subsidies, not help for the truly poor and desperate. We need to spend more is on the truly unfortunate. Schizophrenics in the streets are unbecoming of a great nation, and helping them costs relatively little. They don’t vote.

Labor law and regulation


Our government and politicians keep repeating how much they want to “create jobs” and help Americans to work.

A martian, parachuting down and studying our economy would come to the opposite conclusion. There are few economic activities in which the government throws more obstacles than that of hiring someone.

Start, of course, with taxes: income taxes and payroll taxes are primarily taxes on employment. But the regulatory burdens of employment are larger still, as anyone who has tried to get a nanny legal will attest.

Minimum wages, occupational licensing, anti-discrimination laws, laws regulating hours people can work, benefits they must receive, leave they must be given, fear of lawsuits if you fire someone, and so forth all impede the labor market.

We are swiftly becoming a nation divided, as Europe is, between “haves” with expensive, highly regulated, full time jobs — that are inflexible for people who wish part time work — and often illegal, under the table, part time “gig” work.

Companies have innovated around many of these distortions with contract workers, but the current fight whether contract workers, independent contractors (Uber drivers) and franchisees must be considered employees of the parent company threatens to undo all of that, placing another huge wedge in the labor market and segregation between well paid, hard to get, full time jobs and a larger pool of unemployed.

America needs a vast deregulation of its labor market. I want to work for you, you want to pay me? Good enough.

The usual argument is that workers need protection of all these laws. Well, the supposed protections do cost economic growth, and they do reduce employment. How much do they actually protect workers? The strongest force for worker protection is a vibrant labor market — if you don’t like this job, go take another. The tightly regulated labor market makes it much harder to get a new job, and thus, paradoxically, lowers your bargaining power in the old one. At a minimum let’s revisit just how much protection is actually being given, and just what the cost in growth is, and whether it’s worth it.

Immigration


“Give me your tired, your poor, Your huddled masses yearning to breathe free, ..”
- Emma Lazarus.
“He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither,..”
- Declaration of Independence.
Not any more.

We can end illegal immigration overnight: Make it legal. The question is, on what terms should we allow legal immigration.

The immigration debate has nothing to do with who is allowed to come to this country. That’s the tourist visa debate. The immigration debate is about who is allowed to work in this country, and, later, who is allowed to become a citizen. Our Federal government has a massive program in place to stop people from working. That is immigration law.

Immigrants contribute to economic growth. Even if income per capita is unchanged, imagine how much better off our social security system, our medicare system, our unfunded pension promises, and our looming deficits and debt would be, if America could attract a steady flow of young, hard-working people who want to come and pay taxes. Aha, we can attract them! They’re beating the doors down to come. But then we keep them out.

Allowing free migration is, by many estimates the single policy change that would raise world GDP the most. If you believe in free trade in goods, and free investment, then you have to believe that free movement of people has the same benefits.

The most common objection is that immigrants steal American jobs. No, they create American jobs, just as a higher birthrate of Americans would do. Every immigrant is as much a consumer of things we produce, a buyer of houses and cars, a starter of new businesses, as he or she is a worker. Immigrants come to do jobs that are available, not jobs that Americans don’t have. They do work that complements those of Americans, and thus make Americans more productive and better off.

There is very little economic argument for keeping immigrants out of California from old Mexico that would not also apply to keeping immigrants to California out of new Mexico. (Or, as Oregonians, Coloradans, and Texans might wish, keeping Californians out of their states!)

We worry about immigrants using social programs. Fine, but why then is immigration skewed to family members, likely to use social programs, and excludes workers, least likely to use them? If the worry is that they’ll go on welfare, why on earth do we forbid them from earning a living? If social program overuse is a worry, charge a $5,000 bond at the border, require proof of $10,000 of assets and health insurance, and anyone who is convicted of a felony goes home. This fear does not excuse our immigration system.

The status of the 11 million already here is a national embarrassment. 11 million people live in this country, work, pay taxes, buy food and cars and houses, and yet are deprived of legal protection, easily exploited by employers, afraid to even take airplanes, let alone not allowed to vote. If this were a racial minority, we would be scandalized.

But immigration law is so dysfunctional that we need not discuss radical programs. Let’s fix the basic growth-killing pathologies that we all recognize need to be fixed.

Start by letting in people who obviously contribute to the American economy and society. Ambitious young people come to the US to get degrees in medicine, engineering, and business.They want to stay, work, buy things from our businesses and pay taxes. They want to start businesses and hire people. We kick them out. The H1B visa lottery should simply be abandoned. Any high-skill immigrant should be able to stay. Any high-wealth immigrant should be able to stay. Immigrants often start small businesses that serve poor areas. Anyone who starts a business should be able to stay. People who came at a young age, have been through American schools, served in the US military, and know no other country should be able to stay.

The immigration discussion is full of more nonsense than any other policy question facing the country. No, immigrants are in fact much less likely to commit crimes than Americans. No, terrorists come on tourist visas. They do not swim the Rio Grande and stop to pick vegetables for a few years before blowing things up. And we already spend more than twice — $13 billion dollars — on the border patrol than we do — $ 6 billion — on the entire FBI. They are “illegal” some say. Well, that’s easy to fix. Change the law, and they will no longer be illegal! Constructing a great Ice Wall on the border with Mexico is a canard. Immigrants come on airplanes and overstay tourist visas.

As with taxation, the immigration debate needs to separate completely separate questions: Who is allowed to enter the country? Who is allowed to work here? These are completely separate issues. Restrictions on work do nothing to address security.

Immigration and growth feed each other. Immigrants help economic growth. But conversely, the lack of economic growth is feeding a misguided but understandable resentment towards immigrants.

Education


How often must commenters on all sides of the political spectrum complain that America’s public schools are awful?

They are particularly awful for people of lower income, minorities and new immigrants. The problem is not money. Study after study shows that America spends as much or more money on eduction than other countries, and experiment after experiment has shown almost no effect of showering money on bad schools.

The culprit is easy to find: awful public schools run by and for the benefit of politically powerful teachers’ and administrators’ unions. (Don’t forget the latter! Teachers account for only half of typical public school expenses.) Education poses a particularly large tradeoff between profits to incumbents and economic growth, since education lies at the foundation of higher productivity. In addition, the costs of awful schools fall primarily on lower-income people who cannot afford to get out of the system. It is one of the major contributors to inequality.

The solution is simple as well: widespread financing by vouchers and charter schools. As with health care, a vibrant market demands that people control their spending, and can move it to where they get better results. As with health care, the government does not have to directly provide a service in order to help people to pay for that service. But as with health care, a healthy market also demands supply competition, that new schools be allowed to start and compete for students.

Higher education has been relatively healthy in the US, but Federal policy is busy making a mess of it. The correlation between more and more subsidy to higher education, the astronomical rise in tuition, and the leftward drift of campus politics towards support of a larger government is hard to miss. The Federal government took over the student loan market, and is busy creating a new debt bomb that will likely end in another mass bailout. Immigration restrictions are making it harder for students to access this, one of our great export successes.

There is a strong correlation between college education and later income. That does not mean that more college education will automatically generate more individual income or more economic growth. To some extent, smart people who will earn more money anyway go to college, and smart people who know they will benefit from a college education go to college. To a greater extent, people who choose science, engineering, math, computer, or business majors go on to earn greater incomes. Those who study other subjects may profit personally from the experience, but generally do not go on to contribute as much to economic growth.

Loans that are forgiven if one does not earn a higher income, or forgiven for students who go in to non-profit, social work, government or other low-paying work, or who do not work at all, are particularly troublesome from a growth perspective.

Sweat the little stuff


Our growth needs to be revived by pulling a thousand little weeds. A selected few reminders and examples follow.

We still have agricultural price supports, tariffs and quotas such as sugar and oranges.

Trade is relatively free, but could be freer. And keeping trade open requires endless effort against the forces of protection.

The opponents of free trade, and immigration, adduce long-standing fallacies, that one must constantly fight. When, say, China, sends us cheap manufactured goods, they take dollars in return. Every one of those dollars ends up buying an American export, or invested in America. Trade is not a “competition,” and our trading partners are not “competitors.” We win in trade when American consumers get to buy things more cheaply. The point of trade is not to increase exports. When Germany sent Greece Porsches in return for worthless pieces of paper, it was Greece that came out ahead in the deal, not Germany.

That much of the nation’s infrastructure is crumbling is a common observation. And infrastructure supports growth. Low interest rates are a particularly propitious time to build infrastructure.

So why is there less consensus for a large program to repair and build public infrastructure, including roads and bridges, but also bicycle paths, parks, airports, ports, and so forth? In large, part, I think, our government has squandered its people’s trust in its ability to carry out infrastructure projects in a cost-effective, well-planned, and timely fashion. Instead, voters are used to reading about bridges to nowhere, high speed trains from nowhere to nowhere, billion dollar cost over runs, decade plus waits for permits, massive consulting fees, and other pathology.

The process of infrastructure investment needs a complete overhaul. To mention just a few, it is no surprise that costs spiral when projects must pay “prevailing wages” and obey set-asides for specific contractors, or when environmental review takes years. It is no surprise that projects are not repaired when federal funds pay for new construction but not repair. Federal funding diverts resources to rail, a charming but very inefficient mode of transport, over freeways, airports, buses, bus lanes or bus rapid transit, or other needed modes. Real time tolling, private toll roads, and congestion pricing are easy ideas, used successfully in other countries, but almost never here.

So, yes, we need a growth-supporting infrastructure program. But our political leadership needs to show us it can construct infrastructure in a more competent, less politicized, way, focused on delivering the needed infrastructure at least cost to the taxpayer.

There is good spending


I close this essay with two areas in which I think our Government could spend some more money, in ways that would enhance economic growth.

Our legal and criminal justice system is clearly becoming dysfunctional. This system is trapping many people already struggling with poor schools and job prospects. That we spend tens of thousands of dollars to house prisoners and next to nothing to train them to succeed when they exit guarantees their return. Even doubling resources, so that crimes in poor neighborhoods are routinely solved, so that people accused of crimes have speedy trials and reasonable representation, not life-destroying years waiting for cases to be heard, so that people who are imprisoned receive some basic help in dealing with the outside world, would cost little compared to the trillions we spend on middle-class social programs.

The war on drugs is a massive failure. Not only is it leading to mayhem in poorer areas of the US, it is causing narco-states, corruption, violence, and poverty in our neighbors, and driving much immigration pressure. Al-Quaeda, the Taliban, and ISIS earn lots of money from drug trafficking. Legalization would drive them out of business far more effectively than war.

The federal government has a role in financing basic research. Yes, 95% of funded research is silly. Yes, the government allocates money inefficiently. Yes, research should also attract private donations. But the 5% that is not silly is often vital, and can produce big breakthroughs. Like the military, there are a few things the federal government must do. We are falling behind on basic research investments.

More


And FDA approvals take forever. And patent law is a mess leading companies to spend too much time on lawsuits. And anti-trust law is completely outdated, just throwing sand in the gears. And the NLRB and EEOC are making a mess of labor markets. And the FCC is going to turn the internet into the 1965 French telephone company. And... well, this could go on pretty much forever.

There are a lot of weeds. Just turn to the Hoover research website, especially Economic Policy, Education, Energy Science & Technology and Health care tabs. Turn to Cato’s website and browse down the “Research Areas” tabs, especially the Education, Energy and Environment, Finance, Health Care, Regulatory studies, Tax and budget, and Trade and Immigration tabs. I have kept this essay deliberately free of a forest of numbers and citations for easy reading, but the numbers and citations are easy to find.

This essay summarizes some of my own earlier writings on many of these issues, all available on my webpage. For more on regulation, see “The Rule of Law in the Regulatory State.” For more on health care and insurance see “After the ACA: Freeing the Market for Health Care” and “Health Status Insurance.” On financial reform (alternatives to Dodd-Frank) see “Towards a Run-Free Financial System.”


1 John H. Cochrane is a Senior Fellow of the Hoover Institution, Stanford University. This essay is copyright © John H. Cochrane.

This essay was prepared as a contribution to “Focusing the Presidential Debates.” Other essays and information can be found at  FocusingThePresidentialDebates.com

This essay may evolve over time, so please post or pass on links to the original pdf file or this webpage rather than pass on copies of the file.

2The numbers are based on real gross domestic product, series GDPCA, and total population, series POP, from the St. Louis Fed FRED database. Growth rates are continuously compounded, i.e. log.

3 Congressional Budget Office, June 2015 Long-Run Budget Outlook, Table A-1 p. 112

4Technically, “regulation” means rules written by independent administrative agencies, such as the Environmental Protection Agency, the Federal Aviation Administration or the Federal Reserve. Congress delegates authority to these agencies to write the actual rules. These rules have the force of law, and can carry criminal penalties including jail time, even when no intent to violate rules is alleged. Most economic regulation takes this legal form, but a great deal remains actual laws. I will use “regulation” a bit loosely to refer to both legal forms of government intervention in the economy.

5 Wall Street Journal, April 14 2013, http://faculty.chicagobooth.edu/john.cochrane/research/papers/Alternative_maximum_tax_WSJ.pdf

22 July 2015

Minimum wage and mechanization


A while ago I opined that higher minimum wages might lead companies like McDonalds to substitute to machines. A former student sends me:
here's a photo I took in the McDonald's on the Champs-Élysées, Paris, of the screens where customers can place their orders and pay. After a short wait, you pick up your burger and fries at the counter.
I did not ask just why he is eating at McDonalds in France!

29 June 2015

Wages and inflation

Marty Feldstein has a very interesting opinion piece on Project Syndicate. His main point is that micro distortions from social programs (and taxes, labor laws, regulations etc.) are leading many people not to work, and is well stated.

An introductory paragraph poses a puzzle to me, however,
Consider this: Average hourly earnings in May were 2.3% higher than in May 2014; but, since the beginning of this year, hourly earnings are up 3.3%, and in May alone rose at a 3.8% rate – a clear sign of full employment. The acceleration began in 2013 as labor markets started to tighten. Average compensation per hour rose just 1.1% from 2012 to 2013, but then increased at a 2.6% rate from 2013 to 2014, and at 3.3% in the first quarter of 2015.
These wage increases will soon show up in higher price inflation. 
This is a common story I hear. However I hear another story too -- the puzzle that the share of capital seems to have increased, and that real wages have not kept up with productivity.

So, maybe we should cheer -- rising real wages means wages finally catch up with productivity, and do not signal inflation. The long-delayed "middle class" (real) wage rise is here.

I'd be curious to hear opinions, better informed than mine, about how to tell the two stories apart.  

29 January 2015

Uber and Occupational Licenses

I enjoy moments of agreement, and common sense in publications where it's usually absent. Eduardo Porter writing in the New York Times on the lessons of Uber vs. Taxis for occupational licensing is a nice such moment.
[Uber's] exponential growth confirms what every New Yorker and cab riders in many other cities have long suspected: Taxi service is woefully inefficient. It also raises a question of broader relevance: Why stop here?

Just as limited taxi medallions [and ban on surge pricing, and the mandated shift change  -JC] can lead to a chronic undersupply of cabs at 4 p.m., the state licensing regulations for many occupations are creating bottlenecks across the economy, raising the prices of many goods and services and putting good jobs out of reach of too many Americans.

... like taxi medallions, state licenses required to practice all sorts of jobs often serve merely to cordon off occupations for the benefit of licensed workers and their lobbying groups, protecting them from legitimate competition.

...“Lower-income people suffer from licensing,” Professor Krueger told me. “It raises the costs of many services and prevents low-income people from getting into some professions.
This is an all too often overlooked effect of so much government-induced cartelization. The costs of higher prices are paid by middle and lower income people. And many job opportunities are denied to lower income people.


Why does this happen? The public choice school points out that the government can charge, in the form of political support as well as money, the beneficiaries of its induced cartels, and that impoverishment of the unlucky breeds support for government programs for the unfortunate, whose votes it also buys.  When did you see an anti-inequality protest with signs saying "repeal occupational licensing laws?"
In a study commissioned by the Brookings Institution’s Hamilton Project, Morris Kleiner of the University of Minnesota found that almost three out of 10 workers in the United States need a license from state governments to do their jobs, up from one in 20 in the 1950s. By cordoning off so many occupations, he estimates, professional licensing by state governments ultimately reduces employment by up to 2.8 million jobs. The trend worries the Obama administration. The president’s budget, to be unveiled on Monday, will include $15 million for states to analyze the costs and benefits of their licensing rules, identify best practices and explore making licenses portable across state lines.
The rest of the budget may be DOA, but perhaps Congress will see the value in this proposal. Of course, it's not obvious new studies are needed. We have over a half century of such studies, from Milton Friedman's 1946 Ph.D Dissertation, the "Occupational licensure" chapter in his1962 Capitalism and Freedom, to, more recently (random examples via google search) a 200 page review from the Institute for Justice (Cato coverage here) and many more. Edit copy, edit paste, could save about $14.99 million bucks. Still, cheap at the price.

Portability is an interesting issue too. In the past, Americans moved a lot more. It's a lot harder to do now, especially for lower-income Americans blocked by licensing from moving to a hot state.
Only a handful of occupations are licensed in every state, according to a report by the Institute of Justice, a free-market advocacy group opposed to many occupational licenses.
Notice that the Institute of Justice is "a free-market advocacy group opposed to many occupational licenses," implicitly questioning the validity of their statements, while the Brookings Institution is just the "Brookings Institution," not a ... well, you fill in the quote.  Ah well, it's still the New York Times, don't get your hopes up too far for unbiased reporting.
... Among the tangle of regulations, it is not hard to find rules that defy common sense. An athletic trainer must put in 1,460 days of training to get a license in Michigan. An emergency medical technician needs only 26.
As we know, occupational licensing is even worse in Europe. Here we come. In slides for his paper with Lee Ohanian on European Stagnation, Jesús Fernández-Villaverde tells the Zidane story
  • Zinedine Zidane is one of the top 5 soccer players of all time. He won pretty much everything (World Cup 1998, Euro Cup 2000,....)
  • After retiring, in 2013-2014, he was assistant coach for Real Madrid. Extremely successful year for Real Madrid.
  • In August 2014, he becomes main coach for Real Madrid B Team
but...
  • ... he is sued by the director of the Spanish National Football Coach Education Centre because he does not have a three year higher education degree in Soccer coaching.
  • Fined and expelled from Spanish league.
Soccer being a lot more important than taxis, it ended well for Zidane. Not so, however for Uber, now banned in Spain.

Back to the Times
Workers in licensed occupations can make up to 15 percent more than unlicensed workers with similar skills, according to research by Professors Kleiner and Krueger.

But the claim that they protect consumers often rings hollow.

A study of regulations for mortgage brokers, for instance, found that states with licensed brokers did not enjoy fewer foreclosures but did suffer more expensive mortgages.

... While the tougher restrictions add to the cost of care, they do not have any discernible effect on its quality: Well-child medical exams cost 3 to 16 percent more in states where nurses cannot issue prescriptions, according to one study, but their infant mortality rates are no better. Malpractice premiums, a measure of safety, are about the same.

“Professional organizations that push for licenses can’t say, ‘We want to erect a fence around our occupation,’ so they say it is to protect public health and safety,” said Dick M. Carpenter II, research director at the Institute for Justice. “It is an assertion with zero evidence.”
The WSJ offers a similar story by Tom Gordon about do it yourself legal clinics, no surprise under attack by lawyers on similar "protection" grounds. But of course we expect that from WSJ, a ... how did that Institute for Justice quote go?

Not mentioned. Uber teaches us that star ratings are far more effective than taxi commissions to induce quality. I ride Uber not because of the price. But because every single driver so far is courteous, safe, and the car clean.

A Health Care Thought

The Uber analogy prompts a health care analogy. The conversation around health insurance problems routinely asserts the big problem with health care market is that people don't pay out of pocket.

But people pay for taxis predominantly out of pocket. And before Uber, we got awful service.

Health care with big copays under the ACA and ACO may look a lot like hailing a cab on New Year's eve. In the rain. Supply competition is the key to reaping the benefits of markets.

07 January 2015

Piketty Facts

Most Piketty commentary (like the Deridre McCloskey review I blogged earlier) focuses on the theory, r>g, and so on. After all, that's easy and you don't have to read hundreds of pages.

"Challenging the Empirical Contribution of Thomas Piketty's Capital in the 21st Century" by Phillip W. Magness and Robert P. Murphy is one of the first deep reviews of the facts that I have seen. I haven't read it yet, but the abstract looks promising:
Thomas Piketty's Capital in the 21st Century has been widely debated on theoretical grounds, yet continues to attract acclaim for its historically-infused data analysis. In this study we conduct a closer scrutiny of Piketty's empirics than has appeared thus far, focusing upon his treatment of the United States. We find evidence of pervasive errors of historical fact, opaque methodological choices, and the cherry-picking of sources to construct favorable patterns from ambiguous data. Additional evidence suggests that Piketty used a highly distortive data assumption from the Soviet Union to accentuate one of his main historical claims about global “capitalism” in the 20th century. Taken together, these problems suggest that Piketty’s highly praised and historically-driven empirical work may actually be the book’s greatest weakness.
Comments on the paper welcome. If I get a chance to read it I'll post some.

Time use of the non-employed

Source: New York Times
The decline in labor force participation means that a larger and larger fraction of the population, including many prime-age men, are not working and not actively looking for work.

What do they do all day? The New York Times has a lovely article answering that question.

I took a screenshot at left to advertise the post, but go to the Times where the graph is interactive.

Next question, where does the money come from?

Understanding the lives of people in this predicament seems to me a useful step to understanding the big decline in participation.

22 December 2014

Inequality at WSJ -- the oped

This is a Wall Street Journal oped on inequality. With 30 days passed, I can post it here. It's a much edited version of my evolving "Why and How we Care About Inequality" essay.


What the ‘Inequality’ Warriors Really Want

Progressives decry inequality as the world’s most pressing economic problem. In its name, they urge much greater income and wealth taxation, especially of the reviled top 1% of earners, along with more government spending and controls—higher minimum wages, “living” wages, comparable worth directives, CEO pay caps, etc.

Inequality may be a symptom of economic problems. But why is inequality itself an economic problem? If some get rich and others get richer, who cares? If we all become poor equally, is that not a problem? Why not fix policies and problems that make it harder to earn more?


Yes, the reported taxable income and wealth earned by the top 1% may have grown faster than for the rest. This could be good inequality—entrepreneurs start companies, develop new products and services, and get rich from a tiny fraction of the social benefit. Or it could be bad inequality—crony capitalists who get rich by exploiting favors from government. Most U.S. billionaires are entrepreneurs from modest backgrounds, operating in competitive new industries, suggesting the former.

But there are many other kinds and sources of inequality. The returns to skill have increased. People who can use or program computers, do math or run organizations have enjoyed relative wage increases. But why don’t others observe these returns, get skills and compete away the skill premium? A big reason: awful public schools dominated by teachers unions, which leave kids unprepared even to enter college. Limits on high-skill immigration also raise the skill premium.

Americans stuck in a cycle of terrible early-child experiences, substance abuse, broken families, unemployment and criminality represent a different source of inequality. Their problems have proven immune to floods of government money. And government programs and drug laws are arguably part of the problem.

These problems, and many like them, have nothing to do with a rise in top 1% incomes and wealth.

Recognizing, I think, this logic, inequality warriors go on to argue that inequality is a problem because it causes other social or economic ills. A recent Standard & Poor’s report sums up some of these assertions: “As income inequality increased before the [2008 financial] crisis, less affluent households took on more and more debt to keep up—or, in this case, catch up—with the Joneses. ” In a 2011 Vanity Fair article, Columbia University economist Joe Stiglitz wrote that inequality causes a “lifestyle effect . . . people outside the top 1 percent increasingly live beyond their means.’’ He called it “trickle-down behaviorism.”

I see. A fry cook in Fresno hears that more hedge-fund managers are flying in private jets. So he buys a pickup he can’t afford. They are saying that we must tax away wealth to encourage thrift in the lower classes.

Here’s another claim: Inequality is a problem because rich people save too much. So, by transferring money from rich to poor, we can increase overall consumption and escape “secular stagnation.”

I see. Now we need to forcibly transfer wealth to solve our deep problem of national thriftiness.

You can see in these examples that the arguments are made up to justify a pre-existing answer. If these were really the problems to be solved, each has much more natural solutions.

Is eliminating the rich, to eliminate envy of their lifestyle, really the best way to stimulate savings? Might not, say, fixing the large taxation of savings in means-tested social programs make some sense? If lifestyle envy really is the mechanism, would it not be more effective to ban “Keeping Up With the Kardashians”?

If we redistribute because lack of Keynesian “spending” causes “secular stagnation”—a big if—then we should transfer money from all the thrifty, even poor, to all the big spenders, especially the McMansion owners with new Teslas and maxed-out credit cards. Is that an offensive policy? Yes. Well, maybe this wasn’t about “spending” after all.

There is a lot of fashionable talk about “redistribution” that’s not really the agenda. Even sky-high income and wealth taxes would not raise much revenue for very long, and any revenue is likely to fund government programs, not checks to the needy. Most inequality warriors, including President Obama, forthrightly advocate taxation to level incomes in the name of “fairness,” even if those taxes raise little or no revenue.

When you get past this kind of balderdash, most inequality warriors get down to the real problem they see: money and politics. They think money is corrupting politics, and they want to take away the money to purify the politics. As Berkeley economist Emmanuel Saez wrote for his 2013 Arrow lecture at Stanford University: “top income shares matter” because the “surge in top incomes gives top earners more ability to influence [the] political process.”

A critique of rent-seeking and political cronyism is well taken, and echoes from the left to libertarians. But if abuse of government power is the problem, increasing government power is a most unlikely solution.

If we increase the top federal income-tax rate to 90%, will that not just dramatically increase the demand for lawyers, lobbyists, loopholes, connections, favors and special deals? Inequality warriors think not. Mr. Stiglitz, for example, writes that “wealth is a main determinant of power.” If the state grabs the wealth, even if fairly earned, then the state can benevolently exercise its power on behalf of the common person.

No. Cronyism results when power determines wealth. Government power inevitably invites the trade of regulatory favors for political support. We limit rent-seeking by limiting the government’s ability to hand out goodies.

So when all is said and done, the inequality warriors want the government to confiscate wealth and control incomes so that wealthy individuals cannot influence politics in directions they don’t like. Koch brothers, no. Public-employee unions, yes. This goal, at least, makes perfect logical sense. And it is truly scary.

Prosperity should be our goal. And the secrets of prosperity are simple and old-fashioned: property rights, rule of law, economic and political freedom. A limited government providing competent institutions. Confiscatory taxation and extensive government control of incomes are not on the list.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.

02 December 2014

McCloskey on Piketty and Friends

Deirdre McCloskey has written an  excellent essay reviewing Thomas Piketty’s Capital in the Twenty-First Century.

As an economic historian and historian of economic ideas, McCloskey can place the arguments into the framework of centuries-old ideas (and fallacies) as few others can. She has read philosophy and "social ethics." She can even knowledgeably review the literary references.

Her central point: "trade-based betterment," (she wisely avoids "capitalism" to emphasize that  the focus on "capital" is about a hundred years out of date) has raised living standards by factors of 30 or more -- much more if you think about health, freedom, lifespan, tavel, etc. unavailable at any price in 1800;  it has led to much greater equality in many things that count, such as consumption, health and so on; and stands to do so again if we do not kill the goose that laid these golden eggs.  From late in the review,
Redistribution, although assuaging bourgeois guilt, has not been the chief sustenance of the poor....If all profits in the American economy were forthwith handed over to the workers, the workers ... would be 20 percent or so better off, right now....
But such
one-time redistributions are two orders of magnitude smaller in helping the poor than the 2,900 percent Enrichment from greater productivity since 1800. Historically speaking 25 percent is to be compared with a rise in real wages 1800 to the present by a factor of 10 or 30, which is to say 900 or 2,900 percent. 
As a too-long post on a far-too-long review of a enormously-too-long book, I'll pass on some particularly good bits with comment.

On the long history of fashionable worrying:

.. Piketty’s worry about the rich getting richer is indeed merely “the latest” of a long series back to Malthus and Ricardo and Marx. Since those founding geniuses of Classical economics, a trade-tested betterment (a locution to be preferred to “capitalism,” with its erroneous implication that capital accumulation, not innovation, is what made us better off) has enormously enriched large parts of a humanity..., and bids fair in the next fifty years or so to enrich everyone on the planet. ...And yet the left in its worrying routinely forgets this most important secular event since the invention of agriculture—the Great Enrichment of the last two centuries—and goes on worrying and worrying,... in a new version every half generation or so.

Here is a partial list of the worrying pessimisms, which each has had its day of fashion...: greed, alienation, racial impurity, workers’ lack of bargaining strength, women working, workers’ bad taste in consumption, immigration of lesser breeds, monopoly unemployment, business cycles, increasing returns, externalities, under-consumption, monopolistic competition, separation of ownership from control, lack of planning, post-War stagnation, investment spillovers, unbalanced growth, dual labor markets, capital insufficiency ..., peasant irrationality, capital-market imperfections, public choice, missing markets, informational asymmetry, third-world exploitation, advertising, regulatory capture, free riding, low-level traps, middle-level traps, path dependency, lack of competitiveness, consumerism, consumption externalities, irrationality, hyperbolic discounting, too big to fail, environmental degradation, underpaying of care, overpayment of CEOs, slower growth, and more.
"Secular stagnation," "global imbalances," "deflationary vortices," "hysterisis"... Long lists are fun and a good rhetorical device. She might have added, though, that if you want to stay up at night, read Bob Gordon on the end of innovation. The central mechanism of "trade-based betterment" can come to an end either naturally or if we let the Pikettys of the world kill it. Neither she nor I think it will, but that makes for a much more coherent worry.

On how to get famous in economics:
... [I] can reveal their formula: first, discover or rediscover a necessary condition for perfect competition or a perfect world (in Piketty’s case, for example, a more perfect equality of income). ... conclude with a flourish that “capitalism” is doomed unless experts intervene with a sweet use of the monopoly of violence in government to implement anti-trust against malefactors of great wealth or subsidies to diminishing-returns industries or foreign aid to perfectly honest governments or money for obviously infant industries or the nudging of sadly childlike consumers or, Piketty says, a tax on inequality-causing capital worldwide.
On r > g, self-perpetuating wealth, and the long history of disdain for the returns to capital:
.. In 2014 he [Piketty] declared to the BBC’s Evan Davis in an interview that “Money tends to reproduce itself,” a complaint about money and its interest rate repeatedly made in the West since Aristotle. As the Philosopher said of some men, “the whole idea of their lives is that they ought either to increase their money without limit, or at any rate not to lose it. . . . The most hated sort [of increasing their money], . . . is usury, which makes a gain out of money itself.”

... The [r > g].. argument ... is conclusive, so long as its factual assumptions are true: namely, only rich people have capital; human capital doesn’t exist; the rich reinvest their return; they never lose it to sloth or someone else’s creative destruction; inheritance is the main mechanism, not a creativity that raises g for the rest of us just when it results in an r shared by us all; and we care ethically only about the Gini coefficient, not the condition of the working class.
She left out two important conditions: The wealthy do not consume, and they leave estates intact to one child. With characteristic self-contradiction, the Pikettys of the world bemoan the excessive and garish consumption of the rich, but then claim wealth grows as if it is not consumed, if not directly then by spendthrift heirs. The correct equation is r - c - n > g, where c is the ratio of consumption to wealth and n is the growth rate of heirs.

On the facts:
... The focus on relative wealth or income or consumption is one serious problem in the book. Piketty’s vision of a “Ricardian Apocalypse,” as he calls it, leaves room for the rest of us to do very well indeed, ... as in fact since 1800 we have. What is worrying Piketty is that the rich might possibly get richer, even though the poor get richer, too. His worry,..is... about a vague feeling of envy raised to a theoretical and ethical proposition. 
Finish with a nice epigram.

On the obvious problem -- if wealth accumulation inevitably leads to more inequality, why are the heirs of Astors, Rothschilds, Medici--heck, Julius Caesar--not on top of the heap rather than these upstarts Gates, Walton, and so on?
Yet in fact his own... research, as he candidly admits ... suggest that only in Canada, the U.S., and the U.K. has the inequality of income increased much, and only recently. “In continental Europe and Japan, income inequality today remains far lower than it was at the beginning of the twentieth century and in fact has not changed much since 1945” (p. 321, and Figure 9.6)... 
Piketty’s fears were not confirmed anywhere 1910 to 1980, nor anywhere in the long run at any time before 1800, nor anywhere in Continental Europe and Japan since World War II, and only recently, a little, in the United States, the United Kingdom, and Canada ... That is a very great puzzle if money tends to reproduce itself, always, evermore, as a general law... Yet inequality in fact goes up and down in great waves, for which we have evidence from many centuries ago down to the present, which also doesn’t figure in such a tale..

At one point Piketty says just that: “r > g will again become the norm in the twenty-first century, as it had been throughout history until the eve of World War I (p. 572, italics supplied); ... Why then did the share of the rich not rise anciently to 100 percent? At the least, how could the share be stable at, say, the 50 percent that in medieval times typified unproductive economies with land and landlords dominant? Sometimes Piketty describes his machinery as a “potentially explosive process” (p. 444), at other times he admits that random shocks to a family fortune means that “it is unlikely that inequality of wealth will grow indefinitely, . . rather, the wealth distribution will converge toward a certain equilibrium” (p. 451). On the basis of the Forbes lists of the very rich, Piketty notes, for example, “several hundred new fortunes appear in [the $1 billion to $10 billion] range somewhere in the world almost every year” (p. 441). Which is it, Professor Piketty? Apocalypse or (what is in fact observed, roughly, with minor ups and downs) a steady share of rich people constantly dropping out of riches or coming into them, in evolutionary fashion? His machinery seems to explains nothing alarming, and at the same time too much alarming.
The cure can be worse than the disease -- and sometimes is the disease:
Let us therefore bring in the sweet and blameless and omni-competent government—or, even less plausibly, a world government, or the Galactic Empire—to implement “a progressive global tax on capital” (p. 27) to tax the rich.....
The science writer Matt Ridley has offered a persuasive reason for the (slight) rise in inequality recently in Britain. “Knock me down with a feather,” Ridley writes,
You mean to say that during three decades when the government encouraged asset bubbles in house prices; gave tax breaks to pensions; lightly taxed wealthy non-doms [that is, “non-domiciled,” the citizens of other countries such as Russia and Saudi Arabia living in the U.K.]; poured money into farm subsidies [owned by landlords mainly rich]; and severely restricted the supply of land for housing, pushing up the premium earned by planning permission for development, the wealthy owners of capital saw their relative wealth increase slightly? Well, I’ll be damned. . . . [Seriously, now] a good part of any increase in wealth concentration since 1980 has been driven by government policy, which has systematically redirected earning opportunities to the rich rather than the poor.
In the United States, with its pervasive welfare payments and tax breaks for our good friends the very rich... one can make a similar case that the government, which Piketty expects to solve the alleged problem, is the cause. 
On creative destruction among entrepreneurs, a great leveling force in the 1%
Piketty does not acknowledge that each wave of inventors, of entrepreneurs, and even of routine capitalists find their rewards taken from them by entry, which is an economic concept he does not appear to grasp. Look at the history of fortunes in department stores...

...William Nordhaus has calculated that the inventors and entrepreneurs nowadays earn in profit only 2 percent of the social value of their inventions. If you are Sam Walton the 2 percent gives you personally a great deal of money from introducing bar codes into stocking of supermarket shelves. But 98 percent at the cost of 2 percent is nonetheless a pretty good deal for the rest of us. The gain from macadamized roads or vulcanized rubber, then modern universities, structural concrete, and the airplane, has enriched even the poorest among us.

Piketty... focuses instead on the great evil of very rich people having seven Rolex watches by mere inheritance. Lillian Bettancourt, heiress to the L’Oréal fortune (p. 440), the third richest woman in the world, who “has never worked a day in her life, saw her fortune grow exactly as fast as that of [the admittedly bettering] Bill Gates.” Ugh, Piketty says, which is his ethical philosophy in full.
Again, close with a nice epigram.  Later,
...And in some important ways even French-style equality is improved by an ethic of trade-tested bettermemt. Free entry erodes monopolies that in traditional societies keep one tribe rich and the other poor...
On human capital,  education, and more cure vs. disease:
The technical flaws in the argument are pervasive...

For example—a big flaw, this one—Piketty’s definition of wealth does not include human capital, owned by the workers, which has grown in rich countries to be the main source of income, when it is combined with the immense accumulation since 1800 of capital in knowledge and social habits, owned by everyone with access to them. ...

... The only reason in the book to exclude human capital from capital appears to be to force the conclusion Piketty wants to achieve, that inequality has increased, or will, or might, or is to be feared. .. 
If human capital is included—the ordinary factory worker’s literacy, the nurse’s educated skill, the professional manager’s command of complex systems, the economist’s understanding of supply responses [!]—the workers themselves now in the correct accounting own most of the nation’s capital, and Piketty’s drama from 1848 falls to the ground.

The neglect of human capital on the Problems side of the book is doubly strange because on the Solutions side Piketty recommends education and other investment in human capital. Yet in his focus on raising the marginal product of workers unemployed by government program, rather than helping them by correcting the governmental distortions that created the unemployment in the first place, he joins most of the left, especially those with university jobs. Thus in South Africa the left proposes to carry on with high minimum wages and oppressive regulation, solving the unemployment problem generated governmentally by improving through the same government the education of unemployed South Africans. No one, left or right or libertarian, would want to complain about better education, especially if it falls from the sky at no opportunity cost—though we bleeding heart libertarians would suggest achieving it by some other means than by pouring more money into a badly functioning nationalized industry providing elementary education or into a higher education system grossly favoring the rich over the poor, as it does strikingly in France, by giving the rich student, better prepared, a tuition-free ride into the ruling class. In any case the sweet-sounding “we-love-education” ploy exempts the left from facing the obvious cause of unemployment in South Africa, namely, a sclerotic system of labor-market and other regulations in aid of the Congress of South African Trade Unions, rigged against the wretchedly poor black South African sitting jobless with a small income subsidy in a hut in the back country of KwaZulu-Natal.
Supply and demand:
The fundamental technical problem in the book, however, is that Piketty the economist does not understand supply responses. In keeping with his position as a man of the left, he has a vague and confused idea about how markets work, and especially about how supply responds to higher prices. If he wants to offer pessimistic conclusions concerning “a market economy based on private property, if left to itself” (p. 571), he had better know what elementary economics, agreed to by all who have studied it enough to understand what it is saying, does in fact say how a market economy based on private property behaves when left to itself.

... Startling evidence of Piketty’s miseducation occurs as early as page 6.... "If the supply of any good is insufficient, and its price is too high, then demand for that good should decrease, which would lead to a decline in its price.” The (English) words I italicize clearly mix up movement along a demand curve with movement of the entire curve, a first-term error at university.  The correct analysis ...is that if the price is “too high” it is not the whole demand curve that “restores equilibrium” ... but an eventually outward-moving supply curve. ... entry is induced by the smell of super-normal profits.... New oil deposits are discovered, new refineries are built, new suburbs are settled, new high-rises saving urban land are constructed, as has in fact happened massively since, say, 1973, unless government has restricted oil exploitation (usually on environmental grounds) or the building of high-rises (usually on corrupt grounds). 
Supply, demand, and a simplistic view of government:
..[to Piketty,] supply responses do not figure in the story of supply and demand, which anyway is unpleasant and complicated—so much less so than, say, the state taking a radically larger share of national income in taxes, with its attendant inefficiencies, or the state encouraging the spurning of capitalist ownership in favor of “new forms of governance and shared ownership intermediate between public and private” (p. 573), with its attendant corruptions and lack of skin in the game.
On to larger pursuits:
...the fundamental ethical problem in the book, is that Piketty has not reflected on why inequality by itself would be bad. The Liberal Lady Glencora Palliser (née M'Cluskie) in Anthony Trollope’s political novel Phineas Finn (1867-1868) declares...
Either ethical or economic, that is the gaping open question. Other than envy, why is the object of policy not simply the betterment of people's lives?  I left off the quote here, just to point out McCloskey going mano a mano with philosophical, ethical, and even literary arguments.

You can't dismiss McCloskey with the usual calumnies that "oh, you just don't care." The erudite preamble:
This is not to say that no one in rich countries such as the United States is unskilled, addicted, badly parented, discriminated against, or simply horribly unlucky. George Packer’s recent The Unwinding: An Inner History of the New America (2013) and Barbara Ehrenreich’s earlier Nickel and Dimed: On (Not) Getting By in America (2001) carry on a long and distinguished tradition telling the bourgeoisie about the poor, back to James Agee and Walker Evans, Let Us Now Praise Famous Men (1944), George Orwell, The Road to Wigan Pier (1937), Jack London, The People of the Abyss (1903), Jacob Riis, How the Other Half Lives: Studies among the Tenements of New York (1890), and the fount, Friedrich Engels, The Condition of the Working Class in England (1845). They are not making it up. Anyone who reads such books is wrenched out of a comfortable ignorance about the other half. In fictional form one is wrenched by Steinbeck’s The Grapes of Wrath (1939) or Farrell’s Studs Lonigan (1932-1935) or Wright’s Native Son (1940), or in Europe, among many observers of the Two Nations, Zola’s Germinal (1885), which made many of us into socialists. The wrenching is salutary. It is said that Winston Churchill, scion of the aristocracy, believed that most English poor people lived in rose-covered cottages. He  couldn’t imagine back-to-backs in Salford, with the outhouse at the end of the row. Wake up, Winston.
I suspect that unlike many pundits, McCloskey has actually read these books.

 The eternal conceit of the left that taking counterproductive actions with good intentions makes one worthy:
But waking up does not imply despairing, or introducing faux policies that do not actually help the poor, or proposing the overthrow of the System, if the System is in fact enriching the poor over the long run, or at any rate is enriching the poor better than those other systems that have been tried from time to time. Righteous, if inexpensive, indignation inspired by survivor’s guilt about alleged “victims” of something called “capitalism,” and envious anger at the silly consumption by the rich, do not invariably yield betterment for the poor. Remarks such as “there are still poor people” or “some people have more power than others,” though claiming the moral high-ground for the speaker, are not deep or clever. Repeating them, or nodding wisely at their repetition, or buying Piketty’s book to display on your coffee table, does not make you a good person. You are a good person if you actually help the poor. Open a business. Arrange mortgages that poor people can afford. Invent a new battery. Vote for better schools. Adopt a Pakistani orphan. Volunteer to feed people at Grace Church on Saturday mornings. Argue for a minimum income and against a minimum wage. The offering of faux, counterproductive policies that in their actual effects reduce opportunities for employment, or the making of indignant declarations to your husband after finishing the Sunday New York Times Magazine, does not actually help the poor.
... That even over the long run there remain some poor people does not mean the system is not working for the poor, so long as their condition is continuing to improve, as it is, contrary to the newspaper stories and the pessimistic books, and so long as the percentage of the desperately poor is heading towards zero, as it is. That people still sometimes die in hospitals does not mean that medicine is to be replaced by witch doctors, so long as death rates are falling and so long as the death rate would not fall (as economically speaking in Mao’s China or Stalin’s Russia, they did not), under the care of the witch doctors.
Inequality vs. prosperity, especially of the poor, and substantial mobility
.. Robert Reich argues that we must nonetheless be alarmed by inequality, Gini-coefficient style, rather than devoting all our energies to raising the absolute condition of the poor. “Widening inequality,” declares, “challenges the nation’s core ideal of equal opportunity.” “Widening inequality still hampers upward mobility....” 
Reich is mistaken. Horwitz summarizes the results of a study by Julia Isaacs on individual mobility 1969-2005: “82% of children of the bottom 20% in 1969 had [real] incomes in 2000 that were higher than what their parents had in 1969. The median [real] income of those children of the poor of 1969 was double that of their parents.”...
 There is no doubt that the children and grandchildren of the English coal miners of 1937, whom Orwell describes “traveling” underground, bent over double a mile or more to get to the coal face, at which point they started to get paid, are much better off than their fathers or grandfathers. There is no doubt that the children and grandchildren of the Dust Bowl refugees in California are. Steinbeck chronicled in The Grapes of Wrath their worst and terrible times. A few years later many of the Okies got jobs in the war industries, and many of their children later went to university. Some went on to become university professors who think that the poor are getting poorer.  
Equality vs. prosperity:
Much of the research on the economics of inequality stumbles on this simple ethical point, focusing on measures of relative inequality such as the Gini coefficient or the share of the top 1 percent rather than on measures of the absolute welfare of the poor, focusing on inequality rather than poverty, having elided the two. ... Piketty himself barely gets around to caring about “the least well off” (p. 577, the last phrase in the last sentence of the book, though he does occasionally mention the issue in the body of the book, as on p. 480).
Dworkin and Piketty and too often much of the left, in other words, miss the ethical point, which is the liberal, Joshua-Monk one of lifting up the poor. By redistribution? By equality in diamond bracelets? No: by the dramatic increase in the size of the pie, which has historically brought the poor to 90 or 95 percent of “enough,” as against the 10 or 5 percent attainable by redistribution without enlarging the pie. 
Capital in the 19th century, vs. ideas in the 21st:
The most fundamental problem in Piketty’s book, then, is that the main event of the past two centuries was not the second moment, the distribution of income on which he focuses, but its first moment, the Great Enrichment of the average individual on the planet by a factor of 10 and in rich countries by a factor of 30 or more. The greatly enriched world cannot be explained by the accumulation of capital—as to the contrary economists have argued from Adam Smith through Karl Marx to Thomas Piketty, and as the very name “capitalism” implies. Our riches were not made by piling brick upon brick, bachelor’s degree upon bachelor’s degree, bank balance upon bank balance, but by piling idea upon idea.
The consequence of redistributionary taxation, and prices are always first and foremost signals:
..what about subsequent “distribution” of the fruits? Why shouldn’t we— one might ask, who “we”?—seize the high incomes of the professor and the airline pilot and the heiress to the L’Oréal fortune and distribute them to dustmen and cleaners? ... If medical doctors make ten times more than cleaners, the rest of the society, which pays voluntarily for the doctors and cleaners is saying, “If cleaners could become doctors, viewing the matter in the long run, shift more of them into doctoring.” If we reduce the Great Society to a family by taxing the rich to the limit we destroy the signaling. People wander between cleaning and doctoring without such signals about the value people put on the next hour of the services. Neither doctoring nor cleaning gets done well. ...
Bottom line:
On the next to last page of his book Piketty writes, “It is possible, and even indispensable, to have an approach that is at once economic and political, social and cultural, and concerned with wages and wealth.” One can only agree. But he has not achieved it. His gestures to cultural matters consist chiefly of a few naively used references to novels he has read superficially—for which on the left he has been embarrassingly praised.  His social theme is a narrow ethic of envy. His politics assumes that governments can do anything they propose to do. And his economics is flawed from start to finish. 
It is a brave book. But it is mistaken.
* * *

A few minor criticisms -- in addition to the obvious that it needs to be cut in half by reorganizing and eliminating repetition. (Like another advocate of good writing I know, do as she says not as she does!)

That last sentence. No, it is not a brave book. And more importantly, "brave" is a false summary of McCloskey's devastating review.  It is not "brave" to write five hundred pages that is simply wrong as simple microeconomics (supply and demand) and growth economics (r > g);  that fails, in McCloskey's view, basic ethics; whose evidence is contrary to its thesis; and that advocates policies -- confiscatory taxation by a centralized world government -- that would turn back the trade-based betterment that has saved billions from grinding poverty.

It is not "brave" to write a book so calculated, in McCloskey's analysis, to play the game of academic fame, to guarantee one star status at trendy Parisian cocktail parties and fat speaking fees from bien-pensant "nonprofits." It is not "brave" to write a book full of, as McCloskey points out, old fallacies, fallacies put to the test and failed miserably a hundred times over, and demanding in the end immense power for the author and his fellow travelers. (No, of course, Stalin, Mao, Castro, East Germany and North Korea just implemented it wrong. With us at the helm, the truly smart and caring, it will all work out fine.)

The Road to Serfdom was a brave book. Capitalism and Freedom was a brave book. McCloskey has written bravely. Brave means signing up for all the Proper People in the New York Times savaging you and calling you names, not cheering you on.

I suspect McCloskey, a midwesterner like myself, was brought up always to say something nice. Sometimes, there isn't anything nice to say.

McCkoskey praises Piketty's numeracy, along with many snarky comments about theory and regression-running. But her critique barely mentions the facts, and instead savage's Piketty's misunderstanding of basic...theory. High prices lead to supply curves that shift out, capital includes human capital, growth comes from ideas, and so on. Let us admit then that theory matters. Pure empiricism for a thousand years did not figure out that washing hands stops infections, until we understood the theory. Quantitative theory.  Numbers without equations are as useless as equations without numbers. And, as misleading as regressions can be, simply staring at data does not sort out cause from effect, the central challenge of economics and other non-experimental social sciences, and the central criticism that McCloskey has of Piketty.

McCloskey goes slightly awry, as we all do, when she writes about things she hasn't kept up with.
He does not get entangled as so many economists do in the sole empirical tool they are taught, namely, regression analysis on someone else’s “data” ... Therefore he does not commit one of the two sins of modern economics, the use of meaningless “tests” of statistical significance ... Piketty constructs or uses statistics of aggregate capital and of inequality and then plots them out for inspection, which is what physicists, for example, also do in dealing with their experiments and observations. Nor does he commit the other sin, which is to waste scientific time on existence theorems. Physicists, again, don’t...Piketty stays close to the facts, and does not, say, wander into the pointless worlds of non-cooperative game theory, long demolished by experimental economics. He also does not have recourse to non-computable general equilibrium, which never was of use for quantitative economic science, being a branch of philosophy, and a futile one at that. On both points, bravissimo.
This sort of thing is just out of date. Empirical economics has become very fact-oriented in the last 20 years, and nobody really writes anything about "statistical significance" without establishing economic significance, or clear patterns in the data.  The stars in their 30s are scraping data off the internet. Existence theorems? Non-cooperative game theory? Non-computable general equilibrium? These are straw people from the 1970s.

But as she had to close with something nice, I have to close with something to whine about. A great read, and I recommend the whole thing.

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