Economics – Fundamentals

Mass (Economic) Hysteria: Income Inequality and Related Themes

It seems as though everyone’s talking and writing about stagnant wages, growing income inequality, gender discrimination in pay, concentration of wealth, no/less/too-little upward mobility, shrinking middle class, foreclosure of opportunity, end of the American Dream, higher mortality rates (due to income inequality), and on and on and on. (Insert exclamation marks to heighten the sense of outrage.)

All of these complaints — which emanate from the left and resound loudly in the media — presuppose the existence of several Platonic ideals; for example: correct wage levels, correct degrees of income and wealth inequality, correct rates of upward (and downward) mobility, an actually identifiable and permanent middle class, a measurable and optimum amount of opportunity, a definition of the American Dream that is more than pablum, and on and on.

All such ideals, of course, exist only in the minds of those who complain about stagnant wages, etc. But no matter — any excuse for further government intervention in the economy will do. And further government intervention will only harm those persons whom it is meant to help, by further reducing the rate of economic growth.

But nothing daunts true believers — Paul Krugman, Brad DeLong, Joseph Stiglitz, and their ilk — who always want government to “do something.” Their preachings bolster the pro-government-spending biases of most pundits and a large fraction of politicians. One aim of the true believers is to shape the fickle mood of the general public and garner support for government action.

Anyway, the various manifestations of economic hysteria listed in the opening paragraph can be met with logic and facts — and often are. (See the list of readings at the bottom of this post.) It’s unlikely that logic and facts will sway those who are emotionally committed to the exaction of redistributive justice, and who have no interest in its infeasibility, high costs, and perverse consequences. But until that lucky day when legitimate government is restored to the United States, its defenders must rely on logic and facts.

Consider income inequality. Not only is there inequality — which should be unsurprising, given inequality of ability, ambition, etc. — but there is supposedly a growing gap between America’s “haves” and “have-nots.” A do-gooder would leave it at that. Not being one of them, I’ll ask the questions that they’re unwilling/afraid/too-jejune to ask:

  1. What is a have? Is it someone/a household whose income exceeds the median for all persons/households? Is in the top 20 percent of all such incomes? The top 5 percent? The top 1 percent? The top 0.1 percent? (Pick your favorite point along the continuous curves in the graphs here.)
  2. Or is a have defined by his/her/its wealth? And, if so, how? (See preceding bullet.)
  3. Do haves “rig the game” so that they are, in effect, stealing from have-nots?
  4. If haves are clever and determined enough to do that, isn’t it likely that they’d still be haves without “rigging the game”?
  5. Is one’s economic status a permanent thing, or do people in fact move up and down the economic ladder during their lifetimes?
  6. Are the have-nots of today — who, mostly, aren’t the have-nots of yesteryear — really worse off than their predecessors, or are they really better off?
  7. Are they worse off relatively?
  8. Will tomorrow’s have-nots be better off if the haves are deprived of income/wealth through redistributive actions taken by government?
  9. Or will redistributive actions simply make haves worse off and less likely to do the things that make have-nots better off (e.g., give huge sums to charity, invest in growth-producing investments)?

Questions 1 and 2 are unanswerable; the distinction between a have and a have-not is purely arbitrary. (It has been said, with some accuracy, that a rich person is someone who has more more money than you.) The answers to the other questions are: (3) only to the extent that some of them are aided by government through perverse regulations favored by do-gooders; (4) yes; (5) not permanent, plenty of movement; (6) better-off absolutely than earlier have-nots; (7) probably about the same, relatively, but they’re mostly different people; (8) worse off; (9) yes, redistributive actions make have-nots worse off by hindering economic growth. (For more, see the list of readings, below.)

Before signing off, I want to say a bit more about haves, have-nots, rigging the game, and hypocritical politicians:

Most of the haves — given their ambition, intelligence, and particular skillswould succeed famously, even without rigging the game in their favor. In any event, government does most of the rigging — mainly to “protect” the have-nots from “ruthless” operators. For example, there’s licensing and regulatory barriers to entry to high-paying professions, such as the creation and trading of financial instruments, doctoring, lawyering, and making licensed, patented drugs. The entire left-leaning entertainment industry thrives on government-granted copyrights

In free markets, there would be no rigging, or it wouldn’t last long because the high profits generated by rigging would entice competition. So, if you want to blame rigging for the advantages enjoyed by the haves, blame their cronies in government, many of whom make a career of crying (all the way to the bank) about inequality. (Relevant aside: It is no coincidence that in 2012, five of the top-six counties in median household income were in the D.C. area.)

Isn’t is strange that most of the pissing and moaning about inequality emanates from people who are either in high-income brackets or whose political rank enables them to live as if they were? (Obama, Biden, and members of Congress, I’m looking at you.) Isn’t it evident that the pissing and moaning results mainly from economic illiteracy, guilt, and political opportunism? It should be evident, unless you’re a complete naïf of the kind who still believes in the tooth fairy and free lunches.

I must add that I have yet to meet a pro-equality “liberal” who pays more taxes than demanded of him by the IRS, opens his house to the homeless, or associates with the unwashed masses. As Victor Davis Hanson observes, there are no (true) socialists among the powerful and affluent lefties who spout egalitarian slogans.

I’ve addressed income inequality and related matters in several posts, including “The Last(?) Word about Income Inequality,” “Taxing the Rich,” “More about Taxing the Rich,” “In Defense of the 1%,” and “Progressive Taxation Is Alive and Well in the U.S. of A,” “How High Should Taxes Be?,” and “Some Inconvenient Facts about Income Inequality.” (See also the links embedded in and appended to those posts.)

There’s much more on the web. The following is a small sample of the vast trove of reasoned, fact-filled writings that leftists ignore because they prefer myths to facts.

Income inequality, wealth inequality, and economic mobility
Diana Furchtgott-Roth, “The Myth of Increasing Income Inequality,” The Manhattan Institute, Issues 2012, March 2012
James Pethokoukis, “Obama’s Fact-Challenged Inequality Speech,” AEIdeas, July 26, 2013
James Pethokoukis, “3 Charts That Show What’s Really Going On with Economic Mobility in the U.S.,” AEIdeas, December 12, 2013
James Pethokoukis, “If All You Know about Income Inequality Is This Famous Chart, You Really Don’t Know Much,” AEIdeas, December 23, 2013
Don Boudreaux, “Questions about and for Those People Obsessed with Income Inequality,” Cafe Hayek, December 24, 2013
Raj Chetty, et al., “Is the United States Still a Land of Opportunity? Recent Trends in Intergenerational Mobility,” Working Paper 19844, National Bureau of Economic Research, January 2014 (related: N. Gregory Mankiw, “How Much Income Inequality Is Explained by Varying Parental Resources?,” Greg Mankiw’s Blog, January 24, 2014)
John Goodman, “Myths about Inequality,” John Goodman’s Health Policy Blog, January 15, 2014
Thomas Sowell, “Fact-Free Liberals (parts I, II, and III),” creators.com, January 21, 2014
James Pethokoukis, “Does Obama Know That Wealth Inequality Is Lower Now Than 25 Years Ago?,” AEIdeas, January 21, 2014
Ironman, “Debunking Income Inequality Theory,” Political Calculations, January 23, 2014
David Harsanyi, “State of the Union: Maybe You’re Not As Screwed As They Think You Are,” The Federalist, January 27, 2014
David Henderson, “Why Income Mobility Is Larger in the Middle,” EconLog, February 10, 2014
Linda Gorman, “More Accurate Measures Suggest Declining Income Inequality [not that it matters, one way or the other],” John Goodman’s Health Policy Blog, March 14, 2014
Mark R. Rank, “From Rags to Riches to Rags,” The New York Times, April 18, 2014

Executive pay, the “undeserving” rich, and the “1%”
James Pethokoukis, “Stunning New Study Dismantles Obama’s ’1% vs. 99%’ Inequality Argument,” AEIdeas, August 16, 2013
James Pethokoukis, “Why Steven Kaplan Says Brad DeLong Is Wrong about CEO Pay, the Superstar Theory, and Income Inequality,” AEIdeas, August 19, 2013
James Pethokoukis, “Why the Much-Hyped Oxfam Study on Global Inequality Is Misleading,” AEIdeas, January 21, 2014
Don Boudreaux, “Deidre McClosky on Oxfam’s Calculation of World Wealth ‘Distribution’,” Cafe Hayek, January 27, 2014
Walter E. Williams, “Politics of Hate and Envy,” creators.com, January 29, 2014
Robert J. Samuelson, “Myth-Making about Economic Inequality,” RealClearPolitics, February 3, 2014
N. Gregory Mankiw, “Yes, the Wealthy Can Be Deserving,” The New York Times, February 15, 2014
N. Gregory Mankiw, “CEO’s Are Paid for Performance,” Greg Mankiw’s Blog, February 17, 2014
Mark J. Perry, “‘Rich America Is Not the ‘Idle Rich’, but rather a Working America, an Educated America, and a Married America,” Carpe Diem, February 19, 2014

Rigging the system: “our” government at work
Bruce Yandle, “Bootleggers and Baptists,” Regulation, May/June 1983
Bruce Yandle “Bootleggers and Baptists in Retrospect,” Regulation, Fall 1999
Richard K. Vedder, “Federal Government Has Declared War on Work,” Commentary Articles, The Independent Institute, January 20, 2014

The effect of assortative mating on household income
Henry Harpending, “Class, Caste, and Genes,” West Hunter, January 13, 2012
Henry Harpending and Gregory Cochran, “Assortative Mating, Class, and Caste,” manuscript, December 1, 2013
Jeremy Greenwood et al., “Marry Your Like: Assortative Mating and Income Inequality,” Population Studies Center, University of Pennsylvania, January 12, 2014
Ironman, “In Which We’re Vindicated. Again.,” Political Calculations, January 28, 2014

The non-war on the middle class, women, and blacks
Mark J. Perry, “Yes, the Middle Class Has Been Disappearing, but They Haven’t Fallen into the Lower Class, They’ve Risen into the Upper Class,” Carpe Diem, July 12, 2013
Steve Sailer, “Breakthrough Study: Poor Blacks Tend to Stay Poor, Black,” Vdare.com, July 24, 2013
John B. Taylor, “The Weak Recovery Explains Rising Inequality, Not Vice Versa,” WSJ.com, September 9, 2013
John B. Taylor, “My Take on the Middle-Out View,” Economics One, September 9, 2013
James Bessen, “No, Technology Isn’t Going to Destroy the Middle Class,” The Washington Post, October 21, 2013
Bryan Caplan, “Is Average Over? Two Equivocal Graphs,” EconLog, January 4, 2014
N. Gregory Mankiw, “Does Income Inequality Increase Mortality?,” Greg Mankiw’s Blog, January 29, 2014
Christina Hoff Sommers, “No, Women Don’t Make Less Money Than Men,” The Daily Beast, February 1, 2014

Modern Liberalism as Wishful Thinking

TheFreedictionary.com defines wishful thinking as “the erroneous belief that one’s wishes are in accordance with reality.” There’s a lot of wishful thinking going on, and it’s harmful to liberty and prosperity. I’m referring to the wishful thinking that characterizes modern liberalism, which is more properly called left-statism verging on despotism.

The dysfunctional manifestations of left-statism are too many to enumerate, let alone to detail in a single post. Obamacare is merely a current dysfunctional manifestation. It has many predecessors and will have many successors, unless constitutional government can somehow be restored in the United States. Some of the manifestations take the form of laws, executive decrees, and judicial holdings. Others reflect “big ideas” that give rise to illogical and ill-founded laws, decrees, and holdings.

Without further ado …

REGULATION WORKS

I wrote an entire post about “Regulation as Wishful Thinking.” The underlying theme is that regulators (and those who support regulation) believe that they can fine-tune economic and social behavior to achieve optimal (or at least better) outcomes than the one produced by free markets. If one paragraph sums up the effects of regulation, it’s this one:

Regulation is counterproductive for several reasons. First, it curtails positive externalities [the satisfaction of consumers' wants that is forgone due to regulatory restraints on market activity]…. The other reasons, on which I expand below, are that regulation cannot be contained to “good causes,” nor can it be tailored to do good without doing harm. These objections might be dismissed as trivial if regulatory overkill were rare and relatively costless, but it is pervasive, extremely costly its own right, and a major contributor to the economic devastation that has been wrought by the regulatory-welfare state.

Read the whole thing for the details of the argument and the evidence of the devastation. For a jarring example, see John Goodman, “FDA Regulations Kill,” John Goodman’s Health Policy Blog, February 18, 2014.

Wish: Regulation improves social and economic outcomes.

Reality: Regulation restricts the ability of people to pursue their lawful interests, and thereby harms them socially and economically.

Bottom line: Regulation is harmful, because it substitutes the judgments of “technocrats” for the decentralized knowledge of millions of citizens. Its economic cost is more than 10 percent of GDP — and it leads to unnecessary loss of life.

TAXES ARE GOOD

Consider the intuitive and also well-documented relationship between taxes and economic activity. See, for example, Christina D. and David H. Romer, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,”  Working Paper 13264, National Bureau of Economic Research, July 2007; and William McBride, “What Is the Evidence on Taxes and Growth?,” Tax Foundation, December 18, 2012. One must bend over backward to concoct a theory which says that a rise in taxes will not reduce the rate of economic output or the growth of that rate. But such theories are propounded because their proponents favor higher taxes for two closely related reasons: more taxes enable more government spending, and more government spending usually means “social” spending. (One reason that “liberals” are against defense spending — or more of it — is that it absorbs money that could go into “social” programs.)

Wish: Higher taxes don’t reduce GDP or the rate of economic growth.

Reality: Higher taxes do reduce GDP and the rate of economic growth.

Bottom line: Higher taxes (and more government) actually harm the poor (among others) by reducing economic activity and, thereby, reducing employment. As it turns out, the effect is substantial.

THE MINIMUM WAGE HELPS LOW-SKILL WORKERS

There are economists who support the minimum wage, not necessarily because of the economic soundness of the minimum wage, but because they just like the idea that (some) low-wage workers will make more because of it. Some of those economists have even produced studies which purport to show that a minimum wage has a “small” effect on the employment of low-wage workers. As if “small” were of no consequence to those who are unable to find and keep low-wage jobs because of the minimum wage. Well, the minimum wage — and its more overtly political twin, the “living wage” — do harm low-wage workers. And that’s that. See Linda Gorman, “Minimum Wages,” The Concise Encyclopedia of Economics at The Library of Economics and Liberty. For the latest, see James Pethokoukis, “CBO: The $10.10 Minimum Wage Would Cost 500,000 Jobs, With Most Benefits Going to Non-Poor,” AEIdeas, February 18, 2014.

Wish: Government can help low-skill workers by forcing employers to pay them more.

Reality: Minimum wages and “living wages” result in less employment among low-wage workers.

Bottom line: Those who are in most need of employment, and for whom the private sector would provide employment (other things being the same), are deprived of employment by well-meaning but economically wrong-headed minimum-wage and “living wage” laws.

CAPITAL PUNISHMENT DOESN’T DETER MURDER

What about capital punishment? A paper from 1973, just a year after the U.S. Supreme Court’s decision in Furman v. Georgia effectively outlawed capital punishment, offers an exhaustive statistical analysis of the deterrent effect of capital punishment. See Isaac Ehrlich, “The Deterrent Effect of Capital Punishment: A Question of Life and Death,” Working Paper No. 18, Center for Economic Analysis of Human Institutions, National Bureau of Economic Analysis, November 1973. The author’s conclusion:

[A]n additional execution per year over the period in question [1933-1969] may have resulted, on average, in 7 or 8 fewer murders.

Later:

Previous investigations … have developed evidence used to unequivocally deny the existence of any deterrent or preventive effects of capital punishment. This evidence stems by and large from what amounts to informal tests of the sign of the simple correlation between the legal status of the death penalty and the murder rate across states and over time in a few states. Studies performing these tests have not considered systematically the actual enforcement of the death penalty, which may be a far more important factor affecting offenders’ behavior than the legal status of the penalty. Moreover, these studies have generally ignored other parameters characterizing law enforcement activity against murder, such as the probabilities o± apprehension and conviction, which appear to be systematically related to the probability of punishment by execution.

In my words:

Capital punishment is the capstone of a system of justice that used to work quite well in this country because it was certain and harsh. There must be a hierarchy of certain penalties for crime, and that hierarchy must culminate in the ultimate penalty if criminals and potential criminals are to believe that crime will be punished.

Since the reinstatement of the death penalty in 1976 (Gregg v. Georgia), with restrictions, capital punishment has become less swift and less sure than it had been. There were 1,359 executions in 1976-2013, an average of 36 a year, as against 4,863 in 1930-1972, an average of 113 a year. That is, the rate of executions has dropped by two-thirds from its pre-Furman rate. The drop in the execution rate notwithstanding, the deterrent effect of capital punishment remained strong, at least through 2000. See Hashem Dezhbaksh, Paul Robin, and Joanna Shepherd, “Does capital punishment have a deterrent effect? New evidence from post-moratorium panel data,” American Law and Economics Review 5(2): 344–376 (available in pdf format here. The authors argue that each execution deters eighteen murders, a number that reflects the larger population of the U.S. during the period covered by their analysis. It’s hard to read the two papers cited here and believe that capital punishment doesn’t deter homicide — unless you want to believe it.

Altogether, the more “humane” treatment of murderers since 1976 has cost 600 to 1,400 lives every year, or 23,000 to 53,000 lives in the past 38 years.

Wish: Capital-punishment is nothing more than murder by the state, and (non sequitur) it doesn’t deter murder, anyway.

Reality: Capital punishment is punishment, and when it is administered surely and swiftly it does deter murder.

Bottom line: Perhaps more than 50,000 murders would have been prevented if the rate of executions hadn’t been slowed drastically following the 1972-1976 moratorium on capital punishment.

MORE GUNS MEAN MORE CRIME

There’s a twisted consistency between opposition to capital punishment and support of stringent measures to control the availability of firearms. Both positions tip the scales in favor of predators and away from peaceful citizens.

To favor gun control is to engage in wishful thinking at its best (or worst). Why? Because to favor gun control is to favor the criminal over the law-abiding citizen. But according to wishful thinkers, stringent gun control would lead to a reduction violent crimes. As with the other kinds of wishful thinking addressed here, it just ain’t so.

John Lott‘s More Guns, Less Crime is the elephant in the room, and can’t be ignored. In that book, the article on which it’s based, and other books, Lott argues that allowing adults to own or carry guns leads to a significant reduction in crime. Lott’s work was controversial — some called it incendiary. Not surprisingly, many academics opened fire on it, picking and poking at Lott’s data and methods. I say not surprisingly because — in case it has escaped your attention — academics tend to be (wishful-thinking) leftists.

To save time and space, I fast-forward to a paper by Don B. Kates and Gary Mauser, “Would Banning Firearms Reduce Murder and Suicide?,” first published in Harvard’s Journal of Public Law and Policy (Vol. 30, No. 2, 2007, pp. 649-694). Here are some relevant excerpts:

There are now 40 states where qualified citizens can obtain such a handgun permit.28 As a result, the number of U.S. citizens allowed to carry concealed handguns in shopping malls, on the street, and in their cars has grown to 3.5 million men and women.29 Economists John Lott and David Mustard have suggested that these new laws contributed to the drop in homicide and violent crime rates. Based on 25 years of correlated statistics from all of the more than 3,000 American counties, Lott and Mustard conclude that adoption of these statutes has deterred criminals from confrontation crime and caused murder and violent crime to fall faster in states that adopted this policy than in states that did not.30 (op. cit., p. 658)

Footnote 30 reads, in relevant part:

This conclusion is vehemently rejected by antigun advocates and academics who oppose armed self‐defense. See, e.g., Albert W. Alschuler, Two Guns, Four Guns, Six Guns, More Guns: Does Arming the Public Reduce Crime?, 31 VAL. U. L. REV. 365, 366 (1997); Ian Ayres & John J. Donohue III, Shooting Down the ‘More Guns, Less Crime’ Hypothesis, 55 STAN. L. REV. 1193, 1197 (2003); Dan A. Black & Daniel S. Nagin, Do Right‐to‐Carry Laws Deter Violent Crime?, 27 J. LEGAL STUD. 209, 209 (1998); Franklin Zimring & Gordon Hawkins, Concealed Handguns: The Counterfeit Deterrent, RESPONSIVE COMMUNITY, Spring 1997, at 46; Daniel W. Webster, The Claims That Right‐to‐Carry Laws Reduce Violent Crime Are Unsubstantiated (Johns Hopkins Center for Gun Policy and Research, 1997). Several critics have now replicated Lott’s work using additional or different data, additional control variables, or new or different statistical techniques they deem superior to those Lott used. Interestingly, the replications all confirm Lott’s general conclusions; some even find that Lott underestimated the crime‐reductive effects of allowing good citizens to carry concealed guns. See Jeffrey A. Miron, Violence, Guns, and Drugs: A Cross‐Country Analysis, 44 J.L. & ECON. 615 (2001); David B. Mustard, The Impact of Gun Laws on Police Deaths, 44 J.L. & ECON. 635 (2001); John R. Lott, Jr. & John E. Whitley, Safe‐Storage Gun Laws: Accidental Deaths, Suicides, and Crime, 44 J.L. & ECON. 659 (2001); Thomas B. Marvell, The Impact of Banning Juvenile Gun Possession, 44 J.L. & ECON. 691 (2001); Jeffrey S. Parker, Guns, Crime, and Academics: Some Reflections on the Gun Control Debate, 44 J.L. & ECON. 715 (2001); Bruce L. Benson & Brent D. Mast, Privately Produced General Deterrence, 44 J.L. & ECON. 725 (2001); David E. Olson & Michael D. Maltz, Right‐to‐Carry Concealed Weapon Laws and Homicide in Large U.S. Counties: The Effect on Weapon Types, Victim Characteristics, and Victim‐Offender Relationships, 44 J.L. & ECON. 747 (2001); Florenz Plassmann & T. Nicolaus Tideman, Does the Right to Carry Concealed Handguns Deter Countable Crimes? Only a Count Analysis Can Say, 44 J.L. & ECON. 771 (2001); Carlisle E. Moody, Testing for the Effects of Concealed Weapons Laws: Specification Errors and Robustness, 44 J.L. & ECON. 799 (2001); see also Florenz Plassman & John Whitley, Confirming ‘More Guns, Less Crime,’ 55 STAN. L. REV. 1313, 1316 (2003). In 2003, Lott reiterated and extended his findings, which were subsequently endorsed by three Nobel laureates. See JOHN R. LOTT, JR., THE BIAS AGAINST GUNS (2003). (op. cit., pp. 658-9, emphasis added)

There are so many gems in the article that it is hard to stop quoting it. I should say “read the whole thing,” but I’ll succumb to temptation and quote a few choice passages here, and many more in the note at the bottom of this post (footnote numbers omitted for ease of reading):

[A study by Hans Toch and Alan J. Lizotte shows that] “data on firearms ownership by constabulary area in England,” like data from the United States, show “a negative correlation,” that is, “where firearms are most dense violent crime rates are lowest, and where guns are least dense violent crime rates are highest.” (p. 653)

A second misconception about the relationship between firearms and violence attributes Europe’s generally low homicide rates to stringent gun control. That attribution cannot be accurate since murder in Europe was at an all‐time low before the gun controls were introduced. (p. 653-4)

[T]wo recent studies are pertinent. In 2004, the U.S. National Academy of Sciences released its evaluation from a review of 253 journal articles, 99 books, 43 government publications, and some original empirical research. It failed to identify any gun control that had reduced violent crime, suicide, or gun accidents. The same conclusion was reached in 2003 by the U.S. Centers for Disease Control’s review of then extant studies. (p. 654)

In the late 1990s, England moved from stringent controls to a complete ban of all handguns and many types of long guns. Hundreds of thousands of guns were confiscated from those owners law‐abiding enough to turn them in to authorities. Without suggesting this caused violence, the ban’s ineffectiveness was such that by the year 2000 violent crime had so increased that England and Wales had Europe’s highest violent crime rate, far surpassing even the United States. (p. 655)

[A]doption of state laws permitting millions of qualified citizens to carry guns has not resulted in more murder or violent crime in these states. Rather, adoption of these statutes has been followed by very significant reductions in murder and violence in these states. (p. 659)

[T]he determinants of murder and suicide are basic social, economic, and cultural factors, not the prevalence of some form of deadly mechanism. In this connection, recall that the American jurisdictions which have the highest violent crime rates are precisely those with the most stringent gun controls. (p. 663)

More than 100 million handguns are owned in the United States84 primarily for self‐defense, and 3.5 million people have permits to carry concealed handguns for protection. Recent analysis reveals “a great deal of self‐defensive use of firearms” in the United States, “in fact, more defensive gun uses [by victims] than crimes committed with firearms.” It is little wonder that the

National Institute of Justice surveys among prison inmates find that large percentages report that their fear that a victim might be armed deterred them from confrontation crimes. “[T]he felons most frightened ‘about confronting an armed victim’ were those from states with the greatest relative number of privately owned firearms.” Conversely, robbery
is highest in states that most restrict gun ownership.

Concomitantly, a series of studies by John Lott and his coauthor David Mustard conclude that the issuance of millions of permits to carry concealed handguns is associated with drastic declines in American homicide rates. (p. 671)

Per capita, African‐American murder rates are much higher than the murder rate for whites. If more guns equal more death, and fewer guns equal less, one might assume gun ownership is higher among African‐ Americans than among whites, but in fact African‐ American gun ownership is markedly lower than white gun ownership. (p. 676)

The reason fewer guns among ordinary African‐Americans does not lead to fewer murders is because that paucity does not translate to fewer guns for the aberrant minority who do murder. The correlation of very high murder rates with low gun ownership in African‐American communities simply does not bear out the notion that disarming the populace as a whole will disarm and prevent murder by potential murderers. (p. 678)

In sum, the data for the decades since the end of World War II also fails to bear out the more guns equal more death mantra. The per capita accumulated stock of guns has increased, yet there has been no correspondingly consistent increase in either total violence or gun violence. The evidence is consistent with the hypothesis that gun possession levels have little impact on violence rates. (p. 685)

Wish: Gun-control (or confiscation) will reduce violent crime.

Reality: More guns, no more crime. Crime is a product of underlying social and economic factors that vary from nation to nation, region to region, and socio-economic group to socio-economic group.

Bottom line: The desire to limit or eliminate private ownership of firearms reflects a distaste for weapons and an irrational reaction to relatively rare but horrific instances of gun violence. But the effect of limiting or eliminating private ownership is to disarm law-abiding citizens and encourage crime against them.

THE LIST GOES ON …

If the list of leftist delusions isn’t infinite, it’s certainly very long. For example, there’s wishful thinking about peace, about gender discrimination, about racial equality, about crime, about income inequality, about society, about social welfare, and about the pseudo-scientific religion of global warming.

Why so many delusions? To those who believe — despite the evidence — that persons of the “liberal” (i.e., left-statist) persuasion are smarter or more rational than persons of the right, I commend my own best-selling post, “Intelligence, Personality, Politics, and Happiness,” and two articles by James Lindgren, “Who Fears Science?“and “Who Believes That Astrology Is Scientific?” (The answers may surprise you, though they shouldn’t, now that you’ve read this far.)

To wrap up this long post, I simply urge you to peruse some of my “Favorite Posts,” especially the posts under these headings:

It’s best to start with the newer posts at the bottom of each section, and work up to earlier ones, which often are referenced or incorporated in later posts.

__________
More quotations from “Would Banning Firearms Reduce Murder and Suicide?.”

Since at least 1965, the false assertion that the United States has the industrialized world’s highest murder rate has been an artifact of politically motivated Soviet minimization designed to hide the true homicide rates. Since well before that date, the Soviet Union possessed extremely stringent gun controls that were effectuated by a police state apparatus providing stringent enforcement. So successful was that regime that few Russian civilians now have firearms and very few murders involve them. Yet, manifest success in keeping its people disarmed did not prevent the Soviet Union from having far and away the highest murder rate in the developed world.6 (pp. 650-1)

Luxembourg, where handguns are totally banned and ownership of any kind of gun is minimal, had a murder rate nine times higher than Germany [with 30 guns per 100 persons] in 2002. (p. 652)

[D]espite constant and substantially increasing gun ownership, the United States saw progressive and dramatic reductions in criminal violence in the 1990s. On the other hand, the same time period in the United Kingdom saw a constant and dramatic increase in violent crime to which England’s response was ever‐more drastic gun control including, eventually, banning and confiscating all handguns and many types of long guns. Nevertheless, criminal violence rampantly increased so that by 2000 England surpassed the United States to become one of the developed world’s most violence‐ridden nations. (p. 656)

[V]iolent crime, and homicide in particular, has plummeted in the United States over the past 15 years. The fall in the American crime rate is even more impressive when compared with the rest of the world. In 18 of the 25 countries surveyed by the British Home Office, violent crime increased during the 1990s. This contrast should induce thoughtful people to wonder what happened in those nations, and to question policies based on the notion that introducing increasingly more restrictive firearm ownership laws reduces violent crime. (p. 660)

The “more guns equal more death” mantra seems plausible only when viewed through the rubric that murders mostly involve ordinary people who kill because they have access to a firearm when they get angry. If this were true, murder might well increase where people have ready access to firearms, but the available data provides no such correlation. Nations and areas with more guns per capita do not have higher murder rates than those with fewer guns per capita. (pp. 665-6)

[R]educing gun ownership by the law‐abiding citizenry— the only ones who obey gun laws—does not reduce violence or murder. The result is that high crime nations that ban guns to reduce crime end up having both high crime and stringent gun laws, while it appears that low crime nations that do not significantly restrict guns continue to have low violence rates. (p. 672)

A recent study of all counties in the United States has again demonstrated the lack of relationship between the prevalence of firearms and homicide. (p. 686)

Some Inconvenient Facts about Income Inequality

Follow these three links at Census.gov and you’ll find Table P-28, Educational Attainment—Workers 18 Years Old and Over by Mean Earnings, Age and Sex. (Similar tables are available, but the numbers reported in P-28 are based on a consistent definition of educational attainment.) Drawing on Table P-28, I constructed the following statistics for 1992 and 2012, which are years with similar rates of growth in GDP per capita (2.19 percent and 2.05 percent, respectively):

Employment earnings and 20-year changes in earnings

Men and women are separated because it’s a fact of life that — on average — they don’t earn the same incomes. This isn’t a matter of discrimination, but of differences in education (discipline as well as level of attainment), occupation, experience, and hours worked. (See, for example, “No, Women Don’t Make Less Money Than Men,” The Daily Beast, February 2, 2014.)

Tables 1, 2, 4, and 5 show something that should surprise no one: income rises with age (a proxy for experience) and level of education. This is a key fact that is never mentioned in the usual blather about income inequality. (There is, of course, a drop in real earnings among persons 65 and older, which reflects the fact that most persons in that age bracket have retired or shifted to part-time work.)

Tables 3 and 6 are especially interesting for what they reveal about changes in real income between 1992 and 2012 for cohorts at various levels of educational attainment. For example, the real earnings of men with a 9th grade education who were 18-24 years old in 1992 had risen by 94 percent 20 years later, when they were in the 35-44 age bracket.

Among the male cohorts under the age of 65 in 2012, only one (of  24) experienced a decline in real earnings. Male cohorts in the 35-54 age range show impressive rises in real income between 1992 and 2012. Among women, no cohort below age 65 experienced a drop in real income between 1992 and 2012; and most experienced a healthy increase.

Of course, some persons who worked full-time in 2012 earned less in that year than they did as full-time workers in 1992. But it’s evident that those 20 years were good for almost everyone. Otherwise, the numbers wouldn’t look as good as they do. In addition to the evidence of tables 3 and 6, consider this:  average real earnings rose by 24 percent between 1992 and 2012. (So much for wage stagnation.)

Tables 3 and 6 indicate that persons high levels of educational attainment have done better than persons at the low end of the educational ladder. That’s simply a fact of economic life, not the result of a conspiracy. It reflects the ever-increasing demand for highly technical goods and services — from nanosurgery to Google glass. In 2012, there were 1.7 million, 8.3 million, and 17.1 million persons in the top 1-, 5-, and 10-percent income brackets. Such large numbers are hardly the stuff of conspiracies.

What about the distribution of incomes? (Note to the uninitiated: Incomes aren’t “distributed,” they’re earned. “Distribution,” in this context, is shorthand for frequency distribution, a statistical term. Unfortunately, too many people interpret “distribution” as a reference to a mysterious and conspiratorial doling out of a big pie in the sky.) Taking into account the number of persons represented in each age-education group, I constructed these distributions for 1992 and 2012:

Mean income by percentile, 2012 vs 1992

The two curves have almost the same Gini coefficient: 0.239 for 1992, 0.242 for 2012. That is to say, the distribution of average incomes (taking men and women together) wasn’t any less equal in 2012 than it was in 1992.

The details for 2012 are in the next table. (Professional degrees include MD, JD, DDS, DVM, and similarly occupation-specific advanced degrees; doctorates include PhD and EdD.) The mean is $46,615; the median, $42,250.

Mean income by percentile, sex, education, age - 2012

And don’t forget, these numbers include part-timers as well as full-timers; college students as well as high-school dropouts; and a large contingent of under-educated (and probably not very bright) oldsters. These numbers don’t include the many sources of income and income-in-kind represented in the “social safety net”: unemployment compensation, disability benefits, survivors’ benefits, food stamps, Social Security, Medicare, Medicaid, and on and on.

Note to Obama and friends: Go peddle your phony stories about income inequality where they’ll be appreciated — Tsarist Russia, for example.

*     *      *

Related posts:
Why We Deserve What We Earn
Who Decides Who’s Deserving?
The Main Causes of Prosperity
Why Class Warfare Is Bad for Everyone
Fighting Myths with Facts
Debunking More Myths of Income Inequality
Ten Commandments of Economics
More Commandments of Economics
On Income Inequality
The Causes of Economic Growth
The Last(?) Word about Income Inequality
Status, Spite, Envy, and Income Redistribution
The Causes of Economic Growth
A Short Course in Economics
Addendum to a Short Course in Economics
The Price of Government
Does the Minimum Wage Increase Unemployment?
The Price of Government Redux
The Mega-Depression
The Real Burden of Government
Toward a Risk-Free Economy
Enough of “Social Welfare”
A True Flat Tax
Taxing the Rich
More about Taxing the Rich
In Defense of the 1%
Lay My (Regulatory) Burden Down
The Burden of Government
How High Should Taxes Be?
The 80-20 Rule, Illustrated
Economics: A Survey (also here)
Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth
Progressive Taxation Is Alive and Well in the U.S. of A.

Discounting in the Public Sector

This post is an adaptation of an article that I wrote 25 years ago. It appeared in the May-June 1989 issue of Program Manager, a magazine published in 1972-2003 by the Defense Systems Management College and its successor, the Defense Acquisition University. Several years before the article appeared, I had begun to question the soundness of the federal government’s official policy about discounting. which is stated in Circular A-94, issued by the Office of Management and Budget, Executive Office of the President.

The point of this post is to refute the case for discounting in benefit-cost or cost-effectiveness analyses of government projects. Part of my argument against discounting is made in “Discounting and ‘Libertarian Paternalism’.” This post makes a more complete case against the use of discounting in analyses of government projects.

DISCOUNTING: WHY AND WHY NOT

Discounting is a valid exercise in the evaluation of personal and business alternatives. A business, for example, will use discounting to compare alternative investments in new equipment; for example:

Implementation of project A will cost $1 million a year in years 1-5; project A will yield an annual net cash flow of $1 million in years 6-15.

Implementation of B will cost $1.5 million a year in years 1-4; B will yield $1.1 million a year in years 5-15.

Instead of undertaking either project, the firm could purchase equally risky bonds with a yield of 5 percent.

Should the firm undertake project A or project B? Discounting reveals the answer (though, for the sake of simplicity, I’m omitting risk, uncertainty, taxes, and inflation): The net present value of A, discounted at 5 percent, is $1.72 million; of B, $4.34 million. B is the preferred alternative, all other things being equal.

This result would seem backwards to a person who is used to thinking in terms of gross numbers, irrespective of the timing of outlays and returns. For example, A costs $5 million and returns $1 million a year (20 percent) when it’s up and running; whereas, B costs $6 million and returns $1.1 million a year (18.33 percent) when it’s up and running. Thus an analysis that omits timing would favor project A. But timing is important. Even though B costs more than A, B yields a greater return, and sooner (by a year). Over the relevant time span, the extra year and extra annual return of $0.1 million make B the more profitable alternative.

However, the result is sensitive to the selection of a discount rate and time horizon, both of which are judgment calls. A range of discount rates and time horizons would be chosen, to see if the preference for B is robust or weak. If A is judged less risky than B, it would be appropriate to apply a lower discount rate to A than to B. If A is likely to have a longer productive life than B (less likely to become obsolete, for example), the time horizon for A would be longer than for B.

Discounting makes sense in the private sector, despite the sensitivity of results to changes in assumptions about costs, returns, discount rate, and time horizon. For one thing, the discount rate — however uncertain — is relevant to the decision-maker; it represents the rate of return that the decision-maker could earn if he chose not to undertake project A or project B. It is his discount rate, not one chosen arbitrarily for him by someone else. For another thing, the returns (such as they turn out to be) belong to the decision-maker. When all is said and done, he (or the principal for whom he is acting) will choose a course of action that is meant to maximize his wealth or his profits. Accordingly, different decision-makers, in different circumstances, will use discount rates and time horizons appropriate to their circumstances. Discounting isn’t a one-size-fits-all procedure.

That said, it doesn’t make sense if to discount if you’re analyzing alternative projects for a government decision-maker. Why not?

1. Government is funded (ultimately) by taxes. Taxpayers have myriad discount rates. The use of a particular rate to represent a (fictional) “social” rate amounts to gross presumption.

2. Further, there’s usually a misalignment of costs and benefits. Those who bear the costs (taxpayers) aren’t likely to reap the benefits in proportion to the costs they bear. Discounting doesn’t apply when X bears the costs and Y reaps the benefits.

3. Given (1) and (2), the proponent of discounting will resort to the use of an internal rate of return (e.g., cost reductions generated by maintenance projects that can then be applied to investments in new weapon systems). The use of an internal rate of return turns out to be a horse-before-the cart proposition: the correct choice determines the discount rate; the discount rate doesn’t determine the correct choice.

Now, for the details.

THE FICTIONAL “SOCIAL” DISCOUNT RATE

The academic justification for discounting the costs of alternative government projects goes like this:

The appropriate rate of discount for public projects is one which measures the social opportunity cost. The decision to devote resources to investment in a public project means … that these resources will become unavailable for use by the private sector. And this transfer should be undertaken whenever a potential project available to the government offers social benefits greater than the loss sustained by removing these resources from the private sector. The social rate of discount, then, must be chosen in such a way that it leads to a positive number for the evaluated net benefits of a public project if and only if its gross benefits exceed its opportunity costs in the private sector. (William J. Baumol, “On the Social Rate of Discount,” American Economic Review, September 1968, pp. 789-90)

In mathematical notation:

[NPV(public benefits) > NPV(private costs)] → Undertake public project

In the next section I’ll address the almost-certain misalignment of benefits and costs.  Here, I’ll assume for the sake of argument that benefits flow only to those taxpayers who foot the bill for a public (i.e., government) project, and do so in perfect proportion to the taxes levied on each of them. Would that unlikely condition justify the public project?

Consider this example:

There is a two-person economy consisting of Adam and Eve.

If a public project is undertaken, both will be taxed the same amount and both will receive the same benefits.

Taxes are levied in year 1; benefits are received in year 2.

Adam’s discount rate is 5 percent; Eve’s discount rate is 10 percent. That is, Eve has a “high” time-preference, relative to Adam; she places more emphasis on the present, as against the future.

The public decision-maker uses a discount rate of 7.5 percent.

The dollar value of the benefits accruing to Adam and Eve can be estimated.

The net present value of the sum of those benefits exceeds the net present value of the sum of the costs borne by Adam and Eve.

Nevertheless, Eve is probably made worse off by the undertaking of the public project. Adam is probably made better off, but at Eve’s expense. Why? Let’s say that Adam and Eve each pay $100 in taxes in year 1, and that the public project breaks even (returns exactly 7.5 percent), so that each of them receives $107.50 worth of benefits in year 2. Adam, given his 5 percent discount rate, would have been made whole with benefits of $105 in year 2, so he gains $2.50. Eve, on the other hand, would have been made whole with benefits of $110 in year 2, so she loses $2.50.

All of that assumes, of course, that both Adam and Eve place any value on the benefits delivered by the public project, let alone the same value. How does the government decision-maker know what value Adam and Eve place on the benefits delivered by his project? He doesn’t; he’s just a presumptuous fellow who wants to spend Adam and Eve’s money to satisfy his own sense of how things should be.

THE MISALIGNMENT OF COSTS AND BENEFITS

Professor Baumol admits that “no optimal [social discount] rate exists” (op. cit., p. 798). Actually, no “social” discount rate exists, except in the minds of arrogant economists and government officials.

How does “society” benefit if Adam is made happy at Eve’s expense? It doesn’t, because there’s no such thing as a social-welfare function, that is, a collective degree of happiness (or unhappiness) in which Adam’s gain somehow cancels Eve’s loss.

It only gets worse in the usual case, where the benefits from a government program do not flow to taxpayers in proportion to the taxes that they pay. It would be a major miracle if benefits were somehow aligned perfectly or even passably well with tax payments, especially given progressive tax rates and deliberately regressive benefit payments (e.g., Social Security, Medicare, Medicaid, housing subsidies, food stamps).

With millions of taxpayers and non-taxpayers in the mix — each with his own discount rate, and each receiving benefits (or not) that are disproportionate to the taxes that he pays — how can anyone say with a straight face that any government project can be justified by applying a “social” discount rate to its benefits and costs?

THE IRRELEVANT INTERNAL RATE OF RETURN

Given the foregoing, insurmountable objections, the die-hard defender of public-sector discounting hops on his deus ex machina: the internal rate of return. One such die-hard is Richard Thaler (also a notorious paternalist and purported libertarian), who essayed his views in “Discounting and Fiscal Constraints: Why Discounting is Always Right” (Center for Naval Analyses, Professional Paper 257, August 1979).

In Thaler’s simplified version of reality, a government decision-maker (manager) faces a choice between two projects that would deliver equal effectiveness (benefits). Specifically, the manager must choose between project A, at a cost of $200 in year 1, and equally-effective project B, at a cost of $205 in year 2 (op. cit., pp. 1-2). Thaler continues:

A [government] manager . . . cannot earn bank interest on funds withheld for a year. . . .  However, there will generally exist other ways for the manager to “invest” funds which are available. Examples include cost-saving expenditures, conservation measures, and preventive maintenance. These kinds of expenditures, if they have positive rates of return, permit a manager to invest money just as if he were putting the money in a savings account.

. . . Suppose a thorough analysis of cost-saving alternatives reveals that [in year 2] a maintenance project will be required at a cost of $215. Call this project D. Alternatively the project can be done [in year 1] (at the same level of effectiveness) for only $200. Call this project C. All of the options are displayed in table 1.

Discounting in the public sector_table 1

(op. cit., pp. 3-4)

Thaler believes that his example clinches the argument for discounting because the choice of project B (an expenditure of $205 in year 2) enables the manager to undertake project C in year 1, and thereby to “save” $10 in year 2.

Thaler’s “proof” is deeply flawed, as discussed in “Discounting and ‘Libertarian Paternalism’.” I’ll focus here on the essential emptiness of Thaler’s argument:

1. Even granting the availability of cost-reduction measures, their payoffs will vary widely. Thaler conveniently conjures projects C and D, with costs of $200 and $215 in years 1 and 2, respectively. He could just have well conjured a project D with a cost of $205 in year 2 — throwing A + D into a tie with B + C — or a project D with a cost of $203 in year 2 — causing A + D to look better than B + C.

2. In other words, the “correct” discount rate depends on the options available to a specific manager of a specific government activity. Yet Thaler insists on the application of a uniform discount rate by all government managers (op. cit., p. 6). By Thaler’s own example, such a practice could lead a manager to choose the wrong option.

3. To put it another way, the analyst should consider the specific options that are available to a specific manager, by constructing packages of projects that would cost the about the same in every year. Having done so (and assuming away a great deal of uncertainty about the costs and benefits of the options), the manager can then choose the package that delivers the most bang for the buck — when the bang is needed, in his judgment. There is no need to apply a discount rate. The relevant (and idiosyncratic) “discount rate” is a product of the correct choice, not a determinant of it.

FINAL WORDS ABOUT THE FUTILITY OF DISCOUNTING FOR GOVERNMENT DECISION-MAKING

Even if there were such a thing as a “social” discount rate, and even if the costs and benefits of government programs were well aligned, discounting would be an inadvisable practice in analysis for government decision-making. If a decision is to depend on the application of a particular discount rate, there must be great certainty about the future costs and benefits of alternative courses of action. But there seldom is (see “Analysis for Government Decision-Making: Demi-Science, Hemi-Demi-Science, and Sophistry“). The practice of discounting simply fosters an illusion of certainty — a potentially dangerous illusion, in the case of national defense.

The True Multiplier

I ended “The Keynesian Multiplier: Phony Math” on this note:

If there is a multiplier on government spending, it’s bound to be negative. Stay tuned for more about the effect of government spending on economic output.

Before I get to my estimate of the true multiplier — the one that does lasting damage to the economy — I must say more about the multiplier of Keynesian mythology.

As shown in “The Keynesian Multiplier: Phony Math,” the Keynesian multiplier rests on a mathematical illusion. It is nevertheless possible that an exogenous increase in spending really does yield a short-term, temporary increase in GDP.

How would it work? The following example goes beyond the bare theory of the Keynesian multiplier, and addresses several practical and theoretical reservations about it (some which I discuss in “A Keynesian Fantasy Land” and “The Keynesian Fallacy and Regime Uncertainty“):

  1. Annualized real GDP, denoted as Y, drops from $16.5 trillion a year to $14 trillion a year because of the unemployment of resources. (How that happens is a different subject.)
  2. Government spending (G) is temporarily and quickly increased by an annual rate of $500 billion; that is, ∆G = $0.5 trillion. The idea is to restore Y to $16 trillion, given a multiplier of 5 (In standard multiplier math: ∆Y = (k)(∆G), where k = 1/(1 – MPC); k = 5, where MPC = 0.8.)
  3. The ∆G is financed in a way that doesn’t reduce private-sector spending. (This is almost impossible, given Ricardian equivalence — the tendency of private actors to take into account the long-term, crowding-out effects of government spending as they make their own spending decisions. The closest approximation to neutrality can be attained by financing additional G through money creation, rather than additional taxes or borrowing that crowds out the financing of private-sector consumption and investment spending.)
  4. To have the greatest leverage, ∆G must be directed so that it employs only those resources that are idle, which then acquire purchasing power that they didn’t have before. (This, too, is almost impossible, given the clumsiness of government.)
  5. A fraction of the new purchasing power flows, through consumption spending (C), to the employment of other idle resources. That fraction is called the marginal propensity to consume (MPC), which is the rate at which the owners of idle resources spend additional income on so-called consumption goods. (As many economists have pointed out, the effect could also occur as a result of investment spending. A dollar spent is a dollar spent, and investment  spending has the advantage of laying the groundwork for economic growth, unlike consumption spending.)
  6. A remainder goes to saving (S) and is therefore available for investment (I) in future production capacity. But S and I are ignored in the multiplier equation: One story goes like this: S doesn’t elicit I because savers hoard cash and investment is discouraged by the bleak economic outlook. This is probably closer to the mark: The multiplier would be infinite (and therefore embarrassingly inexplicable) if S generated an equivalent amount of I, because the marginal propensity to spend (MPS) would be equal to 1, and the multiplier equation would look like this: k = 1/(1 – MPS) = ∞, where MPS = 1.
  7. In any event, the initial increment of C (∆C) brings forth a new “round” of production, which yields another increment of C, and so on, ad infinitum. If MPC = 0.8, then assuming away “leakage” to taxes and imports, the multiplier = k = 1/(1 – MPC), or k = 5 in this example.  (The multiplier rises with MPC and reaches infinity if MPC = 1. This suggests that a very high MPC is economically beneficial, even though a very high MPC implies a very low rate of saving and therefore a very low rate of growth-producing investment.)
  8. Given k = 5,  ∆G = $0.5T would cause an eventual increase in real output of $2.5 trillion (assuming no “leakage” or offsetting reductions in private consumption and investment); that is, ∆Y = [k][∆G]= $2.5 trillion. However, because G and Y usually refer to annual rates, this result is mathematically incoherent; ∆G = $0.5 trillion does not restore Y to $16.5 trillion.
  9. In any event, the increase in Y isn’t permanent; the multiplier effect disappears after the “rounds” resulting from ∆G have played out. If the theoretical multiplier is 5, and if transactional velocity is 4 (i.e., 4 “rounds” of spending in a year), more than half of the multiplier effect would be felt within a year from each injection of spending, and about two-thirds would be felt within two years of each injection. It seems unlikely, however, that the multiplier effect would be felt for much longer, because of changing conditions (e.g., an exogenous boost in private investment, private reemployment of resources, discouraged workers leaving the labor force, shifts in expectations about inflation and returns on investment).
  10. All of this ignores that fact that the likely cause of the drop in Y is not insufficient “aggregate demand,” but a “credit crunch” (Michael D. Bordo and Joseph G. Haubrich in “Credit Crises, Money, and Contractions: A Historical View,” Federal Reserve Bank of Cleveland, Working Paper 09-08, September 2009), “Aggregate demand” doesn’t exist, except as an after-the-fact measurement of the money value of goods and services comprised in Y. “Aggregate demand,” in other words, is merely the sum of millions of individual transactions, the rate and total money value of which decline for specific reasons, “credit crunch” being chief among them. Given that, an exogenous increase in G is likely to yield a real increase in Y only if the increase in G leads to an increase in the money supply (as it is bound to do when the Fed, in effect, prints money to finance it). But because of cash hoarding and a bleak investment outlook, the increase in the money supply is unlikely to generate much additional economic activity.

To top it off, a somewhat more realistic version of multiplier math — as opposed to the version addressed in “The Keynesian Multiplier: Phony Math” — yields a maximum value of k = 1:

More rigorous derivation of Keynesian multiplier

How did I do that? In step 3, I made C a function of P (private-sector GDP) instead of Y (usually taken as the independent variable). Why? For the years 1929-2012 (excluding 1941-46, when the massive war effort and its aftermath drastically reduced C), C was more closely linked to P than to Y. (The true consumption function turns out to be C = – $148 trillion in 2012 $ + 0.838P.)

Math trickery aside, there is evidence that the Keynesian multiplier is less than 1. Robert J. Barro of Harvard University opens an article in The Wall Street Journal with the statement that “economists have not come up with explanations … for multipliers above one.”[1]

Barro continues:

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP — consumption, investment and net exports….

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports — personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses — there was a dampener, rather than a multiplier….

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. (“Government Spending Is No Free Lunch,” The Wall Street Journal (online.WSJ.com), January 22, 2009)

This is from Valerie A. Ramsey of  the University of California-San Diego and the National Bureau of Economic Research:

…[I]t appears that a rise in government spending does not stimulate private spending; most estimates suggest that it significantly lowers private spending. These results imply that the government spending multiplier is below unity. Adjusting the implied multiplier for increases in tax rates has only a small effect. The results imply a multiplier on total GDP of around 0.5. (“Government Spending and Private Activity,” January 2012)

The price of the demonstrably small Keynesian multiplier is a “temporary” increase in G — an increase that is likely to be permanent and therefore harmful to economic growth.

If that is the case, whence the continuing clamor for “temporary” increases in government spending? It’s because the Keynesian multiplier isn’t just a phony theory; it’s a “religious” tenet shared by economists, pundits, and policy-makers who are true believers in big government. True believers aren’t swayed by such considerations as slower growth and the loss of freedom that accompanies government interventions in private affairs. True believers — Paul Krugman, Brad DeLong, Joseph Stiglitz, and their ilk — always claim that government should spend more, not just in recessionary times. Their preachings bolster the pro-government-spending biases of most pundits and a large fraction of politicians.

As for “temporary” increases in government spending, they usually are as temporary as the infamous “temporary government buildings” in Washington, D.C. Consider this:

GDP and government spending since WWII
Sources: See footnote 3.

Look at defense spending, which actually fluctuates noticeably. Then look at the two lines for government spending, especially the top line. What do you see? An almost unbroken rise in total government spending (including transfer payments). There’s no give-back of any significance. When government officials latch onto your money, they find a way to keep it. If a reduction in defense spending seems to be in order, the money is shifted to other government programs. If there’s a cut in government programs that don’t provide “social insurance,” the money is shifted to government programs that do provide “social insurance” (mainly Social Security, Medicare, and Medicaid). In other words, our rulers consider our money to be their money, and they find ways to keep it, and to grab more and more of it. That’s why the private sector’s share of GDP — the gap between GDP and top-line government spending — shrank almost steadily from 1947 (the first year of full demobilization after World War II) through 2012.

Let’s now talk about the true multiplier on government spending, which I denote as K. Before I spring some equations on you, I want to take a brief tour of the economy’s performance since World War II. Consider the long, upward trend in government spending (G)[2] as a fraction of GDP:

G-GDP since WWII
Sources: See footnote 3.

The decline of G/GDP in the 1990s can be attributed to the “peace dividend” — the accelerated reduction of defense spending following the end of the Cold War and the Gulf War — and to the overrated “Clinton boom.” (This so-called boom featured a real growth rate of 3.4 percent from 1993 to 2001, which is unimpressive by historical standards. For example, the overall rate of growth from the first quarter of 1947 to the first quarter of 1993 — recessions and all — was 3.4 percent.)

In any event, the cumulative effect of rising G/GDP on the rate of growth is evident here:

Year-over-year changes in real GDP, 1948-2013
Derived from a spreadsheet published by the Bureau of Economic Analysis, Current Dollar and “Real” Gross Domestic Product.

This graph tells the same story in a different way:

Annualized rate of real growth_bottom of recession to onset of next recession
Derived from the same source as the preceding graph. My definition of a recession is given here.

Putting it all together, for the period 1947-2012 I estimated[3] the year-over-year percentage change in GDP (denoted as Y%) as a function of G/GDP (denoted as G/Y):

Y% = 0.09 – 0.17(G/Y)

Solving for Y% = 0 yields G/Y = 0.53; that is, Y% will drop to zero if G/Y rises to 0.53 (or thereabouts)[4]. At the present level of G/Y (about 0.4), Y% will hover just above 2 percent, as it has done in recent years. (See the graph immediately above.)

If G/Y had remained at 0.234, its value in 1947:

  • Real growth would have been about 5 percent a year, instead of 3.2 percent (the actual value for 1947-2012).
  • The total value of Y for 1947-2012 would have been higher by $500 trillion (98 percent).
  • The total value of G would have been lower by $61 trillion (34 percent).

The last two points, taken together, imply a cumulative government-spending multiplier (K) for 1947-2012 of about -8. That is, aggregate output in 1947-2012 declined by 8 dollars for every dollar of government spending above the amount represented by G/Y = 0.234.

But -8 is only an average value for 1947-2012. It gets worse. The reduction in Y is cumulative; that is, every extra dollar of G reduces the amount of Y that is available for growth-producing investment, which leads to a further reduction in Y, which leads to a further reduction in growth-producing investment, and on and on. (Think of the phenomenon as negative compounding; take a dollar from your savings account today, and the value of the savings account years from now will be lower than it would have been by a multiple of that dollar: [1 + interest rate] raised to nth power, where n = number of years.) Because of this cumulative effect, the effective value of K in 2012 was about -14.

For this, the U.S. government should “stimulate” the economy with a burst of “temporary” spending? Think again.

*     *     *

Related posts:
The Price of Government
The Price of Government Redux
The Mega-Depression
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Illusion of Prosperity and Stability
The Stagnation Thesis
Taxing the Rich
More about Taxing the Rich
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Regime Uncertainty and the Great Recession
The Commandeered Economy
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
The Obama Effect: Disguised Unemployment
Economics: A Survey (also here)
Why Are Interest Rates So Low?
Vulgar Keynesianism and Capitalism
Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth
America’s Financial Crisis Is Now
“Social Insurance” Isn’t Insurance — Nor Is Obamacare
The Keynesian Multiplier: Phony Math

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Footnotes:

[1] Theoretical estimates of the Keynesian multiplier [k = 1/(1 - b)] are always greater than 1. How much greater depends only on the value assigned to b, the marginal propensity to consume. The story about “rounds” of additional consumption spending, the sum of which asymptotically approach the value of the multiplier, is just that — a story, a rationalization of phony multiplier math:

The phony math and phony story led Keynes’s intellectual heirs and their followers to believe that the multiplier is greater than 1 — significantly greater, in the minds of true believers. And when people believe in something, it’s easy to find numbers to support the belief. This is especially true of macroeconomic aggregates, which reflect the influence of so many variables that it’s hard to pinpoint what causes what.

Why is 1 the true upper limit of the Keynesian multiplier? I offer the following explanation by way of a thought experiment.

Consider a simple economy with two producers who trade with each other. One (the baker) makes bread; the other (the dairyman) makes butter. With fixed capital, which is kept in repair but never improved or expanded, the output and consumption of bread and butter will change for any or all of four reasons: (1) changes in the tastes and preferences of the producers (as consumers); (2) changes in the availability of resources because of ambient conditions (e.g., a flood that disruptions production, weather conditions that affect the yield of wheat, the health of the baker and the dairyman); (3) innovations that lead to an increase the quality or quantity of output, without requiring additional inputs; and (4) a disruption of credit.

None of these conditions can be remedied at zero cost, that is, simply by printing money in the hope of re-employing the unemployed resources. The fourth condition warrants elaboration. Suppose that the baker had been relying on advances of butter from the dairyman. Then the dairyman cuts off those advances — perhaps because his churn is being repaired., or because he has less tolerance for risk. The baker’s resulting loss of energy causes him to produce less bread, which reduces the rate at which the baker and dairyman exchange bread and butter, which exacerbates the baker’s loss of energy and initiates a decline in the dairyman’s energy, and so on. (You should recognize this as an analog of the process by which an economy is thought to fall into recession or depression. The pervasiveness of the “credit crunch” as a cause of or major factor in recessions and depressions is documented by Michael D. Bordo and Joseph G. Haubrich in “Credit Crises, Money, and Contractions: A Historical View,” Federal Reserve Bank of Cleveland, Working Paper 09-08, September 2009.) No amount of “stimulus” will cause the dairyman to restore credit to the baker, unless and until the dairyman is convinced of the baker’s creditworthiness. (We’re in a barter economy, so throwing money at the baker won’t make him any more credit-worthy or lead to a rise in real output; it will just spread the pain. Nor does throwing money around do much to help in a money-based economy; it doesn’t (a) fix the underlying problem (e.g., a badly managed business in a highly competitive industry) or (b) yield a one-for-one increase in output, inasmuch as the thrown money is inevitably misdirected and must therefore cause some degree of price inflation instead of spurring real output.)

In the absence of any of the kinds of change discussed above, the simple baker-dairyman economy can be characterized as a static circular flow: the same inputs yield the same kinds of outputs, which are consumed at the same rate, year after year. Specifically, the baker keeps some of his output and trades some of it for butter; the dairyman keeps some of his output and trades some of it for bread. The two producers, acting as consumers, use all of the bread and butter that they produce. As a result, they produce the same amount of bread and butter in the next year, which they consume. And so on.

A heretofore unemployed third party enters: a maker of jam, who also wants to consume bread and butter. Where did he come from? Perhaps he’s a son of the baker or the dairyman who has just become old enough to strike out on his own. In any event, his production of jam doesn’t reduce the output of bread and butter; he is drawing on heretofore unused resources that the baker and dairyman couldn’t employ because they are fully engaged in their respective activities.

The producers of bread, butter, and jam decide to engage in three-way trade, so that every one of them becomes a consumer of all three items. The producers of bread and butter willingly consume less bread and butter than before in order to have jam. The producer of jam, of course, trades some of his output for some bread and butter.  As a result of these voluntary trades, all three producers are better off than they were before. (If they weren’t, they wouldn’t trade with each other.)

Because the employment of previously unemployed resources makes everyone better off, those previously unemployed resources will continue to be employed, barring changes of the kind discussed above. That is, the circular flow will continue, but at a higher level of output and consumption. But it won’t expand beyond the level attained when the jam-maker entered the scene and entered into three-way trade with the baker and dairyman.

In sum, the initial “burst” of new employment and output, represented by the jam-maker’s production, doesn’t cause a “ripple effect” that leads to further expansion of output and consumption. Any further expansion would have to be caused by (and limited to) the employment of yet another heretofore unemployed resource; that is, yet another shot of “stimulus.”

Conclusion: The maximum multiplier on the employment of a previously unemployed resource is 1. But it can be (and probably will be) less than 1 if a fourth party (government) tries to entice additional output by issuing directives (spending money) without perfect knowledge of current economic variables (including, but not limited to, knowledge of tastes and preferences, states of health, and producers’ and consumers’ plans and expectations). A good example of government failure: directing (issuing money to) the fully employed baker and dairyman to produce more bread and butter,  while failing to direct (issue money to) the jam-maker to make enough jam to fully employ himself.

[2] G, as I use it here, stands for all government spending, including so-called transfer payments. A transfer payment (usually “social insurance“) is just another way of moving claims on resources from those who earned such claims to those who didn’t earn them. In this respect, transfer payments are no different than other government programs, which involve the coercion of taxpayers to compensate government employees and contractors who do unproductive and counterproductive work (e.g., writing and enforcing regulations). Transfer payments, like other government programs, require administration by vast, costly bureaucracies. In sum, there is no substantive difference between transfer payments and other kinds of government spending; transfer payments are therefore properly considered government spending, arbitrary national-income accounting flim-flam to the contrary notwithstanding.

[3] This equation is based on estimates of GDP and government spending  for 1946-2012. The equation, the intercept, and the coefficient on G/GDP are significant at the 0.05 level and better. The standard error of the estimate is 0.024 percentage points; there is a 95-percent probability that the zero growth point lies between G/Y = 0.41 and 0.75. To derive the equation, I obtained current-dollar estimates of GDP and G from the Bureau of Economic Analysis, GDP and the National Income and Product Accounts (NIPA) Historical Tables, 1.1.5 Gross Domestic Product, line 1, and 3.1 Government Current Receipts and Expenditures, lines 33 and 34. I deflated the current-dollar values using the GDP deflator published at MeasuringWorth.com.

[4] This is is remarkably close to the zero-growth estimate of 0.55 that I derived in “Estimating the Rahn Curve: Or How Government Inhibits Economic Growth.” The equation given in that post is based on a longer view of the effects of government spending on growth. In retrospect, that longer view gives too much weight to the bygone era of low government spending, an era that ended with the Great Depression. I stand by the equation in this post as indicative of reality in the post-World War II era of rampant growth in government spending.

Prescience about Obamacare

The estimable Charles Krauthammer writes about Obamacare:

Obamacare was sold as simply a refinement of the current system, retaining competition among independent insurers but making things more efficient, fair and generous. Free contraceptives for Sandra Fluke. Free mammograms and checkups for you and me. Free (or subsidized) insurance for some 30 million uninsured. And, mirabile dictu, not costing the government a dime….

That was a fraud from the very beginning. The law was designed to throw people off their private plans and into government-run exchanges where they would be made to overpay — forced to purchase government-mandated services they don’t need — as a way to subsidize others. (That’s how you get to the ostensible free lunch.) …

Three years ago I predicted that Obamacare would turn insurers into the lapdog equivalent of utility companies. I undershot. They are being treated as wholly owned subsidiaries. Take the phrase “strongly encouraging.” Sweet persuasion? In reality, these are offers insurers can’t refuse. Disappoint your federal master and he has the power to kick you off the federal exchanges, where the health insurance business of the future is supposed to be conducted.

Moreover, if adverse selection drives insurers into a financial death spiral — too few healthy young people to offset more costly, sicker, older folks — their only recourse will be a government bailout. Do they really want to get on the wrong side of the White House, their only lifeline when facing insolvency?

Obamacare posed as a free-market alternative to a British-style single-payer system. Then, during congressional debate, the White House ostentatiously rejected the so-called “public option.” But that’s irrelevant. The whole damn thing is the public option. The federal government now runs the insurance market, dictating deadlines, procedures, rates, risk assessments and coverage requirements. It’s gotten so cocky it’s now telling insurers to cover the claims that, by law, they are not required to.

Welcome 2014, our first taste of nationalized health care.

I must say, in all modesty, that I (and others) predicted the shape of the future more than four years ago,  well before Obamacare became “the law of the land.” See, for example, my posts dated July 27, September 12, October 9, and October 18, 2009:

Rationing and Health Care
The Perils of Nannyism: The Case of Obamacare
More about the Perils of Obamacare
Health-Care Reform: The Short of It

Other related posts:
The Unconstitutionality of the Individual Mandate
Does the Power to Tax Give Congress Unlimited Power?
Does Congress Have the Power to Regulate Inactivity?
Obamacare: Neither Necessary nor Proper
Obamacare, Slopes, Ratchets, and the Death-Spiral of Liberty
Another Thought or Two about the Obamacare Decision
Obamacare and Zones of Liberty
“Social Insurance” Isn’t Insurance — Nor Is Obamacare

The Keynesian Multiplier: Phony Math

Much is wrong with the Keynesian multiplier. The arguments for it and explanations of it range from incoherent to inconsistent. In time, I’ll address those arguments and explanations. Today, however, I’ll focus on the phony math at the heart of the multiplier.

The bottom line: The Keynesian multiplier is a tautology that explains nothing. To see why, read on.

THE MULTIPLIER: AN IDEA THAT WON’T DIE

Why worry about the Keynesian multiplier, when old-style Keynesian economics has been supplanted — in the academy — by new Keynesianism, new classical macroeconomics, and the new neoclassical synthesis? Economist John Cochrane has the answer:

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people’s pockets, and then they go and spend, and that puts more money in other people’s pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It’s just not economics. A 40 year quest for “microfoundations” came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

But people love the story. Policy makers love the story.  Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation — but they had not been able to publish any of their models in peer-reviewed journals for 35 years. (“New vs. Old Keynesian Stimulus,” The Grumpy Economist, November 8, 2013)

People — in the academy, the media, and politics — love the story so much that Obama’s “stimulus package” was predicated on a multiplier of about 1.6.  That estimate was produced in January 2009 by Christina Romer, who was then chairwoman-designate of Obama’s Council of Economic Advisers. Another prominent economist, Alan Blinder (a member of the CEA under Clinton and former vice chairman of the Fed’s Board of Governors), cites a multiplier of 1.5.

Those of you who have at least a passing familiarity with the multiplier will ask what’s wrong with a multiplier of 1.5, or 1.6 — or even a multiplier of 5. That is, if government spends an extra $1 to employ previously unemployed resources, why won’t that $1 multiply and become $1.50, $1.60, or even $5 worth of additional output?

The answer, my friends, is found in the phony math by which the multiplier is derived, and in the phony story that was long ago concocted to explain the operation of the multiplier. The phony math and phony story led Keynes’s intellectual heirs and their followers to believe that the multiplier is greater than 1 — significantly greater, in the minds of true believers. And when people believe in something, it’s easy to find numbers to support the belief. This is especially true of macroeconomic aggregates, which reflect the influence of so many variables that it’s hard to pinpoint what causes what.

MULTIPLIER MATH

I’ll deal with the phony story in a future post. Today’s lesson is about the phony math. To show you why the math is phony, I’ll start with a derivation of the multiplier. That derivation begins with the accounting identity  Y = C + I + G, which means that  total output (Y) = consumption (C) + investment (I) + government spending (G). I could have used  a more complex identity that involves taxes, exports, and imports. But no matter; the bottom line remains the same, so I’ll keep it simple and use Y = C + I  + G.

Keep in mind that the aggregates that I’m writing about here — Y , C , I , G, and later S  — are supposed to represent real quantities of goods and services, not mere money.

Now for the derivation:

Derivation of investment-govt spending multiplier

So far, so good. Now, let’s say that b = 0.8. This means that income-earners, on average, will spend 80 percent of their additional income on consumption goods (C), while holding back (saving, S) 20 percent of their additional income. With b = 0.8, k = 1/(1 – 0.8) = 1/0.2 = 5.  That is, every $1 of additional spending — let us say additional government spending (∆G) rather than investment spending (∆I) — will yield ∆Y = $5. In short, ∆Y = k(∆G), as a theoretical maximum. (There are many reasons for the multiplier, even if it were real, to fall short of its theoretical maximum; see this post.)

How is it supposed to work? The initial stimulus (∆G) creates income (don’t ask how), a fraction of which (b) goes to C. That spending creates new income, a fraction of which goes to C. And so on. Thus the first round = ∆G, the second round = b(∆G), the third round = b(b)(∆G) , and so on. The sum of the “rounds” asymptotically approaches k(∆G). (What happens to S, the portion of income that isn’t spent? That’s part of the complicated phony story that I’ll examine in a future post.)

Note well, however, that the resulting ∆Y isn’t properly an increase in Y, which is an annual rate of output; rather, it’s the cumulative increase in total output over an indefinite number and duration of ever-smaller “rounds” of consumption spending.

The cumulative effect of a sustained increase in government spending might, after several years, yield a new Y — call it Y’ = Y + ∆Y. But it would do so only if ∆G persisted for several years. To put it another way, ∆Y persists only for as long as the effects of ∆G persist. The multiplier effect disappears after the “rounds” of spending that follow ∆G have played out.

The multiplier effect is therefore (at most) temporary; it vanishes after the withdrawal of the “stimulus” (∆G). (A permanent increase in G would adversely affect GDP in the longer term by diverting resources from more productive private uses and discouraging growth-producing investment spending.) The idea is that ∆Y should be temporary because a downturn will be followed by a recovery — weak or strong, later or sooner. (I can’t resist the observation that enthusiasts of big government relish the thought of any increase in G, hoping that it will become permanent.)

WHY MULTIPLIER MATH IS PHONY MATH

Now for my exposé of the phony math. I begin with Steve Landsburg, who borrows from the late Murray Rothbard:

. . . We start with an accounting identity, which nobody can deny:

Y = C + I + G. . . Since all output ends up somewhere, and since households, firms and government exhaust the possibilities, this equation must be true.

Next, we notice that people tend to spend, oh, say about 80 percent of their incomes. What they spend is equal to the value of what ends up in their households, which we’ve already called C. So we have

C = .8YNow we use a little algebra to combine our two equations and quickly derive a new equation:

Y = 5(I+G)That 5 is the famous Keynesian multiplier. In this case, it tells you that if you increase government spending by one dollar, then economy-wide output (and hence economy-wide income) will increase by a whopping five dollars. What a deal!

. . . [I]t was Murray Rothbard who observed that the really neat thing about this argument is that you can do exactly the same thing with any accounting identity. Let’s start with this one:

Y = L + E

Here Y is economy-wide income, L is Landsburg’s income, and E is everyone else’s income. No disputing that one.

Next we observe that everyone else’s share of the income tends to be about 99.999999% of the total. In symbols, we have:

E = .99999999 Y

Combine these two equations, do your algebra, and voila:

Y = 100,000,000 LThat 100,000,000 there is the soon-to-be-famous “Landsburg multiplier”. Our equation proves that if you send Landsburg a dollar, you’ll generate $100,000,000 worth of income for everyone else.

The policy implications are unmistakable. It’s just Eco 101!! (“The Landsburg Multiplier: How to Make Everyone Rich,” The Big Questions blog, June 25, 2013)

Landsburg attributes the nonsensical result to the assumption that

equations describing behavior would remain valid after a policy change. Lucas made the simple but pointed observation that this assumption is almost never justified.

. . . None of this means that you can’t write down [a] sensible Keynesian model with a multiplier; it does mean that the Eco 101 version of the Keynesian cross is not an example of such. This in turn calls into question the wisdom of the occasional pundit [Paul Krugman] who repeatedly admonishes us to be guided in our policy choices by the lessons of Eco 101. (“Multiple Comments,” op. cit,, June 26, 2013)

It’s worse than that, as Landsburg almost acknowledges, when he observes (correctly) that Y = C + I + G is an accounting identity. That is to say, it isn’t a functional representation — a model — of the dynamics of economic exchange. Assigning a value to b (the marginal propensity to consume) — even if it’s an empirical value — doesn’t alter that fact that the derivation is nothing more than the manipulation of a non-functional relationship.

Consider the equation for converting temperature Celsius (C) to temperature Fahrenheit (F): F = 32 + 1.8C. It follows that an increase of 10 degrees C implies an increase of 18 degrees F. This could be expressed as ∆F/C = k* , where k* represents the “Celsius multiplier.” There is no mathematical difference between the derivation of the investment/government-spending multiplier (k) and the derivation of the Celsius multiplier (k*). And yet we know that the Celsius multiplier is nothing more than a tautology; it tells us nothing about how the temperature rises by 10 degrees C or 18 degrees F. It simply tells us that when the temperature rises by 10 degrees C, the equivalent rise in temperature F is 18 degrees. The rise of 10 degrees C doesn’t cause the rise of 18 degrees F.

Similarly, the Keynesian investment/government-spending multiplier simply tells us that if ∆Y = $5 trillion, and if b = 0.8, then it is a matter of mathematical necessity that ∆C = $4 trillion and ∆I + ∆G = $1 trillion. In other words, a rise in I + G of $1 trillion doesn’t cause a rise in Y of $5 trillion; rather, Y must rise by $5 trillion for C to rise by $4 trillion and I + G to rise by $1 trillion. If there’s a causal relationship between ∆G and ∆Y, the multiplier doesn’t portray it.

And that’s that.

ADDENDUM (12/18/13): PHONY MATH DOESN’T EVEN ADD UP

Well, that’s almost that. I couldn’t resist another jab at the multiplier.

Recall the story that’s supposed to explain how the multiplier works: The initial stimulus (∆G) creates income, a fraction of which (b) goes to C. That spending creates new income, a fraction of which goes to C. And so on. Thus the first round = ∆G, the second round = b(∆G), the third round = b(b)(∆G) , and so on. The sum of the “rounds” asymptotically approaches k(∆G). So, if b = 0.8, k = 5, and ∆G = $1 trillion, the resulting cumulative ∆Y = $5 trillion (in the limit). And it’s all in addition to the output that would have been generated in the absence of ∆G, as long as many conditions are met. Chief among them is the condition that the additional output in each round is generated by resources that had been unemployed.

In addition to the fact that the math behind the multiplier is phony, as explained above, it also yields contradictory results. If one can derive an investment/government-spending multiplier, one can also derive a “consumption multiplier”:

Derivation of consumption multiplier

Taking b = 0.8, as before, the resulting value of k-sub-c is 1.25. Suppose the initial round of spending is generated by C instead of G. (I won’t bother with a story to explain it; you can easily imagine one involving underemployed factories and unemployed persons.) If ∆C = $1 trillion, shouldn’t cumulative ∆Y = $5 trillion? After, there’s no essential difference between spending $1 trillion on a government project and $1 trillion on factory output, as long as both bursts of spending result in the employment of underemployed and unemployed resources (among other things).

But with k-sub-c = 1.25, the initial $1 trillion burst of spending (in theory) results in additional output of only $1.25 trillion. Where’s the other $3.75 trillion? Nowhere. The $5 trillion is phony. What about the $1.25 trillion? It’s phony, too. The “consumption multiplier” of 1.25 is simply the inverse of b, where b = 0.8. In other words, Y must rise by $1.25 trillion if C is to rise by $1 trillion. More phony math.

If there is a multiplier on government spending, it’s bound to be negative. Stay tuned for more about the effect of government spending on economic output.

The sequel is here.

“Social Insurance” Isn’t Insurance — Nor Is Obamacare

Social Security, Medicare, and Medicaid (as revised and expanded by Obamacare) are by far the costliest forms of “social insurance” in the United States. According to estimates prepared by the Congressional Budget Office, those programs (including ancillary activities, such as insurance subsidies) will cost $3.3 trillion in 2023. However, the feds will collect only $1.6 trillion in “social insurance” taxes in 2023. That’s a $1 trillion increase in the “social insurance” deficit from its level in 2013. (Derived from Summary Table 1, Table 1-1, and Table 1-3 of “The Budget and Fiscal Outlook: Fiscal Years 2013 to 2023,” February 2013.)

I put quotation marks around “social insurance” because it isn’t insurance, for the reasons discussed in this post. What is it? Just another set of programs designed to redistribute income, mainly from those who’ve earned it to those who haven’t. “Social insurance” is a trickle-down transfer-payment scheme, wherein some of the money reaches its intended targets after passing through the sticky fingers of the overpaid bureaucrats who live in and around Washington, D.C.

What’s the difference between “social insurance” and real insurance? Insurance — to be insurance and not merely a subsidy — must have the following characteristics:

  • It must apply to defined, undesirable events that might befall any person or business in the insured group.
  • The group will be defined by specific characteristics (e.g., age range, gender, medical history, location relative to a known hazard such as forest fires).
  • The probability of occurrence (frequency) of a particular event can be estimated with some accuracy, for the group as a whole.
  • There is no way to predict the timing or frequency with which the event will befall a particular member of the group.
  • In exchange for a specified premium, an insurer agrees to pay each member of the group a specified amount should an insured event befall that member during a specified time period.
  • The insurer will periodically revise his estimate of the probability of the occurrence of various events and the costs of insuring against those those events, and may accordingly change the terms on which he offers insurance (e.g., covered events, premium, amount to be reimbursed, conditions for insurance eligibility).
  • Insurance should be self-sustaining. The insurer, taking into account risk and uncertainty, will strive for a situation where, in most years, premiums cover payouts plus administrative expenses and enough profit to keep the insurer from moving his capital to other, more-rewarding ventures.
  • But insurance cannot be sustained by force — through taxes levied on taxpayers at large to provide benefits to certain classes of persons, for example. Any such program fails to meet the criteria listed above, and is nothing more than a subsidy.

“Social insurance” isn’t insurance because it fails on all counts.

Consider Social Security. Retirement is not an undesirable event that might occur; it is a desirable event toward which almost everyone strives. Social Security is merely a government-imposed substitute for the prudent act of saving toward one’s retirement and then drawing on the accumulated nest-egg to finance that retirement. The usual excuse for Social Security is that a lot of people, especially low-income persons, can’t or won’t save enough to maintain some (arbitrary) standard of living during retirement. In other words, Social Security isn’t insurance against an unpredictable event, it’s a mechanism for subsidizing low-income and imprudent persons at the expense of their opposites.

The same analysis applies to Medicare, Medicaid, and other forms of federal and State “social insurance.” The risk pools are huge and ill-defined. The premiums are either nominal (Medicare) or non-existent (Medicaid and other programs). All such programs are nothing more than non-contractual “promises” to pay certain amounts for certain events, regardless of the probability of those events and their associated costs.

Even programs that mimic insurance — unemployment benefits and workers’ compensation, for example — are really subsidies because of their all-encompassing nature and the forcible extraction of “premiums” from employers. Those who are at risk for unemployment and on-the-job injuries have no say in the matter of how much insurance they wish to purchase and how much they are willing to pay for it. Unemployment “insurance” is an especially weird kind of “insurance,” in that the benefits expand and contract according to the whims of government actors.

Enough said about “social insurance” as insurance. It simply isn’t insurance. And thanks largely to Obamacare, health insurance is going the way of “social insurance.”

Health insurance, despite heavy regulation and the distortions produced by tax breaks, has until recently retained the characteristics of true insurance. Now comes Obamacare, the point of which is to move toward universal, government-controlled health care under the guise of “insuring” a larger fraction of Americans. What Obamacare really does, of course, is to force Americans, as consumers and taxpayers, to buy and subsidize “insurance” that covers events that aren’t health risks; for example: so-called preventive care, the use of contraceptives, abortion, various kinds of maternity and pediatric care, and the coverage of “children” up to the age of 26.

What about mandatory coverage of pre-existing conditions? Here’s Greg Mankiw on the subject:

A large part of the motivation of the Affordable Care Act is to provide insurance to those with pre-existing conditions. Under the law, insurance is offered to everyone at a price based on overall community risk, not the risk estimated by the insurance company based on a person’s particular characteristics. That has been deemed “fair” by advocates of the law.

I wonder whether advocates of this view are concerned with other insurance markets.  Teenage drivers pay a lot more for auto insurance. The old pay a lot more for life insurance.  Life insurance companies require health screening before granting a policy. Is this a problem, or the natural and desirable functioning of markets?

The answer to Mankiw’s question is that advocates of Obamacare aren’t really trying to insure anyone, they’re trying (successfully) to ram socialized medicine down the throats of Americans. Obamacare is a step in exactly the wrong direction. It’s an effort to emulate the long-discredited nationalized health-care systems of Canada and Britain (small sample here), complete with death panels. And sure enough, they’re already here, in Oregon.

I was prompted to write this post because I happened on a piece by Scott Gallipo, writing at The American [Pseudo-] Conservative. In a patent attempt to defend Obamacare, Gallipo begs real conservatives to “Stop Comparing Health Insurance to Car Insurance.” Gallipo’s “argument” is fatally confused; for example:

It’s helpful to step back and remind ourselves why we ask doctors to perform “preventative maintenance” on our bodies. If diseases are caught early, they’re often cheaper to treat or cure. If we stay in good physical shape, we reduce the chances of developing many diseases in the first place. When we preventatively maintain our cars, however, we are merely forestalling problems that we would have to pay out-of-pocket for anyway. If you don’t change your oil, your car insurance plan isn’t going to cover the cost of fixing a seized engine.

Gallipo is trying to distinguish preventive health care from preventive auto care, but he fails to do so. For one thing, he wrongly asserts that preventive maintenance forestalls problems that would have to be paid for out-of-pocket. Not necessarily. That’s why warranties (insurance) and their cost (premiums in disguise) are baked into the price of new autos. And that’s why many auto buyers obtain extended warranties. As it happens, I obtained my extended warranty from GEICO. It’s additional coverage under my auto policy, and it commands an additional premium And what does GEICO call my extended warranty? Mechanical breakdown coverage (i.e., insurance).

More fundamentally, Gallipo makes some heroic assumptions about preventive care. Yes, routine tests will sometimes result in the detection and treatment of conditions that would otherwise be detected at a later stage. But the cost of checkups and lab tests, when ordered wholesale by doctors because they’re “free,” far exceeds the benefits. (See this, this, this, and this, for example.)

Most fundamentally, Gallipo begs the question. In his (incorrect) view, preventive “care” on a massive scale is a “good thing.” Therefore, it should be covered by insurance. But the massive overuse of “free” checkups and lab tests has nothing to do with insurance, and everything to do with the nationalization of health care. Those “free” checkups and tests will not be paid for by risk-related premiums; they will be paid for by taxpayers and the millions of Americans whose Obamacare “premiums” are really “contributions” to an open-ended national health-care plan.

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Related posts:
Rationing and Health Care
The Perils of Nannyism: The Case of Obamacare
More about the Perils of Obamacare
Health-Care Reform: The Short of It
Toward a Risk-Free Economy
Enough of “Social Welfare”
Points of Agreement and Reinforcement
Death Panels
Government Failure Comes as a Shock to Liberals
The View from Here
Another Obama Lie, and a Rant

Progressive Taxation Is Alive and Well in The U.S. of A.

THIS IS A RE-POSTING OF THE ORIGINAL, WHICH APPEARED ON JULY 20, 2012

Will Wilkinson, in the course of a good post about Obama’s big lie, writes:

I’d like to thank my colleague [a blogger who goes by D.R.] for helping me see how to make my case stronger. Of the comprehensive American tax system, he writes:

The fact of the matter is that the American tax code as a whole is almost perfectly flat. The bottom 20% of earners make 3% of the income and pay 2% of the taxes; the middle 20% make 11% and pay 10%; and the top 1% make 21% and pay 22%. Steve Forbes couldn’t have drawn it up any better.

I happen to agree with Steve Forbes that a flat tax best reflects our intuitions about proportionality and fairness, so I’m tickled to see that our system is so fair!

The link attached to “almost perfectly flat” leads to this:

The source is a “sister organization” of the union-dominated lobbying organization, Citizens for Tax Justice, which is responsible for a graph that I reproduced in “Elizabeth Warren Is All Wet“:

As I said in “Elizabeth Warren…,” Citizens for Justice

acknowledges (backhandedly) that “the rich” pay their “fair share” of all taxes — federal, State, and local….

[G]iven the source, this [graph] can be taken as a “worst case” depiction of the distribution of the total tax burden. “The rich” are paying their “fair share,” and then some, unless you believe (as leftists seem to believe) that  “the rich” are supposed to take care of everyone else.

Not surprisingly, the statistics for 2011 yield a graph that looks much like the one just above:

What puzzled me, briefly, is why the Citizens for Tax Justice and Institute for Taxation and Economic Policy split the top quintile into chunks. Then it occurred to me that those left-wing outfits are trying to suppress the fact that taxpayers in the top quintile pay a disproportionate share of all taxes. Thus:

Further, the effective tax rate isn’t quite as flat as the left-wing outfits would like gullible readers to believe. Thus:

If that isn’t the picture of a progressive tax structure, I’ll eat my external hard drive.

The innumerate reader might say something like “Gee willikers, people who make more ought to pay more in taxes.” Think about it for a minute. If someone earning $100,000 pays taxes at the same rate as someone earning $10,000, the person earning $100,000 does pay more in taxes. For example: $100,000 times a tax rate of 15 percent is greater than $10,000 times a tax rate of 15 percent — 10 times greater, to be precise. Raise to 30 percent the tax rate on the person making $100,000 and, voila, his tax bill is 20 times greater than that of the person making $10,000.

A progressive tax structure penalizes success, which inhibits economic growth, which means fewer jobs and lower incomes for the low-income persons who are the supposed beneficiaries of progressive taxation. I say “supposed” because the “house” (high-paid office holders and bureaucrats, all with cushy health insurance and pension plans) takes its very large cut before any of the money extorted from those who earn it trickles down to those who don’t earn it.

Related reading:
Greg Mankiw, “The Progressivity of Taxes and Transfers
Steve Landsburg, “Charting the Tax Plans

Related posts:
A True Flat Tax
Taxing the Rich
More about Taxing the Rich
In Defense of the 1%
The Burden of Government
Economic Growth Since World War II
Economics: A Survey
The Barbarians Within and the State of the Union
Why Are Interest Rates So Low?
Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth
America’s Financial Crisis Is Now

Are You Happy?

A RERUN OF A POST AT MY OLD BLOG, FROM MAY 6, 2008

Justin Wolfers (Freakonomics blog) has completed a series of six posts about the economics of happiness (here, here, here, here, here, and here). The bottom line, according to Wolfers:

1) Rich people are happier than poor people.
2) Richer countries are happier than poorer countries.
3) As countries get richer, they tend to get happier.

All of which should come as no surprise to anyone, without the benefit of “happiness research.” Regarding which, I agree with Arnold Kling, who says:

My view is that happiness research implies Nothing. Zero. Zilch. Nada. I believe that you do not learn about economic behavior by watching what people say in response to a survey.

You learn about economic behavior by watching what people actually do.

And…you consult your “priors.” It is axiomatic that individuals prefer more to less; that is, more income yields more satisfaction because it affords access to goods and services of greater variety and higher quality. Moreover, income and the wealth that flows from it are valued for their own sake by most individuals. (That they might be valued because they enable philanthropic endeavors is a case in point.)

It is reasonable to conclude, therefore, that the “law” of diminishing marginal utility, which may apply to particular goods and services, does not generally apply to income or wealth in the aggregate. But, in any event, given that Wolfers’s first conclusion is self-evidently true, the second and third conclusions follow. And they follow logically, not from “happiness research.”

America’s Financial Crisis Is Now

A REISSUE (WITHOUT UPDATES) OF THE ORIGINAL POST DATED MAY 1, 2011

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INTRODUCTION

Three Economic Charts That Will BLOW YOUR MIND,” at RightWing News, offers some tantalizing statistics about the relationship between federal tax receipts and GDP. The bottom line:

The key thing to take away from this is that the amount of revenue the government can bring in via the income tax is, for whatever reason, more inelastic than most people think. That’s yet another reason to put more emphasis on balancing the budget via spending cuts as opposed to trying to fix the problem with tax increases.

Now, if Hauser’s law is as spot-on as it has been in the past … it’s going to be difficult to raise the government’s revenue level much beyond the 20% mark….

I have no quibble with the proposition that the U.S. government has made unaffordable, unilateral “promises” about Social Security, Medicare, and Medicaid benefits. But I must take issue with the focus on the income tax and Hauser’s law, which is

the proposition that, in the United States, federal tax revenues since World War II have always been approximately equal to 19.5% of GDP, regardless of wide fluctuations in the marginal tax rate.

It is necessary to step back from a myopic focus on the federal government and look at all government receipts and expenditures in the United States. The need to do so arises from two facts: (1) State and local spending is substantial, and (2) federal, State, and local finances have become tightly bound together since the advent of revenue sharing and block grants, and with the explosion of federal statutory and regulatory commands to the States.

I begin by looking at the historical record of government income and outgo. That leads me to the future, in which “entitlements” loom unaffordably large . There are three broad paths along which to proceed: cut “entitlements,” borrow considerably more, or tax considerably more. I explain why the second and third options are untenable and economically destructive. The only viable alternative is to cut “entitlements,” and to begin cutting now.

GOVERNMENT SPENDING AND RECEIPTS: THE HISTORICAL RECORD

Here is how State and local spending stacks up against federal spending:

Federal vs state and local spending pct GDP
Sources: Derived from U.S. Department of Commerce, Bureau of Economic Analysis (BEA), National Income and Product Accounts (NIPA) Tables: Table 3.2 Federal Government Current Receipts and Expenditures (lines 26 and 40-45) and Table 3.3 State and Local Government Current Receipts and Expenditures (line 33).

State and local spending is not insubstantial, and has risen in recent decades, with a lot of help from the federal government. Federal grants to State and local governments have risen steadily from almost zero in 1929 to upwards of 4 percent of GDP in recent years. (I have excluded those grants from federal spending to avoid double-counting.)

Here is an aggregate picture of federal, State, and local spending and receipts.

Combined government spending and receipts
Source: Derived from NIPA Table 3.1 Government Current Receipts and Expenditures (lines 7, 19, 30, and 33-39).

Despite Hauser’s “law,” government receipts, as a percentage of GDP, rose steadily from 1929 until 2000, peaking at 32 percent. The post-2000 decline can be attributed to slow economic growth (capped by the recession of 2008-2010) and the so-called Bush tax cuts (which Congress approved initially and again in 2010). I have nothing against the tax cuts, except for the fact that they were not matched by spending cuts. The real burden of government is measured by spending, which diverts resources from productive uses to ones that are less-productive (e.g., public education), counter-productive (e.g., regulation), and downright destructive (i.e., growth-retarding and inflationary). The fact that lenders have increasingly borne the monetary cost of the burden of government has not offset its egregious economic effects. And, as I discuss below, without drastic spending cuts (relative to GDP) there will come a day when lenders will shrug off the burden or demand a much higher price for bearing it.

In any event, regardless of generally diminishing receipts in the first decade of the 21st century, government spending rose as a percentage of GDP, for several reasons. First, there was (and is) slower economic growth, due in no small part to the preceding decades of governmental interference in economic affairs. On top of that, there was Obama’s “stimulus package,” which was meant to end the recession of 2008-2010 but did not (because it could not); the recession ended in the normal way, through the recovery of “animal spirits” and consumer confidence. Then there was (and is) a growing population of persons eligible for Social Security, Medicare (supplemented by “free” or “cheap” prescription drugs), and Medicaid — a population made all the more eager to claim its “entitlements,” given the state of the economy. Finally, and almost incidentally, two foreign wars were fought simultaneously (though with varying degrees of intensity) throughout the decade.

To focus only on federal spending, as I say, is myopic because State and local governments have a habit of raising State and local taxes when so-called federal grants are cut back. (I say “so-called” because the money for those grants is provided largely by taxpayers who are, of course, denizens of the States and their political subdivisions.) In addition to the possibility of higher State and local spending in reaction to cuts in federal largesse, taxpayers — not public-sector unions — should be up in arms about the above-market compensation of government employees. A significant portion of that above-market compensation comes in the form of cushy pension plans, which allow “public servants” to receive high fractions of their salary (sometimes as much as 100 percent) for life, and to begin receiving those payments when they are in their 40s and 50s, after having held a government job for 20 years or so. As a result of these obligations and other undisciplined spending habits, State and local governments have liabilities of more than $7 trillion.

Which brings me to the 500-pound gorilla: the federal government.

“ENTITLEMENTS”: THE SOURCE OF OUR PRESENT AND PROSPECTIVE WOES

Perhaps the most interesting lines in the second graph (above) are the three at the bottom. The gap between the cost of social programs (green line) and “contributions” to those programs (gold line) has risen markedly since the late 1990s. By 2010, the size of that gap — 8.5 percent of GDP — accounted for most deficit spending (red line) — 10.6 percent of GDP. And that is but a hint of things to come. The internet abounds with graphs and tables that depict future federal spending and revenues under various assumptions. They all point to the same conclusion: Spending “commitments” must be cut — and cut drastically — in order to avoid (a) economically disabling tax increases and (b) a day of reckoning in credit markets.

The online offerings include these from the Congressional Budget Office (CBO): “Impact of the President’s Proposals on the Budget Outlook” (blog summary), and “Long Term Analysis of a Budget Proposal by Chairman Ryan” (blog summary). The CBO analyses are somewhat dense and must be read in juxtaposition. They are neatly conjoined by the Committee for a Responsible Federal Budget’s “Analyzing the President’s New Budget Framework.” Here is an informative graphic from that analysis:

Debt projections under various fiscal reform plans

Obama’s “framework,” as the report emphasizes, is short on details. It is obviously a slap-dash response to Paul Ryan’s detailed plan (labelled “House Republicans” in the graphic), which is a serious proposal for long-term deficit reduction. To understand the bankruptcy of Obama’s actual budget and current law, which are about the same, one must look beyond 2021.

Drawing on CBO’s work, Cato Institute’s Michael Tanner take the long view in “Bankrupt: Entitlements and the Federal Budget.” Tanner leads off with this:

The U.S. government is about to exceed its statutory debt limit of $14.3 trillion. But that actually underestimates the size of the fiscal time bomb that this country is facing. If one considers the unfunded liabilities of programs such as Medicare and Social Security, the true national debt could run as high as $119.5 trillion.

Moreover, to focus solely on debt is to treat a symptom rather than the underlying disease. We face a debt crisis not because taxes are too low but because government is too big. If there is no change to current policies, by 2050 federal government spending will exceed 42 percent of GDP. Adding in state and local spending, government at all levels will consume nearly 60 percent of everything produced in this country. Whether financed through debt or taxes, government that large would be a crushing burden to our economy and our liberties. (p. 1)

Government spending now consumes almost 40 percent of everything produced in this country. Imagine the lives of your children and their children if and when government spending consumes almost 60 percent of everything produced in this country. But wait — it can get worse. Here, Tanner projects federal spending under current law, through 2080:

Long-term spending projections (Tanner)

Add State and local spending and, by 2080, you have an economy whose entire output is claimed by government entities. Some of that output would be directed to individuals for their sustenance, of course. But the form of that sustenance — along with everything else — would be dictated and allocated by politicians and bureaucrats. They — and their favored intellectuals, artists, and athletes — would live reasonably well (though not nearly as well as they could in a free-market system), while the proles would lead lives of hard work, hard drink, and hard deaths. It would be the USSR all over again. And, as with the USSR, the misdirection of economic activity by politicians and bureaucrats would ensure economic stagnation.

It may not come to that, if there are enough voters who understand the consequences of unbridled government spending, and who put liberty and true prosperity above the illusory promises of security offered by the big-government crowd. But as time goes by and more voters become accustomed to handouts, they will become “European” in their embrace of the welfare state. Slippery slopes and death-spirals lead to the same slough of despond (second definition).

That said, is there a way to have “our” cake and eat it, too? Can the U.S. government raise enough money through borrowing or taxation to fend off the day of reckoning and attain the left’s dream of attaining “Europeanism”?

BORROWING A SEA OF TROUBLES

In fact, financial markets may help to reign in government spending by sending signals that cannot be ignored — if the U.S. government borrows money from willing lenders instead of just printing it. (Economist Karl Smith explains why printing money — deliberate inflation — is an unlikely course of action. He refers to “structured default,” which is explained here.) As government spending rises, and as voters and politicians (in the main) reject significant tax increases, government debt will rise to unprecedented heights. Here, from The Heritage Foundation’s 2011 Budget Chart Book, is a retrospective and prospective look at the size of the federal government’s debt in relation to GDP:

National debt set to skyrocket

Financial markets will reject U.S. government debt — or charge a lot for carrying it — long before it reaches the levels shown above. The events of year ago, when Greece’s financial bind came to a head, gave a hint of the likely reaction of markets to continued fiscal profligacy. Then, earlier this month, there was a sharp, brief stock-market sell off in response to an announcement by Standard & Poor’s about U.S. government debt (“‘AAA/A-1+’ Rating On United States of America Affirmed; Outlook Revised To Negative“):

  • We have affirmed our ‘AAA/A-1+’ sovereign credit ratings on the United States of America.
  • The economy of the U.S. is flexible and highly diversified, the country’s effective monetary policies have supported output growth while containing inflationary pressures, and a consistent global preference for the U.S. dollar over all other currencies gives the country unique external liquidity.
  • Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.
  • We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

If there is no serious effort to control the growth of the U.S. government’s debt by scaling back “entitlements,” two things will happen: Interest rates will rise, thus compounding the problem, and lenders will back away. Megan McArdle outlines a plausible scenario:

Right now, when Treasury goes to sell new bonds, it enters a fairly robust market, with not just the Fed but a bunch of fairly price-inelastic Asian central banks who are willing to take on our bonds at whatever the market offers. If China exits the market, we will either need to borrow less, or attract new lenders by offering higher interest rates. Even a noticeable decrease in volume would force us to pay more for our deficits….

… A lot of people tend to assume that there will be warning signs telling us that we need to get our fiscal house in order: China will slow down its bond purchases, interest rates will gradually rise. But in fact, the lesson of fiscal crises is that the “warning signs” we’re watching for often are the crisis. Unless interest rates increase (or debt buying decrease–which is really the same thing) in a very gradual, orderly fashion, then by the time your interest rates rise, it is already too late to do anything easy; your debt service burden forces you into dramatic fiscal measures, or default.

According to economist Carmen Reinhart, who has made an intensive study of crises, there’s no reason to expect the change to be orderly and gradual. She says the lesson of history is pretty unequivocal: interest rates are not a good predictor of who is about to tip into a crisis. People are willing to lend at decent rates, until suddenly they’re barely willing to lend at all.

When you look at how much of our debt comes due by the end of 2012, it’s easy to see how fast higher interest rates could turn into a real problem for us. To be sure, we’re no Japan–but that’s not necessarily a happy thought, because Japan finances something like 95% of its debt from its pool of thrifty (and nationalistic) savers. Their stock of lenders probably isn’t going anywhere. Ours might.

Lawrence Kotlikoff agrees:

…CBO’s baseline budget updates suggest the date for reaching what Carmen Reinhart, Kenneth Rogoff and other prominent economists believe is a critical insolvency threshold — a 90 percent ratio of federal debt held by the public to gross domestic product — has moved four years closer, in just nine months!…

And if foreigners balk at buying U.S. debt, why would Americans fill the breach? Is there a patriotic duty to finance socialism?

In summary, it seems unlikely that the U.S. can erect a full-blown welfare state on the backs of lenders. Can it be done on backs of taxpayers?

TAXING “THE RICH” — AND A LOT OF OTHERS, TOO?

The short answer to the preceding question is “no.” In evidence, I return to Michael Tanner’s “Bankrupt: Entitlements and the Federal Budget“:

Many observers suggest that we can simply tax the rich. For example, the Center for American Progress has recommended, among other things, imposing a 5–7 percent surtax on households with incomes above $500,000 per year, eliminating the cap on Social Security payroll taxes, increasing the estate tax, and raising the top marginal tax rate on capital gains and dividends.60 That would potentially raise the total marginal tax burden on some people to well above 50 percent.

Setting aside the simple immorality of government taking such an enormous portion of anyone’s income, there are many reasons to be skeptical of such an approach, starting with the fact that it may not actually generate any additional revenue….

…[I]ncentives matter. At some point taxes become high enough to discourage economic activity and therefore produce less revenue than would be predicted under a more static analysis….

But even if one assumes that taxes can be raised without having any impact on economic growth, taxing the rich still wouldn’t get us out of our budget hole—because the hole is quite simply bigger than the amount of revenue we could raise from taxing the rich even if there were no disincentives. To put it in admittedly oversimplified perspective: our current obligations, including both implicit and explicit debt, total more than 900 percent of GDP. The combined wealth of everyone in the United States who earns at least $1 million per year equals roughly 100 percent of GDP…. Therefore, you could confiscate the entire wealth of every millionaire in the United States and still barely make a dent in the amount we will owe.

Clearly, therefore, any tax increases would have to extend well beyond “the rich.” In fact, the Congressional Budget Office said in 2008 that in order to pay for all currently scheduled federal spending both the corporate tax rate and top income tax rate would have to be raised from their current 35 percent to 88 percent, the current 25 percent tax rate for middle-income workers to 63 percent, and the 10 percent tax bracket for low-income workers to 25 percent. It is likely, given increased spending since then, that the required tax levels would be even higher today.

Regardless of how one feels about taxing the rich, taxes at those levels would be devastating to future economic growth.

Harvard economist Martin Feldstein points out that the actual loss from tax increases to the private sector is a combination of the confiscated revenue as well as a hidden cost of the actual increase, known as deadweight loss. This hidden cost can be very expensive. Feldstein calculates that “the total cost per incremental dollar of government spending, including the revenue and the deadweight loss, is . . . a very high $2.65. Equivalently, it implies that the marginal excess burden per dollar of revenue is $1.65.” This means that for every 1 percent of GDP needed to be raised in revenue, the equivalent of 2.65 percent of GDP needs to be extracted from the private sector first.

Clearly, tax increases required to finance an increase in spending of more than 40 percent of GDP would place an impossible burden on the private economy. (pp. 13-4, source notation omitted)

One more thing (from Table 1 of the Tax Foundation’s “Fiscal Facts“): For 2008, federal income tax returns with adjusted gross incomes in the top 1 percent accounted for 38 percent of income taxes; the top 5 percent, 59 percent; the top 10 percent, 70 percent; the top 25 percent, 86 percent; and the top 50 percent, 97 percent. Not only that, but the top 10 percent of American taxpayers is taxed more heavily than the top 10 percent in other developed countries, including those “advanced” European countries that American leftists would like to emulate. (See “No Country Leans on Upper-Income Households as Much as U.S.” at the Tax Foundation’s Tax Policy Blog.) And the left has the gall to claim that America’s “rich” aren’t paying enough taxes!

VIVE LA RÉSISTANCE

It will not do simply to put an end to the U.S. government’s spending spree; too many State and local governments stand ready to fill the void, and they will do so by raising taxes where they can. As a result, some jurisdictions will fall into California- and Michigan-like death-spirals while jobs and growth migrate to other jurisdictions. Contemporary mercantilists to the contrary, the “winners” are “losers,” too. Even if Congress resists the urge to give aid and comfort to profligate States and municipalities at the expense of the taxpayers of fiscally prudent jurisdictions, the high taxes and anti-business regimes of California- and Michigan-like jurisdictions impose deadweight losses on the whole economy. If you believe otherwise, you believe in the broken-window fallacy, wherein an economically destructive force (natural or governmental) is credited with creating jobs and wealth because it leads to the visible expenditure of effort and resources.

So, the resistance to economically destructive policies cannot end with efforts to reverse the policies of the federal government. But given the vast destructiveness of those policies — “entitlements” in particular — the resistance must begin there. Every conservative and libertarian voice in the land must be raised in reasoned opposition to the perpetuation of the unsustainable “promises” currently embedded in Social Security, Medicare, and Medicaid — and their expansion through Obamacare. To those voices must be added the voices of “moderates” and “liberals” who see through the proclaimed good intentions of “entitlements” to the economic and libertarian disaster that looms if those “entitlements” are not pared down to their original purpose: providing a safety net for the truly needy.

The alternative to successful resistance is stark: more borrowing, higher interest payments, unsustainable debt, higher taxes, and economic stagnation (at best).

Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth

UPDATED 12/28/11 — This update incorporates GDP and government spending statistics for 2010 and corrects a minor discrepancy in the estimation of government spending. Also, there are new, easier-to-read graphs. The bottom line is the same as before: Government spending and everything that goes with it (including regulation) is destructive of economic growth.

UPDATED 09/19/13 — This version incorporates two later posts “Estimating the Rahn Curve: A Sequel” (01/24/12) and “More Evidence for the Rahn Curve” (05/27/12).

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The theory behind the Rahn Curve is simple — but not simplistic. A relatively small government with powers limited mainly to the protection of citizens and their property is worth more than its cost to taxpayers because it fosters productive economic activity (not to mention liberty). But additional government spending hinders productive activity in many ways, which are discussed in Daniel Mitchell’s paper, “The Impact of Government Spending on Economic Growth.” (I would add to Mitchell’s list the burden of regulatory activity, which accumulates with the size of government.)

What does the Rahn Curve look like? Daniel Mitchell estimates this relationship between government spending and economic growth:

Rahn curve (2)

The curve is dashed rather than solid at low values of government spending because it has been decades since the governments of developed nations have spent as little as 20 percent of GDP. But as Mitchell and others note, the combined spending of governments in the U.S. was 10 percent (and less) until the eve of the Great Depression. And it was in the low-spending, laissez-faire era from the end of the Civil War to the early 1900s that the U.S. enjoyed its highest sustained rate of economic growth.

Here is a graphic look at the historical relationship between government spending and GDP growth:

(Source notes for this graph and those that follow are at the bottom of this post.)

The regression lines are there simply to emphasize the long-term trends. The relationship between government spending as a percentage of GDP (G/GDP) and real GDP growth will emerge from the following graphs. There are chronological gaps because the Civil War, WWI, the Great Depression, and WWII distorted the relationship between G/GDP and economic growth. Large wars inflate government spending and GDP. The Great Depression saw a large rise in G/GDP, by pre-Depression standards, even as the economy shrank and then sputtered to a less-than-full recovery before the onset of WWII.

Est Rahn curve 1792 1861

Est Rahn curve 1866 1917

Est Rahn curve 1792 1917

Est Rahn curve 1946-2010

The graphs paint a consistent picture: Higher G/GDP means lower growth. There is one inconsistency, however, and that is the persistence of growth in the range of 2 to 4 percent during the post-WWII era, despite G/GDP in the range of 25-45 percent. That is not the kind of growth one would expect, given the relationships that obtain in the earlier eras. (The extrapolated trend line for 1946-2009 comes into use below.)

There are at least five plausible — and not mutually exclusive — explanations for the discrepancy. First, there is the difficulty of estimating GDP for years long past. Second, it is almost impossible to generate a consistent estimate of real GDP spanning two centuries; current economic output is vastly greater in volume and variety than it was in the early days of the Republic. Third, productivity gains (advances in technology, management techniques, and workers’ skills) may offset the growth-inhibiting effects of government spending, to some extent. Fourth, government regulations and active interventions (e.g., antitrust activity, the income tax) have a cumulative effect that operates independently of G/GDP. Regulations and interventions may have had an especially strong effect in the early 1900s (see the second graph in this post). The effects of regulations and interventions may diminish with time because of  adaptive behavior (e.g., “capture” of regulatory bodies).

Finally, and perhaps most importantly, there is the shifting composition of government spending. At relatively low levels of G/GDP, G consists largely of government programs that usurp and interfere with private-sector functions by diverting resources from productive uses to uses favored by politicians, bureaucrats, and their patrons. Higher levels of G/GDP — such as those we in the United States have known since the end of WWII — are reached by the expansion of the welfare state. Government spending (at all levels) on so-called social benefits accounted for only 7 percent of G and 0.8 percent of GDP in 1929; in 2009, it accounted for 36 percent of G and 15 percent of GDP. The provision of “social benefits” brings government into the business of redistributing income, which discourages work, saving, and capital formation to some extent, but doesn’t impinge directly on commerce. Therefore, I would expect G to be less damaging to GDP growth at higher levels of G/GDP — which is the message to be found in the contrast between the experience of 1946-2009 and the experience of earlier periods.

With those thoughts in mind, I present this empirical picture of the relationship between G/GDP and GDP growth in the United States:

Est Rahn curve 1792-2010

The intermediate points, unfortunately, are missing because of the chronological gaps mentioned above. But, as indicated by the five earlier graphs, it is entirely reasonable to infer from the preceding graph a strong relationship between GDP growth and changes in G/GDP throughout the history of the Republic.

It is possible to obtain a rough estimate of the downward sloping portion of the Rahn curve by focusing on two eras: the post-Civil War years 1866-1890 — before the onset of “progressivism,” with its immediate and strong negative effects — and the post-WWII years 1946-2009. Thus:

Est Rahn curve rough sketch

My rough estimate is appropriately “fuzzy” and somewhat more generous than Daniel Mitchell’s, which is indicated by the heavy black line. In light of my discussion of the shifting composition of G as G/GDP becomes relatively large, I  have followed the slope of the trend line for 1792-2010; that is, every 1 percentage-point increase in G/GDP yields a decrease in the growth rate of about 0.07 percent. That seemingly small effect becomes a huge one when G/GDP rises over a long period of time (as has been the case for more than a century, with no end in sight).

For the record, the best fit through the “fuzzy” area is:

Annual rate of growth = -0.066(G/GDP) + 0.054.

Maximum GDP growth seems to occur when G/GDP is 2-4  percent. That is somewhat less than the 7-percent share of GDP that was spent on national defense, public order, and safety in 2010. The excess represents additional “insurance” against predators, foreign and domestic. (The effectiveness of the additional “insurance” is a separate question, though I am inclined to err on the side of caution when it comes to defense and law enforcement. Those functions are not responsible for the economic woes facing America’s taxpayers.)

If G/GDP reaches 55 percent — which it will if present entitlement “commitments” are not curtailed — the “baseline” rate of growth will shrink further: probably to less than 2 percent. And thus America will remain mired in its Mega-Depression.

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Source notes:

Estimates of real and nominal GDP, back to 1790, come from the feature “What Was the U.S GDP Then?” at MeasuringWorth.com.

Estimates of government spending (federal, State, and local) come from USgovernmentspending.com; Statistical Abstracts of the United States, Colonial Times to 1970: Part 2. Series Y 533-566. Federal, State, and Local Government Expenditures, by Function; and the Bureau of Economic Analysis (BEA), Table 3.1. Government Current Receipts and Expenditures (lines 34, 35).

I found the amount spent by governments (federal, State, and local) on national defense and public order and safety by consulting BEA Table 3.17. Selected Government Current and Capital Expenditures by Function.

The BEA tables cited above are available here.

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ADDENDUM: THE RAHN CURVE: A SEQUEL

In the original post (above) I note that maximum GDP growth occurs when government spends two to four percent of GDP. The two-to-four percent range represents the share of GDP claimed by American governments (federal, State, and local) throughout most of the 19th century, when government spending exceeded five percent of GDP only during the Civil War.

Of course, until the early part of the 20th century, when Progressivism began to make itself felt in Americans’ tax bills, governments restricted themselves (in the main) to the functions of national defense, public order, and safety — the terms used in national-income accounting. It is those functions — hereinafter called defense and justice — that foster liberty and economic growth because they protect peaceful, voluntary activity. Effective protection probably would cost more than four percent of GDP in these parlous times. But an adequate figure, except in the rare event of a major war, is probably no more than seven percent of GDP — the value for 2010, which includes the cost of fighting in Iraq and Afghanistan.

In any event, government spending — even on defense and justice — is impossible without private economic activity. It is that activity which yields the wherewithal for the provision of defense and justice. Once those things have been provided, the further diversion of resources by government is economically destructive. Specifically, from “Estimating the Rahn Curve” (above):

It is possible to obtain a rough estimate of the downward sloping portion of the Rahn curve by focusing on two eras: the post-Civil War years 1866-1890 — before the onset of “progressivism,” with its immediate and strong negative effects — and the post-WWII years 1946-2009. Thus:

Est Rahn curve rough sketch

My rough estimate is appropriately “fuzzy” and somewhat more generous than Daniel Mitchell’s [in “The Impact of Government Spending on Economic Growth”], which is indicated by the heavy black line. In light of my discussion of the shifting composition of G as G/GDP becomes relatively large, I  have followed the slope of the trend line for 1792-2010; that is, every 1 percentage-point increase in G/GDP yields a decrease in the growth rate of about 0.06 percent. That seemingly small effect becomes a huge one when G/GDP rises over a long period of time (as has been the case for more than a century, with no end in sight).

The following graphs offer another view of the devastation wrought by the growth of government spending — and regulation. (Sources are given in “Estimating the Rahn Curve.”) I begin with the share of GDP which is not spent by government:

Est Rahn curve sequel_priv GDP as pct total GDP

A note about my measure of government spending is in order. National-income accounting purists would insist that transfer payments (mainly Social Security, Medicare, and Medicaid) should not count as spending, even though I count them as such. But what does it matter whether money is taken from taxpayers and given to retired persons (as Social Security) or to government employees (as salary and benefits) or contractors (as reimbursement for products and services delivered to government)? All government spending represents the transfer of claims on resources from persons who earned those claims to other persons, who either did something of questionable value for the money (government employees and contractors) or nothing (e.g., retirees).

In any event, it is obvious that Americans enjoyed minimal government until the early 1900s, and have since “enjoyed” a vast expansion of government. Here is a closer look at the trend from 1900 onward:

Est Rahn curve sequel_private GDP pct total GDP since 1900

This is a good point at which to note that the expansion of government is understated by the growth of government spending, which only imperfectly captures the effects of the rapidly growing regulatory burden on America’s economy. The combined effects of government spending and regulation can be seen in this “before” and “after” depiction of growth rates:

Est Rahn curve sequel_growth rate of private GDP

(I omitted the major wars and the Great Depression because their inclusion would give an exaggerated view of economic growth in the aftermath of abnormally suppressed private economic activity.)

The marked diminution of growth  after 1900 has led to what I call America’s Mega-Depression. Note the similarity between the downward path of private sector GDP (two graphs earlier) and the downward path of the Mega-Depression in the following graph:

Est Rahn curve sequel_mega-depression

What is the Mega-Depression? It is a measure of the degree to which real GDP has fallen below what it would have been had economic growth continued at its post-Civil War pace. As I explain here, the Mega-Depression began in the early 1900s, when the economy began to sag under the weight of Progressivism (e.g., trust-busting, regulation, the income tax, the Fed). Then came the New Deal, whose interventions provoked and prolonged the Great Depression (see, for example, this, and this). From the New Deal and the Great Society arose the massive anti-market/initiative-draining/dependency-promoting schemes known as Social Security, Medicare, and Medicaid. The extension and expansion of those and other intrusive government programs has continued unto the present day (e.g., Obamacare), with the result that our lives and livelihoods are hemmed in by mountains of regulatory restrictions.

Regulation aside, government spending — except for defense and justice — is counterproductive. Not only does it fail to stimulate the economy in the short run, but it also robs the economy of the investments that are needed for long-run growth.

*     *     *

ADDENDUM: MORE EVIDENCE FOR THE RAHN CURVE

Here:

[W]e have some new research from the United Kingdom. The Centre for Policy Studies has released a new study, authored by Ryan Bourne and Thomas Oechsle, examining the relationship between economic growth and the size of the public sector.

The chart above compares growth rates for nations with big governments and small governments over the past two decades. The difference is significant, but that’s just the tip of the iceberg. The most important findings of the report are the estimates showing how more spending and more taxes are associated with weaker performance.

Here are some key passages from the study.

Using tax to GDP and spending to GDP ratios as a proxy for size of government, regression analysis can be used to estimate the effect of government size on GDP growth in a set of countries defined as advanced by the IMF between 1965 and 2010. …As supply-side economists would expect, the coefficients on the tax revenue to GDP and government spending to GDP ratios are negative and statistically significant. This suggests that, ceteris paribus, a larger tax burden results in a slower annual growth of real GDP per capita. Though it is unlikely that this effect would be linear (we might expect the effect to be larger for countries with huge tax burdens), the regressions suggest that an increase in the tax revenue to GDP ratio by 10 percentage points will, if the other variables do not change, lead to a decrease in the rate of economic growth per capita by 1.2 percentage points. The result is very similar for government outlays to GDP, where an increase by 10 percentage points is associated with a fall in the economic growth rate of 1.1 percentage points. This is in line with other findings in the academic literature. …The two small government economies with the lowest marginal tax rates, Singapore and Hong Kong, were also those which experienced the fastest average real GDP growth.

My own estimate (see above) for the United States, is that

every 1 percentage-point increase in G/GDP yields a decrease in the growth rate of about 0.07 percent. That seemingly small effect becomes a huge one when G/GDP rises over a long period of time (as has been the case for more than a century, with no end in sight).

In other words, every 10 percentage-point increase in the ratio of government spending to GDP causes a not-insignificant drop of 0.7 percentage points in the rate of growth. That is somewhat below the estimate quoted above (1.1 percentage points), but surely it is within the range of uncertainty that surrounds the estimate.

Vulgar Keynesianism and Capitalism

A REISSUE (WITHOUT UPDATES) OF THE ORIGINAL POST DATED DECEMBER 4, 2011

Robert Higgs quite rightly disparages “vulgar Keynesianism”:

Most of the people who purport to possess expertise about the economy rely on a common set of presuppositions and modes of thinking. I call this pseudo-intellectual mishmash vulgar Keynesianism. It’s the same claptrap that has passed for economic wisdom in this country for more than fifty years and seems to have originated in the first edition of Paul Samuelson’s Economics (1948), the best-selling economics textbook of all time and the one from which a plurality of several generations of college students acquired whatever they knew about economic analysis. Long ago, this view seeped into educated discourse and writing in the news media and in politics and established itself as an orthodoxy.

Unfortunately, this way of thinking about the economy’s operation, particularly its overall fluctuations, is a tissue of errors of both commission and omission. Most unfortunate have been the policy implications derived from this mode of thinking, above all the notion that the government can and should use fiscal and monetary policies to control the macroeconomy and stabilize its fluctuations. Despite having originated more than half a century ago, this view seems to be as vital in 2009 as it was in 1949.

Higgs then dissects “the six most egregious aspects of this unfortunate approach to understanding and dealing with economic booms and busts.” These are the aggregation of myriad and disparate economic actions, failure to take into account changes in relative prices, misunderstanding of the meaning and economic role of interest rates, disregard for the importance of capital, blind “money pumping” as a “solution” to recessions, and disregard for the disincentivizing effects of government activism on the private sector.

I agree with everything said by Higgs, and I have said many of the same things (in my own way) at this blog and its predecessor.  However, GDP — an aggregate measure of economic activity — is a useful construct, as flawed as it may be. It is an indicator of the general direction and magnitude of economic activity. Other aggregate measures — such as employment, jobs added and lost, unemployment rate — are also useful in that regard. If, for example, constant-dollar GDP per capita was twice as high in 2010 than it was 40 years earlier, in 1970 (computed here), it indicates that most Americans enjoyed a significantly higher standard of living in 2010 than they and their predecessors did in 1970. Further, the difference is so significant that it overshadows the difficulty of aggregating the value of billions of disparate transactions and separating the effects of price inflation from quality improvements.

What is special about 1970? It marks a turning point in the economic history of the U.S., which I discussed in a post that is now two-and-a-half years old:

Can we measure the price of government intervention [in the economy]? I believe that we can do so, and quite easily. The tale can be told in three graphs, all derived from constant-dollar GDP estimates available here. The numbers plotted in each graph exclude GDP estimates for the years in which the U.S. was involved in or demobilizing from major wars, namely, 1861-65, 1918-19, and 1941-46. GDP values for those years — especially for the peak years of World War II — present a distorted picture of economic output….

The trend line in the first graph indicates annual growth of about 3.7 percent over the long run, with obviously large deviations around the trend. The second graph contrasts economic growth through 1907 with economic growth since: 4.2 percent vs. 3.6 percent. But lest you believe that the economy of the U.S. somehow began to “age” in the early 1900s, consider the story implicit in the third graph:

  • 1790-1861 — annual growth of 4.1 percent — a booming young economy, probably at its freest
  • 1866-1907 — annual growth of 4.3 percent — a robust economy, fueled by (mostly) laissez-faire policies and the concomitant rise of technological innovation and entrepreneurship
  • 1908-1929 — annual growth of 2.2 percent — a dispirited economy, shackled by the fruits of “progressivism” (e.g., trust-busting, regulation, the income tax, the Fed) and the government interventions that provoked and prolonged the Great Depression (see links in third paragraph)
  • 1970-2008 — annual growth of 3.1 percent –  [2.8 percent for 1970-2010] an economy sagging under the cumulative weight of “progressivism,” New Deal legislation, LBJ’s “Great Society” (with its legacy of the ever-expanding and oppressive welfare/transfer-payment schemes: Medicare, Medicaid, a more generous package of Social Security benefits), and an ever-growing mountain of regulatory restrictions.

Taking the period 1970-2010 as a distinctive era — that of the full-fledged regulatory-welfare state — it may be possible to discern some aggregate relationships that were stable during that era (and may well continue to hold). The relationship that I want to explore is suggested by Higgs’s discussion of the vulgar Keynesian view of aggregate demand and the role of capital in economic production:

Because the vulgar Keynesian has no conception of the economy’s structure of output, he cannot conceive of how an expansion of demand along certain lines but not along others might be problematic. In his view, one cannot have, say, too many houses and apartments. Increasing the spending for houses and apartments is, he thinks, always good whenever the economy has unemployed resources, regardless of how many houses and apartments now stand vacant and regardless of what specific kinds of resources are unemployed and where they are located in this vast land. Although the unemployed laborers may be skilled silver miners in Idaho, it is supposedly still a good thing if somehow the demand for condos is increased in Palm Beach, because for the vulgar Keynesian, there are no individual classes of laborers or separate labor markets: labor is labor is labor. If someone, whatever his skills, preferences, or location, is unemployed, then, in this framework of thought, we may expect to put him back to work by increasing aggregate demand, regardless of what we happen to spend the money for, whether it be cosmetics or computers.

This stark simplicity exists, you see, because aggregate output is a simple increasing function of aggregate labor employed:

Q = f (L), where dQ/dL > 0.

Note that this “aggregate production function” has only one input, aggregate labor. The workers seemingly produce without the aid of capital! If pressed, the vulgar Keynesian admits that the workers use capital, but he insists that the capital stock may be taken as “given” and fixed in the short run. And ― which is highly important ― his whole apparatus of thought is intended exclusively to help him understand this short run. In the long run, he may insist, we are, as Keynes quipped, “all dead”; or he may simply deny that the long run is what we get when we place a series of short runs back to back. The vulgar Keynesian in effect treats living for the moment, and only for it, as a major virtue. At any given time, the future may safely be left to take care of itself.

In fact, the Keynesian-Marxian view of capital is about 180 degrees from the truth:

1. A broad array of capital goods (e.g., metal presses and railroad cars) will produce the same outputs (e.g., auto body parts of a certain quality and a certain number of passenger-miles) despite wide variations in the intelligence, education, and motor skills of their operators.

2. That is to say, capital leverages labor (especially unskilled labor).

3. Rewards justifiably — if unpredictably — flow to those who invent capital goods, innovate improvements in capital goods, invest in the production of such goods, and take the risk of owning businesses that use such goods in the production of consumer goods and services.

4. The activities of those inventors, innovators, investors, and entrepreneurs constitute a form of labor, but it is a very special form. It is not the brute force kind of labor envisaged by Marx and his intellectual progeny. It is a kind of labor that involves mental acuity, special knowledge, a penchant for risk-taking, and — yes, at times — hard work.

Without capital, labor would produce far less than it does. Capital, by the same token, enables labor of a given quality to produce more than it otherwise would.

(By “invest in the production of capital goods,” I mean to include individuals whose saving — whether or not it goes directly into the purchases of stocks and corporate bonds — helps to fund the purchases of capital goods by businesses.)

With that in mind, look at the aggregate relationship between the stock of private non-residential capital and private-sector GDP (GDP – G) for the period 1970-2010:

GDP - G vs net private capital stock, 1970-2010
Notes:  Current-dollar values for GDP and G are from Bureau of Economic Analysis, Table 1.1.5. Gross Domestic Product (available here). Capital stock estimates are from Bureau of Economic Analysis, Table 4.1. Current-Cost Net Stock of Private Nonresidential Fixed Assets by Industry Group and Legal Form of Organization (available here). Current-dollar values for GDP – G and capital stock were adjusted to 1982-84 dollars by constructing and applying deflators from CPI-U statistics for 1913-present (available here).

Variations around the trend line indicate fluctuations in economic activity. I treat the difference between “actual” GDP and the trend line as a residual to be explained by factors other than the aggregate value of the private, nonresidential capital stock. Measures of employment or unemployment will not do the job; they are simply proxies for aggregate output. The best measure that I have found is the value of new investment in the current year, relative to the value of the capital stock at the end of the prior year:

Residual vs new invest per PY capital stock
Notes: Residual GDP – G derived from Fig. 1, as discussed in text. Estimates of new investment in private capital stock are from Bureau of Economic Analysis, Table 4.7. Investment in Private Nonresidential Fixed Assets by Industry Group and Legal Form of Organization (available here); adjusted for inflation as discussed in notes for Fig. 1.

Using the trendline equation from Fig. 2, I adjusted the estimates derived from the trendline equation of Fig. 1, with this result:

Adjusted GDP - G vs. net private capital stock

There is precious little for labor to do but to show up for work and apply itself to the tools provided by capitalism:

Change in priv emply vs change in real GDP

*   *   *

Knowledgeable readers will understand that I have taken some statistical liberties. And I have done so as a way of satirizing the view that prosperity depends on labor and its correlate, consumption spending. But my point is a serious one: Capital should not be denigrated. Those who denigrate it give aid and comfort to the enemies of economic growth, that is, to the “progressives” who are the real enemies of the poor, of labor, and of liberty.

Why Are Interest Rates So Low?

A REISSUE (WITHOUT UPDATES) OF THE ORIGINAL POST DATED DECEMBER 7, 2011

Interest rates reflect the supply of and demand for funds. Money is tighter now than it was in the years immediately before the onset of the Great Recession. Tim Congdon explains:

In the three years to October 2008, the quantity of money soared from $10,032 billion to $14,186 billion, with a compound annual growth rate of just over 12 per cent. The money growth rate in this period was the highest since the early 1970s. Indeed, 1972 and 1973 had many similarities to 2006 and 2007, with bubbling asset markets, buoyant consumer spending and incipient inflationary pressures. On the other hand, in the three years from October 2008 the quantity of money was virtually unchanged. (It stood at $14,340 billion in October 2011.) In other words, in the three years of the Great Recession the quantity of money did not increase at all.

But if money is relatively tight, why are interest rates so low? For example, as of October 2011, year-over-year inflation stood at 3.53 percent (derived from CPI-U estimates, available here). In October, Aaa bond yields averaged 3.98 percent, for a real rate of about 0.4 percent; Baa bond yields averaged 5.37 percent, for a real rate of about 1.8 percent; and conventional mortgages averaged 4.07 percent, for a real rate of about 0.5 percent. By contrast, in 1990-2000, when the CPI-U rose at an annual rate of 3.4 percent, real Aaa, Baa, and conventional mortgage rates hovered in the 4-6 percent range. (Real rates are derived from interest rate statistics available here.)

The reason for these (and other) low rates is that borrowers have become less keen about borrowing; that is, they lack confidence about future prospects for income (in the case of households) and returns on investment (in the case of businesses). Why should that be?

If the post-World War II trend is any indication — and I believe that it is — the American economy is sinking into stagnation. Here is the long view:

  • 1790-1861 — annual growth of 4.1 percent — a booming young economy, probably at its freest
  • 1866-1907 — annual growth of 4.3 percent — a robust economy, fueled by (mostly) laissez-faire policies and the concomitant rise of technological innovation and entrepreneurship
  • 1970-2010 — annual growth of 2.8 percent – sagging under the cumulative weight of “progressivism,” New Deal legislation, LBJ’s “Great Society” (with its legacy of the ever-expanding and oppressive welfare/transfer-payment schemes: Medicare, Medicaid, a more generous package of Social Security benefits), and an ever-growing mountain of regulatory restrictions.

(From this post, as updated in this one.)

And here is the post-World War II view:

Annual change in real GDP 1948-2011

This trend cannot be reversed by infusions of “stimulus spending” or “quantitative easing.” It reflects an underlying problem that cannot be cured by those simplistic macroeconomic “fixes.”

The underlying problem is not “tight money,” it is that American businesses are rightly pessimistic about an economic future that is dominated by a mountain of debt (in the form of promised “entitlements”) and by an ever-growing regulatory burden. Thus business investment has been a decline fraction of private-sector GDP:

Non-household GPDI fraction GDP - G
Derived from Bureau of Economic Analysis, Table 1.1.5. Gross Domestic Product (available here). The numerator is gross private domestic investment (GPDI, line 7) less the residential portion (line 12). The denominator is GDP (line 1) less government consumption expenditures and gross investment (line 21).

As long as business remains (rightly) pessimistic about the twin burdens of debt and regulation, the economy will sink deeper into stagnation. The only way to overcome that pessimism is to scale back “entitlements” and regulations, and to do so promptly and drastically.

In sum, the present focus on — and debate about — conventional macroeconomic “fixes” (fiscal vs. monetary policy) is entirely misguided. Today’s economists and policy-makers should consult Hayek, not Keynes or Friedman or their intellectual descendants. If economists and policy-makers would would read and heed Hayek — the Hayek of 1944 onward, in particular — they would understand that our present and future economic morass is entirely political in origin: Failed government policies have led to more failed government policies, which have shackled both the economy and the people.

Economic and political freedoms are indivisible. It will take the repeal of the regulatory-welfare state to restore prosperity and liberty to the land.

Economics: A Survey

I have reproduced this post as a separate page. It will always be accessible by clicking the link that appears near the top of the sidebar.

Until I muster the will to finish a plain-language primer on economics that I began several years ago, this post will have to do. It is an annotated compilation of links to the posts at this blog which, taken together, will enlighten those readers who seek a rounded view of economics, that is, one that is both fundamental and practical. The fundamental posts address the principles of economics without resorting to abstruse mathematical expressions. The practical posts (in the main) address the effects of government policy on economic activity.

Many of the posts cited below are illustrated by statistics that are a few months to several years out of date.  The conclusions remain valid, however.

PRINCIPLES

The place to begin is “Trade.” It explains the benefits of voluntary exchange, which is the essence of economic activity.

Trade, in the jargon of economics, is microeconomic activity. Attempts to aggregate and explain economic activity are called macroeconomics. “Macroeconomics and Microeconomics” addresses the relationship between the two disciplines.

Other foundational posts are “The Rationality Fallacy” and “Income and Diminishing Marginal Utility.” The first exposes an error common among economists, which is to equate wealth maximization and happiness. The second exposes an error common among economists and leftists (but I repeat myself), which is to assume that a person’s marginal utility (gain in happiness) diminishes with income.

A Short Course in Economics” and “Addendum to a Short Course in Economics” state a number of basic propositions about economics and economic behavior. These aren’t rigorous expositions of economic principles, but they will point a neophyte in the right direction — that is, away from the upside-down economics spouted by leftists and “journalists” (but I repeat myself).

Closely related is “The Causes of Economic Growth,” which cuts through the gobbledygook that prevails in academic circles.

All of the above posts are non-mathematical because the principles of economics do not have to be stated mathematically. In fact, the mathematization of economic theory is a scam, as discussed in “Mathematical Economics.” Economics, as a discipline, suffers from “physic envy”; too many of its practitioners believe that a coat of mathematical varnish can turn it into a science. But economics is not a science — or if it is, in is only a “soft science” that relies more on intuition than it does on the scientific method. For more on this subject, see “Science, Axioms, and Economics.”

PRACTICE: THE GENERAL ECONOMIC INFLUENCE OF GOVERNMENT

Minimal government protects citizens from foreign and domestic predators, thus enabling peaceful, mutually beneficial, and voluntary exchange (i.e., free markets). When government goes beyond its minimal role and interferes in the economy it inhibits economic output in three ways. First, government spending and borrowing divert resources from productive uses to (mainly) unproductive and counterproductive ones. Second, taxes penalize success and divert resources from growth-inducing capital creation. Third, regulations inhibit business formation and expansion.  These relationships are explored systematically in “Government in Macroeconomic Perspective.”

You may wish to skip that technical and somewhat plodding post, and go directly to some of my estimates of the scope and economic costs of government intervention. Begin with the qualitative assessment given in “The Real Burden of Government,” then turn to “The Laffer Curve, ‘Fiscal Responsibility,’ and Economic Growth,” “The Commandeered Economy,” “Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth,” “The Mega-Depression,” and “Economic Growth since World War II.” (Another, often overlooked, consequence of government intervention in economic affairs is the resulting diminution of liberty; see, for example, “The Indivisibility of Economic and Social Liberty.”)

The posts cited in the preceding paragraph assess the long-run effects of government interventions. Government policy imposes additional costs in the short run, that is, in the span of years rather than decades. The Federal Reserve, to name the main culprit, can claim responsibility for the Great Depression and the Great Recession, as well as other recessions. See “Mr. Greenspan Doth Protest Too Much,” “The Fed and Business Cycles,” and “Money, Credit, and Economic Fluctuations.”

Then there is a phenomenon known as regime uncertainty, in which entrepreneurship and capital formation are discouraged — temporarily, at least — by the threat of new government interventions. That threat that is more potent now than it has been since the New Deal-Great Society era. I address regime uncertainty in “The Keynesian Fallacy and Regime Uncertainty,” “Regime Uncertainty and the Great Recession,” and “Obamanomics: A Report Card.”

Government interventions in economic affairs are prompted by many interests and impulses — power-seeking, rent-seeking, economic illiteracy, and plain old do-goodism being among them. Among the chief reasons given for interventions is “market failure,” which is among the subjects addressed in “Regulation as Wishful Thinking.” Closely related posts that bear reading are “Socialist Calculation and the Turing Test,” “What Free-Rider Problem?,” and “Don’t Just Stand There, ‘Do Something’.” The political economy of government intervention is treated generally in “Tocqueville’s Prescience” and “Understanding Hayek.” The darker impulses are addressed in “Don’t Use the ‘S’ Word When the ‘F’ Word Will Do.” (The “S” and “F” words are “socialism” and “fascism.”)

Last, but only because I put it here, is the baleful influence of Keynesianism on economic policy. I expose the fallacy of Keynesianism and “stimulus” spending in “The Keynesian Multiplier: Phony Math” and “The True Multiplier.” Also relevant, though superseded by the preceding two posts, are “A Keynesian Fantasy Land,” “Why the Stimulus Failed to Stimulate,” “The Real Multiplier,” “The Real Multiplier (II),” and “Keynesianism: Upside-Down Economics in the Collectivist Cause.”

PRACTICE: SALIENT ISSUES

We’re not through with government, which plays an explicit and implicit role in the following matters (arranged alphabetically):

Government Debt and Deficits. The best posts on this subject were inspired by the Bowles-Simpson Deficit Commission, whose work — flawed as it is — seems to have been ignored. The “can” is still being kicked down the road, and the consequences will be dire. Read on: “The Deficit Commission’s Deficit of Understanding,” “The Bowles-Simpson Report,” “The Bowles-Simpson Band-Aid,” and “America’s Financial Crisis Is Now.”

Income Inequality and Redistribution. Some persons earn more money than other persons because of differences in ability, performance, and the value of their contributions to the well-being of others. This straightforward explanation doesn’t suit idiots like Robert Reich, who are handicapped by economic illiteracy, guilt, and hypocrisy. The inescapable fact of income inequality is often conflated with the so-called “war” on the middle class. (Pending a post on that subject, I refer you to this one by Mark J. Perry.)

I have addressed inequality several times. The brief post, “The Last(?) Word about Income Inequality” provides several links that are worth following. Other posts expose income inequality as a bogus issue and warn of the dire economic consequences of taxing “the rich” more than they are already taxed: “Taxing the Rich,” “More about Taxing the Rich,” “In Defense of the 1%,” and “Progressive Taxation Is Alive and Well in the U.S. of A,” and “How High Should Taxes Be?

If you’re in the mood for a more fundamental treatment of the “inequality problem,” try “Income and Diminishing Marginal Utility,” “Greed, Cosmic Justice, and Social Welfare,” “Positive Rights and Cosmic Justice,” “Utilitarianism, ‘Liberalism,’ and Omniscience,” “Utilitarianism vs. Liberty,” “Accountants of the Soul,” “Rawls Meets Bentham,” “Enough of ‘Social Welfare’,” “Positive Liberty vs. Liberty,” “Social Justice,” “More Social Justice,”  “Luck Egalitarianism and Moral Luck,” and “Utilitarianism and Psychopathy.”

Inflation.  Or the threat of it, seems to be a perennial problem. At root, it is a government problem, as I discuss in “Why Government Spending Is Inherently Inflationary,” “Is Inflation Inevitable?,” and “Does the CPI Understate Inflation?

Interest Rates. Government-induced stagnation, addressed above, reappears in “Why Are Interest Rates So Low?” See also “Bonds for the Long Run?

International Trade and Outsourcing. Start with “Trade” (also cited above) and “Why Outsourcing Is Good: A Simple Lesson for ‘Liberal’ Yuppies.” If you need more, go to “Trade-Deficit Hysteria,” “Trade, Government Spending, and Economic Growth,” and “Gains from Trade.”

Monopoly. It’s a dirty word, on a par with “asbestos.” Monopoly — or the hope of attaining it — is essential to economic growth, as discussed in “Monopoly and the General Welfare.” If you want to see a dysfunctional monopoly, look at government (a central point of “Krugman and Monopoly“). Private monopoly, on the other hand, is preferable to government regulation: “Monopoly: Private Is Better than Public.”

Paternalism. “Libertarian paternalism” is an oxymoron; more accurately, it is dangerous, anti-libertarian treachery. My many posts on the subject begin with an eponymous one, and continue through “The Mind of a Paternalist, Revisited.” Pseudo-libertarians have no corner on paternalism, of course. Witness the wars on smoking and obesity of the past 60 years. My most recent post about paternalism is “Obesity and Statism.” Links to all of my posts on paternalism can be found at “Favorite Posts,” under categories V, VII, X and XI.

Two leading proponents of “libertarian paternalism” are Richard Thaler, an economist, and Cass Sunstein, a law professor and erstwhile “regulatory czar” for Obama. Thaler, given his academic background, might once have been a libertarian, but clearly has lost his way. Sunstein never came close to being one, and is about as anti-libertarian as they come, as you will learn if you read the posts about him, which are listed in category VII of “Favorite Posts.” Begin with this one and continue through this one. See especially (but not exclusively) “Cass Sunstein’s Truly Dangerous Mind.”

Regulation. It is fitting to jump from “Paternalism” to “Regulation,” inasmuch as regulation is paternalism writ huge. Regulation touches every facet of our lives and livelihoods. I have written about it so many times that it is hard to choose a list of representative posts. I began with “Fear of the Free Market — Part I,” and continued with “Part II” and “Part III.” Those three (long) posts make a theoretical and practical case against regulation. “Regulation as Wishful Thinking” makes the same case, though less thoroughly (but in far fewer words). The extent of the regulatory burden, at the federal level, is summarized in “Lay My (Regulatory) Burden Down.” That post includes an estimate of the economic cost of regulation.

“Social Insurance” Schemes.  “Social insurance” is properly called income redistribution. The primary engines of income redistribution — in addition to progressive taxation — are Social Security, Medicare, and Medicaid — as expanded by Obamacare. The monumental government debt that will accrue as a result of these schemes is addressed above, under “Government Debt and Deficits.” I have covered income redistribution, generally, under “Income Inequality and Redistribution.” Posts specifically about “social insurance” schemes include “The Mythical, Magical, Social Security Trust Fund,” “Social Security: The Permanent Solution,” and “Saving Social Security.” Obamacare is treated (not gently) in “Rationing and Health Care,” “The Perils of Nannyism: The Case of Obamacare,” “Health-Care ‘Reform’: The Short of It,”

As a bonus, I offer “Social Security Is Unconstitutional,” “The Unconstitutionality of the Individual Mandate,” “Does the Power to Tax Give Congress Unlimited Power?,” and “Does Congress Have the Power to Regulate Inactivity?.” Yes, Social Security and the individual mandate (along with Medicare and Medicaid) are unconstitutional, various majorities of the Supreme Court to the contrary notwithstanding; no, the power to tax doesn’t give Congress unlimited power (according the Constitution); and no, Congress doesn’t have the constitutional power to regulate inactivity (i.e., to penalize or tax a person for not buying insurance).

Tax Policy. Tax policy is implicated in many of the posts already listed. I also address it, directly, in “Productivity Growth and Tax Cuts,” “A True Flat Tax,” “‘Tax Expenditures’ Are Not Expenditures,” “Taxes: Theft or Duty?,” and “Is Taxation Slavery?” (yes).

Baseball Statistics and the Consumer Price Index

Faithful readers of this blog will have noticed that I like to invoke baseball when addressing matters far afield from America’s pastime. (See this, this, this, this, this, this, this, this, and this.) It lately occurred to me that baseball statistics, properly understood, illustrate the inherent meaninglessness of the Consumer Price Index (CPI).

What does the CPI purport to measure? The Bureau of Labor Statistics (BLS) — compiler of the index — says that it “is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” Read that statement carefully. The CPI does not measure the average change in prices of the goods and services purchased by every urban consumer; it measures the prices of a “market basket” of goods and services that is thought to represent the purchases of a “typical” consumer. Further, the composition of that “market basket” is assumed to change, over time, in accordance with the preferences of the “typical” consumer. (There is more about the CPI in the note at the bottom of this post.)

To understand the arbitrariness of the CPI — as regards the construction of the “market basket” and the estimation of the prices of its components — one must read no further than the Bureau’s own list of questions and answers, some of which I have reproduced in the footnote. As a measure of your cost of living — at any time or over time — the CPI is as useful as the statement that the average depth of a swimming pool is 5 feet; a non-swimmer who is 6 feet tall puts himself in danger of drowning if he jumps into the deep end of such a pool.

The BLS nevertheless computes one version CPI back to January 1913. If you believe that prices in 1913 can be compared with prices in 2013, you must believe that baseball statistics yield meaningful comparisons of the performance of contemporary players and the players of bygone years. I enjoy making such comparisons, but I do not endorse their validity. As I will discuss later in this post, my reservations about cross-temporal comparisons of baseball statistics apply also to cross-temporal comparisons of prices.

Let us begin our journey into baseball statistics with three popular measures of batting prowess: batting average (BA), slugging percentage (SLG), and on-base plus slugging (OPS). The “normal” values of these statistics have varied widely:

Average major league batting statistics_1901-2012
Source: League Year-by-Year Batting at Baseball-Reference.com.

Aside from the upward trends of SLG and OPS, which are unsurprising to anyone with a passing knowledge of baseball’s history, the most striking feature of these statistics is their synchronicity. Players (and fans) of the 1920s and 1930s enjoyed an upsurge in BA, SLG, and OPS that was echoed in the 1980s and 1990s. How can the three statistics rise in lockstep when BA usually suffers with emphasis on the long ball (captured in SLG and OPS)? The three statistics can rise in lockstep only because of changes in the conditions of play that allow batters to hit for a better average while also getting more long hits. By the same token, changes in conditions of play can have the opposite effect of causing offensive statistics to fall, across the board. But given constant conditions of play, there usually is a tradeoff between batting average and long hits. A key point, to which I will return, is the essential incommensurability of statistics gathered under different conditions of play (or economic activity).

There are many variations in the conditions of play that have resulted in significant changes in offensive statistics. Among those changes are the use of cleaner and more tightly wound baseballs, the advent of night baseball, better lighting for night games, bigger gloves, lighter bats, bigger and stronger players, the expansion of the major leagues in fits and starts, the size of the strike zone, the height of the pitching mound, and — last but far from least in this list — the integration of black and Hispanic players into major league baseball. In addition to these structural variations, there are others that mitigate against the commensurability of statistics over time; for example, the rise and decline of each player’s skills, the skills of teammates (which can boost or depress a player’s performance), the characteristics of a player’s home ballpark (where players generally play half their games), and the skills of the opposing players who are encountered over the course of a career.

Despite all of these obstacles to commensurability, the urge to evaluate the relative performance of players from different teams, leagues, seasons, and eras is irrepressible. Baseball-Reference.com is rife with such evaluations; the Society for American Baseball Research (SABR) revels in them; many books offer them (e.g., this one); and I have succumbed to the urge more than once.

It is one thing to have fun with numbers. It is quite another thing to ascribe meanings to them that they cannot support. Consider the following cross-temporal comparison of baseball statistics:

Top-25 single-season offensive records
Source: Derived from the Play Index at Baseball-Reference.com. (Most baseball fans will recognize all of the names but one: Cy Seymour. His life and career are detailed in this article.)

Take, for example, the players ranked 17-25 in single-season BA. The range of BA for those 9 seasons (.384 to .388) is insignificantly small; it represents a maximum difference of only 4 hits per 1,000 times at bat. Given the vastly different conditions of play — and of the players — what does it mean to say that Rod Carew in 1977 and George Brett in 1980 had essentially the same BA as Honus Wagner in 1905 and 1908? It means nothing. The only thing that is essentially the same is the normalized BA that I concocted to represent those (and other) seasons. Offering normalized BA in evidence is to beg the question. In fact, any cross-temporal comparison of BA (or SLG or OPS) is essentially meaningless.

By the same token, it means nothing to say that prices in 2013 are X times as high as prices in 1913, when — among many other things — consumers in 2013 have access to a vastly richer “market basket” of products and services. Further, the products and services of 2013 that bear a passing resemblance to those of 1913 (e.g., houses, automobiles, telephone service) are demonstrably superior in quality.

So, it is fun to play with numbers, but when it comes to using them to make cross-temporal comparisons — especially over a span of decades — be very wary. Better yet, resist the temptation to make those cross-temporal comparisons, except for the fun of it.
____________
A SELECTION OF QUESTIONS AND ANSWERS ABOUT THE CPI, FROM THIS PAGE AT THE WEBSITE OF THE BUREAU OF LABOR STATISTICS:

Whose buying habits does the CPI reflect?

The CPI reflects spending patterns for each of two population groups: all urban consumers and urban wage earners and clerical workers. The all urban consumer group represents about 87 percent of the total U.S. population. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired people, as well as urban wage earners and clerical workers. Not included in the CPI are the spending patterns of people living in rural nonmetropolitan areas, farm families, people in the Armed Forces, and those in institutions, such as prisons and mental hospitals. Consumer inflation for all urban consumers is measured by two indexes, namely, the Consumer Price Index for All Urban Consumers (CPI-U) and the Chained Consumer Price Index for All Urban Consumers (C-CPI-U)….

The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) is based on the expenditures of households included in the CPI-U definition that also meet two requirements: more than one-half of the household’s income must come from clerical or wage occupations, and at least one of the household’s earners must have been employed for at least 37 weeks during the previous 12 months. The CPI-W population represents about 32 percent of the total U.S. population and is a subset, or part, of the CPI-U population….

Does the CPI measure my experience with price change?

Not necessarily. It is important to understand that BLS bases the market baskets and pricing procedures for the CPI-U and CPI-W populations on the experience of the relevant average household, not of any specific family or individual. It is unlikely that your experience will correspond precisely with either the national indexes or the indexes for specific cities or regions….

How is the CPI market basket determined?

The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. For the current CPI, this information was collected from the Consumer Expenditure Surveys for 2007 and 2008. In each of those years, about 7,000 families from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 7,000 families in each of these years kept diaries listing everything they bought during a 2-week period….

What goods and services does the CPI cover?

The CPI represents all goods and services purchased for consumption by the reference population (U or W) BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

  • FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
  • HOUSING (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
  • APPAREL (men’s shirts and sweaters, women’s dresses, jewelry)
  • TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
  • MEDICAL CARE (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
  • RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
  • EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
  • OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses)….

For each of the more than 200 item categories, using scientific statistical procedures, the Bureau has chosen samples of several hundred specific items within selected business establishments frequented by consumers to represent the thousands of varieties available in the marketplace. For example, in a given supermarket, the Bureau may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the Apples category….

How do I read or interpret an index?

An index is a tool that simplifies the measurement of movements in a numerical series. Most of the specific CPI indexes have a 1982-84 reference base. That is, BLS sets the average index level (representing the average price level)-for the 36-month period covering the years 1982, 1983, and 1984-equal to 100. BLS then measures changes in relation to that figure. An index of 110, for example, means there has been a 10-percent increase in price since the reference period; similarly, an index of 90 means a 10-percent decrease….

Can the CPIs for individual areas be used to compare living costs among the areas?

No, an individual area index measures how much prices have changed over a specific period in that particular area; it does not show whether prices or living costs are higher or lower in that area relative to another. In general, the composition of the market basket and the relative prices of goods and services in the market basket during the expenditure base period vary substantially across areas….

Not-So-Random Thoughts (VII)

This is the seventh of a set of occasional post that link to and discuss writings on matters that have been treated by this blog. The first of the posts is here; the second, here; the third, here; the fourth, here; the fifth, here; and the sixth, here.

UPDATED 07/14/13

In “The Reality of the Wartime Economy,” Steven Horwitz and Michael J. McPhillips bang the drum for Robert Higgs’s account of the role of World War II in ending the Great Depression. Horwitz and McPhillips conclude:

The debate over World War II’s role in ending the Great Depression has enormous relevance in connection with the current anemic recovery from the Great Recession. We have offered evidence to support Robert Higgs’s argument that the wartime macroeconomic data significantly overstated the degree of genuine economic recovery. Higgs’s evidence rests on his reinterpretation of several traditional macroeconomic indicators to compensate for the distinct features of a wartime economy. We show that if one digs below the aggregates and looks at how American households lived during the war, as shown in the media, letters, and journals, Higgs’s case appears to be even stronger. Whatever the war’s effects on seemingly booming conventional macroeconomic aggregates, it entailed a retrogression in the average American’s living standards, and that disconnect should alert us to those aggregates’ limitations. Whenever government commands resources, those who finance this acquisition, whether through taxation or purchase of government bonds, incur opportunity costs. Whether the diverted resources go toward building tanks and guns or toward repairing bridges and roads does not alter this fact. As we continue to debate the effectiveness of large-scale government expenditure to speed recovery from the Great Recession, we should not be looking at the wartime experience of the 1940s as a guide.

I quite agree with the bottom line. (See especially my posts “A Keynesian Fantasy Land” and “The Keynesian Fallacy and Regime Uncertainty.”) But there is reason to believe that the glut of saving during World War II helped to fuel the post-war recovery. (See my posts “How the Great Depression Ended” and “Does ‘Pent Up’ Demand Explain the Post-War Recovery?“)

*     *     *

Highly recommended: “What Difference Would Banning Guns Make?” at Political Calculations. The answer is “not much, if any.” Violence will out, especially when the demographics are right (or wrong, if you will). Which leads to my post “Crime, Explained.”

*     *    *

A Bipartisan Nation of Beneficiaries” (The Pew Report, December 18, 2012) suggests (unsurprisingly) that

a majority of Americans (55%) have received government benefits from at least one of the six best-known federal entitlement programs.

The survey also finds that most Democrats (60%) and Republicans (52%) say they have benefited from a major entitlement program at some point in their lives. So have nearly equal shares of self-identifying conservatives (57%), liberals (53%) and moderates (53%).

What choice is there when the state (a) robs us blind and (b) penalizes initiative and success? In those conditions, most of us respond as one would expect — by feeding at the public trough. See, for example, “The Interest-Group Paradox.”

*     *     *

An increasingly regulated economy, that’s what we have, according to “Counting All the U.S. Government’s Regulations” (Political Calculations, October 18, 2012). And a heavy price we pay for it, as I’ve documented in “The Price of Government, Once More,” and the many posts linked to therein.

*     *     *

UPDATES:

Rich Lowry of National Review, famous mainly for having fired John Derbyshire, continues his attack on what Timothy Sandefur calls “Doughface libertarians”:

… Lincoln said, “I have no purpose to introduce political and social equality between the white and black races.” How could he say such a thing? Well, he said it in his debates with Stephen Douglas, when he was playing defense…. (“The Rancid Abraham Lincoln-Haters of the Libertarian Right,” The Daily Beast, June 17, 2013)

Not so fast, Mr. Lowry. Lincoln wasn’t just playing defense. See “The Hidden Tragedy of the Assassination of Abraham Lincoln,” wherein Lincoln’s plan for the colonization of blacks is discussed.

*     *     *

From Michael Ruse’s “Does Life Have a Purpose?” (Aeon, June 24, 2013):

… Today’s scientists are pretty certain that the problem of teleology at the individual organism level has been licked. Darwin really was right. Natural selection explains the design-like nature of organisms and their characteristics, without any need to talk about final causes. On the other hand, no natural selection lies behind mountains and rivers and whole planets. They are not design-like. That is why teleological talk is inappropriate….

This reminds me of Sandefur’s post, “Teleology without God,” which I addressed in “Evolution, Human Nature, and ‘Natural Rights’” and “More Thoughts about Evolutionary Teleology.”

The Price of Government, Once More

I was pleased to read a recent post by Mark Perry, “Federal regulations have lowered real GDP growth by 2% per year since 1949 and made America 72% poorer.” It wasn’t the message that pleased me; it was the corroboration of what I have been saying for several years.

Regulation is one of the many counterproductive activities that is financed by government spending. The main economic effect of government spending, aside from regulation, is the deadweight loss it imposes on the economy; that is, it moves resources from productive uses to less productive, unproductive, and counterproductive ones. And then there is taxation (progressive and otherwise), which penalizes success and deters growth-producing investment.

All in all, the price of government is extremely high. But most voters are unaware of the price, and so they continue to elect and support the very “free lunch” politicians who are, in fact, robbing them blind.

Consider, for example, these posts by James Pethokoukis:
Is the Era of Fast U.S. Economic Growth Coming to an End?AEIdeas, July 13, 2013
My Counter: Why U.S. Economic Growth Doesn’t Have to Come to an End,” AEIdeas, August 23, 2012

Pethokoukis’s thesis, with which I agree, is that government — not lack of opportunity — is the main obstacle to the resumption of a high rate of growth.

For much more, see:
The Price of Government
The Price of Government Redux
The Mega-Depression
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Rahn Curve at Work
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Estimating the Rahn Curve: A Sequel
Lay My (Regulatory) Burden Down
More Evidence for the Rahn Curve

 

The 80-20 Rule, Illustrated

The 80-20 rule “states that, for many events, roughly 80% of the effects come from 20% of the causes.” This rule seems to hold with respect to wealth; that is, about 20 percent of individuals own about 80 percent of the wealth of the world. It’s not that the 20 percent “claim” 80 percent of the wealth (as some would have it), but that the 20 percent have earned 80 percent of the wealth. (The extent of inherited wealth is vastly overstated. And, besides, the prospect of leaving money to one’s heirs — and to charities — stimulates the accumulation of wealth and the beneficial economic activities that give rise to it.)

A good illustration of the 80-20 rule is found in baseball statistics. In the past 50 seasons (1963-2012), there were 1,370 baseball players who compiled one or more seasons in which they appeared at the plate often enough to qualify for a batting championship. Of those 1,370 players, it took only 19.2 percent (264 of them) to compile 80 percent of the single-season batting averages of .300 or higher. (For those of you who live on a remote planet, a batting average of .300 or more — 3 or more hits in every 10 times at bat — has long been considered an outstanding performance in baseball.)

Further, the 1,370 players compiled a total of 6,724 seasons in which they qualified for a batting title. But only 21.4 percent of those seasons resulted in a batting average of .300 or higher. The 19.2 percent of players who accounted for 80 percent of the .300-plus seasons compiled them while playing a total of 1,153 championship-qualifying seasons — 17.4 percent of the 6,724 championship-qualifying seasons played.

Excellence really is a relatively rare (and non-random) commodity. It should be celebrated and emulated. “Progressive” levelers, however, envy those who attain excellence, and use the power of government (i.e., taxation and regulation) to discourage it and penalize its fruits.