The generalized resource curse

A useful way to understand the pickle we’re in, I think, is that we are suffering from the so-called “resource curse”. If you are unfamiliar with the phrase, “resource curse” refers to the regularity with which countries “blessed” with abundant natural resources end up as dystopian polities with dysfunctional economies. Nigeria has a lot of oil but no one wants to live there.

The resource curse is pretty easy to understand. It’s not associated with just any sort of natural resource. Switzerland has beautiful mountains and stuff that people would pay a lot of money for, but it is still well-governed. Accursed resources are of a very particular type. They are valuable tradable goods the extraction of which requires a small numbers of workers relative to the size of the economy as a whole. [*] Goods like this create a very strong tension between private property and social welfare. In the mythology of capitalist economics, “as if by an invisible hand”, the self-interested pursuit of private wealth promotes the general welfare precisely because we all require one another’s help. The butcher slaughters her beasts and the baker sugars his cakes, each with an eye to their own profit. But the butcher needs her carbs and the baker likes his meat, so the end result of their self-interested selling is mutual aid rather than mere accumulation.

This logic breaks down in an economy dominated by a valuable natural resource. Yes, the miners require meat and mead, but if they are small in number relative to the rest of the population, that won’t cost them very much. They are few mouths to feed, and the not-miners are many and lack bargaining power. What makes happy capitalism work, the silent tendon of the mythologized hand, is a kind of balance between individuals’ desire to accumulate and their need for the assistance of others. If there exists a very valuable natural resource, and if that resource can be privately controlled, there is no balance. Self-interested agents drop their butchering and bakering, and try to gain control of the resource. No magic force turns that into a positive sum game. Unless there are “very strong institutions” — whatever that might mean — the pursuit of wealth becomes a game with winners and losers. The invisible hand can manage no more than to lift a middle finger.

So far this is all very comfortable. Clucking about places like Nigeria is almost a reflex, a familiar tic among Western economists. But meanwhile, we’ve hardly noticed that technological and international supply-chain developments have snuck the resource curse in through our own back doors. In aggregate, the goods and services we require have grown ever more tradable, and production has grown ever more amenable to control by relatively small groups of people. There’s a sense in which we are all Nigerians now.

The result of a resource curse, even in Nigeria, is not a triumphant über-class gleefully enslaving those outside the circle of winners in the resource-control game. In human affairs, “legitimacy” matters, and the sources of legitimacy are time- and context-dependent. Nigeria has all the forms of modern government, a civil service many of whose members are no doubt idealistic and hard-working. What evolves is the situation we refer to as corruption, under which those who control the valuable resource create incentives within the institutions that confer legitimacy — government and finance, media and academia — in order to ensure continuation of their control. In doing so, lines are genuinely blurred and resources are genuinely shared. The work of mining and the work of governing cease to be distinct enterprises, they become a partnership in the common project of maintaining control over the special resources. And words with moral valence like “common” and “shared” are appropriate, because within the circle of insiders, that’s what it feels like. There is a “we” that includes all of those fortunate enough to be civilized, that includes “me” and “my family”, “my friends and my family and my coworkers”, “my school and my teachers”, everyone that most people in the civilized circle ever interact with. There are, at the edge of the circle, people who are genuinely brutal, the people who put down insurrections or directly manage low-bargaining-power chattel labor. But those are a small minority. Most people who work to perpetuate “corrupt, extractive” regimes are, in their own eyes, serving their communities. The more resource-curse logic binds, the more likely as a technological matter that control over economic value will be concentrated among a relatively small fraction of the society. This leads to a greater separation of circumstance, between winners who perceive themselves and their communities as “civilized”, and losers exhibiting social pathologies that may be more effect than cause of disadvantage, but are nevertheless real, and usefully assist in reinforcing the arrangement’s legitimacy. Corruption and idealism become impossibly fused. Did Timothy Geithner “save the world”, or did he perpetuate the stranglehold of a particular extractive elite? He did both. He saved his world.

There is a regularity here, an order. We find ourselves on the inside of social phenomena that we have seen before, that we can understand. The global economy is succumbing to a technologically-driven resource curse, coalescing into groups of insiders and outsiders and people fighting at the margins not to be left behind. Our governments are transforming themselves from mediators among widely dispersed and interdependent interests to organizations that maintain and police the boundaries between the civilized and the marginal, who put down the insurgencies and manage the pathologies of the latter so that they do not very much impinge upon the lives of the former. Our financial systems are mechanisms by which legitimacy is conferred upon facially absurd distributions of aggregate wealth, by virtue of processes that claim to be “voluntary”, “private-sector” and “market-disciplined”, but which are none of those things in any meaningful way.

There are lots of places to go with this analogy. “Resource curse” countries are traditionally small, open economies whose elites are less fettered in their neglect of domestic populations because they can trade resource wealth for most of what they want from foreigners. One might argue that the analogy is incoherent for large, mostly self-sufficient economies like the United States or the world as a whole, whose elites must rely on “domestic” production. But here the analogy between technology and trade, usually used to support the latter, comes in to condemn the former. The amenities for which Nigerian elites rely upon Europe, American elites may rely upon robots to produce, once the Chinese labor cycle runs its course. American, like Nigerian, elites will have their tailors and masseuses. But in a resource-curse economy, service providers at the boundary between inside and outside remain small in number relative to pathologized mass publics.

This analogy is not entirely hopeless. Alaska and Norway blunt the resource curse by proactively distributing the proceeds of resource extraction, limiting concentrated control and ensuing disorders. “Technology” is not a tangible thing that can be publicly owned and sold for proceeds. But like oil in the ground, it is a resource the scale of whose product far exceeds the reward required to incentivize its production. If we imagine technology as a source of value embedded in most goods and services, we can distribute claims upon it simply by distributing new purchasing power. A money-financed basic income would amount to a partial dispersion of technological bounty from those involved in concentrated production to “outsiders”. Like Norway’s Oil Fund, this might help preserve balance, economically and politically, in the face of our creeping resource curse.


[*] It’s probably more accurate, although depressing, to qualify this, and rewrite it as “a small numbers of workers capable of achieving bargaining power relative to the size of the economy as a whole.” Feudal economies, in which the majority of people work to produce agricultural goods, look a lot like resource-curse economies, even though numerical involvement in production is not concentrated. Bargaining power, defined as the ability to assert control over production, remains very unequal. If you define the resource curse this way, you end up with “cursedness” as the normal state of human affairs, and it becomes more sensible to talk about the “industrial age blessing”, a fleeting mix of social and technological conditions under which large numbers of workers contributed to production through processes that required scale and coordination. These circumstances allowed unusually broad segments of the population to organize and achieve bargaining power, increasing the scope of economic prosperity and the impetus to mass production that economists eventually label “growth”.

Update History:

  • 29-Apr-2013, 7:30 p.m. PST: “broadening increasing the scope of economic prosperity along with and the impetus to the mass production that economists eventually label as ‘growth'”

A bit more on savings and investment

Steve Roth (1, 2), Scott Sumner (1, 2, 3), Bill Woolsey, and Matt Yglesias have been debating questions of saving versus investment and paradoxen of thrift. See also JW Mason in the comments here, and Simon Wren-Lewis a while back. Cullen Roche reminds us that, even under conventional definitions, the accounting identity S≡I only holds for a closed economy without government spending, and of JKH’s useful tautology S=I+(S-I). [See Update below.] I think the recent recrudation of these issues owes something to Garett Jones’ and my conversation on capital taxation, which Jones has continued and on which Matt Bruenig has weighed in.

As is often the case, I think that the protagonists agree more than we think we do. Our various allegiances — to schools or tribes or policy ideas — exploit the ambiguity of language to manufacture conflicts, through which we reassure ourselves that we are right and they are wrong. (And no, math doesn’t help much, because we must map it arbitrarily to the same ambiguous language for it to be of any use.) Now I will reassure myself that I am right and they are wrong.

I think we have all agreed, one way or another, that the K in a Ramsey model does not map easily to the financial investment whose (non)taxation we debate in the real world. If new cash or government debt can be understood as a kind of capital good, it’s not obvious that it behaves similarly to the physical capital in an aggregate production function. It might, but you’d have to do some work to persuade us. If the conjunction savings supplied, investment demanded, and “at potential” total expenditure depends upon interest rates or other financial variables that may vary independently, there is no reason to believe that privileging saving will unconditionally promote investment, qua Chamley-Judd logic. Savings supplied may not be the bottleneck.

Update: Ramanan (1, 2) and Hellestal say I’m wrong to write that “even under conventional definitions, the accounting identity S≡I only holds for a closed economy without government spending”. They make a very good case! But in doing so, they remind us of the ambiguities and limitations of this “conventional” framework. In the current conversation, we are most immediately confronted by an ambiguity surrounding the letter S. When people say that S ≡ I, they mean total savings equals total investment. But in many of the conventional equations used to discuss this stuff, S is refers only to private savings. That leaves tiny fragile minds like mine liable to confusion. Stealing a lot from Ramanan and Hellestal, in conventional accounting, savings are defined simply as the residual between what is produced and what is consumed (both by private partes and by government). Let’s consider a closed economy:

Y ≡ C + G + I //by definition [eq 1]
Y - C - G = I ≡ TOTAL_SAVINGS ≡ TOTAL_INVESTMENT //by definition [eq 2]
Y ≡ C + S + T //also by definition, but S here means private savings [eq 3]
C + S + T = C + G + I //combining equations 1 and 3 [eq 4]
S = I + (G - T) //remember S here is private rather than total saving [eq 5]

Equation 1 says production is comprised of the resources that we consume (C by definition), that the government consumes (G by definition), and whatever is left over, which is evocatively but perhaps misleadingly designated I for investment. But, as commenter Eric L emphasizes, in these accounts I is just a residual. It refers to whatever resources are not consumed (either by private parties or by government).

Equation 3 is most easily understood as a decomposition of claims on the resources produced. We choose to decompose these into the claims made by government (T), the claims of private consumers to precisely the resources they consume (C), and the claims of private parties on production extinguished by neither taxation nor private use (S). We reconcile the disposition of claims with the disposition of resources in equation 4. This tells us that private savers’ claims to production (at the moment of production, before any real investment outcomes have a chance to muddy things up) include the resources no one used (I by definition) and the resources the government used in excess of the taxes the government claimed.

To keep things clean, let’s adopt, um, a convention. When we use the word “savings” we should refer to claims. When we use the word “investment” we should refer to real resources. Let’s then separate “savings” from “investment”, claims from resources, in Equation 5:

S - (G - T) = I //subtract (G - T) from both sides of Equation 5
S + (T - G) = I //simplify [eq 6]

Equation 6 is what we should really mean when we say S ≡ I (even though algebraically it doesn’t because we mean different things by S). That is to say that total claims on unconsumed resources must equal the quantity of unconsumed resources. I, by definition, for a closed economy, represents unconsumed resources. (T - G) represents the claims government has made on resources by taxation in excess of the resources the government has actually consumed. S represents the claims on resources left to private parties after consumption and taxation. If we call the claims of the state “government savings”, the claims of private parties “private savings” and unconsumed resources “investment”, then we can write:

PRIVATE_SAVINGS + GOVERNMENT_SAVINGS ≡ TOTAL_SAVINGS ≡ INVESTMENT // [eq 7]

So, yay! This is true by definition. It is just a way of saying that balance sheets must balance. It says that total claims on resources must always be equal to the total quantity of resources to be claimed.

But before we get all triumphalist, let’s emphasize how unhelpful this mostly is. First, it is simultaneously conventional to claim that S ≡ I and to write equations in which S refers to private savings, which is not equal to I. It is conventional to claim that the letter I represents “investment”, when in fact it represents any resources that are unconsumed. In a hypothetical, instantaneous sense, unconsumed resources mean resources available for consumption. In an actual sense, much unconsumed production (as vlade emphasizes) goes to waste. I is not “investment”, in the ordinary meaning of the word. It is simply resources that are not consumed in a certain period, regardless of what befalls them. Cars produced and not consumed become “inventory investment”. That’s fine. But electricity produced and not consumed? It dissipates as heat. Bread produced and not consumed grows moldy. The product of a university, when left unemployed, becomes less employable. Trees cut and “invested” in unsellable desert homes get accounted as investment, but fail to contribute to future production.

So we can argue. Maybe stuff that’s wasted should get embedded in C, which keeps “investment” more accurate by doing violence to the commonsense meaning of consumption. But we can’t really embed “bad investment” in consumption, because we can’t know which investment is bad. The letter Y usually gets mapped to “gross domestic product”, but if we want to sum across periods and keep our stocks and flows consistent, when we do our Period 2 accounts, we must define Y as a net product, and include any losses and misadventures that befell our old “investment” in the new period’s I. (We refer to this as a “valuation adjustment”.) Again, the use of conventional mappings between letters in the equations (“Y”) and real-world referents (“GDP”) will mislead us. Alternatively, we can keep the periods separate and let Y ≡ GDP, but then we will need to impose valuation adjustments when summing savings and investment across periods to account for actual investment outcomes.

The framework grows shabbier still when we consider an open economy. Equations 1 and 2 become

Y ≡ C + G + I + NX //by definition [eq 8]
Y - C - G = I + NX ≡ TOTAL_SAVINGS //by definition [eq 9]

But now we’ve really mixed up our treatment of resources and claims. Equation 2 defined resources unconsumed as total savings, but equation 9 redefines it as the resources we have failed to consume, but that may have been consumed by others. Hmm.

S = I + (G - T) + NX // [eq 10]

Equation 10, the open-economy analog of equation 5, is a very useful decomposition of private savings. It stands at the core of MMT-ish intuitions about how a putatively savings-hungry private sector might be accommodated, and inspires JKH’s very clean reminder that private savings represent claims on domestic investment plus some other claims that can’t be mapped to domestic investment. But it might suggest to the incautious that all exported goods are matched by domestic claims, and that those claims against foreigners are good and stable and should be valued at par. In real terms, that is almost never true. The NX component of “investment”, like the I component, is unstable, and if we carry these accounts forward in time, we’ll have to include valuation adjustments there as well.

None of this is to say that this is a “bad” accounting framework. The only thing that’s really terrible is the inconsistent conventions, under which S sometimes means total saving and sometimes private saving. The deeper difficulties would be shared by nearly any accounting framework. In the accounting of private firms, it is not easy to classify “expenses” vs “capital investment”, just like it’s hard to distinguish consumption and investment in national accounts. In corporate accounting, there are valuation adjustments and statements of “other consolidated income” to reconcile differences between values between period t and period (t+1) that cannot be accounted for by current period undistributed profits. The real world is unruly, yet accounts must be defined. The accounts must find ways to track the unruliness of reality rather than expect the world to conform to simple definitions.

However, whenever anybody tries to make a substantive point by quoting S ≡ I, they are offering no insight at all into any nontrivial question. They are saying nothing more or less than balance sheets must balance. They reveal nothing whatsoever about how. It certainly doesn’t mean that the production of new claims (“savings”) is necessarily matched by the production of new resources (“investment”). It just reminds us that, if the new claims are not matched by real resources, we shall have to devalue the claims of others if we wish to keep our accounts straight.

This whole conversation started with questions about whether the S ≡ I identity somehow implies that real-world savings vehicles are necessarily matched by investment in the Ramsey/Chamley/Judd sense. The answer to that question is unequivocally and irrefutably “no”. Real-world savings vehicles need not be matched by any investment whatsoever. Suppose I purchase shares in a mutual fund which then lends it on as consumer loans that finance vacations. In a macroeconomic sense, there is neither savings nor investment, my saving is matched by vacationers’ dissaving, resources are consumed and none are invested. S ≡ I = 0 Nevertheless, my shares in the fund would yield returns in forms like dividends, interest, and capital gains. No matter how hard you squint at accounting identities, nothing in the logic of Chamley and Judd suggests that these “investment returns” should remain untaxed. Lending to finance private and government consumption represents a significant fraction of gross financial savings, even though it contributes nothing to net savings or the aggregate investment Chamley and Judd presume.

Update History:

  • 14-Apr-2013, 10:50 p.m. PST: Very long bold update, responding to Ramanan and Hellestal re S ≡ I
  • 19-Apr-2013, 6:45 p.m. PST: “insight at all to into

Some followups on capital taxation

I’m going to move on to other things, but before I do, I thought I’d point to some very good commentary inspired by the previous post on capital taxation.

You already know that interfluidity is like a really drab version of Playboy, no one reads it for the articles, the really good stuff happens in the centerfold under the fold, in the comments.

The piece provoked smart responses on other blogs, Increasing Marginal Utility, Separating Hyperplanes, and Asymptosis. [1]

Robert Waldmann points out that glib euphemisms like “the long run” lead one to overstate the case against capital taxation even on the most sympathetic understandng of the models, that under human relevant distributions and time parameters the models can favor capital taxation. Here is his case (in a PDF he describes as “heroically constructed by Sigve Indregard”).

Here are a very few substantive comments, in response to responses:

  • Beware fallacies of composition is justifying a constant-returns-to-scale production function at a macroeconomic level. It’s an assumption that is only remotely justifiable if you are sure that your production function includes all factors of production. At a macro level, it’s obvious that you can’t scale all factors of production — see e.g. the smart discussion in comments by Merijn Knibbe, JW Mason, and Douglas Edwards regarding land. Omitting factors of production in a model may be innocuous in microeconomic contexts where their quantities are unconstrained functions of the factors that you do model. We needn’t concern ourselves about oxygen as an input to our beauty salon. But in macro production functions, it is hard to know which factors are bottlenecks to increased production, and failing to include the inputs and their constraints can render the exercises useless. It is conventional in macroeconomics to model the most significant determinant of overall production as “technology”, measured as a residual between what the factors we model predict and the growth we actually observe. That’s an elegant way of ducking the fact that we are omitting important inputs. If we are omitting important inputs, scaling up the factors we do include may be no more effective than multiplying shovels without hiring more humans to wield them.

  • There are lots of ways to get confused about the idea that savings equals investment. It’s an accounting identity, and, as always with accounting identities, there are tensions between the definitions under which the identity is true (by definition) and “common-sense” notions of the phenomena described. There are two approaches to dealing with those tensions:

    1. You can accept the formal definitions that make the accounting identity true, but be very careful to avoid “slips of the tongue” in mapping those definitions to other contexts; or
    2. You can treat those definitions as very narrowly applicable formalisms, and urge caution in the opposite direction, when reconciling the common-sense idea with the formalism.

    Steve Roth takes the second approach. I’ll take the first.

    Let’s assume that S ≡ I, and define investment to mean whatever it must mean for that identity to hold true. The S will always be equal to I. However, that does not imply that investment can be modeled as a cumulation of savings! We add to savings over time, but investment returns are complicated and sometimes negative. So we might describe ΔS ≡ ΔI as a two-term sum of new saving plus return on total investment.

    ΔS ≡ ΔI = new_savings + valuation_adjustment

    Ramsey-inspired models take the second term always to be the marginal product of capital in a production function, less a constant depreciation rate. But that is not likely to be realistic, especially if we let S ≡ I include financial savings, rather than what the models imagine, the direct deployment of an unconsumed real resource. When consumers stuff dollar bills into a mattress, it may or may not be true that the resources they thereby fail to consume get usefully deployed into production. If it is true, it must depend on the complex ability of the monetary and financial system to allocate the slack made available by nonconsumption in ways that contribute to future production. By definition, putting dollar bills in a mattress rather than spending the income may count as investment (if not offset by consumption elsewhere). But there is no guarantee that it is good investment, directly or indirectly. So, in addition to cumulation of savings, we have to think much harder than the Ramsey model does about that second term, about the dynamics of valuation changes. (For a great example, consider how the United States’ chronic current account deficits have failed to cumulate into a large negative NIIP, as pointed out today by Paul Krugman.)

    Ramsey model intuitions do fine if “bad investments” are a relatively constant fraction of total savings. Failed projects just fall into the constant depreciation rate. The key is to assume that investment returns are independent of the qunatity new savings. Unfortunately, if we allow the second, valuation term of ΔS ≡ ΔI to vary as a function of the first term, if, for example, an increased rate of savings tends to be matched by poorer aggregate investment returns, then Ramsey model logic falls out the window.

    In practice, we observe that increased rates of gross saving do correlate with poor investment returns. When the financial system is asked to allocate giant pools of money, it fucks up (and steals a lot). We have to be careful in mapping these real-world observations to modeled constructs — net investment rather than gross savings is the closest Ramsey-model referent. Net domestic saving was actually low during the housing-boom-era of malinvestment, but net investment was not so low thanks to a very large capital account surplus (those scary trade deficits). Total US S ≡ I was robust when foreign saving was included. But returns on that S ≡ I were unusally poor. If you accept the accounting definitions under which S ≡ I, you must be especially attentive to the complex dynamics of financial investment returns. You cannot just map that kind of S ≡ I to the capital term in a Ramsey model.

  • That last point was already over-mathy, but for those of you who like this sort of thing, a concise way to make much of the anti-anti-capital tax case is to observe that conventionally we often write production functions like:

    Y = F(K, AL)

    where A is a stand-in for labor-augmenting technology and is presumed to be either independent of the production process or, in the most common “endogenous growth” models, a function of cumulative capital investment. To break the Chamley-Judd result, all we have to do is write

    Y = F(K, A(w)L)

    that is, let labor-augmenting technology be in part a function of (after-tax) wages, defined either as current wages or especially as a cumulation of past wages. The choice to model A as independent of wages is rarely justified, and is not remotely obvious. It is merely conventional. Funny, the direction conventions in economics seem so frequently to tilt.


[1] If I’ve left you out, it’s because I am an idiot, not because I have judged you to be. Let me know and I’ll add you.

K is not capital, L is not labor

Garett Jones wonders why a standard result in economics is not more widely entrenched, both in policy conversations and conventional wisdom:

Chamley and Judd separately came to the same discovery: In the long run, capital taxes are far more distorting that most economists had thought, so distorting that the optimal tax rate on capital is zero. If you’ve got a fixed tax bill it’s better to have the workers pay it…

Why isn’t Chamley-Judd more central to economic discussion? Why isn’t it part of the canon that all economists breathe in? Why isn’t it in our freshman textbooks?… The result can’t be waved away as driven by absurd assumptions: It’s not too fragile, it’s too solid…

Good economic policy doesn’t try to do things that are impossible. And if the world works roughly the way Chamley and Judd assume it does, a long run policy that redistributes total income from capitalists to workers is impossible.

So, the quick answer, obviously, is that those of us who support redistributive taxation don’t believe that the world works in the way that Chamley and Judd assume. It is very clear that Jones (who is an unusually insightful guy) doesn’t believe in a naïve mapping between real economies and Chamley-Judd-ville. See the “bonus implication” in his handout on the subject.

To annihilate in broad brush strokes, there is little reason to accept the Ramsey model, upon which the Chamley-Judd results are built, as a sufficient description of the macroeconomy. [1] Some economists might argue that it’s a decent workhorse “asymptotically”, as a means of thinking about some long-term to which economies converge. But that’s a conjecture without evidence. Actual experience, as people as diverse and diametric as Scott Sumner and J.W. Mason point out, suggests that “demand-side dynamics” may overwhelm the bounds of a hypothetical production function in determining the actual behavior of the economy, over periods of times as long as we can plausibly claim to foresee. Redistributive taxation, or tolerance of redistributive inflation in the face of poor real-economic performance, may be prerequisite to maintaining production along the sort of path the Ramsey model presumes is automatic. These possibilities, along with any form of uncertainty, are invisible to the work of Chamley and Judd. They are simply omitted from the model.

But let’s be generous. Let’s put very broad objections aside, and understand the world in Chamley-Judd terms. In practice, what does the Chamley-Judd result suggest about policy?

First, it’s worth pointing out that Jones has overstated things a bit when he claims that the Chamley-Judd result is “not too fragile, it’s too solid”. As far as I can tell [2], the optimality of a zero capital tax rate is in fact a “knife-edge” result with respect to returns-to-scale of the production function. If returns to scale are decreasing or increasing, the optimal capital tax rate from workers’ perspective may be positive or negative, and is sensitive to details. A stable, constant-returns-to-scale production function may be attractive for reasons of convention and convenience, but it is unlikely to be true. Once we admit this, we really don’t know what the optimal tax rate is in an otherwise Chamley-Judd world.

But I promised to be generous. So let’s assume that the economy is characterized by a permanent two-factor, constant-returns-to-scale production function. The Chamley-Judd claim is that it is optimal that one of these factors should be taxed and the other not be. For this to be true, there must be some asymmetry: Factor one, which we’ll call K, must be different from factor two, which we’ll call L. What distinguishes these factors and leaves one optimally taxed, the other optimally untaxed? Fundamentally, the difference is that capital accumulates, while labor does not. Judd assumes completely inelastic labor provision, Chamley allows for a labor/leisure trade-off bounded by a fixed number of hours. Each period labor is born anew, while capital stands on the shoulders of its ancestors. This difference is what drives the asymmetry and then the result. Labor is a factor in strictly limited supply, capital is a factor whose quantity can grow indefinitely and which augments labor in production. Under these circumstances, the way to get a big, rich economy — and to maximize the marginal product of labor! — is to encourage the accumulation of capital. Encouraging labor provision directly can’t take you very far, because there is a ceiling. But the sky’s the limit with capital. Further, in Chamley and Judd, nonconsumption automatically implies useful deployment of capital into production.

If these were adequate characterizations of capital and labor, the Chamley-Judd result would be much more plausible than it is. But these are very poor descriptions of the real world phenomena we ordinarily label “capital” and “labor” when we decide how much to tax them.

Let’s talk first about “labor”. As Jones hints in his “bonus implication”, labor is not in fact measurable in terms of homogenous hours. What a brain surgeon can do with an hour is very different from what a child laborer can accomplish. Macroeconomically, our collective capacity to produce improves. You might, as Jones does, refer to this incorporeal je ne sais quoi that enhances labor over time as “human capital”, or as labor-augmenting technology. Like physical capital, it seems to accumulate. In empirical fact, “human capital” and its more sociable, incorporeal twin “institutional capital” seem to be much more important predictors of the growth path of an economy than physical capital. Europe and Japan bounce back quickly after war devastates their infrastructure. But imagine that a Rapture clears the Earth and pre-agrarian nomads take possession of perfect gleaming factories. I think you will agree that production does not recover so fast. Human and institutional capital dominate physical capital. [3]

Like physical capital, and unlike hours of the day, the collective stock of human capital grows over time, without obvious bound. Yet, at least under existing arrangements, we have no means of distinguishing between “returns to human capital” and “wages”. “Capital taxation”, in conventional use, refers to levies on capital gains, dividends, and interest. As a political matter, results like Chamley-Judd are often used to support setting these to zero. But eliminating conventional capital taxes shifts the cost of government to wages, which include returns to human capital. If human capital accumulation is as or more important than other forms of capital accumulation, and if the quality of effort that people devote to building human capital is wage-sensitive, then taxing wages in preference to financial capital may be quite perverse. Further, while physical capital grows by virtue of nonconsumption, it seems plausible that human capital development is proportionate to its use, which would render a tax penalty on “wages” particularly destructive. Fundamentally, Chamley-Judd logic suggests that we should tax least the factor most capable of expanding to engender economic growth. You don’t have to be a new-age nut to believe that human and institutional development, which yield return in the form of wages, may well be that factor. It is perfectly possible, under this logic, that the roles of capital and labor are reversed, that the optimal tax on labor should be zero or even negative, because returns to physical and financial capital are so enhanced by human talent that even capitalists are better off paying a tax to cajole it.

So labor is more capital-like than a naive application of Chamley-Judd would assume. But that’s not all. What we conventionally call “capital” looks very little like the commodity in the models. In the models, there are no financial assets. Capital is crystallized nonconsumption, a real resource which is automatically deployed into production if it is not consumed.

In reality, people forgo consumption by holding financial claims. There is no clear relationship between financial asset purchases and the organization of useful resources into production. Many financial assets are claims against the state which fund current government spending. Are those expenditures “investment” in the Ramsey sense? Maybe, partially, but not clearly. Financial claims can fund consumer loans. Does financing a vacation contribute to the permanent capital of the nation? Maybe — perhaps vacationers are in fact far-sighted investors, whose labor productivity and future wages will be enhanced by a recreative break. But, maybe not. It is not at all clear. Empirically, the relationship between the outstanding stock of financial claims and anything recognizable as productive capital is very weak. [4] Finance is not an inconsequential veil over real production. It is its own messy thing.

Let’s approach the mess more analytically. In the models, foregone consumption and productive investment are inseparable. In the real world, purchasing a financial asset (or holding money!) does imply that some agent forgoes consumption. But it does not imply that the foregone consumption will be invested. The consumption an agent forgoes may be consumed by others. It may be wasted. Identities like S = I don’t help us, they just insist that we call purchases of financial assets “investment”, and then account for eventually fruitless claims via revaluation. In real life, there are a lot of those revaluations, and no measure of observable capital corresponds with a cumulation of financial savings. So, if we want to take Chamley-Judd reasoning seriously, we oughtn’t set tax rates capital gains, dividends, or interest to zero. Instead, we should ensure that real investment activity by firms is tax advantaged. There is no Chamley-Judd case for not taxing the interest on consumer loans or government bonds that finance transfers. There may be a case for policies like accelerated depreciation of fixed capital or even tax credits for education expenses. [5] But given the weak relationship between financial assets and real investment, eliminating conventional “capital taxes” just subsidizes the products of the financial sector. It offers a windfall to financiers and their best customers, but creates no foreseeable “piece of a bigger-pie” benefit for the people to whom the tax burden is shifted.

One final point: The force that drives the Chamley-Judd conclusion is the long-term elasticity of capital provision to interest rates. The intuition is that capitalists make a decision about whether to forego consumption and contribute to growth or whether to consume today based on a comparison between available returns and their time preference. Lower capital taxes keep returns higher and make contributing capital “worth the wait” over a longer arc of the production function, leading to a higher steady state.

Unfortunately, this sort of calculation does not seem to describe economy-wide savings behavior very well. Aggregate purchases of financial assets seem to be insensitive to returns. In the US, yields on debt, risk-free, corporate, and individual, have been falling since the 1980s, while the stock of financial assets held by households (as a share of GDP) has grown inexorably. (Total equity returns were high only in the 1990s; financial holdings grew about as fast during the low-debt-yield, low-return pre-crisis 2000s as they did in the 1990s, see the graph below.) Unless you posit a peculiarly declining time preference, the core implication about aggregate savings behavior in any Ramsey model seems quite false. We need other stories. I have some! Perhaps consumption is approximately satiable, and the fraction of income saved is just a residual, the difference between income and the satiation level. Perhaps wealthier households save, not to endow future consumption, but because they are in a competitive race with other households for insurance or status that derive from financial holdings. Perhaps for the US, aggregate saving is largely a residual of other countries’ return-insensitive economic policy (Asian mercantilism, petrodollar recycling, etc.). In any of these cases, we’d expect gross financial saving not to be especially sensitive to investment returns. Now human capital formation may be less wage-sensitive than we’d guess too. Maybe we become brilliant more because of expectations and support provided by the people and institutions that surround us than because of the extra money we anticipate. But all these uncertainties undermine the Ramsey/Chamley/Judd edifice, rather than suggesting a zero capital tax.

There are lots of more narrow rebuttals of Chamley-Judd. Jones links Matt Yglesias and Piketty and Saez on the ways the tax result changes if you replace infinite-lived consumers with overlapping generations of people who die. The Chamley-Judd result goes away when labor markets are imperfectly competitive, when economic outcomes are uncertain, when savings are sufficiently return inelastic. Also, see Andrew Abel. To dismiss these critiques as “exotic” is to dismiss reality as exotic, and to rely without evidence on an extreme simplification of the world.

But more fundamentally, what we mean in life and politics by “capital” and “labor” are simply not the phenomena that Chamley or Judd (or Ramsey) model. It is wonderful for Jones to remind his students that, especially in a context of full employment, “capital helps workers”. Stories of what a worker can accomplish with a bulldozer versus a shovel are important and on-point. Students should inquire into the process by which in some times and places construction workers get bulldozers and live well, while in other times and places they work much harder with shovels yet barely subsist.

But Chamley-Judd tells us very little about the tax rate appropriate to income from dividends, interest, or “capital gains” in the real world. How and whether an incremental purchase of financial claims contributes to growth or helps workers is a complicated question, one that a Ramsey model can’t resolve. Models that are more realistic about finance, whether Keynesian or monetarist, predict states of the world where financial capital formation is harmful to real economic performance. To the degree that human and institutional capital grow with use rather than disuse, shifting the burden of taxation from financial claims to labor may be harmful over a very long-term. In the asymptotic steady state, who knows? We have as much reason to believe that you will like strawberries as we have to believe that the capital gains tax should be zero.


[1] You’ve got to love Robert Solow on this:

[I]t could also be true that the bow to the Ramsey model is like wearing the school colors or singing the Notre Dame fight song: a harmless way of providing some apparent intellectual unity, and maybe even a minimal commonality of approach [to macroeconomics]. That seems hardly worthy of grown-ups, especially because there is always a danger that some of the in-group come to believe the slogans, and it distorts their work.

[2] Please correct me if this is mistaken; it’s what I observe in simple simulations [pdf, mathematica] similar in spirit to those published by Jones. It’d take a lot more work than I’m prepared (or able) to do to demonstrate this result under the abstract frameworks of the original papers.

[3] It was Garret Jones himself who offered the single most insightful economics tweet of all time, on precisely this topic:

Workers mostly build organizational capital, not final output. This explains high productivity per ‘worker’ during recessions.

[4] Within the sphere of financial claims, the relationship is sometimes stronger: there may be a relationship between, say, the aggregate balance sheet size of the telecoms industry and fixed investment in telecoms. But the aggregate quantity of financial claims as a whole (restricted to those held by households to avoid double-counting of “pass-through” holdings) has no stable relationship to the quantity of measurable investment in the economy:

TFAABSHNO → “Total Financial Assets – Assets – Balance Sheet of Households and Nonprofit Organizations”, “FPI” → Fixed Private Investment; I should probably have included gross foreign holdings in the financial assets measure, but the series I’d need, though available in the flow of funds, seems not to be published on FRED. (It’d be Table L.106, “Rest of the World”, “Total financial assets”, Line 1 if anyone is more motivated than I am to find the full series and add it to household financial assets.)

[5] Interestingly, Andrew Abel points out that, under conventional Chamley-Judd assumptions, not worrying at all about human capital or the imperfections of finance, optimal tax policy may be to tax only capital, but to permit the ultimate in accelerated depreciation, immediate expensing of capital goods.

Update History:

  • 8-Apr-2012, 4:50 a.m. PST: minor grammar fixes, missing the word “a”, missing a comma: “characterized by a permanent two-factor, constant-returns-to-scale production function”; “Factor one, which we’ll call K, must be different”
  • 10-Apr-2012, 11:50 p.m. PST: Fixed misspelling of “Garret Garett Jones”. (Many thanks to Douglas Edwards for pointing out the error.)

Policy wonks, pitchforks, and the contradictions of capitalism

Yves Smith has asked, not entirely gently, that I reconcile differences in my outrage towards health-care chicanery and what she perceives as “a clever defense of abuses by the powerful” in the sphere of finance. This post is a second response; the first is here. In a nutshell, Smith wonders, why so much outrage for rapacious hospitals when I give a pass to rapacious banks?

The premise of the question is mistaken. I’ve been writing interfluidity for about seven years, and precisely one post has been specifically devoted to health care. Mostly I’ve blogged about finance. Many, many of my posts about finance express outrage toward self-dealing and rapacity in finance, including both private sector banks and their public sector enablers. I’ve not been as prodigious or relentless a critic as Smith. No one on the planet has, and I mean that as a completely unalloyed compliment. But I can’t cop to the crime of giving finance a pass, and I don’t think any fair reader of this blog could characterize me as doing so. I hope that readers who wish to play judge and jury will read the posts that angered Smith, and check out many other posts as well. If you think my posts on opacity somehow mark a change in my politics or my views on finance, you are wrong.

But there is a different sort of inconsistency that I think Smith has correctly honed in on by juxtaposing the health care and the opacity pieces. Let’s consider the health care paragraph she excerpted:

As soon as you delve into the policy wonkery in cases like this, you are submitting to a conspiracy by the powerful against the many. The greater the sphere of disagreeable things that are “complicated”, the more it is possible to construct intricate and inscrutable bureaucracies to “arbitrate”. There will be think-tanks and policy papers, funded by people who are well-meaning (in a narrow, idiotically un-self-aware way) but very rich and powerful. The conclusions of which will be earnest and carefully researched but confined to a window not very upsetting to the very rich and powerful. Undoing the ability of plutocrat hospital “CEOs”, or bankers or lobbyists or whatever, to continue the sort of ass-rape to which their lifestyles have grown accustomed will not be on the table. A good society depends on an active public, first and foremost. A society that has allowed the predations of the powerful to become purely private matters mediated via “markets”, courts, academies, and bureaucracies, that has delegated “activism” to a mostly protected professional class, is nothing more than a herd hoping that today it is somebody else who will be slaughtered.

The majority of this blog could be characterized as “policy wonkery”. interfluidity is constantly, in my own words, “submitting to a conspiracy by the powerful against the many” by speaking the language of the wonk, using modes of argument and accepting norms of evidence set by “academies and bureaucrats” who are, per my own analysis, ultimately bought and paid-for. [*] The opacity thesis is, from a moralist’s perspective, perhaps the very worst genre of policy wonkery — the argument that suggests what normal people consider virtue is wrong for clever, counterintuitive reasons. There is an inconsistency between claiming that “[o]utrage and shame are primary” and arguing that “[s]ocieties that lack opaque, faintly fraudulent, financial systems fail to develop and prosper“.

I don’t have a good answer, except to say that the true art of politics lies in reconciling this sort of contradiction. It’s a dilemma I’ve considered at some length. A society governed by technocrats, which chooses what seems “optimal” according to some expert’s criteria without regard to morality, will not (and ought not) survive. Human beings are moral animals. Institutions cannot thrive without being supported and rationalized by a widely-shared ideology. On the other hand, simply following intuitions about morality can lead to technocratically untenable choices. A society that eschews violence might be well and good, until a neighboring tribe makes a different choice. A successful society must find an intersection, some set of institutions that are both technocratically effective and reinforced by a moral ideology. My opacity thesis claims we face a mismatch, which in the past we resolved by devaluing transparency and tolerating a degree of misbehavior in the shadows. I don’t say we should go back to that. But I do argue that it was an arrangement which, however distasteful, served important functions. My own attitude towards finance is the same outrage I bring to health care. I believe we ought to restructure finance into something we can live with morally. I oppose the technocratic impulse to sweep sinning under a rug while doubling down on ever-less-plausible “regulatory” palliations of predation.

But I think finance will prove a harder sphere to bring into line with moral ideas even than health care. “Opacity” is just the tip of the iceberg. The financial sector is where the growing social and economic contradictions of our society go to get papered over. How can we reconcile increasing polarization in wealth and income with our pretensions of being a middle-class society? We’ll invent a special purpose vehicle, stoke a bubble, make it work somehow. If, er, ownership of the means of production, including market-value-weighted labor power, is increasingly concentrated, how can we maintain demand without redistribution? We can lend, even though many of the people without purchasing power now are unlikely to earn a lot later.

We rely upon the financial sector to tell us sweet lies. We impose starkly contradictory requirements on financiers (“lend prudently!”, “support the economy!”), pay them incredible amounts of money when they somehow make it work, and are shocked, shocked that they evolve elaborate schemes to fudge things. I am not excusing anything. We gladly put drug kingpins into jail, even though we understand that high consumer demand plus aggressive criminalization makes the emergence of kingpins inevitable. While we have this cesspool, we’ll need to aggressively police it. But we won’t find our way to a “clean” financial sector until we resolve the contradictions that render dissembling essential to our social peace and economic development.


[*] On “norms of evidence”, Smith and other commenters have me dead to rights. I offered a very sweeping thesis that is internally consistent and that comports with my understanding of finance and history. That is weak evidentiary tea. I ought not to have written, in the second post of the series,

We must give the devil her due. It pissed a lot of readers off and pisses me off too, but the argument I offered in the previous post is true.
I have no right or ability to adjudicate the history of the world.

Opaque finance, again, and solutions

There a few people whose work I more respect than Yves Smith at Naked Capitalism. She is a tireless researcher, remarkably immune to the bleary-eyed depression I experience when digging through the obfuscatory minutia of financial industry predation. I have and will continue to hold Smith in very high regard, whatever her regard for me.

However, in a recent post, I think I have been treated unfairly. I think no fair reading of my financial opacity piece, alone or with its two followups, could characterize my position as “extoll[ing] deception and theft”. The first piece is not satirical, in the sense of advancing a position which its author does not hold. But it is hyperbolic and sardonic, in the sense of laughing into ones execution. I think it is true that the business of banking, in order to effectively perform its social function of mobilizing resources at scale, necessarily involves a degree of deception. It must work to persuade a variety of stakeholders that their claims are very close to risk-free when in fact they cannot all be. That a degree of deception, or at least obfuscation, is inherent to banking does not justify all possible misbehavior. If you must lie for some greater good, you are especially bound to put the proceeds of the lie towards the greater good, and not just run off with the cash. Nothing justifies the sort of looting to which no one has called attention more assiduously than Smith. However, the opacity built into the very structure of modern banking systems, irreducibly if they are to perform the work we now delegate to them, renders it nearly impossible to prevent the pillage. Far from hagiography, in my mind this thesis is bitter eulogy for the hope that a banking system like ours can be “reformed”. I think that we need to find other, very different, means of performing the functions that status quo banks currently perform, so that we can encourage the institutions that currently dominate to wither into obscurity. I know this is a tall order.

That existing institutions are difficult to police doesn’t mean that we shouldn’t do our best while we are stuck with them. It certainly doesn’t mean that when we discover violations of the rules we impose to manage this conundrum, the violators shouldn’t be held accountable. On the contrary, ordinary principles of deterrence suggest that difficult-to-uncover crimes should be punished much more harshly than crimes for which detection is likely. I have never advocated any lenience. I think we should expose and punish relentlessly. But I don’t think we’ll get very far, because bankers will respond with capital strikes, motivated both by both cynical politics and genuine fear. Without alternatives, we will find ourselves unable to tolerate credit slowdowns, and we’ll end up with politicians who help engineer cover-ups. Over the short term, we are addicted to bubbles and bezzles. Over the long term, opaque finance makes important contributions to economic development. We need new institutions that replace existing banks, or we will lack leverage to effectively police the old ones.

This is a judgment call about which reasonable people can disagree. Smith thinks that finance prior to the 1980s worked well, and represents a model to which we can return. Carolyn Sissoko, who knows more about the history of banking than I ever will, thinks eliminating limited liability for banks will resolve the problem. I enthusiastically support that reform, but believe it would leave us in a painful state of macroeconomic withdrawal absent other changes. I think we are in a bind.

Since my opacity posts, I have been thinking more macroeconomically, and trying to come up with solutions. I do have some ideas. I think we should we rely less on personal savings and more on a basic income for insurance by ordinary households against economic risk. I think “risk-free” savings should be placed directly with the state, rather than via the Rube Goldberg machine of bank deposits and a state guarantee. Quantities of truly risk-free savings should be carefully rationed. Beyond that ration, systemic risk should be borne by savers via toleration of inflation. I think we should regulate aggregate demand (in practice, probably target NGDP) by modulating the flow of transfers to the public (“quantitative easing for the people“, “monetary policy for the 21st Century“, “helicopter drops“), and emphatically not by adjusting the price or regulatory scrutiny of bank credit. To replace the role of banks in ensuring sufficient availability of investment capital, the state should subsidize investment by riding along, directly and explicitly, with very simply constituted private investment funds that meet certain criteria. (The state would do so as a senior creditors or via some form of matching equity. However, we will have to be wary of letting more explicit state involvement politicize the investment process. A legal, commercially-viable abortion clinic or gun range should have the same access to government supported, privately allocated credit as a flower shop. The criteria for government co-investment should be as mechanical as possible to prevent quid-pro-quos where politicians exchange investment subsidies for promises of having favored projects funded.)

I don’t know whether any of this will ever become politically possible. In the meantime we are stuck with a system that has “criminogenic” built into its very roots. I don’t applaud this; I can barely live with it. But I do think it is a fact. We’ve got to police the system we have with as much muscle and tenacity as we possibly can. No one contributes to that more than Yves Smith does, and for that I thank her very much.


Note: In her post, Smith asked me to comment about differences in my treatment of health care and finance. I think there’s something interesting to talk about there. That will be a second post.

If you do want to evaluate my opacity theory, I ask that you include the third piece of the series in your reading list, which is written with more care and gentler rhetoric than the first two. The first two posts probably were too belligerently written. Still, this series really did feel like violating a taboo.

Hidden profits, hidden rents

Evan Soltas has a very good post on the explosive growth of the financial industry since the end of World War II. As a share of GDP, in terms of profits, and in terms of payroll, postwar America has been truly been a golden age for bankers, brokers, and fund managers.

In fact, it’s even better than it looks!

Soltas begins with a graph:

The graph above shows that the financial industry now makes roughly half of all nonfarm corporate profits in the U.S., a share which has risen five-fold since the end of World War II.

“Profit” is always something of a sticky subject. We talk about it all the time, like we have any idea what it means. Usually we don’t. There is, for example, the distinction between “accounting profit” and “economic profit”. Accounting profit is what a firm, under generally accepted accounting principles, can claim to be the earnings that accrue to shareholders. Economic profit is revenue that exceeds the true cost, defined as the value of the next-best opportunity, of all inputs. According to theory, in a competitive market, economic profits should be relentlessly pushed toward zero while accounting profits should stay positive but very near the broad market return on capital placed at comparable risk.

In general, only accounting profit is measured while only economic profit is interesting. When we think of economic profit, we need not restrict ourselves to shareholders, who represent just one class of claimants on an enterprise. Suppose there is an industry whose firms about break even in accounting terms, but whose unionized workers, even those without hard-to-find skills, capture salaries much larger than they likely would outside of the industry. Is the industry “profitable”?

In an economic sense, it is very profitable. It generates sales that far exceed the opportunity cost of its inputs. But for institutional reasons, those profits are captured by workers rather than accruing to equityholders, and so are missed by accounting measures. It’s pretty clear that, in its heyday, the US auto industry was like this. The industry generated a great deal more “value” than was captured by its shareholders. The internal negotiations between firm stakeholders over the distribution of economic profit has no bearing on the existence of that profit.

The financial industry is not heavily unionized, but the lack of a union doesn’t mean the struggle over the distribution of economic profit goes away, with shareholders automatically winning. In many industries, economic profit is far higher than accounting profit, with the difference captured by various sorts of insiders. And there is no industry in which the distribution of economic profit to employees is more institutionalized than in finance, where at large banks roughly half of firm revenue get distributed to employees, largely in the form of bonuses. Now, one can argue that the form in which compensation contracts are negotiated says little about whether the level of that compensation exceeds the opportunity cost of the work to recipients. Perhaps bank employees earn higher salaries on average than they could elsewhere as compensation for the bearing much of the risk of firm performance by accepting low base salaries and uncertain bonuses. But.

Economic profit creates an incentive for new entrants. Indeed, given how difficult it often is to measure the true cost of inputs, the best way to observe economic profit is to look for people banging at the door. And people do seem to be banging on the door in finance. Famously large fractions of Ivy league graduates — who can do anything, for whom “the world is their oyster” — end up taking finance jobs, despite very often having no specialized training in the field. I hope it will be uncontroversial to suggest that finance jobs are coveted. Those low base salaries delivered with a variable upside are, it turns out, not so low when compared with salaries in other industries. It is true that much of the “economic profit” earned by bank employees is delivered as a claim on a high-mean-value probability distribution rather than as a certain paycheck. But the opportunity cost of the input is mostly covered by the base. [1]

To the degree that financial firms’ economic profit is unusually captured by employees rather than shareholders, accounting-based estimates of finance’s profit share, like the one that Soltas presents above, will badly underestimate the share of economic profit captured by finance industry stakeholders as a whole. [2]

That an industry captures a lot of economic profit need not be a bad thing. After all, economic profit represents “value added”, the degree to which outputs are worth much more to people than inputs. However, we often divide economic profit into two components, the usually-transient good kind that results from innovations which leave firms a step ahead of their competition, and bad “rents” that result from capturing subsidies and/or restricting competition. To be fair, most successful firms get some of their economic profit both ways. But you’d need a great deal of faith in empirically invisible new value to explain the persistent and growing profit captured by finance, if its source isn’t predominantly rents. And, indeed, Soltas enumerates some of those:

Let’s run though the explicit subsidies: the mortgage-interest deduction and other homebuyer credits, student loan aid, federal guarantees on debt, the preferential tax rates on capital gains and dividends, interest on reserves at the Fed, and the FDIC guarantee. The financial industry also benefits from substantial implicit regulatory subsidies such as “too-big-too-fail.”

That’s a very good list. I’d add one more: the Federal Reserve’s policy of stabilizing the purchasing power of currency. Though stock markets and fancy derivatives get lots of press, most of the abnormal profits in finance are, I think, earned in debt markets. Financial firms borrow money and lend money. They underwrite debt issued by others and structure that borrow and lend. Financial rents seem related to scale and concentration. Debt-based financial intermediation is amenable to economies of scale in ways that equity-based funding is not. Rating agencies can get away with classifying debt products like beef, USDA Triple-A, and trillions of investment dollars flow accordingly. Investors are more idiosyncratic and more cautious with equities. “Too big to fail” is primarily a quality of credit markets — no one thinks that any bank is too big to suffer a stock-price decline. When financial firms extract rents via explicit government support, it is usually in order to ensure that bank creditors are made whole.

But debt finance exists in competition with equity finance. If I’m right that debt finance is a more fertile source of industry rents than equity, then ways that the state tilts the scale towards debt funding are part of the problem. Along with Felix Salmon, James Surowiecki, and many others, I’ve argued against the bias towards debt embedded in the tax system. But stabilizing prices also increases the relative attractiveness of debt. Absent price-level stabilization, the business cycle risk borne by diversified equity investors is somewhat counterbalanced by reduced risk from inflation, as price increases pass through to earnings and dividends over the medium term. If recessions tended to be inflationary, as they would for example under an NGDP target, this pass-through would amount to a very desirable countercyclical feature. Debt, on the other hand, would lose value in real terms during inflationary recessions. (For lower quality debt this loss would be partially offset by reduced risk of default.) The current practice of targeting inflation makes default-risk-free debt a nearly no-lose proposition regardless of macroeconomic performance, while accentuating the exposure of equities to business cycle risk.

There are lots of good reasons to reduce our dependence on the institution of debt in favor of more equity-like arrangements. Evolving towards a smaller financial industry less capable of capturing rents is another reason. Using the power of the state to stabilize the inflation rate is a bad idea, also for lots of reasons, including that the practice encourages debt finance and powerful banks.


[1] Even to the degree that supernormal paychecks are compensation for risk-bearing, part of the compensation should be recategorized as a return on shadow equity, rather than as a cost of labor input. One can decompose a bankers’ variable compensation into a cash payment plus funds that might have been paid but are instead invested on the employee’s behalf into the firm or a subdivision thereof. Much of bankers’ bonuses, the part that is compensation for bearing firm risk rather than paying for labor, should be viewed as a return on shadow equity that doesn’t show up in the formal equity accounts. When banks recruit employees to finance the firm with deferred compensation and then pay a performance-based return on that advance, it is quite similar to issuing new shares or outcome-contingent securities. The return eventually paid on those securities in excess of the original amount deferred ought to be considered distributed profit rather than labor compensation.

To highlight the murkiness of the dividing line between compensation and profit, consider two employees. One employee is paid at the beginning of the year in the form of firm stock, which will not “vest” (be made available) until the end of the year. The other is paid 20% less, but gets conventional cash payments and will receive an end-of-year bonus based on firm performance. Suppose the firm’s stock rises by 10% over the year, and our cash-paid employee receives a bonus worth 40% of her base salary. If you do the math, you’ll find that the cost to the firm of the two employees is almost the same. Both employees bore similar (although not identical) risk. Yet on the books, the first employee’s compensation will be smaller than that of the second employee, with the difference reflected in the earnings of the firm. Rewriting the first employees explicitly equity-based contract into a reduced-compensation-plus-bonus contract changes little of substance, but reduces the firm’s accounting profit (and tax basis!). Since compensation-plus-bonus is common in financial firms, reported profits are low relative to an world in which the variable basis for the compensation was recorded as equity. Yet recording the compensation as equity more accurately captures the division between compensation for labor and the compensation for risk-bearing that defines accounting profit.

Note that this analysis is unchanged if the motivation for the variable payment is to encourage performance, and is based on outcomes close to the employee, rather than firm-level performance. The employee is then compensated in equity in smaller, riskier subdivisions of the firm (and might require a higher salary “in stock” to compensate), but that does not alter the opportunity cost of her own employment or the fact that proceeds from good outcomes represent economic profit.

[2] Finance is unusual but not unique — see also health care, education, and government, together the “information asymmetry industry“.

Shame.

So, of course you should go read Steven Brill’s excellent article on health care price gouging. Or maybe you shouldn’t. It’s very long. Not everybody has to be a fucking policy intellectual, or even au courant in the “public affairs” covered by Time. You don’t have to read much (or, God forbid, write) about policy to be a good person and a good citizen.

But citizenship does carry burdens. Like this:

By the time Steven D. died at his home in Northern California the following November, he had lived for an additional 11 months. And Alice had collected bills totaling $902,452. The family’s first bill — for $348,000 — which arrived when Steven got home from the Seton Medical Center in Daly City, Calif., was full of all the usual chargemaster profit grabs: $18 each for 88 diabetes-test strips that Amazon sells in boxes of 50 for $27.85; $24 each for 19 niacin pills that are sold in drugstores for about a nickel apiece. There were also four boxes of sterile gauze pads for $77 each. None of that was considered part of what was provided in return for Seton’s facility charge for the intensive-care unit for two days at $13,225 a day, 12 days in the critical unit at $7,315 a day and one day in a standard room (all of which totaled $120,116 over 15 days). There was also $20,886 for CT scans and $24,251 for lab work.

Does Alice have neighbors? Does she have friends? Where were they, what did they — and by that I mean we in some earnest and patronizing way — do about this?

The burden of citizenship is to share in, and hold people to account for, the injustices experienced by our neighbors. Alice was fucking ripped off to the tune of any semblance of economic and financial security she might ever have had at the very moment that her husband was dying of cancer. This is beyond awful. This is mortal sin in any religion worth the name. This is pure evil.

Our problem is not a matter of shitty policy arrangements. We have plenty of those. Whatever. Policy is a third-order pile of bullshit. Our problem is that it is a sick excuse for a society when this sort of ass-rape is relegated by custom and practice into the sphere of the “private”, the sort of bureaucratic struggle one quietly hires professionals to deal with and hides as much as possible from friends and coworkers. Ass-rape of the more literal sort is also a private affair, in the first order. We insist upon it being public, because a society whose customs tolerated the maintenance of its first-order privacy would be a miserable, detestable place in which the powerful quietly ass-raped the powerless and were never held to account. The difference between literal ass-rape and what happened to Alice and Steven D. is not that ass-rape is criminal while health-care price-gouging, although regrettable, is not. To say that is to confuse cause for effect. Literal ass-rape is criminal because we-the-people as a broad-based mass are disgusted by it and insist upon it being a public and criminal matter rather than a quiet tragedy and struggle. When we hear about a Joe Paterno who overlooks this requirement, we literally hound the motherfucker to death. Perhaps unfairly, in any particular case — pitchforks are simultaneously sharp and blunt instruments! The sheer fear of which is why the powerful create laws. But where laws aren’t there, the pitchforks must always be. A society that expects laws to substitute for, rather than channel, public outrage, is a society not long for this world in any form worthy of the name. Outrage and shame are primary.

As soon as you delve into the policy wonkery in cases like this, you are submitting to a conspiracy by the powerful against the many. The greater the sphere of disagreeable things that are “complicated”, the more it is possible to construct intricate and inscrutable bureaucracies to “arbitrate”. There will be think-tanks and policy papers, funded by people who are well-meaning (in a narrow, idiotically un-self-aware way) but very rich and powerful. The conclusions of which will be earnest and carefully researched but confined to a window not very upsetting to the very rich and powerful. Undoing the ability of plutocrat hospital “CEOs”, or bankers or lobbyists or whatever, to continue the sort of ass-rape to which their lifestyles have grown accustomed will not be on the table. A good society depends on an active public, first and foremost. A society that has allowed the predations of the powerful to become purely private matters mediated via “markets”, courts, academies, and bureaucracies, that has delegated “activism” to a mostly protected professional class, is nothing more than a herd hoping that today it is somebody else who will be slaughtered.

Is that who we are?

Update History:

  • 22-Feb-2012, 8:50 p.m. PST: “economical economic“; “while although regrettable”; “its it being”; “that laws will to substitute”

Persnickety followups on inequality and demand

Teaser: The following graphs are from “Inequality and Household Finance During the Consumer Age“, by Barry Cynamon and Steven Fazzari. “Demand rates” are expressed as fractions of “spendable income”. There’s more on this paper at the end of the post.


I am always outclassed by my correspondents and commenters. The previous post on inequality and demand was no exception. I want to follow up on a few scattered bits of that conversation. I apologize as always for all the great writing, in comment threads and in e-mails, that I fail to respond to.

First, I want to make a methodological point. Several commenters (e.g. beowulf, JKH, Mark Sadowski) point to discrepencies between measures of income and saving used by various empirical studies and those used in national accounting statements (e.g. NIPA). In particular, there is the question of whether unspent capital gains (realized or unrealized) should count as saving. NIPA accounts quite properly do not treat capital gains as income.

But what is proper in one context is not proper in another. NIPA accounts attempt to characterize the production, consumption, and investment of real resources in the consolidated aggregate economy. A capital gain represents a revaluation of an existing resource, not a new resource, and so properly should not be treated as income.

However, when we are studying distribution, what we are after is the relative capacity of different groups to command use of production. We must divide the economy into subgroups of some sort, and analyze interrelated dynamics of those subgroups’ accounts. Capital gains don’t represent changes in aggregate production, but they do shift the relative ability of different groups to appropriate that output when they wish to. When studying the aggregate economy, capital gains should be ignored or netted-out. But when studying distribution — “who owns what” — capital gains, as well as the dissaving or borrowing that funds those gains, are a critical part of the story. Research on how the distribution of household income affects consumption absolutely should include capital gains. There are details we can argue over. Unencumbered, realized capital gains should qualify almost certainly as income. Gains from favorable appraisal of an illiquid asset probably should not. Unrealized gains from liquid or hypothecable assets (stocks, real estate) are shades of gray. There is nothing usual about shades of gray. All spheres of accounting require estimation and judgment calls. Business accountants learn very quickly that simple ideas like “revenue” and “earnings” are impossible to pin down in a universally satisfactory way.

Similar issues arise in interpreting the excellent work of J.W. Mason and Arjun Jayadev on household debt dynamics, to which Mark Sadowski points in the comments. Mason and Jayadev decompose the evolution of the United States’ household sector’s debt-to-income ratio, breaking down changes into combinations of new borrowing and interest obligations (which increase debt-to-income) plus inflation and income growth (which decrease debt-to-income). It’s a wonderful, fascinating paper. If you’ve not done so already, I strongly recommend that you give it a read. It’s accessible; much of the tale is told in graphs. (A summary is available at Rortybomb, but you want to study especially Figure 7 of the original paper.)

One of Mason and Jayadev’s most interesting discoveries is that the period since the 1980s has been an “Era of Adverse Debt Dynamics”, a time during which household debt-to-income increased because of reductions in inflation, low income growth and a high effective interest rate on outstanding debt. [1] For most of the period from 1980 to 2000, the aggregate US household sector was not taking on new debt. Household sector debt-to-income deteriorated despite net paydown of imputed principal, because of adverse debt dynamics.

So, can a theory that claims borrowing by lower-income households supported demand over the same period possibly be right? Yes, it can. At any given time, some groups of people are repaying debt and others are taking it on. If, say, high income boomers are paying off their mortgages faster than low-income renters are borrowing to consume, new borrowing in aggregate will be negative even while new borrowing by poorer groups supports demand. (Remember how back at the turn of the millennium we were marveling over the “democratization of credit“?)

As always, when studying distributional questions, aggregate data is of limited use. That’s not to say that there is no information in aggregate data. It’s definitely more comfortable to tell the borrowed demand story about the 2000s, when, Mason and Jayadev show us, aggregated households were dramatically expanding their borrowing. But what we really want is research that disentagles the behavior of wealthy and nonwealthy households.

A working paper by Barry Cynamon and Steven Fazzari does just that. It tells a story quite similar to my take in the previous post, but backs that up with disaggregated data. The three graphs at the top of this post summarize the evidence, but of course you should read the whole thing. There is stuff to quibble over. But the paper is an excellent start.

I’ll end all this with an excerpt from the Cynamon and Fazzari paper that I think is very right. It addresses the question of why individuals would undermine their own solvency in ways that sustain aggregate spending:

It is difficult for standard models, most notably the life cycle model, to account for the long decline in the saving rate starting in the early 1980s. A multitude of economists propose explanations including wealth effects, permanent income hypothesis (high expected income) effect, and demographics, but along with many researchers we find those explanations unsatisfying. We argue that the decline in the saving rate can best be understood by recognizing the important role of uncertainty in household decision making and the powerful influence of the reference groups that to which those household decision makers turn for guidance. We propose that households develop an identity over time that helps them make consumption decisions by informing them about the consumption bundle that is normal.9 We define the consumption norm as the standard of consumption an individual considers normal based on his or her identity (Cynamon and Fazzari, 2008, 2012a). The household decision makers weigh two questions most heavily in making consumption and financial decisions. First, they ask “Is this something a person like me would own (durable good), consume (nondurable good), or hold (asset)?” Second, they ask “If I attempt to purchase this good or asset right now, do I have the means necessary to complete the transaction?” Increasing access to credit impacts consumption decisions by increasing the rate of positive responses to the second question directly, and also by increasing the rate of positive responses to the first question indirectly as greater access to credit among households in one’s reference group raises the consumption norm of the group. Rising income inequality also tends to exert upward pressure on consumption norms as each person is more likely to see aspects of costlier lifestyles displayed by others with more money.

People will put up with almost anything to live the sort of life their coworkers and friends, parents and children, consider “normal”. Over the last 40 years, for very many Americans, normal has grown increasingly unaffordable. And that created fantastic opportunities in finance.


[1] Mark Sadowski suggests that the stubbornly high effective interest rates reported by Mason and Jayadev are inconsistent with a claim that the secular decline in interest rates was used to goose demand. But that’s not quite right — it amounts to a confusion of average and marginal rates. At any given moment, most household sector debt was contracted some time ago. The effective interest rate faced by the household sector is an average of rates on all debt outstanding, and so lags headline “spot” interest rates. But incentives to borrow are shaped by interest rates currently available rather than rates on debt already contracted. Falling interest rates can increase individual households’ willingness to borrow much more quickly than they alter the aggregated sector’s effective rate.

In my first encounter with the Mason and Jayadev paper, I thought I saw in the stubbornly high effective rates evidence of a rotation from more-creditworthy to less creditworthy borrowers. (See comments here.) I’ve looked into that a bit more, and the evidence is not compelling: the stubbornly slow decline in household sector interest rates pretty closely mirrors the slow decline in the effective interest rate of the credit-risk-free Federal government. There’s a hint of spread expansion in the late 1990s, but nothing to persuade a skeptic.

Inequality and demand

I’d rather interfluidity take a break from haranguing Paul Krugman. But I think that the relationship between distribution and demand is a very big deal. I’ve just gotta weigh in.

Here’s Krugman:

Joe [Stiglitz] offers a version of the the “underconsumption” hypothesis, basically that the rich spend too little of their income. This hypothesis has a long history — but it also has well-known theoretical and empirical problems.

It’s true that at any given point in time the rich have much higher savings rates than the poor. Since Milton Friedman, however, we’ve know that this fact is to an important degree a sort of statistical illusion. Consumer spending tends to reflect expected income over an extended period. If you take a sample of people with high incomes, you will disproportionally include people who are having an especially good year, and will therefore be saving a lot; correspondingly, a sample of people with low incomes will include many having a particularly bad year, and hence living off savings. So the cross-sectional evidence on saving doesn’t tell you that a sustained higher concentration of incomes at the top will lead to higher savings; it really tells you nothing at all about what will happen.

So you turn to the data. We all know that personal saving dropped as inequality rose; but maybe the rich were in effect having corporations save on their behalf. So look at overall private saving as a share of GDP:

The trend before the crisis was down, not up — and that surge with the crisis clearly wasn’t driven by a surge in inequality.

So am I saying that you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs? Well, yes.

Let’s start with the obvious. The claim that income inequality unconditionally leads to underconsumption is untrue. In the US we’ve seen inequality accelerate since the 1980s, and until 2007 we had robust demand, decent growth, and as Krugman points out, no evidence of oversaving in aggregate. Au contraire, even.

And Krugman is correct to point out that simple cross-sectional studies of saving behavior are insufficient to resolve the question.

But that’s why we have social scientists! Unsurprisingly, more sophisticated reviews have been done. See, for example, “Why do the rich save so much?” by Christopher Carroll (ht rsj, Eric Schoenberg) and “Do the Rich Save More?”, by Karen Dynan, Jonathan Skinner, and Stephen Zeldes. These studies agree that the rich do in fact save more, and that they do so in ways that cannot be explained by any version of the permanent income hypothesis. Further, these studies probably understate the differences in savings behavior, because the “rich” they study tend to be members of the top quintile, rather than the top 1% that now accounts for a steeply increasing share of national income.

So how do we reconcile the high savings rates of the rich with the US experience of both rising inequality and strong demand over the “Great Moderation”? If, ceteris paribus, increasing inequality imposes a drag on demand, but demand remained strong, ceteris must not have been paribus.

I would pair Krugman’s chart with the following graph, which shows household borrowing as a fraction of GDP:


includes both consumer and mortgage debt, see “credit market instruments” in Table L.100 of the Fed’s Flow of Funds release

Household borrowing represents, in a very direct sense, a redistribution of purchasing power from savers to borrowers. [1] So if we worry that oversaving by the rich may lead to an insufficiency of purchases, household borrowing is a natural place to look for a remedy. Sure enough, we find that beginning in the early 1980s, household borrowing began a secular rise that continued until the financial crisis.

And this arrangement worked! Over the whole “Great Moderation“, inequality expanded while the economy grew and demand remained strong.

Rather than arguing over the (clearly false) claim that income inequality is always inconsistent with adequate demand, let’s consider the conditions under which inequality is compatible with adequate demand. Are those conditions sustainable? Are they desirable?

Suppose that the mechanism that reconciles inequality and adequate demand is household borrowing. Is that sustainable? After all, poorer households would have to borrow new purchasing power in every period in order to support demand for as long as inequality remains high. That’s jarring.

But quantities matter. Continual borrowing might be sustainable, depending on the amount of new borrowing required, the interest rate on the debt, and the growth rate of borrowers’ incomes. If the interest rate is lower than the growth rate of income to poorer households, then there is room for new borrowing every period while holding debt-to-income ratios constant. Even without much income growth, sufficiently low (and especially negative) interest rates can enable continual new borrowing at constant leverage.

If the drag on demand imposed by inequality is sufficiently modest, it can be papered over indefinitely by borrowing without much difficulty. But as the drag grows large and the quantity of new borrowing required increases, sustaining demand will become difficult for institutional reasons. Economically, there’s nothing wrong with letting real interest rates fall to very sharply negative values, if that’s what would be required to create demand. But that would require central banks to tolerate very high rates of inflation, or schemes to invalidate physical cash. It would piss off savers.

I think the behavior of real interest rates is the empirical fingerprint of the effect of inequality on demand:

Obviously, one can invent any number of explanations for the slow and steady decline in real rates that began with but has outlived the “Great Moderation”. My explanation is that growing inequality required ever greater inducement of ever less solvent households to borrow in order to sustain adequate demand, and central banks delivered. Other stories I’ve encountered don’t strike me as very plausible. Markets would have to be pretty inefficient, or bad news would have had to come in very small drips, if technology or demography is at the root of the decline.

It’s worth noting that these graphs almost certainly understate the decline in interest rates, at least through 2008. Concomitant with the reduction in headline yields, “financial engineering” brought credit spreads down, eventually beneath levels sufficient to cover the cost of defaults. This also helped support demand. John Hempton famously wrote that “banks intermediate the current account deficit.” We very explicitly ask banks to intermediate the deficit in demand, exhorting them to lend lend lend for macroeconomic reasons that are indifferent to microeconomic evaluations of solvency. We can have a banking system that performs the information work of credit analysis and lends appropriately, or we can have a banking system that overcomes deficiencies in demand. We cannot have both when great volumes of lending are continually required for structural reasons.

Paul Krugman argues that “you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs”. What about that? In theory it could happen, but there’s no evidence that it does happen in the real world. As we’ve seen, high income earners do save more than low income earners, and that is not merely an artifact of consumption smoothing.

If the rich did consume in quantities proportionate with their share of income, we would expect the yacht and celebrity chef sectors to become increasingly important components of the national economy. They have not. I’ve squinted pretty hard at the shares of value-added in BEA’s GDP-by-industry accounts, and can’t find any hint of it. I suppose personal trainers and celebrity chefs would fall under “Arts, entertainment, recreation, accommodation, and food services”, a top-level category whose share of GDP did increased by 0.5% between 1990 and 2007. Attributing all of that expansion to the indulgences of the rich, more than 90% of the proportional-consumption expected increase in the top one percent’s consumption remains unaccounted. The share of the “water transportation” sector has not increased. If the rich do consume in proportion to their income, they pretty much consume the same stuff as the rest of us. Which would bring a whole new meaning to the phrase “fat cats”. Categories of output that have notably increased in share of value-added include “professional and business services” and “finance, insurance, real estate, rental, and leasing”. Hmm.

Casual empiricists often point to places like New York City as evidence that rich-people-spending can drive economic demand. Rich Wall-Streeters certainly bluster and whine enough about how their spending supports the local economy. New York is unusually unequal, and it hasn’t especially suffered from an absence of demand. QED, right? Unfortunately, this argument misses something else that’s pretty obvious about New York. It runs a current-account surplus. It is a huge exporter of services to the country and the world. Does New York’s robust aggregate demand come from the personal-training and fancy-restaurant needs of its wealthy upper crust, or from the fact that the rest of the world pays New Yorkers for a lot of the financial services and media they consume? China is very unequal, and rich Chinese have a well-known taste for luxury. But no one imagines that local plutocrats could replace all the world’s Wal-Mart customers and support full employment in the Middle Kingdom. Why is that story any more plausible for New York?

While it’s certainly true that rich people could drive demand by spending money on increasingly marginal goods, the fact of the matter is that they don’t. To explain observed behavior, you need a model where, in Christopher Carroll’s words, “wealth enters consumers’ utility functions directly” such that its “marginal utility decreases more slowly than that of consumption (and hence will be a luxury good relative to consumption)”. It’s not so hard to believe that people like to have money, even much more money than they ever plan to spend on their own consumption or care to pass onto their children. You can explain a preference for wealth in terms of status competition, or in terms of the power over others that wealth confers. I’ve argued that we desire wealth for its insurance value, which is inexhaustible in a world subject to systemic shocks. These motives are not mutually exclusive, and all of them are plausible. Why pick your poison when you can swallow the whole medicine cabinet?

If the world Krugman describes doesn’t exist, we could try to manufacture it. We could tax savings until the marginal utility of extra consumption comes to exceed the after-tax marginal utility of an extra dollar saved. This would shift the behavior of the very wealthy towards demand-supporting expenditures without our having to rely upon a borrowing channel. But politically, enacting such a tax might be as or more difficult than permitting sharply negative interest rates. (A tax on saving rather than income or consumption would be much the same as a negative interest rate.) Moreover, the scheme wouldn’t work if the value wealthy people derive from saving comes from supporting their place in a ranking against other savers (as it would under status-based theories, or in my wealth-as-insurance-against-systemic-risk story). As long as one’s competitors are taxed the same, rescaling the units doesn’t change the game.

So. Inequality is not unconditionally inconsistent with robust demand. But under current institutional arrangements, sustaining demand in the face of inequality requires ongoing borrowing by poorer households. As inequality increases and solvency declines, interest rates must fall or lending standards must be relaxed to engender the requisite borrowing. Eventually this leads to interest rates that are outright negative or else loan defaults and financial turbulence. If we insist on high lending standards and put a floor beneath real interest rates at minus 2%, then growing inequality will indeed result in demand shortfall and stagnation.

Of course, we needn’t hold institutional arrangements constant. If we had any sense at all, we’d relieve our harried bankers (the poor dears!) of contradictory imperatives to both support overall demand and extend credit wisely. We’d regulate aggregate demand by modulating the scale of a outright transfers, and let bankers make their contribution on the supply side, by discriminating between good investment projects and bad when making credit allocation decisions.


[1] Readers might object, reasonably, that since the banking system can create purchasing power ex nihilo, it’s misleading to include the clause “from savers”. But if we posit a regulatory apparatus that prevents the economy from “overheating”, that sets a cap on effective demand in obeisance of some inflation or nominal income target, then the purchasing power made available to borrowers is indirectly transferred from savers. The banking system would not have created new purchasing power for borrowers had savers not saved.

Update History:

  • 24-Jan-2012, 1:00 a.m. PST: Fixed a tense: “would have had to come”
  • 24-Jan-2012, 11:20 p.m. PST: God I need an editor. Not substantive changes (or at least none intended), but I’m trying to clean up a bit of the word salad: “in the world we actually live in in the real world“; “spending drives supports the local economy”; “It is a huge exporter of services to the rest of the country and the world.”;”pays New Yorkers of a wide variety of income levels for much a lot of the financial services, entertainment, and literature and media they consume?”; “Wal-Mart customers to sustain and support full employment”; “which is inexhaustible in a world subject to systemic shocks that people must compete to evade.” Also: Added link to NYO piece around “piss off savers”.