Krugman’s Weak Defense of High Marginal Tax Rates

Alexandria Ocasio-Cortez recently proposed a 70% marginal tax rate on top income earners. Given that this policy almost doubles the current marginal tax rate, many view the plan as a bit too much. Don’t worry though, because Paul Krugman is here to assure you that actually AOC’s proposal is just espousing standard economics. In fact, “there isn’t any body of serious work supporting G.O.P. tax ideas, because the evidence is overwhelmingly against those ideas.”

I don’t think Krugman is right about that, but before getting to him I should concede a couple points. First, I really don’t think the tax plan AOC is proposing would destroy the economy. Her 70% rate would only kick in at $10 million per year. That hits almost nobody. It’s also a marginal rate not an average rate so it doesn’t mean that rich people are giving 70% of their total income to the government, only income above $10 million. Most rich people aren’t making the majority of their money through wages anyway so the effects of this plan probably aren’t huge either way (note that also means it won’t raise very much revenue).

Krugman, however, is making a much stronger claim. He’s not only arguing that more progressive taxes are better, but that there isn’t any support for the idea that low taxes can be good. Here’s an excerpt from a 2009 JEP article summarizing key findings from the optimal taxation literature:

1) Optimal marginal tax rate schedules depend on the distribution of ability; 2) The optimal marginal tax schedule could decline at high incomes; 3) A flat tax, with a universal lump-sum transfer, could be close to optimal; 4) The optimal extent of redistribution rises with wage inequality; 5) Taxes should depend on personal characteristics as well as income; 6) Only final goods ought to be taxed, and typically they ought to be taxed uniformly; 7) Capital income ought to be untaxed, at least in expectation; and 8) In stochastic dynamic economies, optimal tax policy requires increased sophistication. For each lesson, we discuss its theoretical underpinnings and the extent to which it is consistent with actual tax policy.

Mankiw et al, 2009

Funny enough, 2, 3, 6, and 7 sound strikingly like those GOP tax ideas that Krugman says are entirely unsupported by the economic literature. So maybe he just meant the evidence he already agrees with. Of course, Krugman has his own evidence, which argues that the optimal top marginal tax rate for the US economy is 73%. I admit I haven’t read the paper he references. I’m sure they offer a better justification for that rate than Krugman. His would fail my Econ 1 class. Quoting the relevant section:

In a perfectly competitive economy, with no monopoly power or other distortions — which is the kind of economy conservatives want us to believe we have — everyone gets paid his or her marginal product. That is, if you get paid $1000 an hour, it’s because each extra hour you work adds $1000 worth to the economy’s output.


In that case, however, why do we care how hard the rich work? If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change, does it? Ah, but it does — because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort — and conversely the cost of their working less is the reduction in the taxes they pay.


Or to put it a bit more succinctly, when taxing the rich, all we should care about is how much revenue we raise. The optimal tax rate on people with very high incomes is the rate that raises the maximum possible revenue.

To summarize what Krugman is saying here: If we ignore the welfare of the rich themselves, we only care about how much they work to the extent that they pay taxes. In other words, if taxes were 0, there is no difference between rich people working 0 hours or a million. The welfare for the rest of us is unchanged.

To anybody but an economist this is obviously ridiculous. Does Krugman really think that if Bill Gates had never worked a day in his life we wouldn’t miss Microsoft or any of the products that it produced? We’d only lose out on the taxes he paid? I don’t think so.

So what’s wrong with Krugman’s analysis? Isn’t it true that all workers in a competitive market get paid their marginal product? And if that’s the case then doesn’t losing their efforts just mean that we only lose what we were paying them anyway? Not exactly. His logic is correct for an infinitesimal (virtually 0) drop in labor, but not for a large change. If rich people are actually doing valuable work and that stops because they are discouraged by taxes, the output of everybody else will fall. If Bill Gates works 1 second less, it’s true that that won’t impact anybody else’s welfare. If Bill Gates never invented Microsoft at all (because he thought the gains were too low to take the risk), hundreds of thousands of people would need to find other (less productive) work. The welfare benefits of Gates’s creations are far far above any compensation he has ever received.

Krugman also ignores the costs on the consumer side from reduced labor. Even if a worker gets paid their marginal product in nominal dollar terms, the output they produce is more valuable to the person who buys it than it is to the person who created it (otherwise the trade wouldn’t have occurred). If taxes reduce the amount people want to work and create new products, this consumer surplus is lost.

This isn’t the first time Krugman has tried to argue that when workers are paid their marginal product then their work has no value to the rest of society because they take everything they put in. Bob Murphy offers an excellent rebuttal in this post. John Cochrane also has a great recent post on the tax issue. His evaluation of Krugman’s argument:

Krugman gets the benefit of labor to society wrong in an astonishing econ 1 way

If you are paid your marginal product, as you are in a competitive market, then you are paid how much revenue your efforts add to your employer’s bottom line. But society benefits by the consumer surplus, the area under the demand curve, and loses that consumer surplus when taxes put a wedge between your effort and your wage. When Steve Jobs worked hard and sold us all Iphones, he made a ton of money, and apple made a huge profit. But we all benefitted by far more than we paid Apple for the phones.

No, the world is not a static, zero-sum game.

Tax policy is hard. I don’t know what the optimal tax rate should be. It could very well be higher than what we have now. But to say that it’s settled economics is misleading if not an outright lie.

Why College?

The value of a college education is clear. People who attend college earn a significant wage premium over those with only a high school degree as the time spent in college supposedly teaches valuable skills that will transfer to the workplace. Increasingly, many have argued that everybody should attend college, that college is a fundamental human right as well as an investment in the future. A more educated society will also be a more productive, more innovative, and more balanced one.

I disagree. I’ve spent almost my entire life in the education system and my perspective on the value of education does not follow this standard view at all. It’s not that I think education has nothing to offer. I’ve been able to teach introductory and intermediate macroeconomics over the last couple years and it has been one of the most fulfilling experiences I’ve ever had. I’ve spent years learning and thinking about macroeconomics and being able to share that with new students is something I would never want to give up. The education system has worked great for me. It probably works great for anyone whose goal is to learn or share information and ideas. But I’m not sure it works so well for people who just want a better job.

Economics teaches that increasing competition in a market tends to drive down prices. In recent years, the internet has introduced a flood of competitors for the traditional education system. A student in 1950 who wanted to learn linear algebra or differential equations had relatively few options. Today, they can take an entire course on Khan Academy or Coursera for free. Google almost any question and some resource will appear to help answer it. Wikipedia alone has as much information as any college library. Bernie Sanders and Alexandria Ocasio-Cortez want free education for all. It’s already available. And yet despite the rise of these potential competitors to physical universities, the price of attending college has skyrocketed instead of fallen.

There’s a few explanations for why internet alternatives for education have not decreased the cost of traditional education. One is that traditional education is just so much better than trying to learn from an online course that it is still worth paying more to actually go to college. And there’s certainly some truth to this point, even if it’s only because of the increase in commitment that comes from a teacher, exams and GPA driving you. But is it $50,000 a year better? In my own experience, which includes many hours spent on Khan Academy because the actual professors can’t teach, absolutely not.

A more plausible explanation is that traditional colleges and online learning are not actually competitors at all. There’s one thing that Khan academy can never offer that Harvard can – a Harvard diploma. And it’s the diploma that employers care about. Bryan Caplan has convincingly argued that the benefit of a college education is mostly signaling. The skills you learn in college aren’t really what employers are after, but learning those skills shows you are a person who is capable and intelligent. Even as somebody who still uses much of what I learned in college economics and math classes, I still took a bunch of classes that were essentially useless. Can’t we come up with a better way of signaling these traits that doesn’t involve spending years of our lives listening to professors drone on about topics we don’t really care about or have any use for?

Modern universities have become a strange amalgamation of different features. On the academic side are professors who care mostly about their own research teaching students who care mostly about grades. But colleges also serve as quasi hotels complete with state of the art gyms and world class dining facilities. Some schools even seem to be more about glorification of their football or basketball teams than anything else (why athletics and school should be smushed together I will never understand). And on top of everything is the idea that all of this is somehow supposed to prepare students to work. Why?

Instead of college, what if people simply paid to be trained by employers in their desired fields? Would Google turn down a proposal for an aspiring programmer to work for them for a year for $10,000 (paid to Google not by Google). People who are already upset by unpaid internships might be horrified by the thought of negative internships, but why is paying to get a year of real world work experience worse than paying even more to go to college? A liberal arts education can still be valuable for a lot of people. Maybe it’s worth paying $50,000 a year for the knowledge and discourse that comes with the college experience. That option can still exist for those who want it. But for those who don’t, they should be able to get only the skills they need and move on.

The other important parts of college life can still remain as well. It would be easy to set up communities for young people to live together. College sports are big enough on their own to survive without the academic component. And there are plenty of ways for new workers to signal their worth to future employees. I’m not sure how we got in this equilibrium of college being the only ticket to a well-paying job, but I think it’s time to find a way out of it.

Does it “Take a Model to Beat a Model”?

Imagine being a chemist in the Middle Ages. Your colleagues are all working on fanciful tasks like trying to develop a philosopher’s stone to grant immortality or turning lead into gold. You continually point out to them that all of their attempts have pretty much failed completely. In fact, based on your own research, you have strong reason to believe that the path they are taking is going completely the wrong direction. They aren’t just failing because they haven’t found the right formula to transform metal into gold, but because the task they have set out to do cannot be done. You urge them to abandon their efforts and focus on other areas, but they don’t seem to listen. Instead, their response: “well sure we haven’t been able to turn lead into gold yet, but can you do any better? I don’t see any gold in your hands either.”

You can probably already see where I’m going with this metaphor. Replace chemist with economist and turning lead into gold with DSGE macroeconomics and you’ll have a good sense of what criticizing macro feels like. I don’t think it’s an exaggeration to say that every critique of macro is invariably going to be met by some form of the same counterargument. Of course the model isn’t perfect, but we’re doing our best. We’re continually adding the features to the benchmark model that you claim we are missing. Heterogeneity, financial markets, even behavioral assumptions. They’re coming. And if you’re so smart, come up with something better. It takes a model to beat a model.

I won’t deny there is some truth to this argument. Just because a model is unrealistic, just because it’s missing some feature of reality, doesn’t mean it isn’t useful. It doesn’t mean it isn’t a reasonable first step on the path to something better. The financial crisis didn’t prove that the methods of macroeconomics are wrong. Claims that nobody in the macro profession is asking interesting questions or trying to implement interesting ideas are demonstrably false. We certainly don’t want criticisms of macro to lead to less study of the topic. The questions are too important. The potential gains from solving problems like business cycles or economic growth too great. And if we don’t have anything better, why not keep pushing forward? Why not take the DSGE apparatus as far as we possibly can?

But what I, and many others, have tried to show, is that the methods of macroeconomics are severely constrained by assumptions with questionable theoretical or empirical backing. The foundation that modern macroeconomics is building on is too shaky to support the kinds of improvements that we hope it will eventually make. Now, you can certainly argue that I am wrong and that DSGE models are perfectly capable of answering the questions we ask. That’s quite possible. But if I am not wrong about the flaws in the method, then we shouldn’t need a new model to think about giving up on the current one. When somebody points out a flaw in the foundation of a building, the proper response is not to keep building until they come up with a better solution. It’s to knock the building down and focus all effort on finding that solution.

I can confidently say that if a better alternative to DSGE exists, I will not be the one to develop it. I am nowhere near smart or creative enough to do that. I don’t think any one person is. What I have been trying to do is convince others that it’s worth devoting a little bit more of our research efforts to exploring other methods and to challenge the fundamental assumptions that have held a near monopoly on macroeconomic research for the last 40 years. The more people that focus on finding a model to beat the current model, the better chance we have to actually find one. As economists, we should at the very least be open to the idea that competition is good.

Where do we start? I think agent based simulation models offer one potential path. The key benefit of moving toward a simulation model over a mathematical one is that concerns about tractability are much less pressing. Many of the most concerning assumptions of standard macro models are made because without them the model becomes unsolvable. With an agent based model, it is much easier to incorporate features like heterogeneity and diverse behavioral assumptions and just let the simulation sort out what happens. Equilibrium in an agent based model is not an assumption, but an emergent result. The downside is that an ABM cannot produce nice closed form analytical solutions. But in a world as complex as ours I think restricting ourselves to only being able to answer questions that allow for a closed form solution is a pretty bad idea – it’s looking for your keys under the streetlight because that’s where the light is.

Maybe even more important than developing specific models to challenge the DSGE benchmark is to try to introduce a little more humility into the modeling process. As I’ve discussed before, there isn’t much of a reason to put any stock in quantitative predictions of models that we know bear little resemblance to reality. Estimating the effects of policy to a decimal point is just not something we are capable of doing right now. Let’s stop pretending we can.

The Righteous Mind Review

More and more in our political discourse, it seems that many of us are forgetting the value of disagreement. We definitely still like to argue against people who disagree, but the goal of those arguments seems to be more about winning than about learning. I’m right. They’re wrong. That’s the end of it. Jonathan Haidt, in his excellent book The Righteous Mind, offers a  counterpoint to this mindset. The book is a plea to “disagree more constructively,” to set aside our differences and find points of commonality, and, even when we do come to find irreconcilable moral or political disagreement, to recognize that the other side has value.

A series of metaphors guides the structure of the book. In the first section, Haidt argues that “intuition comes first, strategic reasoning second.” To illustrate this point, he compares human thought to a small rider trying to guide a large elephant. Since the rider (the rational part of our brain) can do little to actually steer the elephant (our intuition), instead he just makes post hoc justifications for the elephants actions. In other words, in political and moral arguments, we usually come to the answer before we figure out the reason. Although we often claim to be forming our opinions based on a fair reading of the evidence, I think most of us can admit to sometimes simply looking for evidence that conforms to our preconceived judgements.

The second piece of the book argues that human morals are aligned across six “moral foundations:” care/harm, fairness/cheating, loyalty/betrayal, authority/subversion, sanctity/degradation, and liberty/oppression. Here he uses the metaphor of a tongue with six taste receptors. Liberals tend to focus on the care/harm and fairness/cheating axes while conservatives draw from all six. More importantly, Haidt draws on his own experience observing different cultures in India to argue that different moral systems make sense for different societies and different times. Some actions that seem morally repugnant (like eating your dog after it got hit and killed by a car) are actually somewhat difficult to explain in a consistent moral framework. They just seem wrong to us. The case for a universally correct moral standard, in Haidt’s view is quite weak.

Finally, the last section, and perhaps the one I found most interesting, talks about humanity’s tendencies towards group behavior. He describes humans as “90 percent chimp and 10 percent bee.” Each of us generally acts towards our own self interest, but occasionally our “hive switch” is turned on and we act in the way that’s best for the group. He cites Emile Durkheim’s observation that being a member of a group can generate a “‘collective effervescence,’ which describes the passion and ecstasy group rituals can generate.” Haidt points to the feeling you get when you observe incredible views in nature, or participating in raves or sporting events, as examples of this Durkheimian hive switch being flipped.

He then extends this observation to explain people’s attachment to religious communities. “Religion is a team sport,” he quips as he notes the similarities between the “rituals” involved in cheering for a sports team (songs, superstitions, traditions, etc.) and those of religious groups. Although Haidt himself is atheist, he does not take the view of many atheists that religious people have simply been duped into believing. Instead, he sees religion as a natural way to get people to flip their hive switch and think in terms of groups. Religious societies have been more successful because they cause people to create moral, caring communities where individual benefits can sometimes be pushed aside in favor of group success. He writes. “If you think about religion as a set of beliefs about supernatural agents, you’re bound to misunderstand it.” Instead, its best to see religion as a way to “suppress cheating and increase trustworthiness. Only groups that can elicit commitment and suppress free riding can grow.”

Haidt presents each of these concepts in an incredibly convincing style. His arguments are well written and well researched. Even more, he does an excellent job at giving a fair shot to both sides of every argument. Although its clear he has his own biases (he is just a rider trying to control an elephant as well), I never felt that I wasn’t getting the full story on any of his points. Each conclusion he makes feels like one of careful deliberation, of considering the best work that has been done on an issue and providing a clear justification for agreeing or disagreeing. Haidt’s memories of how his own views were challenged or changed over time give the reader a look into his own inner intellectual struggle with these ideas and help provide a balanced view on many issues.

This balanced approach is especially apparent in the final section of the book where he discusses the “yin and two yangs” of American politics. The “yin” being points liberals tend to get right, and the two “yangs” being the best points of libertarians and conservatives. While I certainly have some room to quibble with his “liberal wisdoms” (focused on the benefits of regulation), he does a better job of defending the conservative and libertarian positions than many self described conservatives and libertarians could do themselves. Haidt could almost certainly pass an Ideological Turing Test, which cannot be said about most people of any political background.

I particularly liked his summary of the conservatives’ strength with the principle that “you can’t help the bees by destroying the hive.” He writes, “liberals are trying to help a subset of bees (which really does need help) even if doing so damages the hive.” Although this idea unfortunately seems to be losing its place at the center of the current Republican Party, I do think it is a good description of the foundation of conservative thought. Tradition, family, American values. Preserving the institutions that, for lack of a better term, made America great, is the main priority for conservatives. Policies that help individuals in the short run should be viewed with suspicion if they threaten to wear down these institutions in the long run.

Protecting the hive is also a distinctly Hayekian idea (even though he claims he was not a conservative). Hayek takes an evolutionary view of societal development. The institutions that have developed across history were not designed. We shouldn’t honor tradition and norms because people in the past were smarter or more moral than we are. But we should respect them because “the result of the experimentation of many generations may embody more experience than any one man possesses” (The Constitution of Liberty). To challenge existing social structures requires a careful consideration of the reasons they developed and the consequences of removing them. These reasons are usually not obvious and we should therefore be wary of attempts to upend the status quo.

There is far more in the book than can be discussed in a blog post, and I highly recommend it to anyone who has trouble understanding where their political opponents stand (no matter what side they are on themselves). I strongly believe that it is as important to listen to what the other side has to say and not to pretend that those who disagree are just uninformed or unintelligent. As Haidt concludes in the final line of the book, “we’re all stuck here for a while, so let’s try to work it out.”

Don’t Think About Money. Think About Stuff

There has been a lot of fuss in the last few weeks about the ridiculously large wealth of Amazon’s CEO Jeff Bezos. Bloomberg recently reported that Bezos has increased his wealth by $67 billion just this year ($8 million per hour!), which is about 8 times as much as the other 499 billionaires Bloomberg tracks have increased their wealth combined. So you could say he’s doing pretty well for himself.

Of course, this insane achievement has brought out the usual suspects (and even some unusual ones). Bernie Sanders has been on a crusade against Bezos for a while now and has proposed a bill to force Amazon to pay for its workers welfare benefits. It’s literally called the “Stop BEZOS” bill (BEZOS here is an acronym for “Bad Employers by Zeroing Out Subsidies” – how creative). While Sanders’s views are not surprising, Fox pundit Tucker Carlson is also getting in on the Bezos-hating action. Here’s Carlson:

Jeff Bezos, the founder of Amazon, is worth about $150 billion. That’s enough to make him the richest man in the world, by far, and possibly the richest person in human history. It’s certainly enough to pay his employees well. But he doesn’t. A huge number of Amazon workers are so poorly paid, they qualify for federal welfare benefits. According to data from the nonprofit group New Food Economy, nearly one in three Amazon employees in Arizona, for example, was on food stamps last year. Jeff Bezos isn’t paying his workers enough to eat, so you made up the difference with your tax dollars. Next time you see Bezos, make sure he says thank you.

I don’t want to get into the economics of Sanders and Carlson’s statements. Others have taken care of that (hint: Sanders’s tax isn’t going to do what he thinks it will). Instead, I want to touch on this point that the rich owe us something. That they should be thanking us. The reality is exactly the opposite. Next time you see Bezos, make sure you say thank you.

And I think the reason so many people have this concept exactly backwards is because we’ve been trained to think about everything in terms of money. Don’t think about money. Think about stuff.

Looking at Bezos’s monetary wealth on its own misses half of the equation. Sure Bezos has a ton of money. But the way he got that money was by creating an incredible business that revolutionized the retail market. Bezos gets $150 billion in pieces of paper (or more realistically, lines on a computer). We get Amazon. We get stuff (delivered across the country in 2 days or less). Now, of course Bezos does spend some of his wealth, and that’s not so good for our stuff. And his wealth does entitle him to a lot of our future stuff if he wants it. Maybe we’ll be worse off at the time. As for now, we’re making out like bandits.

Unfortunately I think what a lot of people have in mind when they think about the wealth distribution is a big pot of money. If Bezos takes $150 billion out of the pot that’s $150 billion the rest of us can’t use. This metaphor is absolutely the wrong way to think about wealth. Imagine Bezos never existed at all. His $150 billion is never created in the first place. The wealth doesn’t go back to the pot. It’s just gone. Half a million Amazon employees have to find other work. Hundreds of millions of consumers have to go back to shopping at Walmart. Now, there is another option, which is to redistribute Bezos’s wealth after he creates it. That’s a more justifiable policy than preventing him from ever earning it, but it can only be taken so far before it starts reducing the incentive to create – reducing the incentive to make stuff.

The same kind of mistaken thinking shows up in many other policy discussions. Take funding for higher education. Bernie Sanders’s solution is again focused on money. Pay for everyone to get a college education. But what about the stuff? Only so many people can go to Harvard. UCLA only has so many seats in a class. They already reject the vast majority of people who are willing to pay tens of thousands of dollars to attend. Making college free doesn’t do anything to change those facts (and actually it exacerbates the issue). Perhaps increased demand for education services would lead to an expansion of supply on the lower end, but college degrees only work by being somewhat exclusive (especially if the value of education is all signaling). It’s pretty hard to think of a solution that increases the supply of real educational services.

International trade is another good example. If the US imports from China, China gets a bunch of US dollars. The US gets a bunch of Chinese stuff. If we think about the US trade deficit, its essential to remember that it’s just a monetary deficit. But that money deficit gives us a huge stuff surplus. Is either side winning that transaction? China gets more dollars it can use to invest in US assets. US consumers get more cheap products from China. Unless you think you are getting ripped off by Amazon when you trade your dollars for a product, there’s no reason to believe the US consumer is getting a bad deal here either.

There is some nuance here that I’ve been deliberately avoiding. We don’t live in a pure exchange economy, which means money does matter. In economics, we sometimes make the mistake of going in the other direction by only worrying about stuff and never thinking about money. And sometimes it’s worth thinking about money, especially when it doesn’t work so well (as I’ve discussed in other posts). But even then, discussions of money should only be allowed if they’re in the context of figuring out how to get more stuff.

It’s really easy to get people more money. We can quite literally print it whenever we want. It’s a lot harder to get people more stuff. But stuff’s the stuff that really matters.

Don’t Worry, Insider Trading Doesn’t Hurt Your Retirement Savings

Another Trump tweet has sent the media into a frenzy. The culprit this time – a tweet by Trump at 7:21 am on Friday June 1 with the seemingly innocuous text, “Looking forward to seeing the employment numbers at 8:30 this morning.” So what’s the problem? Well, apparently the president usually finds out the job numbers for the month the night before they are released, but it is illegal for them to make any comment until at least an hour after they are made public the next day.

Even with this information it might still not seem like such a big deal, but we are dealing with Trump so any opportunity to attack will surely be taken. The issue (if you can call it that) with Trump hinting at a good jobs report before it’s official release is that it gives some financial traders an unfair advantage. Good jobs reports tend to increase stock prices so somebody who happened to notice Trump’s tweet could have used the information to preemptively buy up some stock in anticipation of a rise once the information was made public. In this sense, Trump’s tweet could be seen as a kind of “insider trading” (except that’s a bit of a stretch since it was a public tweet before the markets opened – but let’s forget that for now).

Betsey Stevenson and Justin Wolfers, two professors at the University of Michigan, took particular exception to the tweet. Stevenson questioned who else Trump tips off about the numbers, tweeting: “Privately leaking this information makes money for those who get it. Where does the money they “make” come from? People who don’t have the information.” Wolfers piled on with “Betsey’s point is spot on: If someone made money trading on a tip from the President, who do you think they’re making it from? It’s you. Your retirement account. The money’s got to come from somewhere, after all.”

Both Stevenson and Wolfers’ comments stem from the idea that when a speculator makes money, they are stealing that money from your retirement. Though they frame it in terms of insider trading, their logic is applicable to any situation where a financial transaction results in a gain. All financial transactions are zero-sum. Somebody can only buy a stock if somebody else is willing to sell. If the price of the stock subsequently increases, the buyer wins and the seller loses.

So it’s certainly true that somebody lost out from Trump’s tweet. But somebody also loses when the job numbers are revealed normally. Whoever trades first is going to gain the most from the new information being revealed. The poor guy who sold the stock (almost certainly another speculator) misses out (but note that even he doesn’t actually lose money, just fails to realize potential gains). What is less clear is why this process would have any effect on anyone’s retirement accounts.

If your retirement account relies on making money from short term fluctuations in stock prices, you are doing something very wrong. Take a look at this graph of the S&P 500 index over the last 5 days:

Source: CNN Money

The gains here are probably all going to speculators trying to play the market. They want to buy the lows and sell the highs and come out ahead. Some will win and some will lose. In the short run, the gains and losses approximately cancel out. Your retirement account doesn’t work this way. Here’s what the 5 year S&P 500 looks like:

Source: CNN Money

It’s not the up and down fluctuations of the stock market that provide the returns on your retirement. It’s that long term upward trend. Unlike the zero-sum game that makes up speculative short-term trading, these long term gains accrue to everybody who owns stocks (most retirement accounts are based on index funds so they should move around the same as the return shown here). Rather than constant trading to try to make a quick return, retirement earnings rely on buy and hold strategies. Barring major anomalies like a recession right before you plan to retire, day to day movements of the stock market should be of little concern to almost everyone.

And the best part, contrary to Stevenson and Wolfers’ claims, the money people “make” on these long term investments doesn’t actually have to come from anywhere, at least not directly. When the stock market works as it should, long run gains come from economic growth. Companies continuously inventing new ways to provide more and better products to consumers drives up the value of their business, and therefore their stock price. Your retirement account going up does not mean somebody else’s went down. Technological progress, new ideas, and the brilliant people behind them pull everyone up simultaneously.

Unfortunately, the kind of thinking that makes people worry that one person’s gain is another’s loss is prevalent across many economic discussions. Trump’s views on trade seem to follow a similar pattern. When you buy something made in China that’s not a gain for China and a loss for you. It’s good for both sides. Many also seem to have this view of profit. When a firm makes profit, it is not stealing from its workers. I’m planning another post on the profit issue soon. Hopefully less than two months in between posts this time.

Job Guarantee Proposals Have a Long Way to Go

Recently, the idea of a “job guarantee” has become increasingly popular on the left. If you are unfamiliar with these proposals, the most detailed that I have seen comes from a recent report from the Center on Budget and Policy Priorities. Bernie Sanders also plans to announce a version soon. The main goal of a job guarantee is simple – completely eradicate unemployment (besides some frictional unemployment that they estimate to be around 1.5%). The method is even simpler – if you can’t find a job in the private sector, the government will give you one.

Obviously these jobs have to be good enough to keep people out of poverty. The starting wage rate in the CBPP proposal is $11.83 an hour ($24,600 per year for full time workers), which would increase over time. Including healthcare and other benefits bumps the cost per worker up another $10,000. They estimate the total cost per job (including spending on supplies and capital) to be $56,000. Using an estimate of the unemployed of  around 10.7 million people, they get a cost of the program around $543 billion.

To put that in perspective, total federal expenditures are around $4 trillion. Of that, social security is about a quarter, while medicare and medicaid are around half a trillion each. So the jobs guarantee would be adding an additional category of spending on the same scale of the largest existing government programs. And that’s assuming the estimates make sense. There is every reason to believe they do not.

Beyond the general rule that government estimates of costs are almost always underestimates, there is a pretty good reason to believe that a job guarantee would cost an order of magnitude more than estimated here. The 10.7 million workers estimated to take a government job is almost surely an underestimate. Adam Ozimek describes the absurdity of this assumption pretty well. As he points out, in addition to the 10 million unemployed, there are 41 million people that work in jobs that pay less than $15 per hour. Maybe not every one of these people would prefer to work in a nice government job, but certainly a lot more than zero would. If we assume half of these worker switch, we’re now talking about spending $1.5 trillion on this program. And this is when we are basically at full employment already. In a recession that number balloons even further.

To be fair, some of the spending could offset spending in other programs. If workers are getting benefits through their job guarantee, they won’t need to collect other forms of welfare. But I would need to see a much more rigorous estimate of those savings before deciding that they would do anything to prevent this program from being the most expensive project the government has ever done.

The cost of the program is certainly concerning, but on this point I can definitely see an argument that it could be worth it. For a progressive who has a lot more faith in government institutions to actually run the program well, eliminating unemployment for a meager $1.5 trillion probably seems like a great deal. Unfortunately a major question still remains unanswered. How does a Job Guarantee actually work?

Many important details of the implementation of a job guarantee are either brushed over or ignored entirely in every proposal I have ever seen. Most importantly: what in the world is the government going to have these 20 million people do? The CBPP proposal has a short section on “logistics,” which claims “The Secretary would administer employment grants to eligible entities, including state, county, and local governments, as well as Indian Nations, to engage in direct employment projects. These projects should be designed to address community needs and provide socially beneficial goods and services to communities and society at large.” Some examples of potential jobs include production of “infrastructure, energy efficiency retrofitting” and “elder care, child care, job training, education, and health services.”

So let me get this straight. The government is going to take on a bunch of unemployed people, presumably unemployed because they lack some skills necessary to get private sector employment (not to say it is their fault that they lack these skills), and put them in charge of your kids. The same government that wants all childcare workers to have college degrees.

Where would these jobs be? If I live in a small rural town in the middle of the country, is the government going to provide a job for me there or force me to move? Who evaluates my skills and decides what job I get? What if I prefer something else? Who organizes these projects? Can I get fired? If progressives want people to take job guarantee proposals more seriously they’re going to have to do a lot better than handwaving about identifying “areas of needed investment in the U.S. economy.” Give me some specific job descriptions and then we can talk. Any proposal that does not get into these details is not worth even thinking about actually passing.

But maybe the fine print isn’t actually that important. Keynes famously remarked that digging holes and filling them back up would be better than doing nothing when unemployment is high. Does it matter what people are doing for work as long as they are working? I think it does, but even if you accept the Keynesian story it still seems hard to justify such a program when we are not in a recession. I would still disagree with a program that provides government jobs only in a recession (for different reasons), but at least that has some theoretical backing. In normal times, I just can’t see how providing government jobs doesn’t crowd out private sector jobs that are actually aimed at providing valuable goods and services rather than just work for the sake of work.

The ideal scenario for  a jobs guarantee proponent seems to be that having government as a major player in the labor market will increase the bargaining power of workers. If a Walmart worker can make more money by working for the government, Walmart would either need to increase wages and benefits or risk losing the worker. In this sense it acts like a minimum wage, reducing monopsony power in the labor market.

A more likely outcome is that the job guarantee simply destroys a lot of those jobs entirely. Even if Walmart were to increase its wages to compete with the government, would anyone really ever choose a career as a Walmart cashier over one of these government jobs? Progressives can’t simultaneously emphasize how horrible it is to have to work for giant corporations and then come back with estimates that say nobody would rather work for the government. And once they are there, would they ever leave? Changing jobs is costly and hard work. Better to just settle in at the government digging holes and filling them back in (Maybe progressives actually like this outcome and the job guarantee is really a stealth plan to socialize half the economy. Mises and Hayek already took care of explaining why that’s not such a good idea).

I definitely understand why the left likes the idea of a job guarantee. It’s a Keynesian stimulus, a massive expansion of welfare, and an increase in the minimum wage all in one. But with it comes all the problems that those policies have. Putting it in a nicely branded but vaguely specified package doesn’t solve those problems. Before fundamentally changing the nature of the United States economy, it might be worth thinking this through a little bit more.

Are Amazon, Facebook, and Google Killing Consumer Choice?

In a recent EconTalk podcast, Matt Stoller makes the argument that Amazon, Facebook, and Google have gotten too large. In fact, he argues that their size enables them to undermine the democratic institutions that the United States was founded upon (Stoller’s argument can be found in written form here). I think that claim is quite clearly an overstatement, but I want to focus on a somewhat smaller claim made in the podcast. During their discussion, Stoller and host Russ Roberts get into a debate about whether large companies like Amazon are increasing or reducing consumer choice in the marketplace and about whether their size represents a loss in consumer welfare.

Stoller argues that Amazon has the power to push whatever products it wants to the front pages, and therefore can control what people can buy. It may look like you have access to an incredibly diverse set of products, but that set is actually carefully curated only to improve Amazon’s bottom line. Google and Facebook operate in the same way. Your search results or the items in your Facebook news feed are not necessarily best for you, they are merely best for Google and Facebook.

I agree with everything in the previous paragraph. I disagree that anything in it is worrisome. Stoller, like many who make similar arguments, seem to operate under the assumption that everything that is good for Amazon, or Facebook, or Google is bad for consumers. To me, the opposite is far more likely to be true. If Amazon sells me bad products I’ll stop buying from Amazon. If Google gives me bad search results, I’ll stop using Google. I hardly use Facebook at all except as a messaging service. The reality is that each of these companies only has my business because they offer a service that’s pretty good.

Now, to be fair to Stoller, he does acknowledge this argument. But he quickly dismisses it. Instead, he argues that consumers are trapped in these ecosystems. He relays a story of a parent who can’t block youtube on his kid’s computer because they need to use Google products for school. I’m sure there’s away to block youtube without blocking Google docs, but if not then I admit that this is a (small) problem. But Stoller then goes on to make larger claims that these companies can then use this power to influence our behavior. Amazon only sells books that supports it’s views. Google only shows news that works in their favor.

I decided to test these claims. I went to Amazon and searched “Amazon Monopoly.” Now it would be very easy for Amazon to manipulate these results to put itself in a positive light. It could only show me books that are in favor of monopoly power. It could show me inspirational stories written about Amazon’s rise and how much they help the consumer. It doesn’t. The second item on the list (after the board game Monopoly) is a book called “Move Fast and Break Things: How Facebook, Google, and Amazon Cornered Culture and Undermined Democracy.” The New York Times review on the page explains “Jonathan Taplin’s Move Fast and Break Things argues that the radical libertarian ideology and monopolistic greed of many Silicon Valley entrepreneurs helped to decimate the livelihoods of musicians and is now undermining the communal idealism of the early internet.”

I haven’t read the book, but it’s an “Amazon Best Business and Leadership Book of 2017” so it must be good. Hmm. Wait. A book that “traces the destructive monopolization of the Internet by Google, Facebook and Amazon, and that proposes a new future for musicians, journalists, authors and filmmakers in the digital age” is also highlighted by that very same Amazon as one of the best books of 2017? What’s going on here?

I suppose one option is that the book is terrible and Amazon is highlighting the worst attack on its business in the hope that people won’t read other more substantive critiques. Or it could be that Amazon doesn’t actually profit from hiding any kinds of books from consumers, even those that are openly and directly hostile to it making profits. The way Amazon makes profit is by offering products that people want. Consumers drive its business, not the other way around. I won’t argue here with Taplin’s claim that “radical libertarianism” (where?) has worked to “decimate the livelihood of musicians” but it does at least seem to be working out pretty well for his book sales.

Another test. I googled “why Google is a terrible search engine.” I also searched the exact same phrase on Bing. In one of the searches, the third result was “Reasons Why Google Search is the Best Search Engine” – the opposite of what I wanted.  In the other, “5 Reasons Not to Use Google for Search – Field Guide – Gizmodo.” comes up. If I told Stoller these results he’d probably claim vindication. Google is obviously manipulating the results.

In fact, the anti-Google headline only shows up in my Google search. The pro-Google one comes from Bing. Again, maybe Google is secretly hiding a bunch of really good critiques of its service, but it’s pretty hard to believe that’s the case. Instead, Google gave me exactly what I was looking for and Bing gave me the opposite. I think I’ll stick with Google.

Stoller does have a counterargument to the results above. He argues that it may be true that Google has better search results than Bing or others, but that’s only because they have much better data. It would take years for a startup search engine to get even a fraction of the information that Google has obtained as it rose to dominance. Google has had time to learn what works and what doesn’t firsthand in a way that could never be replicated in the current world simply because Google already exists to squash any competition. Since no search engine can ever hope to match Google’s quality, they will never be able to compete and therefore Google can never have a true competitor.

Once again, I concede everything about the previous argument. And once again I fail to see much to worry about. What Stoller is essentially arguing is that there are increasing returns to scale in the search engine market. A large firm has the ability to offer a better service at a lower price than a small firm (if they choose to). If this is the case, it’s true that a true competitor to Google is unlikely to emerge. It also makes it very difficult to envision policy responses that improves search results overall for consumers. Increasing returns means that 100 Googles 1/100 of its size would never be able to operate as efficiently as one large Google so breaking it up would likely hurt consumers rather than help. And even standard textbook solutions to natural monopoly like regulating prices seem difficult to imagine when Google offers many of its services for free (although I do have to admit my relative ignorance on the economics of natural monopoly – maybe there is a policy well suited to this situation and I just don’t know it).

Google’s size may also introduce additional benefits. If Google was engaged in cutthroat competition that drove its profits to zero, would it ever be able to take risks? Would a smaller Google be working on developing self driving cars that will probably take years to see any profit whatsoever? Could they have survived failures like Google glass? I also very much like having all of my Google services integrated automatically. If each piece was run by a separate company, would the experience be as seamless?

The benefits of size are perhaps even clearer for Amazon. If Amazon were broken into smaller online marketplaces, would they ever have increased their shipping capacity as much as they have? I don’t see how they ever could. These companies can only be as successful as they are at providing benefits to the consumer because they are so large.

Perhaps some day in the future Amazon, Facebook, and Google will begin to exploit their market power and make profits at the expense of their consumers. I have no confidence in my ability to predict how the market will look 10 or 20 years from now. I am more confident in saying that that day is not today. It seems quite clear to me that these companies (as well as many others) have been able to achieve the success they have had only by giving consumers what they want.

Thoughts on Economics Seminars

My Twitter feed has recently been filled with people arguing about whether economics seminars are conducive to improving research in the field. For those unfamiliar with academic economics, our seminars tend to encourage active participation from the audience. While it varies across individuals, many economics professors have no problem interrupting a presentation to ask a question (or voice their displeasure) about something in your presentation. Fabio Ghironi, a professor at the University of Washington, recently compared economics seminars to a fencing match. Professors try to stab with you by asking you challenging questions about your models and methods and it is up to you to defend yourself.

I like this analogy and I think it perfectly describes my experience in macroeconomics at UCLA so far. Especially in the student seminars it is a rare occurrence to see somebody make it past their first slide without somebody chiming in. In general, I like this style of seminar. Rather than waiting until the end to answer a bunch of questions at once, it allows the presenter to deal with confusion and make clarifications as they go. Being forced to defend your work against criticism also helps make the parts that need improvement immediately clear.

I do see some problems with the current format of economics seminars, however. One issue arises when the questions seem aimed at proving the questioners intelligence rather than helping understand or improve the research. Especially for early work in progress where the paper is unpolished, too often have I seen audience members shaking their heads or making faces at ideas that are undeveloped but might still have potential. I think I am probably guilty of this as well. Another problem is when questions try to anticipate the rest of the presentation. The introduction slide should not be the place to figure out the identification strategy or the specifics of the model.

The biggest problem though is that being a good researcher and being able to sell your work in a presentation are not necessarily correlated. Many people are great at coming up with ideas and writing down interesting models, but not so good at presenting these ideas in a way that convinces other people that they are interesting. Of course, there is some truth to the idea that if you cannot present your idea well it may actually just not be that interesting, but the opposite is also true. Do we want economics to be dominated by used car salesmen that can make any idea sound great in an hour long seminar? Confidence and the ability to think on your feet are certainly valuable skills for any job, but shouldn’t they be less important for researchers whose goal is to seek out the truth, not just sell their own idea?

Too often it seems that communication ability and value as a researcher are conflated. But if we really want economics to stand as a science beside physics and chemistry (I’m not sure we do, but some people seem to want to), then we should avoid making this mistake. Research should be judged based on how well it improves our understanding of the real world. If a paper makes accurate predictions or useful methodological advances it shouldn’t matter if it’s presented or even written well or not.

The obvious objection to this point is that if research cannot be communicated well, how do we know if it’s good or not? We can’t carefully read every paper and spend time figuring out what it really means. A presentation is supposed to provide a quick overview of the main results to prove that the full paper is actually worth reading. How can we keep this benefit without throwing out good research done by poor presenters?

My solution is to separate research and the communication of research. Why does the person that wrote the model or collected the data have to be the one that presents it? It seems to me that current economics academics actually have two jobs. First, they have to write a paper that they know is interesting, often with fancy math that is difficult to understand for anyone not closely related to their field. Their second job is then to convince others that their idea is worth looking at, explaining complex ideas in a short amount of time to those who aren’t heavily invested in the literature. Why do both of these jobs have to be done by the same person? Manufacturers hire marketing firms to sell their product. Why can’t economists do the same thing?

One way around this problem comes through co-authoring papers. By forming a pair where at least one author is a relatively good communicator, researchers who lack communication skills can leverage their other skills and still be successful. However, this strategy can’t work for students looking to be hired since they need to prove they have value as a researcher on their own. With a co-authored paper it is impossible to tell how much each of the authors actually contributed. But what if they could hire somebody just to present? The economist writes the model, deals with the data, and produces all of the results. The presenter then turns that into something others can understand and evaluate.

I can see why some people wouldn’t like this setup. There is something pure about research being an individual project from start to finish. Coming up with a great idea, answering it in a clever way, and then explaining it to colleagues in the best possible way. But the goal of the profession should not be to find the most well-rounded researcher, but to advance our understanding of economics. If good ideas are being pushed aside simply because they aren’t communicated well enough, we should do everything we can to correct that.

Blackboard Economics and the Coase Theorem

Introductory economics is often criticized for providing an overly idealized version of the world. The price system functions perfectly, markets are competitive, and information is freely available. A well known result from microeconomics, the First Welfare Theorem, says that under certain assumptions, a competitive equilibrium is Pareto efficient. Government intervention in the market cannot make anybody better off without making somebody else worse off. Critics of neoclassical economics point out that the conditions under which this result holds are incredibly unrealistic. As soon as those assumptions are relaxed, the door opens for government to improve upon the market.

The classic example of these kinds of “market failure” are externalities like pollution where the total cost to society is more than the private cost faced by the producer. Our modern treatment of such problems in introductory classes is essentially unchanged from Pigou’s analysis of the problem almost 100 years ago in The Economics of Welfare. He outlined a simple solution to the problem of externalities. If producers impose costs (like pollution or noise) on others through their production activities, we can simply tax them to force them to internalize the social cost of their actions. Unlike standard taxes that introduce inefficiencies to a market economy, these “Pigovian taxes” actually improve efficiency.

Much of economics tends to follow a similar pattern. We begin with the perfect world, the benchmark economy of full information and a perfectly competitive economy. We then show that relaxing some of these assumptions, putting in asymmetric information, or monopoly power, or externalities, can mess up this perfect benchmark. Finally, we outline how government can solve these problems. The left loves to complain about how we too often stop at step 1 (especially in intro courses) and forget about all the problems of markets that government really needs to fix.

I also take issue with this kind of economics, but for a different reason. To understand my view, we need to take a look at an incredibly famous, but sometimes misunderstood paper, called “The Problem of Social Cost” by Ronald Coase.

Coase begins his paper by responding to Pigou. He shows, in several numerical examples, that Pigovian taxes or other government solutions are entirely unnecessary if the price system functions costlessly. This argument has been summarized in what is now known as “The Coase Theorem.” Private actors will always find the most efficient solution as long as transaction costs are not too high. Although perhaps unintuitive at first, Coase’s intuition is actually quite simple. If bargaining is costless, there is no reason why private agents wouldn’t be able to work out a solution that is beneficial for everyone. I recommend reading the article for many numerical examples of how this kind of bargaining could work to produce an outcome just as good as that produced by the Pigovian solution.

Unfortunately, most discussions of Coase tend to stop there. Supporters of free markets use Coase to argue against any form of government intervention. Detractors respond that of course transaction costs are not zero and therefore Pigovian solutions are still needed. Both sides miss Coase’s broader point. As Deirdre McCloskey puts it, “Something like a dozen people in the world understand that the “Coase” theorem is not the Coase theorem…One of this select few is Ronald Coase himself so I expect we blessed few are right.”

Here’s what I think is a better “Coase theorem” (from Coase’s paper): “All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm. Satisfactory views on policy can only come from a patient study of how, in practice, the market, firms and governments handle the problem of harmful effects”

Coase’s use of a world without transaction costs was not an attempt to make a statement about the real world, but rather to demonstrate the emptiness of doing analysis in a world without transaction costs. His article serves a deeper purpose than simply a criticism of Pigou’s treatment of externalities. It more importantly acts as a response to what Coase called “blackboard economics.” He thought the exercise of comparing “a state of laissez-faire and some kind of ideal world” to be entirely pointless. Economics without some consideration of the set of institutions, of the laws and the legal system that govern agents actions, is just an analysis of some imaginary world that will never exist. He wanted to bring economics back to reality.

For Coase, “a better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects
of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one. In this way, conclusions for policy would have some relevance to the actual situation.”

Shifting lines on a blackboard makes for nice undergraduate exercises. It is less useful for real policy analysis. Coase’s approach is less elegant. Blackboard economics gives nice simple answers to a wide range of policy questions. Unfortunately those answers don’t always tell us much about the much more complicated questions of the real world.

Coase’s argument against blackboard economics is essentially the same as Hayek’s criticisms of economic analysis. If we assume away all the hard stuff like who sets prices and who possesses knowledge of relevant economic information then of course we can come up with solutions to all sorts of economic problems. But those answers only hold in a world that looks nothing like our own and more importantly in a world where those policy choices are completely unnecessary in the first place. To get any kind of policy answers that our actually relevant for the world we actually live in, we occasionally need to ask these much harder questions about institutions and the economic environment in which economic actions take place.