Steven Landsburg. Is He Crazy?

I don’t think he is. I enjoyed his book, “The Big Questions”, and I even made a set of desktop images for him, which (if you’d like) I can send you the full sized images and you can use them for free if you enjoy them (p.s. I also do design work)!

In any case, his recent post has gotten play from Alex Tabarrok, Brad DeLong, and tonight, Noah Smith.

The only thing I find wrong is the fact that you can’t do economics from accounting identities. If you could, then Steven’s basic model would be correct, as a matter of arithmetic, and a matter of reality. To my mind, that is where you stop.

Start with GDP: Y = C + G + I + Nx. I think we can probably disregard Nx to make the model easier. In this case, consumption is constant, as the assumption is that our idle millionaire consumes zero at $84 million, and you can’t consume less than zero (even when dead!). In this case, we’ll hold C constant at $100. Now say G is currently 0, but the government sees a nice pile of money, maybe $84 million, sitting around in a bank account. Well, that money isn’t just sitting there, S (savings) is related to I in our GDP model! So assuming a quick 1:1 relationship between S and I, what the government is doing, in order consume $84 is reducing investment by $84. Assuming there is some sort of relationship between I and C, than in future periods, C will have to be reduced by a cumulative total of $84.

Of course, none of that is literally true. As I (and Noah) said before, doing economics from accounting identities leads to patently absurd conclusions. There are no concrete relationships between savings and investment. They are both dependent variables. Neither is there a concrete relationship between I and C. Both depend on other economic variables, as well. But, zero-sum accounting would get you this result.

But I think there is a deeper fallacy that Landsburg’s experiment falls into, and that is the myth of government as consumer. It is very common to hear in right-wing (usually non-economist) circles that the private sector produces wealth, and that the government produces nothing, it only consumes wealth that is generated in the private sector. The fact is that the state produces the exact same amount of wealth as the market. That is none at all.

The fact is people produce wealth, and people consume wealth. The state and the market are simply institutions which people have arranged to coordinate production and consumption. The socialist calculation debate was not regarding how the state stole wealth from the market, it was regarding the limitations of the state as an institution for coordinating economic activity. Corporations in-and-of themselves do not produce any wealth, either. The organization of a corporation is wealth enhancing, but that is only to the point that it is more efficient than other such arrangements that bring people together to produce and consume.

Per James Buchanan’s excellent analysis [JSTOR] of the political economy, the (tax and spend*) state is largely concerned with providing club goods, that is: goods that are largely non-rival, and at least partially non-excludable. So to assume away transaction costs, deadweight loss, and the like…in this simple model, a society is choosing to purchase some goods as the “club of everyone”, instead of as individuals. Consumption increases when the government steals “idle millionaire’s” money, and doesn’t decrease at all (assuming no effect on I, or rather, that he government’s investment produced a form of capital to substitute for direct savings) because the types of goods provided by the “club of everyone” wouldn’t necessarily be purchased by the individual, but individuals are (presumably) wealthier for having them.

Brad DeLong is actually correct (and this fallacy is what he is pointing out in his post, although he doesn’t explicitly state it). “We” are the state. Arnold Kling is also correct, “lose the we”…the catch is that he just wants a different arrangement of the provision of club goods. Kling is re-stating Milton Friedman’s sentiment when he said (paraphrasing), “I’ve never seen a tax cut I didn’t like”. Friedman was stating a preference for institutional arrangements, not a statement about consumption.

Note: This isn’t an argument that allows the government to run roughshod over “idle millions” sitting around. Our capital stock does determine investment in the long run. Savings do have a role in the economy. In a hypothetical situation, if the government can get a higher ROI from stealing a millionaire’s money from under his mattress, then society is richer. But if not; if the government simply determines that government mattresses are where money goes, society is no worse off, and if the government consumes goods or invests the money in a ridiculous fashion, then society is worse off.

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*I specifically point to the tax and spend state because the “tax to finance regulations” state is a completely different animal. And so you can see how you can get mislead by simple accounting identities!

Taxes Cuts Drive Deficits

A couple of points

First, I am a bit late to this Op-Ed by Charles Koch but it so plainly illustrates a common fallacy I have to bring it back up. Koch writes

Years of tremendous overspending by federal, state and local governments have brought us face-to-face with an economic crisis. Federal spending will total at least $3.8 trillion this year—double what it was 10 years ago. And unlike in 2001, when there was a small federal surplus, this year’s projected budget deficit is more than $1.6 trillion.

The clear implication is that our budget deficit is the result of overspending. Now there are a lot of reasons people will point to as to why that’s not the case this time, the economy, the Bush Tax cuts, etc.

However, I want to make the more general point that spending is pretty much never the cause of budget deficits. Or, to be a bit more formal, variations in spending do not predict variations in the deficit. Variations in tax revenue, however, do predict variations in the deficit.

We can look at the US experience quickly

The blue line is spending, the redline is tax receipts, the green line is the deficit. Actually the green line is “government savings” which is the inverse of the deficit. So when the green line goes down the deficit gets bigger.

You can see that dips in the redline are associated with dips in government savings. Surges in the redline are associated with surges in government savings.

Now of course the deficit is mechanically related to spending and revenues, so what does it really mean to say that revenues are “more predicative.”  It simply means that revenues bounce around more than spending and where revenues bounce so does the deficit. Spending is more or less smooth. Its only real changes are associated with war and peace.

Which brings me to a second point. Arnold Kling says

Everybody talks about a monetary "exit strategy" once a strong recovery takes hold. But what about a fiscal exit strategy? Other than Ron Paul, does anyone have several hundred billion in spending cuts ready to go?

Tyler Cowen’s NYT column is on what he calls "fiscal illusion." Maybe it should be the "fiscal allusion," because he alludes to so many things, or the "fiscal elusion," because the implications of his writing may be elusive. But one interpretation is that we need fiscal rules, because discretionary fiscal policy is biased toward deficit. That is, the Keynesian prescription is for surpluses when times are good and deficits when times are bad, but the Keynesian prescription is only taken when times are bad.

There are a myriad of problems that cause the Keynesian prescription of saving when times are good and deficits when times are bad to go awry.

However, one of them is that continued emphasis on the spending side of the budgetary equation. Arnold is looking at spending cuts as an exit strategy. Both proponents and detractors of stimulus use the word as a synonym for government spending.

It would be simpler and easier if stimulus were a synonym for broad based tax cuts. For example, small and potentially ineffectual as it might have been, no one is talking about how we need to keep the tax rebate of 2008 going.

The Making Work Pay Credit of 2009, 2010 was similarly jettisoned though there was a 2% payroll credit in its place. Still I predict that will be gotten rid of when its term expires as well.

No one has a problem letting broad based tax cuts go. They have a problem letting upper income tax cuts go and entitlement spending go. So, lets steer the focus towards broad based tax cuts as the Keynesian remedy.

Educational Reform vs. Financial Reform

Arnold Kling asks why economists think they can improve educational outcomes by firing the worst teachers (a position he labels E) but none of us think that we could improve financial performance by firing the worst financial managers (a proposition he labels F).

He concludes

Both (E) and (F) are false, but economists have much softer priors about (E). That is, economists are strongly inclined to believe that outstanding performance in money management is luck. As a result, when someone claims to find something like (F), you can be sure that a significant effort will be expended on research designed to disprove that finding. On the other hand, economists would, if anything, like to believe (E), so that when someone claims to find something like (E), relatively little effort is expended trying to disprove that finding.

On a basic level the difference , somewhat reflected in Arnolds third option, is that economists believe that we know up front who the best or worst teachers are going to be over the next five years. Its the teachers who were the best or worst over the last five years. That is, economists believe individual teacher quality explains a huge fraction of the variation in student outcomes.

However, economists don’t believe that we can pick the best or worst financial managers over the next five years, just by looking at the best or worst from the preceding five years. That is, economists tend to think luck is the primary determinant of financial returns.

Now, admittedly Warren Buffet is an embarrassing counterexample for the luck hypothesis. On the other hand Merton and Scholes really looked like the smartest guys in the room until Long Term Capital blew-up in everyone’s faces. Moreover, Buffet’s legendary status makes him the exception that confirms the rule.

More deeply, economists argue that the most sensible way to invest is to simply buy a weighted average of all investment vehicles based on your risk tolerance.

Yet, few of us believe that the most sensible education is simply to take a weighted average of all currently used curricula and methods.

Arnold Kling on PSST

Just listened to Arnold Kling on Econ Talk. I think I have a lot better idea of his concept now than I did from his posts. The value in a good dialog is enormous.

A couple of comments that will only really make sense if you listen to the podcast.

One, Arnold is the first person I’ve heard on EconTalk in a while who spoke about the New Keynesian paradigm in a way that was recognizable to me. Foremost, he made clear that money demand is a key part of this whole story.

There was still a bit more old Keynesian stuff in his explanation than I would feel comfortable with but the story was recognizable.

Second, the core idea of PSST, I think I more or less agree with. That is, that key in making the economy work is finding new and better ways to exploit comparative advantage.

In a draft dissertation I worked on an exogenous growth model, in which there were different tasks rather than different types of capital and (1) that developing tasks took time and resources and (2) a minimum number of workers had to do each task so technological change was limited by the size of the market, transportation costs and even marginal tax rates. The math turned about too much and I dropped it.

Anyway, the larger point is that while its very clear that this concept is key to growth and prosperity, its not clear that its key to understanding recessions. I think the key fact that we are working around is that recessions are related to accelerations and decelerations in the rate of inflation.

This inexorable tradeoff is the fact that turns our eye always back to money.

Third, Arnold says the 70s should have shaken people of the Aggregate Demand story. Why? I can see why they would shake one of a simple Phillips Curve, but why Aggregate Demand generally?

Fourth, if we have any sort of cash in advance, or credit in advance story then doesn’t it immediately pop out why entrepreneurs would have an easier time in a loose money environment than a tight money environment? I prefer thinking more in terms of “money in the production function” but either way when there is looser money its easier to start a business.

Fifth, one other word on money in the production function. A key part of getting any complex system of production is that work has to be done first then you get output. In order to coordinate this work you need to have access to cash before you can produce. Otherwise, every employee is basically an equity partner and getting someone to go in both as an equity partner and have the skills you need is a lot harder than just paying them up front from a pile of cash.

Sixth, doesn’t the ability to exploit comparative advantage along with access to capital – organizational and physical – explain why jobs are a good thing even if work is not? Maybe its just miscommunication but it still irks me when some people say “why do we want to create jobs, we work to live, not live to work”

Yes, but you have to work a lot harder to survive if you don’t have a job than if you do. Getting a job decreases the amount of work it takes to live. That’s why jobs are good.

Give the Poor Money!

Matthew Yglesias posted a blog with a similar title, without the exclamation which I express for this idea. Here’s Matt, channeling his inner William Easterly:

Alternatively, one under-discussed possibility is for a guy who has a lot of money and a desire to help poor people to just identify some poor people and give them some money. It sounds banal when you say it, but one of the main obstacles to people being less poor is that they don’t have enough money. If you give them money, they’ll have more of it. Will this be optimal in all cases? Of course not. But in the vast majority of cases, you’ll do some good. It’s tempting to believe that you’re on the [v]erge of some major conceptual breakthrough in the field of philanthropy. But give some consideration to the possibility that you’re not. Perhaps if you have a special talent for anything, it’s a talent for making money. It’s not very hard to identify some people who might need money more than you do. Maybe you should just give them some, and then go back to making money.

Indeed, I think that Matt discounts the effectiveness of making simple transfers of cold hard cash (or digital numbers) from one section of society to another. Here’s me:

This tendency [to fiddle with wages] is called the “just price fallacy“, and it is very popular in politics…and unfortunately, seems to be human nature to decry prices we don’t deem to be “just”. Going all the way back to Diocletian, we can find examples of people verily condemning “price gouging” or “profiteering”. Of course, as we know from economic theory (and experience) setting price floors causes unemployment, and setting price ceilings causes shortages.

In (nearly?) all cases, simply giving poor people money is much better anti-poverty measure. Ironically, Milton Friedman, widely regarded as a “conservative economist” was one of the strongest backers of the negative income tax — a policy deemed “too liberal”! Why the tepid response to things like the Earned Income Tax Credit from the non-economist left (we know the right do it to simply score political points with constituents)? Well, it seems that it stems from what I like to call the “Barbara Ehrenreich theory of value[1]“. For those of you who do not know who Ehrenreich is, she pretty much built the industry of authors working undercover doing low-paying jobs, with the intent on writing a normative essay about the experience. Of course, the common conclusions are that we should treat these people nicer (which is fairly uncontroversial), and we should pay them more based on the humility that they face. By giving money directly to the poor, it seems that we are “justifying” employers that profit from “slave labor”. Of course, this is wrong and wrong-headed, but the view persists.

I’m guessing that I have a much weaker paternal instinct than Matthew, such that once it was identified the socially optimal level of transfer, then I say just simply give people money — which is the cheapest thing to do from a deadweight loss perspective. I am guessing that Matthew would much prefer a system of voucher payments, in order to exert more control over how poor people spend money. At least this is a tacit acknowledgement that hyperbolic discounting is a major problem for poor people. This is one of the big criticisms that I have for “solutions” politicians dream up. As I outlined in this article:

There is a very high correlation between poverty and hyperbolic discounting. Because this is true, many of the left simply deny that the fact that it exists, or worse — even if they acquiesce to the fact that poor people tend to heavily discount the future, they claim that we need better education, more information, etc., to battle the problem. The traditional hard-line right wing (not Hayek, yes Rothbard) is Mathus’ and Franklin’s prescription; let them suffer.

Why these strategies are wrong is that they both exaggerate the problem. Education is the perfect example of something that people who heavily discount the future will not tolerate. The whole problem with extreme hyperbolic discounting is that it makes people unwilling to tolerate short-term deprivation in order to receive exponential long-term benefits. The right’s preferred solution does the exact same thing. Making alcoholics ineligible for liver transplants, or not paying for cigarette smokers’ chemotherapy so that they have to suffer financially isn’t going to deter anyone, because the punishment is so far off that it is effectively discounted to zero. There is no use in kicking people after they’re down, in the same way that it is unconstructive to repeatedly tell people how badly they are screwing up.

I’m not personally all that interested in how poorly people spend their money. However, it is relatively straightforward to design incentive systems that take hyperbolic discounting into account.

Interestingly this is an area where I sort of disagree with Arnold Kling, who bills himself as a ‘civil societarian’. He believes that voluntary donation to public services will provide a superior outcome in gaining high-quality public services. I’m skeptical of this, as there are search costs, and information asymmetries inherent in judging the quality and efficacy of the vast amount of public services. I think it would simply lead to the most visible services getting all the money, with the less visible services suffering…independent of the value they create for society. For example, it is a monumentally large task to maintain records of property rights. It’s easier now, but historically it has been so difficult that possession became “9/10ths of the law”, simply because records were so poorly kept. This service creates an immense amount of value for society, but it is nearly invisible. It would probably get shafted in a voluntary donation drive in competition with Food Stamps, Medicaid, and Welfare. I think that government has important economies of scale in distribution that would be hard to match with private institutions. The problem is dealing with the inefficiencies of our institutional arrangements.

It is definitely in everybody’s interest that everybody becomes as rich as possible. To that end, we should provide poor people with the means and (possibly) the incentives to make choices that increase their wealth over time (and most importantly, increase intergenerational wealth). To that end, simply giving poor people money that is phased out slowly over the course of an income quintile is much more efficient than the hodge-podge of a safety net we currently have.

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Addendum: Before I had a chance to peruse Kevin Drum’s blog, I see he commented on the same thing, taking roughly the opposite view. Although I’m confused by this statement: “The generosity of the American taxpayer is not exactly legendary, after all.” Is that taken to mean that people don’t voluntarily pay more to the government, or that Americans aren’t charitable in general?