Stimulate This!

Unless we are talking about cutting marginal tax rates, economic stimulus is woefully ineffective. It doesn't matter if we are talking about Keynesian style deficit spending or, as we are seeing around the world, moves to permanently increase the size of government.

What is Keynesian style spending? Basically, the idea here (owing to JM Keynes, coming from his book "The General Theory of Employment, Interest, and Money") is that the government should adjust its spending patterns depending on what the economy is doing. If the economy is tanking, the government should spend more money and run a deficit. If the economy is doing well, the government should run a surplus and pay off the debt it ran up during the downturns. First of all, we should note that this is most certainly NOT what is going on with these stimulus packages, despite what the politicians and talking heads are saying. The Keynesian prescription is for easily reversible increases in spending, while most of what is being put into these bills are new government programs, and are thus not easily reversible. The general economic idea here is what is called the "flypaper effect," which basically says that money sticks where it lands. Once the government creates new programs and new bureaucracies, bureaucrats become entrenched and will do anything they can to keep the money flowing. As nice as the Keynesian idea sounds, the politics of spending means that temporary spending is chimeric, as Robert Higgs work on the ratchet effect has pointed out.

Why won't this sort of spending work? The basic answer lies in the economic concepts of crowding out, Ricardian equivalence, and the permanent-income hypothesis and consumption smoothing. The basic logic of crowding out says that, if the government wants to temporarily spend money, that money has to come from somewhere and will lead to increases in inflation or interest rates or reductions in private spending (or some combination of all three) and will thus have no real effect on the economy. Let's say the government decides to start spending more money. They have to get the money somehow. One method is through an increase in taxation. It is obvious to see that this will result in those being taxed spending less money than before. So government spending will crowd out private spending. Another method is through the selling of bonds. As they flood the market with enough bonds to do their spending, this will push interest rates up. Firms who are thinking of borrowing money to finance projects (new factories, construction, etc., all of which increase employment!) now face a higher cost of so doing and, as a result, will cut their investment. Thus, government spending through debt finance will crowd out private investment. Moreover, taxpayers are not stupid. They see the government raising money with bonds and realize that the government will be forced to pay off those liabilities sometime down the road. As a result, taxpayers will start saving so that when those government liabilities come due, the tax bill they are hit with doesn't force them to cut their spending in a huge way (this is the gist of the permanent-income hypothesis). Thus, raising money for spending via bonds will have the roughly the same effect of cutting spending now as would raising the money through taxes--this principle is called Ricardian equivalence. Finally, the government could simply generate the money by printing it, which would of course lead to inflation.

Even at face value, however, these bills look less like temporary spending bills and more like permanent increases in government. I have been watching the spectacle of the US bill fairly closely, and it certainly looks like a move toward European style socialism, which is being lauded on the left as a good thing. A couple observations should be made. First of all, European countries are not doing any better than the more market based economies--nearly all European economies have experienced a sharp increase in unemployment in the past few months. Second, European unemployment numbers are consistently higher than more market-based economies. We are calling 7-8% unemployment bad--imagine if it was like that all the time, as it is in the best of time in Europe. And before people start calling me on that (Sweden has had official unemployment rates that rivalled those of the US for quite a long time), unemployment numbers are very difficult to compare across countries. You can't simply look at the official figures in a handful of countries to determine where market conditions are the best, because the way that unemployment is measured varies from country to country. A few years ago, the very left Swedish Secretary of Labour Hans Karlsson is reported to have had announced that Swedish unemployment was really in the 20-25% range but most of the unemployed were "stashed away" in various categories that statistically removed them from the calculation, but in effect they were unemployed. Finally, there is a ton of evidence that points out the simple fact that governments are not as effective as private markets in generating economic progress, for a whole host of reasons. According to most statistically based evidence (i.e. the Rahn Curve), the ideal size of government in terms of generating economic progress is for government spending to be something like 15-20% of total GDP. The US, which is considered by most to be a "small" government as far as developed countries go, has a government size over 35% of GDP. Most major European countries (aside from the UK) are in the 50-60% range.

What will work? Simply giving people stimulus checks or issuing "refund checks" will do nothing. I know they are politically attractive, but the crowding out mentioned above will still happen. The only real route is through cutting marginal tax rates. Now I know that people like to complain that tax cuts favor the rich--at face value it is unmistakeable that the rich gain a lot more in absolute terms than the poor from tax cuts. That can't be helped, simply because the rich are paying a lot more in taxes to begin with. But in percentage terms, the poor generally make out much better than the rich. Cutting marginal tax rates work because people make their working decision on the margin. They ask themselves how many hours they want to work, taking into account the costs and benefits of doing so. The benefit of working is obviously money, whereas the cost of work is reduced time with the family, less leisure, and so forth. If you reduce taxes, the marginal benefit of working an extra hour goes up, because you get to keep more of the money from that hour, so people work more. The basic logic of taxation is simple...the higher the marginal tax rate, the less people do of the activity that attracts the tax. The higher the tax on income, the less people work. The higher the tax on profits, the less energy firms spend on profitable activity, which can manifest itself in a number of ways, like gold-plating (the Averch-Johnson effect) or racial/sexual discrimination.

$500K Executive Salaries Redux

I blogged earlier today about the $500K salary cap. It turns out that this cap is only really applicable to firms that take future TARP funds, not those who already have. Does this make the cap more palatable? After all, the only firms that are likely to request future funding are those who are already in dire straits. I think this is the wrong way to look at the cap. The form of the cap seems to me to be hugely anticompetetive--early TARP recipients got no-strings-attached loans, whereas future TARP recipients will have huge strings attached to any funding they receive. The federal government appears to have engaged in an attempt to not only pick winners (which they are notoriously bad at), but to help out their "chosen ones" by forcing their competitors enter into a Faustian bargain should they want access to the same same government funds.

$500K Executive Salaries

In a shocking move, Obama has issued an order that caps the pay of executives in companies receiving TARP money at $500,000 per year.  We have seen in the past year that opening the company pocketbook to pay as much money as is necessary to attract the best and brightest CEOs doesn't guarantee good results, I wonder what happens when these companies can't compete with firms in other industries who are free to pay as much as necessary to attract these top talents.

Schipwreck!

The current SCHIP expansion recently passed by the house and now being considered by the senate is a SCHIPwreck. While the prospect of millions of poor children having increased access to health care sounds great at first glance, in actuality this proposal is a lot like sending a kayak out to rescue passengers on a sinking ship.

While SCHIP is being touted as a program to aid the poor, in actuality SCHIP is aimed more squarely at the middle class. Families with incomes below the poverty line are not eligible for SCHIP, but rather go into Medicaid. SCHIP covers families with incomes between 100% and 300% of the poverty line: Depending on which state one lives in, 300% of the poverty line implies a household income (for a 4 person household with two children) of between approximately $60,000 and $72,500. When one compares this with the US median income in 2007 of roughly $50,000, it becomes evident that the SCHIP expansion is not a program for the poor, as it has the potential to apply to well over half of all households in the US. Moreover, the SCHIP expansion explicitly prohibits states from subjecting applicants to an assets test, meaning many people who can legitimately afford health care (e.g. people living off inheritances, retired dot-com millionaires, and the like) will be eligible for SCHIP.

In addition, this piece of legislation has a nice fat pork clause in it, as pointed out by Forbes, which attempts to reduce the competition faced by hospitals by banning physicians from opening specialty hospitals. This pork is quite emblematic of one of the key underlying causes of rising health care costs--a serious lack of competition within the industry. Licensing laws severely restrict the entry of medical practicioners to provide service, leading predictably to higher prices. The morass of state-level insurance regulation makes it impossible to provide the same insurance plan in two different states, which ultimately harms consumers by depriving them of hundreds of insurance options. The safety and efficacy tests mandated by the FDA cost nearly a billion dollars per drug and can take over a decade, cutting significantly into the patent life of a drug--these huge fixed costs deter many new entrants into the pharmaceutical industry.

It is true that the health care industry needs an overhaul to help improve the access of Americans to quality care. Rather than concoct pork-laden legislation, a better route is though the liberalization of many of the highly regulated health-related markets.

Sachs on "The Case for Bigger Government"

Over in TIME, Jeff Sachs argues that the time has come for the US to go Euro and fully embrace high taxes and large governments. In his parting statement, he argues that "Obama's long-term success will depend on his ability to lead Americans to a new, even revolutionary consensus that the U.S. government can offer value for money." Most people, even those on the libertarian fringe of the libertarian movement, are probably willing to accept larger government and increased taxes if the government can indeed "offer value for money." The fundamental nature of government, however, is that this goal will always be elusory.

The nature of private production is quite simple. Entrepreneurs put their own assets at risk in an attempt to create a product that people want. If they are correct, and the product they create is a hit, then they will reap profits. Why? Because the product they have created has offered value for money. If they are incorrect, and their product flops, they will lose money. In this case, they have not offered value for money. Absent $700B bailouts, there is no opportunity to pass the buck and make someone else bear the losses. This continual process of earning profits and realizing losses send feedback to the entrepreneur that informs their production decisions. In the private sector, value for money is the norm, because the entrepreneur only gets paid if consumers like their product, and entrepreneurs making products consumers do not like are weeded out of the market.

In the public sector, these mechanisms simply cannot work. Politicians, and especially the bureaucrats who implement the selected policies, have very few assets staked in any project. At best they have their reputations to worry about, and opportunities to pass the buck (i.e. blame the othe party) for bad outcomes abound. At the same time, private citizens do not have the option not to purchase the product being offered if they do not like it. They have the option not to use it, but are compelled under threat of criminal prosecution to pay for it nonetheless. The combination of these elements means that the feedback mechanisms present in the private sector that tend to lead to value for money are significantly weaker, if not conspicuously absent, in the public sector.

New York Tax Hike

The New York Government is attempting to introduce nearly 100 new taxes to make up for a looming budget defecit. I have two points to make. First, most obviously, perhaps the answer is not to increase taxes but rather to reduct spending. But that ideological point aside, I think the more important point is that these taxes are likely to flop and not provide the amount of revenue expected, and in a worst case could potentially lead to an absolute reduction in revenues. When over half the state's population live extremely close to a state border (New York City accounts for nearly 40% of the state's population), these taxes could potentially induce consumers to drive a few extra miles (to New Jersey or Connecticut, say) to avoid paying taxes.

Good at predicting the past?

An epithet I've heard often in the past is that economists are simply "good at predicting the past," and in all honesty it doesn't seem like an unfair criticism. Economics is a predictive science, but it appears that economists aren't all that good at prediction. Why is this?

I think there are a number of answers to this. The first is idiology-most economists have a particular viewpoint that they are wedded to, so you don't get a lot of consensus on matters. Think about the current financial crisis...there are leftist economists arguing that the problem lies in the capitalist system and is the result of greedy rich white guys trying to profiteer from the nation's poor. On the right you might hear that it is a problem of misregulation-the necessary checks are in place but for inept bureaucrats, and that the greed isn't the problem, people committed crimes of fraud. And of course I'll tell you that the problem is entirely government created through very loose monetary policy combined with excessive subsidies in the housing market. It's not like any of us are lying-we all think we hold the truth. But it turns out that these explanations are mutually exclusive-only one can be right.

To understand this, and sort of differentiate this from a "harder" science like medicine, think about supply and demand. There is a supply of economics and a demand for economics, just as there is a supply and demand for medicine. On the supply side, you do see that occasionally doctors differ-one patient may see three different doctors about a set of symptoms and get three different diagnoses. And when it is demonstrated that one diagnosis is incorrect, that doctor can (as economists do) easily justify why their diagnosis was wrong but it was still a good diagnosis. For example, a doctor can say that their diagnosis was the best given the evidence presented, however if given another piece of evidence, they would have gotten the right answer. Economists are similar-they can make untrue predictions and blame their not coming to fruition on changing factors in the economy. This is why we always qualify statements with the phrase ceteris parebus; we are confident that if nothing changes our prediction will be right, which gives us the easy out if our prediction does not come to fruition, since something will always change. And of course, if a doctor is always wrong, he will soon lose his income stream, meaning bad doctors will tend to get weeded out by the market. I don't think that matters (at least as much) for economists because of what is happening on the demand side.

On the demand side, we see another phenomenon keeping bad predictions/explanations of the economy going, which is related to the ideology comments above. If you are sick, do what do you want? A doctor to tell you that you have disease "x" and treat disease "x" or a doctor to tell you what disease you actually have and treat that? Most people who go to a doctor simply want a correct diagnosis. It is true that there are exceptions to this, but I think that this is far less prevalent in medicine than it is in economics. If a labor union asks an economist to write a report on John Howard's Industrial Relations law reforms, and that economist writes either that they are great or that the government didn't go far enough in deregulating labour markets, what is the union going to do? Post it on their website and trumpet the benefits of free markets? Or find another economist who will argue that the IR laws will put worker rights back 50 years? I think that they will do the latter 100% of the time. Economics is unique in that the demanders of our services want us to tell them what they already "know."

Another key difference between economics and the "hard" sciences is the combination of the incredible complexity of the economy and its rapid rate of change. Yes, the physical universe is extremely complex-and yet the laws that govern the physical are immutable. The human body is incredibly complex, but human evolution occurs at a snail's pace-a drug that had a 70% success rate at curing disease "x" when it was discovered/invented in 1900 probably has the same likelihood of curing that disease today. It will probably be equally efficaceous in 3000, as would it have been in 1000 had they known about it. Sure, from time to time a new deadly disease will pop up, but for every avian influenza there are hundreds of thousands of new technologies, laws, regulations, financial/business innovations that have a huge change on the economic landscape. Every quarter in the US, there are about 7-9 million jobs that are destroyed as a result of these changes, and another 7-9 million new jobs that are created as well. I believe (and I could be wrong about this) that the rate of change in the forces that affect the economy dwarfs those of the physical world.

What drives this I think is the difference betweens the subjects of analysis in economics (and the other social sciences) and the subjects of analysis in the hard sciences. What does a white blood cell do? As a non-doctor, I may be way off here, but my understanding is that they are in your arteries and veins attacking everything that shouldn't be there. But they are not making decisions on the margin. To personify them a bit, it is as if they are hard coded to swim around in a certain way and have a list of what should be there. If they encounter an object, they check
their list to see if it should be there. If it should, they leave it alone. If not, they go Chuck Norris on it. They follow rules, never making decisions, because they are not sentient. Humans, on the other hand, are. They have the ability to choose the rules they follow, modify them if they aren't working, or be entrepreneurial and make a whole new set. If those new rules are good, they get rich. And it turns out that these rules are very private-sometimes even the people choosing them or inventing them don't know what they are exactly. It is very hard to make accurate predictions when there are no rules that we know every person will follow-however we can look at what has happened, attempt to figure out what rules were being followed, and in so doing, predict the past. Does this mean that economists have nothing to offer? If I thought that I'd have to quit my job, so I must think that we have more to offer than just being historians (not that there is anything wrong with being historian, mind you). Some things are unpredictable-new technologies, for instance. But it turns out that entrepreneurial action is quite rare, and most people roughly follow the same sets of rules most of the time. So while we can't predict WHAT will change all the time, we can predict what will happen-that is what ELSE will change-as a result. We can predict changes on the margin pretty well, we predict inframarginal changes rather poorly. And that is something.