Professor Cringed (A Note on Ayn Rand)

One of the weirder aspects of Alan Greenspan's life was his association with Ayn Rand. In his excellent NY Times review of Greenspan's memoir, Michael Kinsley writes:

Freedom. For this proud square, this eager conformist and joiner of the establishment, freedom is nevertheless the supreme value of his life. Freedom and, he would add, rationality. In the early 1950s he joined the inner circle of Ayn Rand, the author of ''The Fountainhead'' and ''Atlas Shrugged,'' whose philosophy, known as Objectivism, was an extreme form of libertarianism that actually celebrated selfishness and greed. Many young brainiacs of dorkish tendencies go through an Ayn Rand period (her books are very popular at Microsoft). But Greenspan credits Rand as ''a stabilizing force in my life'' and was ''a regular at the weekly gatherings at her apartment'' through the early 1960s. She stood at his side when he was sworn in as chairman of the Council of Economic Advisers in 1974, and they ''remained close until she died in 1982.''

Occasionally I encounter students who are going through an "Ayn Rand period" - its just a phase, I remind myself. One I fortunately managed to avoid (I was more inclined towards Leon Trotsky), though one of my high school friends did make me read "The Fountainhead."

For Greenspan, though, it was more than just a phase. While I can excuse a central banker with questionable taste in literature, I always found it troubling to have a bona fide acolyte - a man who could say "objectivism" with a straight face - in such a powerful position. Lest I smirk too much, Paul Krugman's latest column is a reminder of the real consequences of Greenspan's worldview.

To the students I say: if you must be libertarian, its time to graduate to Hayek and "The Road to Serfdom," which is actually a good book.

As my for high school friend - he made it to the other side, and is now an attorney with a federal regulatory agency in Washington (take that, Ms Rand!).

No, We Don't Do That

Reuters reports: "Economists Smile As Greenback Drops." I realize its tough to write headlines, but surely the folks at Reuters know that economists never smile. It's the "dismal science" after all.

The Economic Consequences of Mr. Torre

The market for New York Yankee mangers was once a notoriously flexible labor market, but now it provides an example of the rigidity known as "sticky wages."

Joe Torre recently turned down a $5 million contract to return to the team. That's lots of money - more than any other baseball manager - but a cut from the $7.5 million he received this year. Torre explained his decision:

If your salary is such and it’s reduced, yeah, $5 million is a lot of money; I’m not going to sneeze at that. I’m not going to make that this year. So it’s nothing I take for granted. The fact that someone is reducing your salary is telling me they’re not satisfied with what you’re doing.

Sports Illustrated columnist Tom Verducci described it as a de facto firing of Torre. The Yankees made "a contract offer they thought would strike just the right balance: just good enough for public relations purposes, but insulting enough that no man of Torre's pride and accomplishments would ever accept."

The psychological response to interpret a nominal wage reduction as an insult - preferring to withdraw labor rather than accept a cut - means that wages cannot effectively adjust in a downward direction.

This type of behavior has implications for the macroeconomic aggregate supply curve. One standard version of Keynesian* aggregate supply is based on sticky wages: a nominal wage is set in advance, and the quantity of labor demanded increases with the price level, leading to an upward sloping AS curve. In a recession, the adjustment of nominal wages necessary to return to the full-employment (classical) equilibrium is downward, while in a boom when output is above potential (i.e. the economy is "overheating") wages should adjust upward. If the upward adjustment can be accomplished easily, while the downward adjustment is resisted - i.e. wages are more sticky downward than upward - the resulting aggregate supply curve is flatter below potential output (full employment) and becomes vertical when potential output is reached. This is described by Keynes in chapter 20 of the General Theory:

There is, perhaps, something a little perplexing in the apparent asymmetry between Inflation and Deflation. For whilst a deflation of effective demand below the level required for full employment will diminish employment as well as prices, an inflation of it above this level will merely affect prices. This asymmetry is, however, merely a reflection of the fact that, whilst labour is always in a position to refuse to work on a scale involving a real wage which is less than the marginal disutility of that amount of employment, it is not in a position to insist on being offered work on a scale involving a real wage which is not greater than the marginal disutility of that amount of employment.

In addition to the implications for aggregate supply, The Economist suggests Torre's behavior illustrates a problem with efforts to improve corporate governance and reduce obscene CEO compensation:

In theory, if executive pay rose too high because it was set in a market dominated by cronyism (ie, a board of directors who are chums of the boss, who appointed them), then shouldn’t a move to a system in which the board actually tries to get value for the shareholders’ money result in lower pay?

Mr Torre’s fate shows why the answer is probably no. Once a pay level has been reached, it becomes a minimum. Mr Torre may still have been the best paid manager in baseball under the new contract, but he would not have been as well paid as before. He is already wealthy and successful. He needs the extra money less than he needs respect—much like the typical boss of a big company after a few years in the job.

Or, as Keynes wrote in chapter 3 of the General Theory:

Though the struggle over money-wages between individuals and groups is often believed to determine the general level of real-wages, it is, in fact, concerned with a different object. Since there is imperfect mobility of labour, and wages do not tend to an exact equality of net advantage in different occupations, any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is a sufficient justification for them to resist it...

Of course, the alternative interpretation of his decision is that Torre places an extremely high value on leisure time activities, like watching the Red Sox play in the World Series on TV.

* There is some dispute regarding whether this is an accurate interpretation of what Keynes really meant.

Wage Insurance

The government provides unemployment insurance for workers who lose their jobs, but in the US, most unemployment spells are relatively short. In the Washington Post, University of Chicago public policy professor Robert LaLonde argues the more serious risk workers face is that they will be re-employed in lower-paying jobs and suffer a permanent decrease in lifetime income. Although this risk is often associated with trade and globalization in the popular imagination, such displacements are part of the job churn associated with a capitalist economy and can occur due to changes in consumer demand or technological change. The US currently has a limited program "Trade Adjustment Assistance" for workers displaced by international competition. LaLonde argues for replacing it with a broader wage insurance program. He writes:

This insurance would not discriminate between job losers from different industries. A manufacturing worker who loses his job as a result of free trade policies should not be treated differently than a service worker who loses his job as a result of automation. The insurance would pay beneficiaries a percentage of their earnings losses once they are reemployed, but it would not make up the whole gap; this would preserve the incentive for workers to search for better paying jobs. Benefits would be available to middle-class workers, and not just to the poor, since it is the middle class that is most exposed to the threat of downward mobility. Finally, the program would pay benefits so long as workers continued to suffer substantial reemployment earnings losses.

The argument, in part, is political - wage insurance might help increase support for trade agreements. LaLonde writes:

Congress has an opportunity to significantly reduce middle class workers' well-founded fears of catastrophic job loss. By replacing failed trade adjustment assistance with sensible wage insurance, it can start to rebuild support for free trade agreements and other policies that promote economic growth.

Viva AMT?!

One of the more prominent tax policy issues these days is the Alternative Minimum Tax (AMT). The AMT was enacted in 1969 as a way of ensuring that high-income earners would indeed owe some income taxes, even if, under the regular system, they could find enough loopholes, deductions and credits to reduce their obligations to zero. The AMT is an alternate, simpler, income tax - high income taxpayers are supposed to calculate their taxes under the regular system and under the AMT and pay whichever is greater.

The AMT has become a big issue because the number of taxpayers affected by it is expected to grow significantly. This reflects two things: (i) the thresholds for the AMT are not adjusted for inflation, so as nominal incomes rise with inflation, an increasing number of upper-middle-class taxpayers will be affected and (ii) the tax cuts of 2001 and 2003 have reduced the regular tax liabilities for many, especially high-income earners.

In the Washington Post, Michael Kinsley defends the AMT. He writes:

If you were designing the tax system from scratch, you might come up with something that looks a lot like the AMT. It resembles the "flat tax" of many reformers' dreams: a high basic exemption, so that low-income people don't pay it at all; very few deductions, credits or exclusions; and (because of that) a much lower top rate than the current system: 26 percent, compared with almost 40 percent in effect today. What makes it complicated is having to figure your taxes twice to see if the AMT applies to you. Of the two parallel tax systems we have -- the regular income tax and the alternative minimum tax -- it might make more sense to scrap the regular one and keep the AMT.

The Urban/Brookings Tax Policy Center has background on the issue.

Black Monday (and Gordon Gekko) Revisited

Wall Street marked the 20th anniversary of the largest-ever one-day percentage plunge in the Dow Jones Industrial Average with a 367-point (2.6%) drop. On October 19, 1987 - "Black Monday" - the Dow fell 508 points, which was a 22% decline from its previous close of 2247. The New York Times revisited its coverage (check out the screaming headline). The Wall Street Journal marked the anniversary on Monday with a comparison to today's market (and some nifty charts and a video interview with floor broker) and an interview with NYU financial historian Richard Sylla.

It was scary stuff indeed - certain middle-schoolers anticipated an economic depression - but the economy ultimately shrugged it off. Financial markets sometimes seem oddly disconnected from the real economy. The recovery that had begun in November 1982 continued until July 1990.

Though it was an economic non-event, perhaps it marked a cultural turning point - an end to the greedy, selfish materialism of the 1980's. In a recent Slate essay on the movie "Wall Street," which starred Michael Douglas as greedy corporate raider Gordon Gekko, Jessica Winter wrote:

Released in December 1987, two months after the Black Monday stock market crash and just one week before Ivan Boesky was sentenced to three years in prison for securities fraud, Wall Street appeared like the indignant coda to an era that had suddenly self-destructed. (Parts of Gekko's famous "Greed is good" speech are freely paraphrased from comments Boesky made in 1985.) "The eighties are over," Newsweek announced in its first issue of 1988, adding, "Maybe the best pop-culture indicator of the post-'80s spirit is the respectful reception given to Oliver Stone's dreadfully ham-handed Wall Street."

George Bush was elected in 1988 promising a "kindler, gentler America" - an implicit rebuke to the harshness of the Reagan era. Two decades later, as Winter notes, it seems like the 1980's didn't so much end in 1987, they just paused. "Corporate raiding" is now called "private equity," the second gilded age rolls on apace, and that Don Henley CD I'm listening to now seems oddly un-dated. Just as we did with "Born in the USA," we seemed to miss the point of Wall Street:

Douglas says he's still stunned by the number of people who tell him that his Oscar-winning role was the reason they went to work on Wall Street. "It's so depressing and sad," Douglas says.

A sequel, "Money Never Sleeps" is in the works.

Taxes: Fairness and Incentives

Former Labor Secretary Robert Reich makes a case for raising taxes on high earners. He cites the IRS data on growing inequality (see earlier post) and, what's more:

The biggest emerging pay gap is actually inside the top 1 percent. It's mainly between CEOs, on the one hand, and Wall Street financiers – hedge-fund managers, private-equity managers (think Mitt Romney), and investment bankers – on the other. According to a study by University of Chicago professors Steven Kaplan and Joshua Rauh, more than twice as many Wall Street financiers are in the top half of 1 percent of earners as are CEOs. The 25 highest paid hedge fund managers are earning more than the CEOs of the largest five hundred companies in the Standard and Poor’s 500 combined. CEO pay is outrageous; hedge and private-equity pay is way beyond outrageous. Several of these fund managers are taking home more than a billion dollars a year.

Here's why Reich argues the government needs more revenue:

Taxing the super-rich is not about class envy, as conservatives charge. It’s about the nation having enough money to pay for national defense and homeland security, good schools and a crumbling infrastructure, the upcoming costs of boomers’ Social Security (the current surplus has masked the true extent of the current budget deficit, but it won’t for much longer), and, hopefully, affordable national health insurance. Not to mention the trillion dollars or so it will take to fix the Alternative Minimum Tax, which is now starting to hit the middle class.

So, how high does Reich think top rates should go?

What’s fair? I’d say a 50 percent marginal tax rate on the very rich (earning over $500,000 a year). Plus an annual wealth tax of one half of one percent on net worth of people holding more than $5 million in total assets.

Greg Mankiw responds:

If I were a redistributionist, here is what I might propose: A large fixed payment to every citizen, paid at the beginning of every month, financed by a proportional tax on consumption, such as a value-added tax.

That's very sensible if one takes seriously the possibility that, because they effect incentives, high marginal tax rates reduce saving and investment. Under Mankiw's proposal, there would be no tax on income which is saved - in theory, this should encourage investment and capital accumulation. The large fixed payment would result in very low - even negative - average tax rates for low-income earners. In a recent NY Times column, Bob Frank also argued for taxing consumption, rather than income, but in a much more progressive way:

As taxable consumption rises, the tax rate on additional consumption would also rise. With a progressive income tax, marginal tax rates cannot rise beyond a certain threshold without threatening incentives to save and invest. Under a progressive consumption tax, however, higher marginal tax rates actually strengthen those incentives.

But how worried should we be about the effect of marginal tax rates on incentives and behavior? By instinct and training most economists are inclined to believe incentives matter, but as I noted earlier, the economy actually grew faster in the 1950's and 1960's, when the top marginal tax rate was higher.

On a related note, the OECD has compared tax burdens (i.e. taxes as a % of GDP) across member countries (the OECD is a group of rich countries). Of the 30 countries in the study, Sweden had the highest tax burden (50.7%) and Mexico the lowest (19.9%), and the US (27.3%) was below the average of 36.2%. Its hard to see a clear connection between taxes and economic performance in the OECD data - certainly, high taxes haven't prevented some countries from being prosperous (of course, overall tax burdens are not the same thing as marginal tax rates). The NY Times has a nice story on the OECD data.

Morning in America (Finally!)

Critics of the "supply side economics" employed to justify President Reagan's tax cuts sometimes refer to the idea as "trickle-down economics" (Reagan's opponent in the 1980 Republican primary, George H.W. Bush, called it "voodoo economics"). But now middle-income Americans are finally seeing the benefits - The Onion reports "Reaganomics Finally Trickles Down to Area Man:"

Twenty-six years after Ronald Reagan first set his controversial fiscal policies into motion, the deceased president's massive tax cuts for the ultrarich at last trickled all the way down to deliver their bounty, in the form of a $10 bonus, to Hazelwood, MO car-wash attendant Frank Kellener...

The [hilarious!] article details the path of the $10, and has reactions from Arthur Laffer, Ted Kennedy and Hank Paulson.

Taming The Twins

The trade deficit and fiscal (federal budget) deficits are sometimes referred to as the "twin deficits." They are linked by the identity: NX + NFP + Tr = NS - I; where NX is net exports (if negative, a trade deficit), NFP is net income from abroad and Tr is international transfers. Together, they are the current account, of which NX is by far the largest part - i.e. the US trade deficit drives the US current account deficit. The other side is national savings (NS) less investment (I), where national savings is private savings and government savings. The fiscal deficit is negative government savings; NS can therefore be thought of as the savings left after subtracting the part borrowed by the government. So, ceteris paribus, the trade deficit (-NX) and the fiscal deficit (which reduces NS) move together - hence the "twin deficits."

Last week brought news that both of deficits are shrinking. The CBO reported preliminary estimates that the federal deficit decreased to $161 billion in fiscal year 2007, from $248 billion the year before (the federal fiscal year ends in September). The biggest change in the spending side was a $65 billion decrease in "other programs and activities" (i.e. not defense or entitlement programs), which the CBO attributes to some one-time-only events:

The decrease in outlays for "other programs" was mainly due to unusually high spending in 2006 for activities related to the 2005 Gulf Coast hurricanes and for the subsidy costs recorded for student loans. Payments received in 2007 for licenses auctioned in 2006 for use of the electromagnetic spectrum further reduced net outlays. Excluding those three activities, spending for this category rose by about 1 percent.

On the revenue side, income tax revenue surged by $118 billion - partly this is the "automatic stabilizer" effect (taxes rise as incomes rise). A large part of the increase came from "nonwithheld income":

Nonwithheld income and payroll tax receipts gained about $55 billion (or 13 percent) in 2007. The two main components, quarterly estimated payments and final payments with tax returns, both grew at about that same rate. Nonwithheld receipts grew more slowly than the 19 percent rate recorded in 2006. The double-digit growth in 2007 probably reflects continued strong growth in income from sources other than wages and salaries.

Presumably, that would mostly be "capital income" like dividends, interest income and capital gains - growth in this type of income is consistent with the rising inequality reported by the IRS (see previous post).

As for the trade deficit - the BEA and Census Bureau reported exports of $138.3 billion and imports of $195.9 for a deficit of $57.6 billion for the month of August. That's $1.4 billion less than July and $10 billion less than August, 2006. This may, in part, reflect the continuing decline the in the value of the dollar, which makes US products cheaper to foreigners (increasing exports) and makes foreign products more expensive to Americans (decreasing imports). By country/region, the largest deficits were with China ($22.5 billion), OPEC ($11.4 billion) and Europe ($11.1 billion). Here's the NY Times story.

Income Inequality Update

The Wall Street Journal reports:

The richest Americans' share of national income has hit a postwar record, surpassing the highs reached in the 1990s bull market, and underlining the divergence of economic fortunes blamed for fueling anxiety among American workers.

The wealthiest 1% of Americans earned 21.2% of all income in 2005, according to new data from the Internal Revenue Service. That is up sharply from 19% in 2004, and surpasses the previous high of 20.8% set in 2000, at the peak of the previous bull market in stocks.

The bottom 50% earned 12.8% of all income, down from 13.4% in 2004 and a bit less than their 13% share in 2000.