Archives For Economics
Old Moose & I tackle one of the great questions of the cosmos… can you really trust the American voter to make the right decision?Continue Reading...
As campaign season has been heating up, embattled Democrats are taking serious poundings over the government’s failure to restore employment numbers to pre-recession levels. Their prevailing defense, when one is given, is that government action did create jobs, however the economy lost more jobs than were created, therefore the economy lost net jobs, even though the various stimulus programs were successful.
This sounds reasonable, but it overlooks the basic theory underlying government job creation policies, which I laid out in an earlier note this summer. According to modern Keynesian economic theory, which has been endorsed, at least nominally, by Democrats since the time of FDR, jobs are created by demand and consumption. Under-consumption leads to underproduction, as fewer goods are necessary if no one is buying them. Underproduction causes unemployment, as fewer employees are necessary to manufacture fewer goods. Therefore, to whatever degree the economy is under-consuming and under-producing, unemployment will rise, and to whatever degree that output gap closes, unemployment declines.
Now, here’s where things get problematic for the President’s defenders. When we calculate the relationship between underproduction and unemployment, both are given in terms of deviation from trend by percent. In other words, we don’t say that an increase of X dollars of GDP creates or saves X many jobs. We say that a GDP which is trending X percent below its usual growth rate creates X percentage points of unemployment above the usual rate. Since World War II, that ratio has been roughly 2 percentage points of underperformance to one percentage point of unemployment. We call this relationship Okun’s Law, and used it to calculate the impact of government stimulus, until it broke.
Over the course of 2009, when the stimulus was taking effect, GDP stabilized. For the sake of the argument, let’s assume the stimulus was responsible for that. If we apply Okun’s law, unemployment should have reached only around eight percent, which is what the administration said it should be. Instead, it jumped to nearly ten. It can’t be argued that this was simply the consequence of the economy being worse than we imagined it was – if that were so, this unexpected one and a half percent increase in unemployment would have coincided with an additional unexpected three percent decrease in GDP. That didn’t happen. Thus, it isn’t that the administration fed optimistic GDP numbers into the economic model to calculate an optimistic impact for the stimulus. The numbers are fine; the problem is that we no longer know what the relationship is between GDP underperformance and unemployment rates, such that the model itself is suspect. With more and more frequency economists are suggesting that we’re in a period of structural unemployment instead of cyclical unemployment, which means among other things that unemployment can’t be fixed with traditional recession mitigation tactics, such as, say, propping up GDP through government spending. If so, America flushed nearly a trillion dollars down the toilet which had very little effect on unemployment.
Incidentally, if government spending doesn’t end up in worker’s pockets, it’s worth exploring where it actually does go. If we accept the idea that government spending efficiently stimulates the Gross National Product (which is itself dubious given the lack of long term effects of certain programs like Cash for Clunkers), then the stimulus money is paid to those industries which do the producing of said products. If, for whatever reason, those industries find they don’t actually need more employees to fulfill these new orders, then part of the stimulus money goes to cover other kinds of overhead, but much of it is kept as profit. So the next time you hear someone advocate that government should do something about these greedy profit makers who prosper while millions are out of work, remember: if Obama is to be believed when he claims that the stimulus increased GDP, then government already has done something about these “outrageous” profits. In large part, it created them.
Once a year, America celebrates the end of summer with a national holiday dedicated to dubious economics: Labor Day. Organized labor, we are assured, lifted the working poor out of poverty, allowing us all to escape wage-slavery by redistributing wealth from the greedy fat-cats to the working classes. Why, without unions, we’d probably still be working sunup to sundown just to provide food and rent! Clearly, we need a holiday to celebrate our excellent standard of living, brought to us by trade unions. So in honor of this auspicious occasion, I bring you a parable.
Off hidden away in the wilderness is a village you’ve never heard of before. In this village are one hundred families, who each send one member to work each day in the town factory. In this factory, villagers build boxes-of-stuff. Each box is filled with the necessities and basic niceties of life: food, clean water, medicine, fuel, clothing, and a number of other sundries. At the end of each day, the factory produces about one hundred crates and ships them off to the market.
After being paid, all the village men head off to the market to supply their households. Each day, the headmen find that they’ve been paid enough to purchase a single box-of-stuff, which they take back to their families. Now, a box is good enough to keep a family from dying of starvation, but it’s not exactly high luxury. Families are fed, but not quite to their satisfaction. Houses are heated, but you’d still want to keep a sweater on. People have sweaters, but they’ve all seen better days.
Eventually, the town workers are quite fed up. “Every day,” they protest,” we work and work, but our wages are never high enough for us to buy two crates, not one single day of the week!” A union is formed. Demands are made. A general strike is called. “Workers of the village, unite! Two boxes for every house!” As no one works, no one gets paid, and people grow thinner while houses grow colder, but everyone is assured that eventually the factory must give in, and new, higher wages will make up for this current suffering.
After two weeks, the factory gives in, and wages are doubled. After their first shift back, the workers rush to the market with more money than they’d ever dreamed of before. The first man in line buys two crates and heads home, as does the second, the third, and so forth, until the fifty-first man. For, you may recall, the factory only makes one hundred crates a day. After the first fifty men bought two apiece, there remained nothing more to sell to the last fifty. Half the village feasted, while the other half starved. The next day, those who starved decided not to risk the same thing happening twice, and made a dash to the market after work in record time. Each of these bought two crates apiece and feasted, while the other half found the market oddly sold out before they arrived.
By the third day the shopkeepers realized that the workers had more money, but were competing for the same number of resources, so they doubled the price of a crate of goods. After all their trouble, the villagers found themselves unable to afford anything more than the one box apiece they had to make do with in the beginning.
We in the modern world often make the serious mistake of confusing currency for wealth. Currency isn’t wealth. Currency buys wealth. Real wealth consists of the goods and services people actually consume. If we increase the amount of currency people receive in wages, but do not increase the quantity of goods manufactured, it doesn’t make anyone richer, it just makes the same finite quantity of goods more expensive to purchase, stimulating inflation. Instead, if through industrial and technological advances we increase the quantity of goods we can manufacture per capita, we’ll find that the purchasing power of our wages will increase. In America, the drastic increase in standard of living over the past century cannot be explained as a consequence of unions fighting for higher wages. No level of wage would allow the masses to consume goods which weren’t being produced in sufficient quantity. Instead, as technology improved in the 20th century, things like mass production and free trade made market prices drastically cheaper, and the working poor found they could suddenly afford luxuries previously afforded only to the rich.
So, this Labor Day, enjoy the ability to live a comfortable life and still take a three-day weekend, brought to you by capitalism. Not unions.
Photo Credit – www.bilerico.com
It’s 1929, and the stock market has just crashed. You’re a classical economist, and you’re trying to reassure everyone that these things happen from time to time, and the economy will soon make a turnaround and in no time we’ll be following the roaring twenties with the roaring thirties. You’ll soon eat those words. Unemployment skyrockets. Factories close. Soon everyone is searching for an explanation as to what happened.
None of this should be happening. The country’s capital, it’s means of production, are still intact. People aren’t out of work because the factories all burned down, they’re out of work because their factories are closed. Their factories in turn have only been closed because they can’t turn a profit. They can’t turn a profit because no one buys their goods. No one buys their goods because no one has expendable income, because so few have jobs, because the jobs are gone, because no one can turn a profit, and so on, and so on. The country’s physical infrastructure is perfectly intact. Everything could basically go back to the way things were if only everyone resumed their previous buying and hiring habits, but no one’s going to do that. Everyone is shell-shocked by the collapse.
It was into this situation that John Maynard Keynes introduced his economic theories. Keynesian economic policy can be roughly summarized as a theory of demand-management. The country’s industry and infrastructure are intact. They could supply any demand if there were a demand. Demand, on the other hand, is trapped well below where it could be, because of the above catch 22: no one’s buying anything because they don’t have jobs because they don’t buy anything. In technical terms,there is an output gap between how much we could manufacture and how much we do manufacture because the the aggregate demand, the total amount of stuff that people are willing to purchase, isn’t high enough to consume all that we could produce if everyone were fully employed.
The Keynesian solution to the above is that government should step in and spend money for no other purpose than to raise the aggregate demand. This is one of the reasons that so many public works projects were undertaken during the Great Depression. Sure, they provided gainful employment for masses of the unemployed, and those politicians who organized them touted that fact as their primary purpose in order to get good press, but the real reason we built things like the Hoover Dam is because projects like that represented millions of dollars of extra spending to boost aggregate demand.
This is also one of the reasons we have a minimum wage. A minimum wage is touted as one of the great equalizers in society, one step on the way to stamping out poverty. That’s one of the bigger lies in all of modern politics. When you use price controls to drive the price of a good up, you invariably increase the number of people who want to sell (since they’ll make more money) and drive down the number of people that want to buy (since they’ll pay more money). This creates a surplus of a good which sellers cannot find a buyer for. When that good is an hour’s worth of labor, that surplus is called unemployment. Minimum wages thus favor those who are employed, but make it very difficult to enter the job market for those who are the very least qualified. Such people, being the last to be hired and the first to be fired, never get the job experience needed to compete against the more qualified. For this reason, the minimum wage is the first thing that needs to be blamed for the inability of the chronically poor to improve their circumstances. If, then, it doesn’t at all accomplish what its proponents assert it does, why do we have it? Because the higher wages being paid to fewer people will still amount to more money than the lower wages paid to more people, which drives up aggregate household incomes, which drives up aggregate demand.
Now, often you’ll hear certain conservatives and libertarian types argue that it wasn’t Keynesian economics at all that pulled us out of the Great Depression, it was World War II. This overlooks the dirtiest secret of Keynesian economists: war is very good for the economy. Patriotic citizens buy government bonds in large amounts, providing the government with huge amounts of low interest loans, with which it buys all the weapons it can possibly convince its citizens to produce, which in the case of World War II, boosted aggregate demand so high that unemployment fell so low that when the country ran out of men to work in their factories they had to turn to (*gasp*) women to fill the labor shortage. Or, at least , that’s what the Keynesian says.
Generally speaking, a theory is judged correct if it can reasonably explain all the evidence until it runs up against a piece of evidence it can’t explain. And for the most part, after Keynes introduced his ideas, they could provide reasonable explanations of all the economic development of the West for several decades. Governments in North America and Western Europe who used Keynesianism as the basis for public policy led the western world into three decades of fairly steady growth after World War II, often called the Golden Age of Capitalism. So if you were looking back at the history of 20th century economics from, say, 1970, you might be inclined to agree with words often misattributed to Richard Nixon, “We are all Keynesians now.”*
But as the Republicans and Democrats joined together in mutual love of demand-management, the economy geared up to send everyone’s heads spinning. The onset of “Stagflation” would mark the beginning of the end for traditional demand-management theories.
Stagflation was one British MP’s clever way of referring to an economic situation consisting of both economic stagnation and inflation. Not only would there be high unemployment rates, but people’s savings would be decimated as inflation drove up the cost of everything, lowering a dollar’s purchasing power and turning what was once considered a fair sized savings account into something considerably less. This is a particularly unpleasant situation, which is perhaps why stagflation is commonly measured with something called the “misery index.” Stagflation also happened to be totally impossible, at least according to the dominating demand-management economic theories.
As you’ll recall, Keynesianism posits that unemployment is caused by an insufficient aggregate demand. When demand falls, prices fall, and deflation sets in. Accordingly, high unemployment rates should only be possible in periods of low inflation or even deflation, whereas high inflation should only be possible in periods of low unemployment. Instead, while the unemployment rate jumped from about 3.5% to 8.5% between 1969 and 1975, the inflation rate spiked to 11% by 1974, after just having been 3% two years earlier. In the 1976 election, Carter hammered Ford over these numbers, but by the end of Carter’s term, unemployment was at 7% and inflation peaked at 13.5%.
To explain this, Keynesians were forced to make significant concessions to competing economic theories. Monetarism, a theory stating more or less that inflation can be managed by controlling the supply of money, could suddenly explain what Keynesians could not. Monetarism, however, was not merely able to explain stagflation, it also proposed a competing explanation for why the Great Depression happened in the first place: the Great Depression coincided with a huge series of bank failures, which drastically decreased the money supply. Now, a smaller money supply will also negatively impact aggregate demand, but it needs to be addressed differently than Keynes suggested: the Federal Reserve needs to act to increase the money supply. Indiscriminate government spending cannot fix a monetary issue.
Demand-managers in general also needed to make another serious concession: the supply side of the economy, not just the demand side, can be broken. Shocks to the market, particularly such as the 1973 OPEC oil embargo, were now believed to be able to intimidate suppliers to stay out of business regardless of whether there would be demand for their goods. It wasn’t long before some started wondering whether other burdens placed on employers could be causing economic malaise, and soon a new economic theory, supply side economics, was being formulated, which argued that high taxation and complicated regulations were keeping suppliers from expanding and thus increasing employment. Reagan soon turned supply side economics into official policy, Thatcher fought off inflation rates that had dwarfed America’s with Monetarism, and the days when Keynesianism was the only theory in town were over – unless one is a Democrat, that it.
Among Democrats, the central idea of driving up aggregate demand with government spending hangs on stubbornly in the form of modern economic stimulus packages, but unfortunately, the politicians who support them have largely and incorrectly reduced Keynesianism to the following principle: “if you throw money at your problems, they go away.” Most of our politicians don’t come from a background of economics, so some ignorance in this area is to be expected, but unfortunately, can no longer be tolerated. Government spending is supposed to repair the economy by targeting a very specific economic problem. If your economic troubles aren’t due to low demand, driving up demand can’t fix your economy, and the days are now over when you could just presume low demand is the problem.
I have yet to hear a coherent argument out of Washington as to why today’s economic troubles are such that stimuli are going to have any effect. I seriously doubt that the people trying to spend trillions of dollars on them even understand that the above is an issue, that stimuli are not a magic “fix the economy” button. I’ve grown up watching a certain party try to solve all our problems by spending for spending’s sake, and I have no reason to believe that’s not what’s going on now. Our economic recovery is being managed by people eternally stuck on the cutting edge of the 1930′s.
*Actually written in an article by Milton Friedman. Nixon did make a similar, but less catchy statement: “I am now a Keynesian in economics.”
Whenever a government proposes to cut spending to fill a budget shortage, it seems guaranteed that you’ll hear protesters object that we ought to raise taxes to fill the gap, rather than defund our programs and lay off government employees. Such proponents usually carry one dangerous presumption into this discussion. It seems common to believe that an increased tax rate will bring in new revenue proportionally to the increase. If, for instance, a tax of twenty percent on an industry with a billion dollars in profits brings in two hundred million in revenues, raising it to thirty should bring in three hundred. In believing this, we overlook an age-old observation regarding the relationship between tax rates and tax revenues.
Economists have observed since nearly the beginning of the profession that taxation disincentivizes the taxed activity. All economic activity involves risk, and investors are willing to take risks only for the sake of profit. While governments have always believed they should have a share of your profits, they haven’t (historically) been keen on the idea that they should share in your risk and bail you out if your business goes under. Decreased opportunity for profit at the same level of risk tends to cool some businessmen from taking that risk at all. Now if someone closes shop on account of this skittishness, he won’t make any taxable profits selling taxable merchandise. From this we conclude that higher tax rates decrease the amount of transactions that can be taxed.
That conclusion has great significance for tax revenues, because tax revenues are equal to the tax rate times the total value of the taxed transactions. Accordingly, if raising the first value lowers the second value, at a certain point tax revenues will hit their maximum possible level and indeed begin declining if taxes rise above it. A tax above that point is called a prohibitive tax, and lowering such a tax will counter-intuitively increase overall tax revenues. Ibn Khaldun was probably the first man to write about this in the fourteenth century, but after Arthur Laffer raised this objection regarding Ford’s tax increases to a couple of Ford’s staffers (Rumsfeld and Cheney, incidentally) a Wall Street Journal coined the term that stuck: the Laffer Curve. There are four consequences of this that I want to touch on.
First, if you need to raise a certain amount or revenue, you cannot calculate the necessary tax hike based on the presumption that the transactions being taxed will still occur at the same rate as they did at the former tax rate. With a smaller tax base, your new taxes will certainly bring in less money than projected, and if tax rates become prohibitive, tax revenues will actually decline.
Second, if you intend to lower taxes, it will not cost you as much revenue as you project, and may even increase it if your taxes are prohibitive. Now on this point, it needs to be noted that if an economic downturn coincides with your tax cuts, you may find yourself in deficits worse than projected. Such was the case when the Bush tax cuts coincided with the general economic malaise of the better part of the last decade. However, this needs to be blamed on the downturn, not the tax cuts, since the higher rates, especially of the capital gains tax (tax on sale of stock, among other things), would certainly have scared away even more investors had they remained. When pundits argue that the deficits would be such-and-such an amount lower without them, they’re presuming the economy would not have fallen to even lower levels with them. Had the taxes remained where they had been, they would have still brought in extra revenue, just not as much as is often projected. This seems also to be a good place to point out: contrary to some who use the Laffer Curve to defend every tax cut, not every tax cut will increase revenues or be deficit neutral. This only occurs if taxes are lowered from above the point where tax revenues have been maximized. The US is probably not near this point at the moment. Nonetheless, at any point cutting taxes will increase the taxable income, such that at least some portion of the cost of the tax cut will be offset.
Third, if you are seeking a tax hike to fund social programs, you must be careful that the programs you pay for do not create more victims than they help. While tax increases suffer from diminishing returns, such that every one percent increase to the tax rate raises revenues less than the one before, the accompanying contraction of the economy puts more and more people in need of such programs. It is possible, depending on many factors, that an increased tax rate causes unemployment to rise and wages to fall to the point where your tax is harming the standard of living more than your program is helping it. This is certainly not a guaranteed consequence, but it’s a possibility, and it’s one I’d like progressives to investigate thoroughly before advocating the need for a new tax.
Fourth, if your tax only targets one specific kind of income or transaction, especially tax on goods that are regarded as non-essentials, it is least likely to approach anywhere near its estimated revenue. People will most likely choose to find alternative kinds of investments or transactions that aren’t subject to the tax. For instance: historically income has been taxed, but employer based health insurance hasn’t. For this reason, most employees try to get their insurance direct from employers, thus avoiding the need to pay income tax on that part of their wages. Now congress wants to get sixty billion dollars over ten years by taxing employer provided insurance plans worth over $10,200. If history is any indication, workplaces with such a plan should be rolling out new $10,199 plans any time now to avoid that tax, and the sixty billion dollars will never materialize.
Now, a caveat. There’s no simple formula for computing the point at which revenues have been maximized. Accordingly, this is somewhat difficult to put into practical use. Nevertheless, it remains a warning which we need to hear often when we determine our tax policy: tax rates and tax revenues have a complicated relationship and it is not easy to project the latter from the former.