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Tax price, not value

Property rights are primarily rights to exclude. If I “own” something, what that means is that it is legitimate for me to exclude others who may wish to use or consume it.

Exclusion, very obviously, carries externalities. My choice to exclude alternate uses of a resource affects those who might have benefited from those uses. By convention, we don’t usually refer to the effects of the exclusion at the core of a property right as an “externality”. One could argue, as is often argued of so-called “pecuniary externalities“, that the effect of property rights on alternative users is the sort of externality that should not be discouraged — because undoing the externality would amount to a mere redistribution rather than a welfare gain, or because the operation of the externality is part and parcel of the process by which the market system functions. But, as with pecuniary externalities, there are devils in details.

The social cost of the excluding alternative uses varies dramatically between resources. A Ferrari, for example, may be a costly and valuable resource, but it is plausible to claim that its owner’s exclusive control does not subject potential alternative users to real deprivation. On the other hand, the exclusive right to commercialize a potentially lifesaving medicine may impose huge costs on potential users deprived of access because a patent owner has chosen not to make a drug available where they live, or has chosen to set an inaccessible price. The new urbanists (Yglesias / Avent / Glaeser ) frequently argue that homeowners’ ability to exclude alternative uses of their neighborhoods (a kind of tacit property right) imposes very large social and economic costs by preventing higher-density alternative use of uniquely situated real estate.

I presume that most ordinary property rights don’t burden alternative users so much as to merit policy intervention. It is wise to simply tolerate very small externalities and address their consequences collectively, rather than create annoyances and transaction costs by trying to impose fine-grained discipline. We don’t tax humans for eating beans, despite the fact that methane is a powerful greenhouse gas.

But for some classes of property, most notably patents and real estate, a tax on the externalities of exclusion might be very sensible. You can frame it as a Pigouvian tax, or alternatively as a kind of user fee that compensates the state for its enforcement of a right to exclude despite external harms. But on what basis should such a tax be collected?

Usually property or wealth taxes are levied against the “market value” of an asset, with the scare quotes particularly appropriate. When property taxes are assessed against real property, some appraisal or estimation has to be made of what is often an entirely hypothetical value. Assessment procedures are vigorously contested and frequently reflect social and political concerns unrelated to the question of what a property “would” sell for. Patents are extraordinarily specialized and illiquid assets. Any bureaucratic value assessment would be a farce.

There is, of course, a much easier way to gauge what a property would sell for: Solicit from its owner a price.

The price at which an owner would be willing to sell a thing has a particularly valuable characteristic. It limits the burden to alternative users of the exclusion in a property right. If the price is set low, a user harmed by exclusion can simply purchase the thing and have at. If the price is set high, alternative users may be seriously burdened yet be unable to buy access.

So, for the sorts of exclusion that do impose substantial burdens to alternative users, a natural policy intervention would be to require property owners to declare a price at which they commit to sell the property (for some period of time), and levy a tax of some legislatively determined percentage against that actual, actionable price, rather than a hypothetical market value. Property owners could pay as much or as little tax as they choose. When they set their price, they face a trade-off, between the risk of being undercompensated for losing the asset if the price is too low, and an exaggerated tax burden if they set a price so high that the risk of sale is negligible or the required overcompensation extreme. The owner is free to choose how much she values certainty of continued ownership, but she must pay for that.

The price set by the property owner might constitute an option to buy for all comers, or just for the state. (I’m not sure which would be best. What do you think?)

This sounds very dry and complicated, but ultimately it’s a simple and natural scheme. Suppose that a drug company invents a cure for a rare tropical disease that could cure thousands in the developing world but only hundreds domestically. It might well be the case that the profit-maximizing commercialization strategy would be to make the drug available at a very high price domestically, but not sell it cheaply in poor countries, to prevent reimportation from cannibalizing sales. As long as the tax rate is material, the drug company would try to set its price no higher than the discounted value of domestic profits, less the discounted cost of the new tax. However, since the social value of the drug if the patent were not used to exclude is much higher than that market value of the profits, governments and nonprofits could pool funds to buyout the patent. In theory, this can happen already — governments and nonprofits could band together and negotiate with drug companies to buy out patents. But the coordination costs of that are very high, and once interest has been signalled the patent owner has every incentive to hold out for a price very near the drug’s social value, which is much higher than the market value it would otherwise have realized. A tax on enforcement of exclusion would force all patent holders to decide a value and precommit to a price without the negotiating advantage of knowing they have a captive buyer. Of course, if a company thinks a public-interest buyout is very likely, it might set its price high in hopes of earning a windfall gain from a sale. But there are limits to that strategy unless a swift buyout is certain. The cost in overpayment of taxes and the risk that a buyout won’t actually happen increases with the level at which the price is set.

Firms will set a dear price on patents with such high and unique social value that a prompt buyout is inevitable. But as long those patents are genuinely for new, nonobvious inventions — admittedly a weak point! — that’s arguably a feature, as the scheme creates incentives that don’t now exist for firms to develop goods with high social value but low market value. At present, there is no functioning market in public-interest sales of patents. Instead, firms understandably avoid high-social-value, low-market-value projects. Given the negotiating realities and political perceptions surrounding licensing or sale of patent rights to the public sector, the prospect of a high payout is offset by risks of outright expropriation and public relations catastrophes.

Urban property is another domain where the externalities associated with enforcing exclusive property rights are arguably very large. Suppose a developer or a city government believes that a neighborhood is horrifically underutilized, and wants to redevelop it at high density. Under this proposal, every parcel in the neighborhood would have a prearranged price. The developer (with or without a requirement of political buy-in) could plan to buy the lots she needs and those of near-neighbors with effective veto power, and then do with them what she will. As with patentholders, for most homeowners the best strategy would be to set the price at the actual value that would compensate them for the loss of the house and the trouble and heartache of eviction from their home (which might be a lot!), less the discounted cost of expected taxes. As with patents, some homeowners might strategically try to set very high prices in hopes of a windfall buyout, but again, that’s a costly and self-limiting strategy, unlikely succeed except in very rare cases where some parcel is so unique that alternative development plans that exclude it cannot compete. A real problem here is that this scheme would disadvantage property owners so cash poor they cannot afford any substantial taxation, who might set prices below what would actually compensate for the loss of property. But then these property owners have a hard time paying existing property taxes too. That devil would live in the detail of arranging the actual tax burden.

Just what should the tax rate on stated price be? Should it be a flat or progressive? I don’t know. Maybe some clever modeling can be done to try to elucidate the issues. Qualitatively things are pretty clear: the higher the tax rate, the more costly it will be to enjoy the rights of exclusion that come with property ownership. That’s already true with any sort of property tax. This new sort of property tax simply gives the owner the right to pay the tax in cash or in risk of being forced into a sale. A low tax rate, especially the status quo zero tax rate for patents, is very comfortable for property holders. It encourages people to set an infinite “sticker price” and so force potential buyers to reveal themselves as needful in bespoke negotiations. A high tax rate would be less comfortable. Owners would be forced to either pay up for the right to exclude or bear real risk that their property will be bought-out for a higher value use. In each domain — patents, real estate, whatever — legislators (or city councilpersons) would have to balance the social benefits associated with certain and inexpensively maintained property ownership, the social costs of excluding high-value alternative uses, and of course revenue requirements.

There are more radical, arguably better, solutions to problems created by socially costly exclusive use of real or intellectual property. But within the confines of incremental, neolibbish ideas, I think this one merits some consideration.

This proposal owes something to a recent conversation with Leigh Caldwell (@leighblue), the king of prices. The good ideas are his. The crappy ones are mine.

Update History:

  • 9-Jan-2014, 5:10 a.m. EST: Cleaned up a bunch of awkward sentences in this particularly awkwardly written piece. No substantive changes, but I didn’t track the small edits.

Not terrible.

Last week, I objected unquietly to what I thought and still think was a very poor column by Ezra Klein. However, Klein has followed that piece up with several more on the same subject. Although I doubt Klein worries all that much what I think, I feel honor bound to point out that his most recent columns, one at Bloomberg and another at his Wonkblog home, are decidedly not terrible. They are excellent.


On the bright side, I guess I couldn’t ask for a better example of the phenomenon I described in “Standards of Evidence” than this piece by Ezra Klein.

It’s terrible.

I have no idea whether inequality is the “defining challenge of our time”. That’s a meaningless trope. But Klein takes the phrase from a speech by President Obama and turns it into a question in order to knock inequality down a few pegs from the economic priority list. He does a very dishonest job of it.

Here’s the worst:

Economist Jared Bernstein has been worrying about inequality since way before worrying about inequality was cool. But in a careful paper released on the same day as Obama’s speech, Bernstein found that there wasn’t strong evidence for the idea that inequality is weakening demand — or for any of the other theories tying inequality to a weaker economy. There “is not enough concrete proof to lead objective observers to unequivocally conclude that inequality has held back growth,” Bernstein wrote.

That doesn’t mean inequality isn’t hurting growth. It just means it’s difficult to find firm proof of it. But if inequality really was the central challenge to growth, would proof really be so hard to come by?

Read Bernstein’s paper. Klein is misrepresenting Bernstein’s views. An intelligent reader would interpret Klein as saying that Bernstein looked for evidence, failed to find it, and concluded it just wasn’t there. In fact, Bernstein reviews the research and finds lots of suggestive connections between inequality and growth. The unfortunate bit that Klein quotes reflects a kind of handwringing on Bernstein’s part — no, the research is not incontrovertible, there are a lot of “moving parts”, the research is young. Bernstein offers a cautious invitation to take seriously evidence of connections between inequality and growth. Klein pulls the caution out of context and misuses it as an excuse to dismiss those connections.

[And “worrying about inequality since way before worrying about inequality was cool”? Excuse me? Way to conflate concern over an ongoing social catastrophe, and a genuine vocation on Bernstein’s part, with the latest thing to go viral on Buzzworthy. Not all of us are paid by the click.]

There is no such thing as “the central challenge to growth”. Proof is impossible to come by with respect to all macroeconomic controversies. Klein vapidly handwrings that, “Growth simply isn’t producing enough jobs” without meaningfully addressing the question of how to achieve growth, or addressing the arguments that Bernstein carefully catalogs for why a broader distribution might be growth-supportive. When Klein writes “fixing [unemployment] is necessary, though not sufficient, to making real headway against inequality”, he is making an empirical assertion without evidence, and probably getting causality backwards. We might well move towards economic arrangements in which wages become less central to the income of the middle class, just as labor income is only one of multiple income sources for the wealthy. Broadening the distribution of income may well be prerequisite to full employment going forward, as jobs that cannot be automated or outsourced are largely in personal services, and mass employment in personal services requires a mass of customers with disposable income.

There is little tension between addressing inequality and pursuing the other goals Klein says we should focus on. Klein sets up a straw man when he argues

A world in which inequality is the top concern is a world in which raising taxes on the rich is perhaps the most important policy choice the government can make. A world in which growth and unemployment are top concerns are worlds in which very different policies — from stimulus spending to permitting more inflation — might be the top priorities.

One could make the world more equal just by burning everything down too! But no one advocates this. So obviously inequality doesn’t matter, right?

People concerned with inequality in fact argue not to tear down the rich but to raise up the rest — at the expense of the rich to the degree that is necessary, but not just because. We argue for policies like basic income, wage subsidies, and, yes, more inflation-tolerant macro policy and more fiscal stimulus where those policies help support the poor and middle. A focus on inequality sometimes does create wedges between us and other “progressives”. We might not be so excited, for example, by a fiscal policy that is “expansionary” by virtue of a deficit accounted for in large part by tax expenditures to the rich. We might celebrate less than a Democratic party that treats inflation in the price of real estate and financial assets as unambiguously good news.

A policy apparatus for which inequality is not a “top concern” might content itself with spurring demand by protecting and increasing the wealth of the politically-connected rich, on the theory that anyone’s misfortune hurts at the margin and providing support to the non-rich is politically impossible. But that’s, like, totally science fiction, right?

Update History:

  • 13-Dec-2013, 8:45 p.m. PST: Added context that the phrase “defining challenge of our time” comes from President Obama’s speech, and reworked that sentence. (Rereading, the beginning of the piece was incomprehensible to people who didn’t click through to Klein’s piece.)

Standards of evidence

In a broadly excellent discussion of theories relating inequality and growth, Jared Bernstein writes:

all of this research is relatively new, and while it makes suggestive connections, there is not enough concrete proof to lead objective observers to unequivocally conclude that inequality has held back growth.

Bernstein absolutely right, of course. But really? “concrete proof to lead objective observers to unequivocally conclude” Is that a remotely meaningful standard of evidence for, well, anything?

People on the political right, including many respected economists, make strong claims that ceteris paribus taxation is bad for growth. They certainly have plausible models in which it would be. But as an empirical matter, the fair thing to write would be there is not enough concrete proof to lead objective observers to unequivocally conclude that taxation has held back growth. The evidence is very conflictatory! To steal Bernstein’s apt metaphor, there are a lot of moving parts! It is in fact almost certainly false to claim that taxation is always and everywhere bad for growth, and almost certainly true that there are circumstances under which it has been and would be good. If you are behaving as a scientist, it’s kind of a shitty, stupid question, “how does XXX affect growth?” How does molybdenum affect life? They are related! But if you start running regressions of liveliness against concentrations of molybdenum, you won’t get very far. If you want to study the relationship between molybdenum and life, or XXX and growth, for any XXX, you’ll have to characterize mechanisms and offer detailed, contingent accounts. You won’t find simple, black box relationships.

But we are not always, or even usually, behaving as scientists. The Tax Foundation will tell you right off that taxes are bad for growth, much worse than spending cuts. Studies prove it, and if you disagree you are simply wrong. Steve Roth aptly wonders why so few voices among “respectable progressives” are willing to even give fair consideration to the case that inequality might be an impediment to growth. I think he has a point. This isn’t a general phenomenon. It’s not like “liberals are cautious scientists, while conservatives run roughshod over the truth”. Progressive economists are willing to assert, in the same stentorian, authority-of-science voice as the Tax Foundation people, that fiscal multipliers are real or that evidence against expansionary austerity is incontrovertible. But on connections between inequality and the macroeconomy, it feels like respectable progressives are always looking for an excuse to say there’s no there there. People who are usually very smart make very thin arguments that are frankly beneath them to cast doubt on the relationship.

Now let’s be perfectly clear: there is no reliable quantitative relationship between inequality and growth, just as there is no reliable quantitative relationship between taxation and growth, between government spending and growth, monetary policy and growth, or pretty much anything else and growth. There are studies, which pare and tease their panels in ways they justify on some grounds or other, and those studies yield conclusions. You can buy the assumptions, methodologies, and mechanisms implicit in those parsings or not, it’s your choice. But you won’t find a clear, incontrovertible relationship between any simple thing and developed world, per-capita growth. It’s too complicated a phenomenon. You have to buy someone’s stories, and interpret the numbers through those stories, to claim the evidence is strong.

But that doesn’t mean there is nothing at all that we can say about inequality and the macroeconomy. We can, for example, say that marginal propensity to consume effects are real. The intellectual history of MPC goes something like this:

  1. There is and has always been an obvious, intuitive, and robust stylized fact that people with higher incomes save greater fractions of their incomes than people with lower incomes. In the post-Great-Depression intellectual climate, which was acutely sensitive to the dangers of demand shortfalls, this suggested, uncomfortably to some, that inequality could be a macroeconomic hazard.

  2. Milton Friedman pointed out that differing marginal propensities to consume observed in the data might have nothing at all to do with inequality. If people try to smooth consumption over time, then in a stochastically equal society (one in which everyone’s expected incomes are the same, but each individual is subject to random fluctuations in any period), we would observe that individuals who happen to have unusually high incomes in one period save a lot, to cover the periods where they will have unusually low incomes. Friedman’s elegant Permanent Income Hypothesis suggested people just spend a constant fraction of their lifetime incomes in every period, so (under perfect information about that “permanent” income) each individual’s spending would be constant and apparently different marginal propensities to consume would be due solely to fluctuations in income, with no actual changes in spending.

  3. For reasons that would be baffling, if I weren’t so cynical about the economics profession, the Permanent Income Hypothesis was generally accepted as sufficient explanation of observed MPC effects in cross-sectional data, and the issue was considered closed. You were naive and ill-informed if you thought MPC effects in the data had anything to do with inequality. They had been explained.

Of course, you had to be an idiot to believe that the Permanent Income Hypothesis fully accounted for MPC effects. Undoubtedly consumption smoothing explains a part of cross-sectional variation in marginal propensities to consume, but you don’t need careful empirics to prove that it can’t explain all of them. Why not? Because not consuming leaves a residue, something called savings, which becomes wealth. If across the income spectrum everyone spent and saved in equivalent proportions, we’d expect no cross-sectional variation in terminal wealth as a proportion of lifetime income. But in real life, much of the bottom of the income distribution dies with zero or negative wealth (i.e. they stiff their creditors), while those near the top of the distribution leave large bequests. An intergenerational Permanent Income Hypothesis could only explain this if poorer people expect their kids to be much wealthier then the children of moguls. Which is not so plausible.

If things that are obvious don’t persuade you, if something has to have tables in the back and be peer-reviewed to qualify as “rigorous”, you are a very severely deluded human. Nevertheless, a few courageous researchers have done the work of examining in numerical detail whether the Permanent Income Hypothesis is sufficient to account for variations in spending, and the answer is always no. I’ve cited ‘em before, I’ll cite ‘em again: “Why do the rich save so much?” by Christopher Carroll; “Do the Rich Save More?”, by Karen Dynan, Jonathan Skinner, and Stephen Zeldes. I’m sure if MPC makes a comeback in macroeconomic conversations, someone prestigious will find some way to parse the data differently and explain it all away again. That researcher will surely die rich.

OK. So inequality-related MPC effects are real. But what to they have to do with growth? Nothing at all, in an unconditional sense. I’ll go further than Bernstein. It’s worse than “there is not enough concrete proof to lead objective observers to unequivocally conclude that inequality has held back growth.” There’s little reason at all to think that inequality has held back growth, in the past tense, through an MPC channel. Why not? Because we didn’t observe in the past anything that looked like an intractable insufficiency of aggregate demand! Past-tense, we reconciled inequality with growth. MPC effects suggest that one way to generate more demand would be to broaden the distribution of income. They do not imply that broadening the distribution of income is the only way. The macroeconomic footprint of increasing inequality lies not in growth, but in the interest rates and financial chicanery that were necessary to support that growth. Call it the monetary offset.

Prior to 2008, we found means of supporting aggregate demand despite an almost certain drag imposed by increasing inequality. Those means included a broad mix of fiscal policy (we ran deficits), unsustainable equity booms, the “democratization of credit” and unsustainable credit booms, and of course straightforward monetary policy. Real interest rates have collapsed since the early 1980s. The reason we might talk about inequality is not because it is mechanically, unconditionally, here-is-the-regression-now-STFU connected with growth. It’s because many of us have decided that other, more “conventional”, demand stimulants have run their course, that repeating them or increasing the dose won’t work, or would have adverse side effects we’d prefer to avoid.

We have a large menu of ways we can try to support demand. We can go the Scott Sumner route, double down on monetary policy. We could do big, old-style fiscal stimulus, have the government give money to those who lobby best without worrying about fairness or income distribution. We could embrace inefficient health care provision and build more university rec centers. We could have the financial sector figure something out again, some means of enabling those who otherwise wouldn’t be able spend to do so. We can find ways of persuading rich people to spend more. We can import demand from elsewhere, like China and Germany. We can try electronic money and negative interest rates. We are, as they say, free to choose.

But the reality of MPC effects means that, along with all those other possibilities, broadening the distribution of income would be expansionary and narrowing that distribution would be contractionary, ceteris paribus. If, like Larry Summers, it pains you that maybe the “natural interest rate” is negative now, the reality of MPC effects means that policy which broadens the distribution of income would help push it positive, and put us back into more comfortable territory. If, like me and Pope Francis, you think that present levels of inequality are horrific for human and communitarian reasons, then among the many macro policies that might support demand, it is rational to tilt towards those more likely to engender a broad distribution. It is quite irrational, as I think some well-meaning economists do, to hold MPC effects to much higher standards of evidence than the mechanisms that justify other interventions, because “economics is not a morality play” and reducing inequality would be the moral thing. Better to err on the side of human welfare rather than reputational purity.

I happen to think that the macroeconomic case for reducing inequality is much stronger than the case I’ve made here. I think the character of growth is badly misshapen when demand is narrowly sourced, that technological stagnation is mostly a distributional problem, that institutional correlates of growth are harmed by increasing inequality. But those are all more speculative claims. You can tell me the “jury is still out” on those. But the jury is not out, it never reasonably has been out, on the reality of distribution-related MPC effects. I’ll disagree, respectfully, if you claim that for supply-side or libertarian reasons we should ignore that reality and prefer other means of supporting demand (or that we should not worry about supporting demand at all). But don’t say “it’s unclear” whether income distribution affects aggregate demand, holding other factors constant. Of course it does.

Update History:

  • 27-Sep-2016, 11:10 a.m. PDT: “Those means included a broad mix that included of fiscal policy…”

Why (and when) interest-on-reserves matters…

Paul Krugman writes:

Incidentally, small nerdy note. Some people argue that the concept of the monetary base has lost its relevance now that the Fed pays (trivial) interest on reserves. I disagree. Reserves and currency are fungible: banks can turn one into the other at will. But the total of reserves and currency is fixed by the Fed — nobody else can create either. That, as I see it, makes them a relevant aggregate — and anyone who believes that all those reserves are sitting idle because of that 25 basis point reward is (a) silly (b) ignorant of Japan’s experience, where the BOJ sharply increased the monetary base without paying interest on reserves, and what happened looked exactly like our own later experience.

Nerdy indeed! Some might even describe it as dork-ish.

But I think that Krugman is mischaracterizing the view he is arguing with. I’m not sure he would even argue with the view properly characterized. Of course he might!

Perhaps there are people in the world who think that paying 25 basis points of interest on reserves means that base money doesn’t matter, but I have not met any of them. I certainly agree with Krugman that those 25 basis points have a pretty negligible macroeconomic effect now.

The view of people who think that interest-on-reserves permanently diminishes the macroeconomic meaning of base money is contingent on a conjecture that, henceforth, the Fed will always pay interest-on-reserves at a rate comparable to the rate paid by short-term US Treasury securities. If that conjecture is false, then the quantity base money will someday matter again.

In either case, the quantity of base money that exists right now is largely meaningless , and would be meaningless if the Fed were not paying any interest on reserves, because Treasury rates are near zero. This is Krugman’s liquidity trap, an effect of the negative unnatural rate of interest.

The quantity of base money is meaningless right now even if I am wrong about the Fed henceforth always paying interest on reserves at the short-term Treasury rate. Because if I am wrong, the only way that the Fed can create a spread between the interest rate paid on base money (whether zero or something higher) and the Treasury rate is to dramatically reduce the quantity of base money, so that some convenience yield on holding scarce base money offsets the opportunity cost implied by a T-bill / base money spread. Current quantities of base money simply can’t coexist with with a spread between the interest paid on reserves and the interest paid on Treasury bills. (Unless some unexpected thing dramatically increases the convenience yield of holding base money!).

So, there is almost no direct informational value to the current quantity of base money. Perhaps there is indirect information that matters. It could well be that the rate of change of the quantity of base money contains information about the likelihood of future interest rate changes, so it is not irrational of market participants to respond to rumors of tapering or moar QE. Perhaps there are institutional quirks related to the fact market participants can only hold interest-paying base money indirectly via banks, while the stock of risk-free securities depleted by monetary expansion can be held (and hypothecated) by non-bank actors. (If so, “monetary expansion” might be contractionary!)

But the first-order effect of monetary policy is gone. Changes in the base used to engender straightforward imbalances between a direct opportunity cost and the convenience yield of holding money. A reduction of interest rates / expansion of the monetary base would lead to an increase in the direct cost of holding money rather than Treasuries, and put the economy in disequilibrium until NGDP or (too frequently) asset prices adjusted to increase the convenience yield attached to the monetary base. A contraction did the reverse. While we are stuck at zero we can argue over expectations or collateral chains, but the old, blunt, simple channel no longer functions.

And it will never function, as long as the Fed always pays interest comparable to Treasuries on base money. There is nothing special about zero, or 25 bps. What makes a liquidity trap is that the rate of interest paid on money is greater than or comparable to the rate of interest paid on Treasury bonds. So long as that is true, whatever the level of interest rates of interest, macroeconomic outcomes will be much less sensitive to changes in the quantity of money than in once-ordinary times. That is not to say, full-stop, that monetary policy is impotent. Those squishy expectations and institutional quirks may matter. But post-2008, we live in a world where insufficiently expansionary monetary policy has meant tripling the monetary base. Pre-2008, tiny changes in the quantity of base were sufficient to halt an expansion or risk an inflation. The relative impotence of changes in the monetary base is not a function of the zero-lower-bound. It is a function of the spread between base money and risk-free debt, a spread which may well be gone forever.

A conspiracy theory of the debt ceiling

So, my working hypothesis is that, should the debt ceiling actually bind, the US Treasury will prioritize payment on formal debt securities and then institute some form of delayed payments on the rest of its obligations. Like the vaunted small business struggling to make payroll, it will borrow funds from suppliers and other creditors by stretching accounts payable. If I’m wrong about that, everything that follows will be wrong.

This is my second post trying to think through the consequences of such a regime. In the first, I pointed out that claims to future delayed payments would be securitized, and that prices of those securities would be informative, they would constitute a kind of back-door approximation of an NGDP futures market, which, as Scott Sumner has persuasively argued, would be a useful thing to have around.

That was an optimistic take on delayed payments. But there is a flip-side of the missing platinum coin that is a bit darker. If Treasury delays payments, what will not happen is a simple withdrawal of missing government expenditures from the economy. (It really is important to think about banks!) One of the oldest and most basic functions of a bank is to discount accounts receivable, to advance funds today against credible obligations of third parties to pay in the near future. Originally this was a service offered to business clients. Today, the same principle underlies credit lines offered to individuals, including direct-deposit, payday, “structured settlement”, and tax-refund loans.

If the government starts delaying payments, banks will be able to fill in the gap, quickly and profitably. Advances against government obligations would require no meaningful credit analysis. As they would be secured by obligations of the Treasury, they would have little or no cost in terms of regulatory capital. The banking system faces no meaningful reserve constraint. Nothing whatsoever would prevent the banks from simply lending “from thin air” payments that the US government is withholding.

The first hit might even be free! (ht Brad Plumer) But this service won’t be free over an indefinite long-term. Large business customers might pay the few basic points implied by a loan against government security for a few months time. But individual marks customers will undoubtedly be charged “convenience fees” for the service of drawing advances on government payments that render the overall cost of the loans, when annualized, very high. We will, of course, be treated to the usually litany of justifications for exorbitant short-term loan costs: You don’t annualize hotel rates and compare them with apartment rents! Dealing with stinky, not-rich people is expensive! But in the end, this would be a nice line of business, which would multiply over time if delayed payments become the new normal for debt-ceiling-constrained government borrowing.

A delayed payments regime would amount to a regressive tax issued at two levels: first by the Federal government, and then by the financial industry. By delaying payments, the Federal government would tax recipients of government disbursements by forcing them to finance loans to the Treasury for free. Like all taxes, the actual incidence would be more complicated than the direct hit. Payees with bargaining power — say vendors of bespoke military systems or well-connected contractors — would find ways to add the finance cost to their bills, and largely escape the tax. Payees without bargaining power — your average social security recipient, for example — would have to simply accept the delayed payment and eat the interest cost that the government should be paying. A second regressive “tax” would be imposed by financial service providers. They would, as usual, compete to offer cost-efficient products to wealthier and more astute customers, while charging smaller, weaker, more desperate customers large fees. In the end, the Federal deficit would be reduced and bank profits would swell, primarily on the backs of the least-savvy, lowest-bargaining-power government payees.

A common narrative about the debt ceiling is basically a Frankenstein story: businesspeople funded these Tea Party crazies, and now despite pulling all their levers, they just can’t control the monster they have created. And maybe that’s right.

But suppose, plausibly, that the Jamie Dimons of the world know what Treasury has assiduously ensured the rest of us do not, which is exactly what Treasury is capable of and planning to do when George Washington bumps his head. And suppose it is debt prioritization plus delayed payments. Is it too much to wonder whether some quarters of the business community — you know, the ones who own the place — may not be pushing quite as hard as they pretend to raise or eliminate the debt ceiling?

I hope that it is too much to wonder. I hope it is evidence only of my own paranoia that I do wonder.

Update History:

  • 15-Sept-2013, 10:15 p.m. PDT: Added link to mathbabe post at “exorbitant short-term loan costs”.

Mobility is no answer to dispersion

Lots of times in conversations about inequality, mobility is cited as a potential remedy. What matters, according to this argument, is not how much inequality there is, but whether there is opportunity for people anywhere in the wealth/income spectrum to rise. American politicians of both parties, loathe to tackle actual inequality, have made a religion of the phrase “equality of opportunity”.

It is easy, and accurate, to counter the “equality of opportunity” fetish on practical grounds. “Equality of opportunity” echoes another famous phrase in American politics, “separate but equal”. Even if one concedes the theoretical point (which one should not), neither sort of equality is achievable in a real-world social context. The schools into which an impoverished and oppressed minority are herded were never going to match those offered to children of the affluent and well-enfranchised. Children born to parents who can barely afford even to be present themselves will never have the same opportunities as kids tutored for hundreds of dollars an hour and groomed for internships by well-connected professionals.

But if you are a utilitarian, the case for social mobility is incoherent even on theoretical grounds. Under ordinary assumptions of diminishing marginal utility and a social welfare function that aggregates individual utilities, for any distribution of wealth, overall welfare is maximized when each individual knows her place with perfect certainty from the start. A person who expects to land on the bottom of the distribution might prefer that some uncertainty be added into the mix, but that benefit will be more than balanced by the cost to someone near the top of the distribution facing downward mobility. If we augment standard utility functions with plausible notions of habit formation and social reference group comparison, the case against mobility grows even stronger. The cost and shame of downward mobility dramatically outmatches the potential benefit of upward mobility. If that sounds abstruse and theoretical, it shouldn’t. For example, I don’t think you can understand the United States response to the financial crisis without taking into account the genuine sympathy of policymakers and other influencers for the plight of people within their social communities who faced banishment to dramatically lower stations under theoretically superior policy alternatives. A functional polity values rising fortunes across the wealth spectrum, but it fears and resists falling fortunes much more strenuously. I would go so far as to claim this is a universal social fact, a characteristic of all polities that endure. Capitalism is always crony capitalism — and socialism tends towards crony socialism! — not because of corrupt bad actors but because human lifestyles are sticky-downward. Large social divergences can in practice be remedied smoothly only by convergence upward from the bottom. The wise course is to prevent extreme divergence from emerging in the first place. Once it has, the only way out is to hope for growth, and to direct the fruits of growth towards the bottom of the distribution.

These issues are glaringly obvious at a global level. The United States and Europe are full of people who tut and cluck about poverty and misery in the erstwhile Third World and elsewhere. But no one imagines that “mobility” in the sense used in domestic politics would be an acceptable answer. If we are honest, do we want, would we even remotely tolerate, any sort of political change that gave our children “equality of opportunity” with children born in Gabon today, holding the global distribution of outcomes constant? Obviously not. We might embrace a fig-leaf “level playing field”, where advantages we can reliably provide would ensure our kids the 90+ percentile lifestyles we consider civilized despite some self-aggrandizing formal equality. (All hail the meritocracy!) But we would resist with the full horror of our armaments any reform that meant our kids should face anywhere near the probability of deprivation and poverty implied by a fair lottery of the global distribution of outcomes. At a global level, we will either have “stability” that is really ossification (or expansion) of present divergences, or convergence via rise from beneath. Convergence from the top, downward absolute mobility, is simply unthinkable.

The first-order utilitarian costs of social mobility outweigh the benefits, full-stop. Obviously, there are more complicated stories you can tell about why social mobility is a good thing, desirable to some degree. Perhaps the prospect for social mobility creates incentives for individuals that cause the distribution of outcomes for the full population to shift upwards. Perhaps concerns about justice (however we define that) should supervene to some degree the utilitarian cost of social mobility. I buy all that. To some degree.

But if you fancy yourself a utilitarian, you have to acknowledge that mobility, like the inequality that renders it possible, is attended by first-order costs to social welfare. Those costs may be outweighed by second-order “dynamic” effects over some range, but that’s a case you have to work to make that goes well beyond conventional utilitarian analysis, well beyond most models that economists actually write down and use. And it’s a case with built-in limits. The first-order costs of inequality and mobility will eventually overwhelm whatever second-order benefits we wish to ascribe to them.

The case for both inequality and social mobility is very much like the case for patents and copyrights. Patents and copyrights are first-order economic distortions, grants of monopoly power by the state. But we claim these particular distortions also “promote the progress of science and useful arts“. So we face a trade-off. We accept and even encourage the distortions, within limits. But we understand (or we should understand) that we are playing with fire, that there is only a narrow range within which these prima facie bad ideas might be redeemed by more complicated virtues. I favor inequality, but not too much of it, just as I favor copyrights for strictly limited terms. But in this era of Mickey Mouse protection acts and rent extracting oligarchs, those limits have been exceeded and the bad ideas are just bad ideas that need to be pared back.

Update: Unsurprisingly, Alex Tabarrok and Tyler Cowen at Marginal Revolution were miles ahead of me on this, see Stasis, Churn, and Growth. My mind is a device which operates by so thoroughly confusing unoriginal thoughts that I can no longer identify their provenance.

Update History:

  • 24-Nov-2013, 1:50 p.m. PST: Added pointer to Marginal Revolution piece, which remarkably echoes my own, 14 months in advance…

Why Scott Sumner should love the debt ceiling

Suppose that the debt ceiling is never raised. Never ever. It remains in perpetuity at its current level of $16.7 trillion dollars.

Suppose also that the Treasury chooses to (and is operationally able to) prioritize payments on formal Treasury securities so that there is never a default on a US bond or bill. At or near the statutory debt limit, Treasury suspends other payments to build up a cash buffer sufficient to cover any spikes in payments due net of taxes. Once that is accomplished, Treasury securities can resume their role as the nearly default-risk-free asset at the center of the global financial system.

The question, then, is how are the other obligations of the US Treasury to be discharged? If the US government cannot (formally) increase its borrowings, then it is in theory subject to a cash-in-hand constraint. It can only spend the money it has, primarily in the form of funds on deposit at the Federal Reserve. (Yes, my chartalist friends, this is stupid, since the consolidated government/central-bank need never be bound by a financing constraint in a currency it issues. But in this case, the political system chooses, however bizarrely or foolishly, to constrain itself. C’est la vie!)

Humans, when ostensibly subject to a cash-in-hand constraint, do not in fact always live within their means. In particular, humans sometimes surreptitiously borrow money by writing checks against funds they don’t actually have. If I write a check for goods and services you provide today, you are lending me money. Usually that is mere transactional credit — an advance of convenience against funds I already have. But not always. If I write a check against funds I hope I’ll have in my account before it clears, you’re lending me money, whether you know it or not.

This is usually an expensive borrowing strategy for humans, because if I fail to assure an inflow of funds before my bank is ordered to pay the check, I will be hit by all kinds of costs — overdraft fees, returned-check fees, perhaps even fines or jail time if the “bad check” (defaulted loan) is deemed to be fraudulently arranged.

However, the government has a much cozier relationship with its bank than your typical check-kiter. Suppose the government, in response to the insoluble problem presented by congressional spending mandates and a debt limit, simply decides to pay all its bills as old-fashioned paper checks. It then asks the Federal Reserve not to “bounce” checks presented for payment against insufficient funds, but simply to hold them and make payments on a first-in, first-out basis as funds become available. Everyone who deposits a US Treasury simply finds that the funds don’t appear in their account until weeks or even months later. (Banks, in order to protect their own cash flows, would revise their “hold period” policies with respect to checks from the US Treasury, making funds available only when the checks actually clear, like they might with deposit of a large personal check.)

Suddenly, the debt ceiling is moot. Every check issued by the US Treasury is basically a credit line that does not count towards the debt limit. The Treasury pays its bills, on time and as usual, in the form of paper checks. It’s just that those checks clear a bit sluggishly.

Of course, recipients of US Treasury checks may not be happy to wait some indeterminate period before actually spendable funds appear in their bank accounts. There would quickly arise a liquid market discounting endorsed Treasury checks. Suppose “the market” expects payment of checks two months following a deposit, and the current short-term Treasury bill rate is about 1%. then you should be able to sell an endorsed $100 check from the Treasury for $99.83. Let’s call it $99.80, because the purchaser would want to be compensated for the uncertainty surrounding the exact time of payment. Of course, 1% is much higher than current T-bill rates. At a more realistic yield of 0.02%, you’d pay about a nickel per $1000 to redeem a two-month delayed check today, including some compensation for buyers’ uncertainty.

But this would be a very large market, and banks would quickly find themselves accumulating and trading billions of dollars of endorsed Treasury checks every day, with each day’s cohort trading at slightly different prices. The delay would initially be short, but it would expand for a while, then slow and eventually become pretty stable, somewhere (I am guessing!) between several months and two years. More precisely, the delay would be (total_debt - traditional_debt) / (tax_receipts - interest_on_traditional_debt). Traditional US Treasuries would remain actively traded in a $16.7T market, providing us with full risk-free yield curves. So we’d have good market predictions of the interest cost of traditional debt, and know the appropriate risk-free rate to discount for any length of delay. The only real unknowns relevant to pricing endorsed Treasury checks would be 1) the rate of future tax receipts and 2) a risk premium surrounding date-of-payment uncertainty. Date-of-payment uncertainty would itself be mostly a function of tax-receipt uncertainty. To a first, pretty good, approximation, the price of these these securities would just reflect a market estimate of the rate of future tax receipts relative to the known current stock of debt. One would have to adjust a little bit for illiquidity and uncertainty premia, but on these ultimately very low-risk securities, the adjustments would probably be quite small.

Holding tax law and the character of economic activity constant, tax receipts are pretty proportional to… nominal GDP. Of course, tax law and the character of economic activity are never constant. But periods of real uncertainty surrounding near-future tax law are infrequent, and the character of economic activity changes slowly. So a “futures market” in Federal tax receipts would not be a bad approximation of a futures market in nominal GDP!

I think Scott Sumner is the Svengali behind all of Ted Cruz’s antics. He must be. It’s the only sensible explanation.

I can’t quite wrap my head around what Treasury will actually do when the debt ceiling binds, if they won’t “mint the coin” or issue super-premium bonds, or invoke the “constitutional option”. Obviously the scenario described here is very speculative. But prioritizing Treasuries and slowing payments to everyone else doesn’t sound totally wacko. And if they do that, even if it’s not via paper checks, financial markets will try to figure out ways to discount and trade the loans implicit in delayed Treasury obligations. Maybe that will turn out to be a good thing!

p.s. i’ve been interested for a while in the possibility securities that pay-out fixed, predetermined sums on uncertain, revenue-dependent schedules. they strike me as a nice sort of debt-equity hybrid, offering some of the certainty of debt but much less hazard to issuers that payments will come due when they cannot easily be met. prices of such securities would be informative and easy to interpret. i’ve primarily thought about these with respect to small business finance. they seem an odd fit for a government that can in theory issue currency at will. such a government would pay for insurance it does not need because investors would on average demand a higher-rate of return than for fixed-term debt. but the informative prices might be worth the extra cost! and, in the debt-ceiling-forced scenario described here, the cost would be borne at least in part by recipients of government checks, who face an implicit tax.

Ersatz individualism makes the American collective strong

Here’s a statement that I don’t think will be too contentious, across the ideological spectrum:

The American way is to draw sharp distinctions between winners and losers, in order to encourage people to hustle.

People on the political left might rephrase this in stronger, more derogatory language. People on the political right would mostly celebrate the statement. But as a description of the American status quo, I think it is fairly uncontroversial. It expresses the barely tacit rationale behind a whole panoply of American institutions that comfort the already comfortable and afflict the already afflicted. Consider the so-called corporate welfare state, or tax expenditures like the mortgage interest deduction and the deductibility of health costs (only) of the stably employed. These things come to exist for specific historical reasons, they are won by particular lobbies, but they endure because of widespread hospitable ideology. It should be possible to “make it”. “Making it” should be a safe, comfortable place, while those who fail to make it should bear consequences for their deficiencies.

Suppose, as I think many people on the right would argue, this ideology or worldview has contributed to power and prosperity of the United States. Sharp distinctions between winners and losers encourage individuals to work hard rather than slack off. Some succeed, some don’t, but the net effect is to reward effort and enterprise, generating a vibrant, prosperous economy. The punishment of losers is a price that must be paid to create a nation that is collectively a winner. And the burden of that price falls on those who most deserve it, those who lose — in part due to misfortune sure, but largely because they simply failed to work as hard or as well as their competitors.

People on the political left would dispute this account for all kinds of (good) reasons. But let’s put that aside, and consider it on its own terms. This perspective on American life would, I think, be described as “rugged individualism”.

But, in the lingo of economics, consider the “social welfare function” embedded in this story. The claim is emphatically not that this system maximizes some measure of aggregate utility that could be decomposed to a sum of individual welfares. On the contrary, it celebrates as necessary large costs in individual welfare for the sake of impersonal characteristics of the aggregate: “prosperity”, or “strength”. It is an entirely collectivist justification for policies that are deeply harmful at an individual level, if you take seriously at all the idea of diminishing marginal utility. The individualist approach to maximizing welfare would be to redistribute. If we (contentiously but commonly) assume people share comparable utility functions, aggregate utility is maximized by taking from the rich and giving to the poor. At least in a methodological sense, it is socialists who are the individualists, attending to the sum of individual welfares, while unsympathetic capitalists rely upon collectivism to justify their good fortune and the policy apparatus that magnifies and sustains it.

People on the political right who are uncomfortable with the claim that their policy views are only coherent if they put the welfare of a depersonalized collective above the welfare individual humans might respond in two ways. Some libertarians would slough off the whole conversation, and argue that they are not concerned with either the well-being of any collective, or of individual human beings in the abstract, but require only that just procedures should be followed and concrete liberties respected, regardless of outcome. That’s a self-consistent view, but one that will never be very useful or interesting, other than to its disproportionately comfortable adherents. The more interesting rejoinder is a claim that there is no tension between individualism and collective goals like American strength and prosperity. Even accounting for the utilitarian harms provoked by celebrating and therefore engineering sharp divergences in outcome, the success of the collective improves characteristics of the population of outcomes so much that welfare gains due to increased prosperity outweigh welfare losses due to tolerance of internal divergences.

That’s an interesting claim, contestable but not incoherent. It would in principle depend upon the scale of the increase in prosperity and the degree to which it “raises all boats”. I think it’s a hard view to support, what with sinking rowboats and rising yachts and successful counterexamples like the Nordic countries. But perhaps Acemoglu, Robinson, and Verdier are right and the Nordics only succeed by free-riding off of America’s collective achievement.

Regardless, it’s a very communitarian view, one in which welfare dynamics cannot be adequately understood by building from individual microfoundations. It is a theory that both acknowledges divergences in individual welfare and posits an important role for social or “meso”-level abstractions in explaining (and justifying) the American status quo. The religious right and “national greatness” conservatives will be perfectly at home with all this. But it’d be nice if the economists on whom they rely to craft (and justify) policy would catch up.

Inspired by @zerg_rush01 and @MattBruenig.

Update History:

  • 25-Sept-2013, 4:05 p.m. PDT: edit a badly phrased sentence: “a self-consistent view, but one the rest of us will never consider that will never be very useful or interesting, other than to its disproportionately comfortable adherents.”
  • 6-Aug-2014, 3:50 p.m. EEDT: “they are won by particular lobbies”

Terminal demographics

About a week ago, I argued that the Great Inflation of the 1970s was largely a demographic phenomenon. That claim has provoked a lot of debate and rebuttal, in the comment sections of several posts here, and elsewhere in the blogosphere. See Kevin Erdman, Edward Lambert [1, 2, 3], Marcus Nunes [1, 2], Steve Roth [1,2], Mike Sax, Karl Smith [1, 2, 3], Evan Soltas, and Scott Sumner [1, 2], as well as a related post by Tyler Cowen. I love the first post by Karl Smith. My title would have been, “Arthur Burns, Genius.”

These will be my last words on the subject for a while, though of course they needn’t be yours. To summarize my view, I dispute the idea that the United States’ Great Inflation in the 1970s resulted from errors of monetary policy, errors that wise central bankers could have avoided at modest cost. During the 1970s, the simultaneous entry of baby boomers and women into the workforce meant the economy had to absorb workers at more than double the typical rate to avoid high levels of unemployment. This influx was effectively exogenous — it was not like a voluntary migration, provoked by the existence of opportunities. Absorption of these workers required a fall in real wages and some covert redistribution to new workers, which the Great Inflation enabled.

I don’t dispute that monetary contraction could have prevented the inflation of the 1970s. But under the demographic circumstances, the cost of monetary contraction in terms of unemployment and social stability would have been unacceptably high. As a practical matter, monetary policy was impotent, and would have been even if Paul Volcker had sat in Arthur Burns’ chair a decade earlier. I am perfectly fine with Evan Soltas’ diplomatic rephrasing of my position, that perhaps inflation remained a monetary phenomenon, but that the 1970s generated a “worse trade-off [for policymakers that] was not a monetary phenomenon”. I don’t claim that monetary policy was “optimal” during the period. Policy is never optimal, and in an infinite space of counterfactuals, I don’t doubt that there were better paths. But I do think it is foolish to believe that the policy decisions of the early 1980s would have had the same success if attempted during the 1970s. Monetary contraction was tried, twice, and abandoned, twice, in the late 60s and early 70s. There was and is little reason to believe that just holding firm would have successfully disinflated at tolerable cost in terms of employment and social peace. I don’t claim that demographics was the only factor that rendered disinflation difficult. With Arthur Burns (ht Mark Sadowski) and Karl Smith, I think union power may have played a role. It also mattered, again with Smith, that “unemployment was poisonous to the social fabric and the social fabric was already strained, most notably by race relations”. Monetary contraction succeeded — third time’s the charm! — when the demographic onslaught was subsiding, when Reagan cowed the unions, when the country was at relative peace. It might not have been practical otherwise.

I’ve had a wonderful nemesis and helper the last few days in commenter Mark Sadowski, who challenged me to provide evidence for a demographic effect on inflation in international data. Mostly I made a fool of myself (twice actually, and not unusually). Looking at the graphs — after Sadowski helped me get them right! — I see support for a relationship between labor force demographics and inflation in the United States, Japan, Canada, and Finland. Italy is a strong counterexample — it disinflated in the middle of its labor boom. The rest you can squint and tell stories about. (I now have 14 graphs now.) Italy notwithstanding, the claim “it’s hard to disinflate when labor force growth is strong” looks more general than “inflation correlates with labor force growth”. Decide for yourself.

Sadowski is not much impressed by my demographic view of the Great Inflation. But he paid me the huge compliment of devoting time and his considerable expertise to testing my speculations. He writes

I took your set of eight nations plus the four from my original set of counterexamples that you excluded (West Germany, Ireland, Luxembourg and the Netherlands), combined civilian labor force data from the OECD with CPI from AMECO, and computed 5-year compounded average civilian labor force growth rates and CPI inflation rates. The time periods ran from 1960-65 through 2007-12.

Then I regressed the average CPI inflation rates upon the average labor force growth rates. Five of the twelve were statistically significant, and all at the 1% level. The average civilian labor force growth rate and average CPI inflation rate were positively correlated in the U.S. and Japan, and negatively correlated in Spain, the Netherlands and Luxembourg.

Next I conducted Granger causality tests using the Toda and Yamamato method on the level data over 1960-2012 for the U.S., Japan, Spain, the Netherlands and Luxembourg.

The U.S. data is cointegrated, so although the majority of lag length criteria suggested using only one lag, since Granger causality in both directions was rejected at a length of one, I went to two lags based on the other criteria. The results are that CPI Granger causes civilian labor force at the 10% significance level but civilian labor force does not Granger cause CPI.

In Japan’s case civilian labor force Granger causes CPI at the 1% significance level but CPI does not Granger cause civilian labor force.

Granger causality was rejected in both directions for the other three countries.

In short, out of the 12 countries I looked at, only five have a significant correlation between average civilian labor force growth and average CPI inflation, and only two of five have a positive correlation. Of the five, only the two with positive correlation demonstrate Granger causality. But in the US case the direction of causality is in the opposite direction to that which you predict. Only Japan seems to support the kind of story you are trying to tell.

and follows up

I added your set of seven new nations (Canada, Finland, Greece, Italy, New Zealand, Switzerland and Turkey) plus seven additional nations (Belgium, Denmark, Iceland, Korea, Norway, Poland and Portugal) to the set of 12 that I commented on last time. I did the same analysis as I did last time for this new set of 14, that is I combined civilian labor force data from the OECD with CPI from AMECO, and computed 5-year compounded average civilian labor force growth rates and CPI inflation rates. The time periods ran from 1960-65 through 2007-12 with the exception of Korea which started with 1967-72. I regressed the average CPI inflation rates upon the average labor force growth rates. Ten of the fourteen were statistically significant, and all at the 1% level with the exception of Poland which was at the 10% significance level. The average civilian labor force growth rate and average CPI inflation rate were positively correlated in Canada, Denmark, Finland, Greece, Iceland, Italy, Korea, New Zealand and Norway and negatively correlated in Poland.

Next I conducted Granger causality tests using the Toda and Yamamato method on the level data over 1960-2012 (except for Korea which was over 1967-2012) for the ten countries which had statistically significant correlations.

In Finland, Poland and Korea civilian labor force Granger causes CPI at the 5% significance level but CPI does not Granger cause civilian labor force. In Greece CPI Granger causes civilian labor force at the 1% significance level but civilian labor force does not Granger cause CPI. In Iceland CPI Granger causes civilian labor force at the 10% significance level but civilian labor force does not Granger cause CPI.

So out of the 26 countries I have looked at, fifteen have a significant correlation between average civilian labor force growth and average CPI inflation with eleven of the fifteen having a positive correlation. Of the eleven with positive correlation six demonstrate Granger causality with three showing one way causality from civilian labor force to CPI and three showing one way causality from CPI to civilian labor force. Of the four with negative correlation one demonstrates Granger causality from civilian labor force to CPI.

Only three countries (Japan, Korea and Finland) out of the 26 support the kind of story you are trying to tell.

Mostly I am very grateful to Sadowski for his work.

Alas, I am not at all dissuaded from my view. At the margin I’m even a bit encouraged. The direction of Granger causality is not very meaningful here. (Granger causality, in the econometric cliché, is not causality at all but a statement about the arrangement of correlations in time. Expectations matter and near-future labor force growth is easy to predict, so there’s no problem if CPI changes can precede labor force changes.) I see some support for my thesis in the significant and usually positive correlations Sadowski observes in many countries. However, much as I am grateful, I don’t take this work as strong evidence either way. Sadowski overflatters my graphical analysis technique by translating it directly to an empirical model. Collapsing growth into overlapping 5-year trailing windows smooths out graphs that would otherwise just look like choppy tall-grass noise. But it creates a lot of autocorrelation unless the data is chunked into nonoverlapping periods. (Sadowski may well have done that! It’s not clear from the write-ups.) More substantively, to generate a good empirical model we’d have to think hard about other influences and controls that should be included. One wouldn’t model inflation as always and everywhere a univariate function of domestic labor force growth.

Maybe my view has been definitively refuted and I’m just full of derp! You’ll have to judge for yourself. In any case, I thank Sadowski for the work and food for thought, and for help and correction as I made a fool of myself.

I want to address some smart critiques by Evan Soltas:

Consider a standard Cobb-Douglas production function: Y = zKαLβ. Consider a large and sustained shock to L, as Waldman shows. Consider, also, that the level of K has some rigidities, such that the level of K is not always optimal given the level of L, but that in a single shock to L, K will eventually approach the optimal level of K over some lag period. With this background, the marginal productivity of labor should drop and remain low over that lag period.

Now assume that real wages tend towards the marginal productivity of labor with a lag. What we should expect to see is that real wages should drop in the 1970s. Why? Surplus labor reduces the bargaining power of workers relative to that of employers. We don’t see that; real wages begin to fall after monetary policy tightens in the 1980s. My Cobb-Douglas model is also a bit limiting, but if anything, we might expect to see downward pressures on the labor share of income β. We don’t see that either — as compared to later periods, the 1970s appears to be a time of slightly stronger labor-share performance.

Under Soltas’ nice description of what I’ll call the “first order” effects of a demographic firehose, we should indeed expect real wages to fall relative to an ordinary population growth counterfactual. Did they? Yes, I think so. Let’s graph a few series.

The blue line is one of the series that Soltas graphed, CPI-adjusted hourly wages of nonsupervisory employees. They fell during the course of the 1970s in absolute terms. The black line is the broadest measure of hourly compensation I could compute, CPI-adjusted employee compensation divided by hours worked. It is essentially flat over the course of the decade, breaking a strong prior uptrend. The red line is CPI-adjusted compensation per employee. It fell in absolute terms over the decade.

Soltas suggests that compensation did not fall based on a graph of CPI-adjusted average manufacturing sector hourly wage, which rose over the 1970s. But manufacturing was simply an unrepresentative sector. (Those unions again?)

Overall, I think it’s fair to say that real wages did fall. They certainly fell relative to the prior trend, and probably in absolute terms. Still, looking at that black line, you might say they fell a bit less or more slowly than you might expect. More on that below.

Soltas also points to a strong labor share during the 1970s as disconfirmative, but that’s hard to interpret. Under the “first-order” demographic firehose story, we expect real wages per unit of labor to fall, but the number of units paid to increase. Which effect would dominate would depend on details of the production function. (It’s not clear that labor share was strong in the 1970s. Labor share seems to have declined over the decade from unusually high levels in the late 1960s.)

Let’s continue see the rest of Soltas’ critique:

Let’s simplify. Waldman’s thesis, stated uncharitably, is that a large increase in the labor supply acted as an inflationary pressure on the economy of the 1970s. I don’t see how that works. Show me the model. Less uncharitably, it forced a worse trade-off on the Fed, specifically forcing higher unemployment or higher inflation. I don’t see how that works, either. Unemployment might have been higher, but that would have put a deflationary pressure on the central bank, all else equal, given the exogenous surge in the labor supply.

Think about it this way: Whatever the Fed of the 1970s did in monetary policy, it faced an unstoppable surge in the labor supply. That should be a tremendous headwind against wage increases and broader inflation. You can argue that the capital stock wasn’t ready for the higher labor supply, and I would grant that point, but that should translate into a downward pressure on wages, not an upward pressure on inflation. It’s not an adverse supply shock.

Now we come to the “second order” story.

The piece of the model that Soltas isn’t seeing is rigidity. First, there is that most conventional rigidity, nominal wage stickiness. If real wages must decline for the labor market to clear, but nominal wages are sticky downward, then the only way to avoid unemployment is to tolerate inflation.

But in addition to nominal rigidities, there are real rigidities. All those kids in the 1970s graduating high school or college and entering the labor force had expectations about the kinds of lives they should be able to live when they got a job. They would not have been satisfied with increasing dollar wages, if those dollars could not support starting lives and families of their own, independent of Mom and Dad. Middle class labor force entrants then expected to be able to support a home, a car, even start a family on a single income.

Rigidities aren’t forever. Those expectations have evaporated over the past 40 years. That is the famous Two Income Trap, under which the necessities of “ordinary life” as most Americans define it now require two, rather than just one, median earner. But Rome wasn’t destroyed in a day. Baby boomers entered the labor force with real expectations. They were not mere price takers. But the declining marginal productivity in Soltas’ Cobb-Douglas production function meant boomers could not earn sufficient real wages to meet those expectations in a hypothetical perfect market. They faced precisely a supply shock [1], arising from each boomer’s own diminished capacity to supply relative to prior cohorts, for reasons entirely beyond their control. They would not be very happy about it. A tacit promise would have been broken.

To avoid social turmoil, the political system had to find ways of not disappointing the budding boomers’ expectations too abruptly. That implied some redistribution, from older workers and capital holders to new workers. Among other things, inflation can be a means of engineering covert redistributions. This is the part, I think, that puzzles Scott Sumner. High inflation reduces the real purchasing power of people living off of interest, and of people already employed who are slow or lack bargaining power to negotiate raises. That foregone purchasing power liberates supply, which becomes available to subsidize the real wages of the newly employed. Real GDP did not collapse during the 1970s, but the inflation created losers. The share of production that losers lost went to someone. I think that, among other mischief, it helped subsidize the employment of new workers at real wages below but not too far below what the generation prior had enjoyed.

We’ve seen that Arthur Burns was a genius, but I don’t think that any of this was conscious strategy. Like most real-world policymakers, Burns felt his way towards the least painful solution, then used his considerable intellect to justify what he found himself doing. When Burns tightened money, unemployment rose sharply and Greg Brady got mad that the jobs he was refusing wouldn’t pay enough to cover wheels and a pad across town from his annoying sisters. He started to smoke dope, get into politics, frighten his parents and neighbors. (We won’t even talk about J.J and the Panthers.) When money was loose and inflation roared, times were bad for everyone, which helped ease the sting. Greg’s job offers still paid less in real terms than he’d have hoped, but the money illusion made the numbers sound OK, and he could stretch the salary to move away, albeit into a smaller place than he had hoped. Carol and Mike breathed a sigh of relief, as did their congressman, Richard Nixon, and Arthur Burns.

If you’ve read all of this, there is something terribly wrong with you. I thank you nonetheless. As I said at the start, this will be my last episode of “That ’70s Show”, at least for a while. (Thanks @PlanMaestro!) I want to move on to other things. Do feel free to have the last word, in the comments or elsewhere.

[1] More abstractly, fix the median new worker’s market clearing real wage as our numeraire. Prior to a population boom, the median new worker supplies her labor for a particular bundle of goods and services. But in the population boom, because of the diminishing marginal productivity of labor (holding K constant), the median new worker cannot produce enough in real terms to purchase the same bundle. The worker’s demand curve has not changed at all: she remains willing to trade one unit of salary for one unit of consumption bundle, just as her predecessor did. But that trade is no longer available to her, because she herself is unable to supply real production in sufficient quantity to purchase those goods, despite expending her fullest effort. This is a supply shock, from the worker’s perspective, not a demand shock. The population boom is a shock to her ability to supply, which would be reflected by inflation of the cost of goods relative to the numeraire of her labor.

Update History:

  • 11-Sept-2013, 1:55 p.m. PDT: “Congressman congressman“; “her fullest less effort”; Also, a while back, corrected (again) my persistent misspelling Sadowski’s name “Sandowski Sadowski