Alex Tabarrok at Marginal Revolution has it figured out:

When I discuss minimum wages in class I tell my students that one of the best ways to get a high-paying job is to get a low-paying job and work your way up. The minimum wage can put the least employable out of work and have permanent negative effects when training and work skills not acquired in youth are difficult to accumulate later on….

The bottom line? If you don’t work at McDonald’s when you are a teenager, don’t expect to manage a McDonald’s when you are middle-aged.

Read the whole thing. It includes useful links, including a link to a recent study to corroborates Tabarrok’s thesis.

No wonder Arnold Kling (EconLog) is such a good economist. He has experienced reality and he understands it:

One of the issues with which I struggle in teaching my [George Mason University] course is integrating my business experience with my academic learning. For example, take the topic of “profit maximization.” In academic economics, it means solving a mathematical optimization problem. In business, you don’t have the equation to work with. You’re guessing about what will sell, to whom you can sell it, and how much it might sell for. You’re guessing about how you can get technology to fit together, and how new developments could affect you.

P.S. Check out Kling’s take on Paul Samuelson, whose never strong grasp of reality seems to have slipped away.

What’s wrong with this story from the dependably lachrymose New York Times?

Always on the Job, Employees Pay With Health
By JOHN SCHWARTZ

Published: September 5, 2004

American workers are stressed out, and in an unforgiving economy, they are becoming more so every day.

Sixty-two percent say their workload has increased over the last six months; 53 percent say work leaves them “overtired and overwhelmed.”

Even at home, in the soccer bleachers or at the Labor Day picnic, workers are never really off the clock, bound to BlackBerries, cellphones and laptops. Add iffy job security, rising health care costs, ailing pension plans and the fear that a financial setback could put mortgage payments out of reach, and the office has become, for many, an echo chamber of angst.

It is enough to make workers sick – and it does.

Decades of research have linked stress to everything from heart attacks and stroke to diabetes and a weakened immune system. Now, however, researchers are connecting the dots, finding that the growing stress and uncertainty of the office have a measurable impact on workers’ health and, by extension, on companies’ bottom lines….

Does someone hold a gun to these people and force them to work at stressful jobs? Ah so, they just want what everyone else has — a huge-screen TV, a cell phone for every family member, a car or two for every family member, a McMansion, and on and on. Life is full of choices. If you can’t stand the stress, do something less stressful and give up some material things.

I’d like to be sympathetic — really I would — because I know how hard some people work to provide the goods and services I buy. But what’s the point of whining about it? Do the job you’re paid to do as well as you can, or do something else if you don’t like the job you’re doing. Or quit wasting your money on conspicuous consumption and save more so that you can retire early. (By the way, I follow my own advice, so I don’t mind giving it to other people.)

Imagine the reaction of readers who had to struggle through the Great Depression to put stale bread on the table. What a self-indulgent nation we’ve become.

UPDATED

Fed chairman Alan Greenspan, in recent testimony before Congress, suggested several ways to deal with the impending deficit in Social Security receipts*. One of those ways is to index Social Security payments to a “true” cost-of-living index. According to Greenspan, who is picking up on the findings of the “Boskin report” — a study done for the Senate Finance Committee in 1996 — the CPI systematically overstates increases in the cost of living.

How is that? Quoting from the executive summary of the Boskin report:

There are several categories or types of potential bias in using changes in the CPI as a measure of the change in the cost of living. 1) Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change. 2) Outlet substitution bias occurs when shifts to lower price outlets are not properly handled. 3) Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all. 4) New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.

I agree that the second, third, and fourth biases are a problem. But I disagree with respect to the substitution bias. Why? Let’s start with this excerpt of part IV of the report:

The “pure” substitution bias is the easiest to illustrate. Consider a very stylized example, where we would like to compare an initial “base” period 1 and a subsequent period 2. For simplicity, consider a hypothetical situation where there are only two commodities: beef and chicken. In period 1, the prices per pound of beef and chicken are equal, at $1, and so are the quantities consumed, at 1 lb. Total expenditure is therefore $2. In period 2, beef is twice as expensive as chicken ($1.60 vs. $0.80 per pound), and much more chicken (2 lb.) than beef (0.8 lb.) is consumed, as the consumer substitutes the relatively less expensive chicken for beef. Total expenditure in period 2 is $2.88.

The simplest comparison is to ask “How much more must I spend in my current situation (period 2) to purchase the same quantities that I purchased initially (in period 1)?”22 This is the question asked by the CPI. The price index for period 2 relative to period 1 uses the initial period 1 basket of consumption as the weights in the computation. To buy 1 lb. of beef and 1 lb. of chicken in period 2 costs $2.40. The price index for period 2 relative to period 1 is 1.20 (2.40/2.00), that is a 20 % increase.

Intuitively, it is easy to understand why such a computation imparts an upward (substitution) bias to the measure of the change in the true cost of living. It assumes the consumer does not substitute (cheaper) chicken for beef. In the real world, as in the hypothetical example, consumers change their spending patterns in response to changes in relative prices and, hence, partially insulate themselves from price movements.

Okay, consumers tend to substitute cheaper products for more expensive products as relative prices change. So what? The consumer was happy with 1 pound of beef and 1 pound of chicken before the price of beef went up relative to the price of chicken. Now the consumer will have to spend 20 percent more to be just as happy as she was before. That’s a good measure of the increase in her cost of living. Or to put it another way, she would have to spend 20 percent more in order to maintain a constant standard of living.

It’s true that tastes change with time, which is why the Bureau of Labor Statistics occasionally changes the “market basket” of goods and services it uses in computing the CPI. But, in the short run, the consumer is definitely worse off when prices rise, because she has to buy less of something she likes and more of something she likes less. In that respect, the CPI gets it right.

Aside from the substitution effect, how much does the CPI really overstate the cost of living? Table 3 in part VI of the report summarizes the effects of the various types of bias. As of 1996 — taking into account recent and prospective changes in the computation of the CPI — the report estimated that the CPI would overstate increases in the cost of living by 1.1 percentage points a year. But 0.4 percentage points of that total is accounted for by substitution bias. That leaves about 0.7 percentage points for other types of bias, which can add up over the years. In 10 years, for example, an overstatement of 0.7 percent in the CPI would cause Social Security benefits to rise 7 percent more than necessary in order to maintain a constant standard of living.

Bottom line: Greenspan may be right to urge the adoption of a more realistic cost-of-living index for Social Security, but that index won’t be realistic if it doesn’t handle the substitution bias correctly.

UPDATE:

A working paper by Robert Gordon (a co-author of the Boskin report), published by the National Bureau of Economic Research in June 2000, says that changes to the method of calculating CPI made in the wake of the Boskin report have reduced the CPI’s overstatement of the cost of living from 1.1 percentage points to 0.65 percentage point. The changes, however, include corrections for the “bias” due to the substitution effect, which isn’t really a bias, as I argue above.

A note on the Bureau of Labor Statistics website, dated 02/20/02, discusses the creation of a new index called the Chained Consumer Price Index (C-CPI), which supplements but does not supplant the CPI. The C-CPI attempts to correct for the substitution effect across item categories (e.g., if the price of cigarettes goes up, consumers buy more bread). The same note says that the basic CPI was adjusted in 1999 to capture the effects of substitution within product categories (e.g., if the price of bourbon goes up, consumers buy more beer). So, in spite of all logic (or at least my logic), the CPI and its companion index have eliminated the so-called substitution bias.

Those are the key points I have been able to glean by searching the BLS website and by Googling. The business of computing price indices is exceedingly murky and complex. It’s safe to say that price indices are approximations wrapped in estimates surrounded by great statistical uncertainties. Changes in the CPI could well overstate (or understate) changes in the cost of living by 100 percent and we’d never know the difference. Anyway, as the BLS wisely says somewhere on its site (or perhaps it was in the Boskin report), the cost of living is a personal thing that can’t really be captured by an index.

I’m sorry I started this. I’ll never write on the subject again — I think.

__________

*Of course, the real solution to the impending deficit in Social Security receipts is to privatize Social Security. But that’s another argument, which I’ve already made here.

Paul at Wizbang quotes Reuters:

WASHINGTON (Reuters) – The U.S. economy slowed more sharply in the second quarter than first thought as oil prices rose and the trade gap swelled, the government said on Friday in a report that confirmed momentum faltered in the spring.

U.S. gross domestic product — which measures total output within the nation’s borders — expanded at a 2.8 percent annual rate…

Paul says, “I need someone to ‘splain this one to me.”

My answer: Reuters is simply showing off its advanced knowledge of mathematics. In calculus, the rate of change of a quantity is the first derivative — that’s the growth rate — which in this case is positive. If, however, the growth rate drops, then the change in the growth rate — the second derivative — is negative. Thus, a rigorous organization like Reuters, which is full of “advanced” thinkers, is correct in saying that the U.S. economy slowed, if by “slowed” Reuters is referring to the second derivative. Got it? I’m sure Reuters doesn’t.

Arnold Kling writes about “Understanding ‘Middle-Class Squeeze'” at Tech Central Station. He debunks the notion of “middle-class squeeze” and concludes with these observations:

[P]oliticians who take on middle-class squeeze…as [a] public policy [issue] may be causing harm. Sending out a message that government is the solution may serve to weaken the cause-effect connections that people need to make in order to solve what are fundamentally personal problems. The damage caused by exacerbating the cause-effect disconnect that weakens personal willpower may far exceed the benefits of whatever actual remedy the government is able to deliver.

Well, let’s suppose that politicians are unable to resist dealing with “middle-class squeeze” — just as many of the middle class are unable to resist McMansions and fattening foods. What to do?

To the extent that there is such a thing as middle-class squeeze, it reflects a lack of fiscal discipline, which means that the middle class (on the whole) is spending more and saving less. If that’s the case, a public-policy solution would be to (1) increase taxes on consumption (perhaps by levying a national sales tax, including a sales tax on homes), (2) eliminate income tax deductions for property taxes and mortgage interest (for starters), and (3) reduce taxes that discourage saving (perhaps by eliminating all taxes on capital gains and interest).

That combination of actions — which could easily be made revenue-neutral — would have the effect of raising investment, thereby increasing productivity and real incomes. At the same time, by encouraging Americans to save at a higher rate, Americans would become less dependent on Social Security as a source of retirement income, which is another way of dealing with the coming “crisis” in Social Security.

Experimental economics is being used to create data about economic behavior, with which to test economic theories. An economist has even won a Nobel prize for his work in experimental economics. In a earlier post I argued that

A controlled experiment involving human behavior doesn’t yield valid results if its subjects know they’re participating in an experiment or if their environment is manipulated for the purpose of an experiment.

It happens that some behavioral psychologists are conducting laboratory studies to see if liars can be detected by their behavior. Critics of those experiments make this point:

Some researchers think…that the design of the laboratory studies is responsible for the poor rates of lie detection. “People are very good liars when nothing is at stake,” says Aldert Vrij of the University of Portsmouth in England. “But a lab setting is not real life.”

In most experiments, researchers tell the subjects whether or not to lie, and the lies have no effect on their lives. There’s no significant reward for a liar who’s believed or punishment for a judge who’s duped.

“There is definitely a lack of real-life stuff in this field of research,” says Vrij.

Exactly!

UPDATED 08/21/04

In an earlier post, I reported that government intervention in the economy since 1906 has reduced per capita GDP in the U.S. by about 40 percent. What happened?:

First, the regulatory state began [in 1906] to encroach on American industry with the passage of the Food and Drug Act and the vindictive application of the Sherman Antitrust Act, beginning with Standard Oil (the Microsoft of its day). There followed the ratification of Amendment XVI (enabling the federal government to tax incomes); World War I (a high-taxing, big-spending operation); a respite (the boom of the 1920s, which was owed to the Harding-Coolidge laissez-faire policy toward the economy); and the Great Depression and World War II (truly tragic events that imbued in the nation a false belief in the efficacy of the big-spending, high-taxing, regulating, welfare state).

The Great Depression also spawned the myth that good times (namely the Roaring ’20s) must be followed by bad times, as if good times are an indulgence for which penance must be paid. Thus the Depression often is styled as a “hangover” that resulted from the “partying” of the ’20s, as if laissez-faire — and not wrong-headed government policies — had caused and deepened the Depression.

You know the rest of the story: Spend, tax, redistribute, regulate, elect, spend, tax, redistribute, regulate, elect, ad infinitum. The payoff: GDP per capita was almost $38,000 in 2003; without government meddling it might have been as much as $68,000.

Now that the U.S., like most other countries, has attained a high level of government spending, taxation, regulation, and welfare, how is the U.S. able to maintain its outstanding record of economic performance?

The relative prosperity of a market economy* today depends mainly on three things: the rule of law, free trade, and educational attainment. I base this conclusion on statistical analyses of data for 59 countries. I used the indices of economic freedom for 2000 from Economic Freedom of the World** and 1998 data for average national IQ and GDP per capita published by La Griffe du Lion (who derived the data from an article by Richard Lynn and Tatu Vanhanen, “National IQ and Economic Development: A study of Eighty-One Developing Nations,” in Mankind Quarterly (Summer 2001).

I correlated GDP per capita with the various indices of economic freedom. Based on those correlations and some preliminary regression analyses, I found that GDP per capita can be explained mainly by two indices: The rule of law (Area 2: Legal Structure and Security of Property Rights) has a significantly positive effect on GDP per capita; the mean tariff rate (Area 4.A.ii) has a significantly negative effect on GDP per capita. The rule of law is a measure of the independence and integrity of the judicial system and the degree to which intellectual property rights are protected. The use of law to regulate the economy is captured in various other indices, of which the tariff rate is one.

IQ (verbal IQ to be precise) has a significantly positive effect on GDP per capita. IQ, in this instance, probably measures education, which should be the proximate cause of prosperity, at least up to the point where education ceases being an investment and becomes conspicuous consumption.

(For the statistically minded, the R-squared of the regression equation is 0.89 and the t-stats for the independent variables are as follows: rule of law, 7.55; mean tariff rate, -4.03; verbal IQ, 4.47.)

I don’t mean to imply that prosperity is determined solely by the rule of law, free trade, and education. Those three factors simply yield powerful statistical relationships. My analyses of the indices of economic freedom also point to several other significant factors, especially transfers and subsidies as a share of GDP, bribery as a cost of doing business with government, and the regulation of business. Most of the countries in the data set have large welfare programs (transfer payments) and impose a heavy regulatory burden on business. Thus those activities are unlikely to show up as statistically significant in a multivariate analysis of cross-section data. Similarly, it is hard to find a country with a robust economy that doesn’t impose high taxes on its citizens.

The moral of the story is that, although we in the U.S. could adopt policies that would make us worse off (e.g., eliminating patents and raising tariffs), we would be significantly better off if we hadn’t veered from the path of laissez-faire capitalism a century ago. The main cause of prosperity is economic freedom.

__________

* Command economies are excluded from the analysis because their performance is so far below that of market economies. For example, as of 1998 (the year of the IQ and GDP data) China was far from a market economy. If China had a market economy, and if that economy operated under the same rule of law and tariffs as the U.S. economy, the per capita GDP of China would have been about the same as that of the U.S. because China’s average IQ was about the same as that of the U.S. In fact, China’s per capita GDP was about one-tenth that of the U.S. That’s the cost of decades of political repression and central planning.

** The compilation of indices of economic freedom in Economic Freedom of the World is a continuing endeavor of The Fraser Institute of Vancouver, British Columbia, Canada. There are 37 individual indices. The individual indices are organized into five areas, each of which has a weighted index. And there is a summary index, which is a weighted index of the area indices.