By Edward Conard –
Since 1991, France’s, Germany’s, and Japan’s GDP per worker have each fallen more than 10% relative to that of the U.S. – Why?
If loose monetary policy was the primary cause of the financial crises, why are loan defaults predominantly confined to subprime mortgages and not spread more broadly?
The world of economics is deeply divided and inherently political. Advocates for stronger incentives for risk taking and those for income redistribution each work backward from their conclusions to find a set of indisputable beliefs on which to build their arguments. The economy is so complex that it is impossible to definitively isolate the effect of any one factor. This book attempts to explain how the economy works, why the U.S. has outperformed its high wage rivals, what caused the financial crisis, and what improvements might better protect our economy without damaging its growth.
Chapter 1 – A Brief History of the US Economy
The advanced education of the American workforce accelerated the growth of the post WWII economy. The U.S. became the first nation to educate all its citizens. The GI bill allowed hundreds of thousands more Americans to attend college. In the 50’s and 60’s, workers with college degrees propelled the transition of the U.S. economy and wage growth accelerated. Eventually, immigration and entry of women into the workforce put downward pressure on men’s wages. The U.S. was extraordinarily prosperous for the second half of the twentieth century for a unique set of reasons – recovery from a decade’s long depression, the destruction of the rest of the developed world’s infrastructure in WWII, a failure of potential foreign competitors to educate their people, and a highly restricted supply of workers elsewhere.
The higher pay of union jobs represents an unfair tax on consumers. This transfer is not economically sustainable without government mandated labor laws and closed trade borders. The U.S. lost high paying union jobs because unions lost their ability to tax consumers. By 2009 the fifty million new immigrants and their U.S. born children were putting downward pressure on wages. From 1996 on, over half of new employment was created by small firms with only 5% of U.S. employment. In the 1990’s the U.S. economy began again to grow faster than its advanced competitors. Its innovation grew faster which meant its productivity accelerated. Most of the increase in productivity came from an increase in knowhow. The increase in knowhow coincided with the commercialization of the Internet and email. Most innovation comes from novel combinations of pre-existing ideas and the more the communication the better the connections between the ideas come to light. The U.S. GDP per capita is over a third higher than other developed economies if we adjust for our less productive demographic mix of workers due to low skilled immigration and the higher birthrates of the lower skilled part of the population. Our government productivity statistics fail to account for shifts to demographics with lower productivity. (Stopped on pg. 22)
Consumption does not grow productivity, only successful investment and innovation. Understanding why the U.S. outperformed other developed economies in the past few decades is critical to our continued success. As we try to pass legislation to avoid the next financial crisis, we must avoid damaging those factors that are responsible for our success.
Chapter 2: The Role of Investment
Economists who don’t understand incentives see minimal costs to the economy from redistribution. Investment accelerates the rate of innovation. Cutting edge economies invest largely by paying the salaries of talented thinkers who invent and redesign products and processes. Innovation grows the economy in two ways: By reducing the cost of existing products, and by discovering new ones that are more valuable. Improvements in agricultural productivity freed up labor for the Industrial Revolution. Workers capture most of the value of innovation; through productivity gains that enable higher wages, and through the lower prices that productivity produces by lowering the cost of goods and services. It doesn’t matter whether prices have fallen or wages have risen, they are two sides of the same coin. The chart on page 35 shows that labor has consistently captured about 70% of GDP as wages during the entire period 1950-2005. Innovation continues to drive the cost of products down and their value up. Competition forces all profitable competitors to invest in valuable innovation or face extinction. Consumer choices are driven by the ratio of value to price. Companies must produce enormous value above price to survive against competitors.
Most workers consume nearly everything they earn and are inclined to vote for politicians who promise them more government services and benefits than they pay for in taxes. The difference must be covered by borrowing, or by increased taxes on rich investors which reduces funds available for investment. Deficit spending reduces constraints to government spending and consumption by covering shortfalls with borrowing, thus avoiding tax increases on rich equity investors. By redistributing income government reduces equity available for increased investment. Since most economies suffer from large shortages of equity, and the risk taking it underwrites, increased investment usually produces large productivity gains and economic growth.
Relieving credit constraints with monetary policy will only grow the economy if the economy has excess capacity and the growth will only be temporary. Printing money doesn’t grow the economy – increased risk taking does, which increased money supply successfully encourages only when the economy has excess productive capacity. Increased money supply when the economy is already at full capacity produces inflation, not increased production volume.
Conventional accounting obscures the cost to innovation by under reporting the level of investment required to drive it. Adding both tangible and intangible investment shows business investment grew from about 15% of GDP after WWII to a level approaching 25% today. Germany’s and France’s intangible investment rates are only 60% to 70% of ours.
Unexpected inflation redistributes ownership from lenders and investors to borrowers and consumers and from the private sector to the public sector.
The productivity of the most talented workers is growing faster than the economy as a whole and innovation has disproportionately increased their productivity. Innovations in the gathering and analysis of information have increased the ability to manage things geometrically, and made the most talented workers so much more valuable that 5% of the workforce now produces over a third of the output. Any increase in this group’s productivity has a huge impact on the economy.
The median wage has not risen in proportion to increased levels of productivity. The median is the highest wage of the lowest 50% and productivity growth has occurred mostly at the top of the wage scale. Demand for this talent is growing faster than the supply. Half of all new jobs created over the last 25 years have been in thought or thought related professions. Successful innovation creates highly productive communities that train people to innovate and commercialize related ideas. This can’t happen without supporting resources and knowledge networks. To increase productivity the economy must divert scarce resources from production for current consumption to the search for, and implantation of, new ideas, many of which will not work. The growth in U.S. productivity and asset values since the early 1990’a stems from an increase in investment relative to consumption. Increased investment explains why U.S. productivity accelerated. But why did the U.S. capitalize on the new improved investment opportunity so much faster than other advanced economies?
Chapter 3 – The Role of the Trade Deficit
As long as the U.S. continues to earn a higher rate of return on its investments from borrowed funds than its cost of debt service, the trade deficit can grow forever. Those who overlook the tradeoffs between the value of producing innovation versus consumption goods, and the savings from buying, rather than producing, goods for consumption when those goods can be produced more cheaply offshore, fail to see that shifting labor from production for consumption to innovation increases, rather than decreases, domestic employment. The increase is so large that the U.S. employed tens of millions of immigrants and offshore workers. No economy has done more for the poor. Far from demonstrating a lack of competitiveness, the trade deficit facilitated an increase in U.S. investment. As an economy shifts production to investment, it must increase offshore borrowing to maintain consumption.
While the Internet increased the productivity of the most talented, businesses poured money into intangible investments and the value of assets skyrocketed in anticipation of future profit growth. The trade deficit allows offshore economies to provide us constrained resources – both labor and capital.
If trade is to balance, we must use the U.S. capacity gained by moving production offshore to produce goods for export rather for increased domestic investment. The flow of dollars out of the United States to buy imports must flow back to the United States to buy exports or assets. It’s simple math.
How cheap is offshore labor? We not only pay much less per hour, we also avoid the cost we would have if these workers immigrated here. We don’t pay for their medical expenses, their pensions, their children’s public education, their out of wedlock children, their unemployment benefits, etc. We outsource pollution and they don’t vote and seek political handouts here. When they dump goods on us at cheap prices we gain the benefit. We can’t tax offshore workers, but low skilled, low wage U.S. workers pay far less taxes than the government services they consume.
The products driven offshore are those predominantly produced by low skilled labor and are price sensitive, low margin, undifferentiated commodity-like products. The use of low cost offshore resources frees up domestic resources for other uses. Mathematically, there’s no difference between low cost, offshore sourcing and domestic productivity improvements – both lower costs, free up resources for other uses, and increase the relative value of those alternative uses. Low cost offshore goods allowed our economy to shift talented workers to innovation and lower skilled workers to the service economy. Many countries have dealt with their employment problem by exporting labor and capital rather than growing domestically from successful investment.
The ideal trading partner is risk averse, preferring to buy debt instead of equity. U.S. companies have preferred to make offshore equity investments rather than debt investments and to retain the upside from expanding the offshore use of their intellectual property.
The economy will not reach full potential if we leave risk averse capital sitting idle. If we put risk averse short term capital to work it exposes the economy to the risk of panicked withdrawals. In 2008 the widespread panicked withdrawals rendered our entire financial infrastructure insolvent.
The need to tax voters normally restricts government spending. Borrowing from citizens in lieu of taxation has about the same effect economically. Taxpayers must lower consumption or investment to buy government debt. When politicians can raise expenditures without taxing or borrowing from citizens because risk averse offshore investors will eagerly buy government guaranteed debt, there is little left to restrain government spending. Lawmakers used the abundance of capital to grow government’s spending, principally on entitlements.
If anything has restrained lower middle class wages it’s likely an abundant supply of cheap immigrant labor.
Chapter 4: The Role of Incentives
Lucky risk taking produces innovation. The greater the payoffs the greater the incentive to risk investment in innovation. As the payoffs rise wagering increases. Europe and Japan lacked the economic incentives to take the risks necessary to transform their economies. This left their best thinkers mired in declining sectors. The best talent is hard to hire and retain. It largely works for itself. The most talented U.S. thinkers created nearly impossible to duplicate communities of experts around companies like Google, Microsoft, Apple, Facebook, etc., companies that remain critical to the advancement of cutting edge innovation.
In the U.S., more valuable on the job training, lower labor redeployment costs, and lower marginal tax rates increased payouts for successful risk taking which increased the motivation to take risks, which accelerated growth and accumulation of equity. So U.S. investors underwrote still more risks in a virtuous circle. A risk taking culture is largely a byproduct of incentives. With lower labor redeployment cost the U.S. aggressively implemented productivity enhancing improvements that countries with high labor redeployment costs could not duplicate. The incremental nature of progress makes it difficult for late entrants to gain the knowledge and market share needed to leapfrog existing competitors. Germany’s and Japan’s pursuit of growth through exports slowed their growth relative to the U.S., and ultimately reduced their employment growth instead of increasing it. U.S. companies built low cost factories offshore to compete internationally and kept their cash flow overseas to fund international growth and avoid U.S. taxes.
People who have never struggled for power and money underestimate the ferocity of these struggles. Talented workers with valuable careers face more risk than most people realize. Powerful incentives most overcome their logical aversion to risk and these incentives must be in the form of money and perceived status, the most powerful motivators of economic risk taking. To illustrate how successful lucky risk taking has become in the U.S. – the share of national income earned by the top one tenth of 1% of U.S. workers has gone from 2% in 1980 to 8% in 2010, whereas in France and Japan it has risen from just a little less than 2% to a little over 2% in that same thirty year period.
The average person in the world earns 3x as much now as in 1955 and the average Chinese 10x as much. This has all come from increased productivity led by the U.S. and emulated by others.
Proponents of income redistribution are skeptical that payoffs motivate increased effort, which is obtuse. Conard uses this illustration to explain why: Students at competitive colleges who are competing for honors and those struggling to pass work much harder than the rest of the student body. Why? A small amount of effort yields a much larger likelihood of payoff for these two groups than for the average student. Both the size and the probability of the payoffs matter enormously.
Most tax studies measure only short term changes in taxpayer behavior from changes in tax rates. Taxable income always declines when governments raise tax rates and the decline always occurs exclusively among the highest income earners. Higher marginal tax rates reduce productivity over the long term by reducing entrepreneurial activity and are far more growth retarding than the same amount of taxes on consumption. High tax Scandinavian countries that do well spread taxation more broadly to lower income workers through sales and value added taxes, and better match taxes to the beneficiaries of government provided insurance, and they have lower tax rates for corporations and investors to raise investment incentives.
To incentivize risk taking we must pay lucky risk takers well because the probability of failure is so great. There are great benefits to society from unequal distribution of income. A country’s level of income inequality has a significant positive relationship to subsequent economic growth, but only in countries where this wealth is not politically favored. Political favor to entrenched wealth is a terrible impediment to innovation and productivity growth because it cripples competition. Unequal distribution of income has critical motivational effects for growth via the risky innovation. Proponents of income redistribution don’t seem to realize that the savings rates and risk profiles of low income earners are hugely different from those of high income earners.
Economic activity is proportional to risk taking. Investments to produce innovations usually don’t work at all, but when they do they can create enormous increases in value and subsequent economic activity. The willingness to take risks is largely a function of wealth, i.e. available equity.
Risk underwriting is as important as funding investment. As a larger share of the U.S. economy is invested rather than consumed, and this investment increasingly funded by risk averse offshore saving, Wall Street’s share of the economy grows proportionally. (Stops on pg. 94).
Risk taking is a function of the amount of capital available to underwrite risk and the willingness to take risk per dollar of equity. The economy contracts when risk willingness recedes.
What drives risk tolerance over the long run? The percentage of income saved increases steadily across all income groups as income rises – from a savings rate of 5% for the bottom quintile of income to more than 40% for the top 5%. In the years leading up to 2008, the bottom 50% of income earners consumed more than 100% of their incomes. The difference in risk tolerance between income groups has a huge impact on the capital available to underwrite risk. The deferred consumption of middle class consumers i.e. their savings, funds mostly risk averse debt – these savers are unwilling typically to underwrite risk. There is plenty of risk averse capital to fund increased investment, but a shortage of risk equity. It is in the unequal distribution of wealth that makes possible the accumulations of capital that funds capital improvements and innovation. The wealthier the economy the more risk it should logically bear.
Proponents of income redistribution argue that we don’t need to encourage U.S. savings because of capital flows into the U.S. from foreign countries. The problem is that offshore savings are risk averse, and innovation and growth are powered by risk tolerant innovators needing equity risk underwriters. Equity investors are much more likely to invest their risk capital in their own country. Risk underwriting is every bit as important as funding investment. More so than ever today because the trade deficit leaves us with so much risk averse short term debt which funds investment only when someone else underwrites the risk.
Redistribution is the raison d’etre of populist liberal politics. The Reagan administration had a profound effect on labor policies and private sector unions by deregulating industries and freeing trade for international competition. Reagan recognized that unions were a significant hindrance to productivity improvements and to the creative destruction necessary for innovation. When Reagan was elected 20% of the private sector work force was unionized and by 2007 this had dropped to 8%.
Chapter 5: What Went Wrong – The Role of Banks and Regulators
The financial crisis was caused by reduced down-payments on residential mortgages which shifted risk from borrowers to lenders.
No serious economist would argue that anyone can systematically outguess the markets, which statement illustrates the folly of believing that regulators can anticipate and prevent market bubbles.
Throughout history increased foreign capital flows, like the inflows from the trade deficit, have systemically increased the chances of economies misallocating resources. Our trade deficits with big inflows of imported capital before the financial crisis led to a misallocation of capital to housing. This, combined with the Democratic leadership’s insistence on reducing credit standards to promote more affordable housing, led to the collapse of the subprime mortgage market, which in turn precipitated the financial crisis. (There’s a hard to understand explanation of CDO’s and FCI’s pg.138-139)
The largest buyer of subprime mortgages was the government through Fannie May and Freddie Mack. The government was clearly to blame for the housing crisis, but has been successful in shifting the blame to others. Access to low cost offshore funds pumped up government spending by loosening the electorate’s control of political incentives and made it easier for lawmakers to promise voters and labor unions retirement benefits that future taxpayers cannot afford. We must recognize the policies that lead to misallocations and make more rational the incentives they distort.
The case for free markets is that government control of markets has always been much worse. If there is no rational model for predicting irrational valuations, we can’t expect our government to successfully protect our financial infrastructure through regulation. Policies that increase the chances of defaults, like the subsidies for sub-prime home mortgages, are very costly. Panicked withdrawals leave banks vulnerable to failure even under economically logical management.
The lesson the crisis teaches is that there is no magic in the market: underlying asset prices cannot be rational relative to some known and agreed model of value since there is no such model. Before the fact it is almost impossible to draw conclusions opposite the market.
Conard maintains that AIG had plenty of capital during the crisis, what it lacked was cash to fund withdrawals. CDS (credit default swaps) allowed banks to offload risk to outside equity investors and have been quite valuable to the economy. The crisis occurred because bankers and regulators failed to recognize that homeowner defaults would trigger a run on the banks despite buffers of bank capital large enough to protect against default related losses. Since misplaced exuberance is unidentifiable until after the fact there is no way to protect our financial infrastructure other than by holding more capital in reserve to underwrite risk. Wishful thinking is the enemy of critical thinking.
Finance exists to pay investors the amount necessary to motivate them to bear risks. Virtually all return comes from underwriting systematic market risk, not from outperforming markets.
Chapter 6: The Role of Short Term Debt and Government Policy
Bankers and regulators failed to see that home owner defaults would trigger a run on banks despite adequate capital buffers. Three main factors caused the bank run; government policy that allowed banks to fund long term loans with short term debt, a large buildup of short term debt, and the 30% drop in real estate prices.
Additional factors increased the likelihood of panic. First, securitization facilitated the growth of no money down mortgages by allowing first tranche investors to, in effect, make the down-payments for homeowners who, with no equity at risk, were much more likely to default. Government policies that encouraged subprime lending increased the magnitude of the defaults and the likelihood of panic. And finally, misunderstanding about the magnitude of credit default swaps and the impact on banks in the event of withdrawals, added to the panic.
Profits from borrowing short and lending long come at the risk of widespread panicked withdrawals. Withdrawals en-mass have rendered banks insolvent throughout history. Failure of banks from temporary withdrawals is not a failure of free markets; it’s a consequence of a logical policy decision.
Leaving short term capital sitting idle causes high unemployment. Increased savings slows growth when savers are unwilling to put their savings at risk but increase growth when they are. The economic gains from borrowing short and lending long come at the risk of widespread panicked withdrawals which can render the economy’s financial infrastructure insolvent. For banks to hold idle buffers of long term capital large enough to fund panicked withdrawals, not just defaults, defeats the goal of putting short term capital to work.
To solve the dilemma of panicked withdrawals policymakers supplement the banks’ capital buffers with implicit and explicit government guarantees of liquidity rather than leaving short term debt sitting idle. There was not a panicked run on U.S. banks in the 79 years between 1929 and the 2008 financial crisis. Government is the only entity large enough to provide credible guarantees without idling massive amounts of equity.
The financial crisis shows that the value of government guarantees is enormous and the cost of those guarantees low because government doesn’t have to set aside massive equity reserves to make the guarantees credible. The cost to the government of the guarantees is low because the panic is only temporary. The bigger problem is the long-term cost of moral hazard. Distortions caused by moral hazard increase the likelihood of defaults that trigger panics. The problem with offering insurance is pricing it properly. To reduce the risk of moral hazard, the government, when acting as insurer, must charge the insured for the true cost of the guarantee – more for higher risk and less for lower risk portfolios.
Regional banks still look like traditional banks. Retail deposits, much of which the FDIC explicitly guarantees, supply 80% of their capital. Large money center banks’ capital comes mostly from uninsured institutional funds and they are the vehicles that invest implicitly insured short term funds. These are the debt holders that panic and run en -mass with great speed.
The repo market has become one of the largest financial markets. The government’s campaign to increase subprime home ownership played a major role in the crisis. Only the government is large enough to create momentum investing in a market as large as the mortgage market. Government intervened in the mortgage market on a massive scale. Freddie and Fannie bought 2/3rds of the non-conforming loans in the six years before the crisis. Greenspan, Ruben, and Summers all objected to the growing magnitude of the GSE’s mortgage portfolios. The Bush administration and a group of Republican Senators tried to get reform legislation to limit the GSE’s risky mortgage portfolios, but could not overcome opposition from Democratic Senate advocates of high risk affordable housing. In return for political protection, Fannie and Freddie were forced to placate their Democratic Congressional protectors with an increased commitment to sub-prime lending. During 2002-2005 credit growth was more than twice as high in low income as in middle income neighborhoods all over the country. To illustrate the difference in the growth of subprime lending vs. traditional home mortgages, Hispanic home ownership increased by 47% between 2000 and 2007 while the nation’s home ownership rose only 8%.
The panicked withdrawals during the crisis didn’t stop until the Fed guaranteed virtually all short term debt. The government issued 15-20 trillion of guarantees and bought a trillion and a half in short term paper. Contrary to popular belief CDS’s do not increase or multiply risk; they just transfer it from one investor to another. Exposures taken on by banks with credit derivatives were only 2-6% of exposures from traditional lending. Banks used CDS’s to reduce their credit exposure. Large notional values of outstanding CDS’s are misleading because approximately 90% of that value offsets in hedges of existing positions. Modern banks loan money to one another against collateral passed between banks. If credit defaults or panicked withdrawals threaten one bank, its bankruptcy proceedings may impair other banks’ access to funds and collateral which can cause the flow of loans and collateral through the entire network of banks to freeze up.
Chapter 7: What Comes Next – Preventing another Bank Run
The way to minimize the risk of bank runs without harming the economy by idling short term investment funds is to strengthen government guarantees of liquidity to reduce the risk of withdrawals, while simultaneously taking steps to minimize moral hazard. Government guarantees are much cheaper than the alternatives as long as it can manage moral hazard. This can be done by charging banks an appropriate price for government insurance based on the risks individual banks take, using public markets to price its insurance more accurately, by requiring banks to hold more adequate reserves and by holding banks responsible for the risk they can manage, default risk.
Dodd-Frank’s approach is dangerously misguided – an accident waiting to happen. Reducing the size and interconnectedness of banks will not reduce the threat of panicked withdrawals. Busting up big banks will only reduce our economy’s competiveness. Requiring bigger down payments on home mortgages will reduce the risk of default, as would increasing recourse to home owners. Policymakers know that Dodd-Frank’s increased threats of bankruptcy are impotent and that banks will never hold reserves large enough to forestall bank runs on unguaranteed short term debt, nor are threats to hold banks accountable for withdrawals credible, because the cost of allowing them to fail is astronomic while the cost of saving them is low.
The worst moment for the economy to confiscate profits from unwise risk taking is when panicked withdrawals are melting down our financial infrastructure. Wiping out the equity of banks like Lehman, Bear Stearns and Countrywide during the financial crisis accelerated the withdrawals and consolidated the banks further, which permanently reduced competition, widened bank profit margins and consolidated the financial industry into an even smaller number of banks already too big to fail. It is illogical and irresponsible not to save the banks once they begin to fail from panicked withdrawals.
Dodd-Frank weakens the Fed’s ability to act as lender of last resort and limits its role. Its real threat to banks comes from the increased latitude it gives politicians to hinder the Fed’s ability to act swiftly in a crisis by politicizing its response. Dodd-Frank facilities political interference, which increases the potential damage to the economy from withdrawals. The cost of withdrawals and insolvency are enormous and the cost of avoidance is near zero, so the government should go to extraordinary lengths to stop panicked withdrawals and minimize the damage. The economy can’t reach full employment without putting risk averse short term funds to work and to do this efficiently we need to mitigate the risk of withdrawals. The proper pricing of risk encourages banks to underwrite the risk in the most optimal ways rather than hamstringing them with ill-advised regulations. To force banks to continue to fund default prone subprime mortgages increases the risk of defaults and bank runs and is costly to the economy. Restricting banks to long only positions substantially increases withdrawals in the event of a panic so we need to avoid restrictions on derivative trading by banks. Restrictions that limit short selling lead to the over pricing of financial assets.
The way to increase prosperity is to reduce the risk of withdrawals without idling equity needed to underwrite risk taking. The cost of government guarantees large enough to mitigate the risk of withdrawals is near zero if regulation properly manages the risk of moral hazard. No other option provides these valuable economics. To work, the guarantees must be credible which requires capacity to fund withdrawals and assurance that lawmakers will use the capacity effectively. Increasing the threat of damaging withdrawals by politicizing opposition to bailouts reduces the reliability of guarantees.
Chapter 8: Reducing Unemployment
Investment that produces innovation, not investment to increase production for consumption, grows the U.S. economy. In economies open to trade and operating under flexible exchange rates near full capacity, fiscal expansion leads to no significant output gains.
Theoretically the government could make investments in innovation that accelerate the economy, but historically the political investment process has been entirely the opposite. With absurd levels of confidence, politicians undertake massive endeavors with little or no experimentation, and political undertakings do not compete against real world alternatives. There is normally no reliable definition of success or failure for political undertakings. Political power (not economic logic) rules – special interests fight to shape political choices. The political process is a highly inefficient resource allocation process – a way to game our allocations that Darwinian economic survival doesn’t allow.
What is the true likelihood of success from government directed investment? The government is ill-equipped to replace the efficiency of the market even without special interests vying for control of allocations. Lawmakers typically design projects for their ability to attract votes, not for their economic viability. Lawmakers reallocate value rather than creating it. It’s hard to create value – easy to reallocate. Politicians get elected by reallocating income from investors to consumers. Conservative lawmakers cater to the taxed, liberal lawmakers to the untaxed. (stopped on pg.235)
Research indicates that tax increases have a large negative effect on investment and investment is the expenditure with the highest multiplier effect. Government programs that borrow to fund increased consumption, or fund ineffective investment projects, are in the long run tax increases. All the money that government borrows, unless it effectively funds economic growth, represents a future tax increase. Cutting the taxes of rich investors who are willing to take risk and invest their tax cuts is a growth multiplier. Unlike an increase in consumption, increased investment grows the future tax base needed to repay the increased debt. No surprise that the effect of recent fiscal and monetary stimulus on the U.S. economy has been marginal.
We should skim the cream from the rest of the world’s work force and replace the less skillful and less reliable with an unlimited flow of skilled temporary workers. By doing so we will save money on retiree benefits, etc. and save domestic employment by sending unreliable workers home in recessions.
Risky innovation and access to cheap offshore goods and capital will drive growth, and the value of innovation will drive up demand and wages in the local service economy. Rational expectations theory says potential investors will invest more if they see a brighter future and better chances of success for the risk taken. To boost risky investment, lawmakers must do everything possible to bolster their confidence. Our current leadership has done everything possible to discourage optimism among knowledgeable investors about future economic growth. Dodd-Frank increases the risk of damage from bank withdrawals, reduces short selling by restricting proprietary trading (thus increasing systemic risk) and threatens credit default swaps with unspecified rule changes.
Usage of health care is wasteful because it is ungoverned by cost. Health insurance under Obamacare is like going to dinner with friends who agree to split the bill evenly no matter what each orders. With government supplied health care market discipline is lost, because the beneficiaries – retirees and the poor – are not the same voters who pay the costs. Failure to rationalize usage of health care based on the cost of services is the single biggest obstacle to long term economic growth. Obamacare expands coverage without first controlling usage. It’s clever politics but reckless economic policy.
Current Immigration policy increases the likelihood of heavy taxes on successful risk takers by increasing the number of low income voters.
Chapter 9 – Redistributing Income
The rich invest rather than consume most of their income. Their investment creates enormous value for consumers and wage earners. Workers, not investors, capture as wages nearly 70% of the value of investment, as well as the excess value over cost of the products they purchase (buyers’ surplus). Entrepreneurs and inventors capture only a tiny fraction of the value created by their innovations. Conard believes that non-investors capture more than 85% of the value created by investment.
The top 5 percent of income earners pay nearly 50% of all federal income taxes, which reduces the capital available for investment. P.257 Figure 9:1 Shows percentage of taxes paid by income categories.
Each breakthrough innovation is foundational to the advancements that follow.
According to Conard’s calculations, income redistribution by government leaves the middle class much worse off.
Only 20% of wage earners gain mathematically from the redistribution/investment trade off. Of the 28 million adults in poverty, less than 3 million work full time. Two thirds of the 16 million children living in poverty are accounted for by single mothers. Since less than 10% of poor people work full time, it follows that income redistribution and its detrimental effect on investment is harmful to almost everyone who does.
Small increases in the supply of talented risk takers would produce significant increases in GDP. The top 1% of income earners produce about a fifth of U.S. gross domestic income. The top 10% produces almost half. The contribution of talented risk takers is critical to growing the prosperity of the world and for a growing middle class. Given the vast quantity of underutilized talent, the economy is capable of enormous growth in productivity and wages if it can motivate this talent. Outsized pay plays a critical role in increasing the supply of talented risk takers.
In addition to reducing investment, and the motivation that drives it, redistribution of income by government uncouples the full cost of labor from its market price. Detroit illustrates the long term effects of such a misallocation. Ultimately, it doesn’t matter whether labor achieves unsustainable pay through monopolistic labor union bargaining or whether politicians are elected that force taxpayers to provide government benefits in excess of workers’ taxes. The misallocation diverts resources from more productive to less productive endeavors. Investment declines and growth slows. We will not be as prosperous in the long run if we load taxes on lucky risk takers to provide the same benefits to all regardless of their economic contributions. Providing government services somewhat proportional to each person’s economic contribution is critical to the country’s long term success. Innovation and investment, especially innovation in the United States, is the only thing that has gradually pulled the World out of poverty.
Divorcing morality from economics hurts the poor. International perspective reveals the problem of divorcing morality from economics. Large cross-country samples provide no evidence that pro poor policies (through redistribution) raise the share of income of the poorest quintile. Evidence overwhelmingly demonstrates that aid in Africa has made the poor poorer and growth slower. US poverty programs have contributed to a greater number of children being born out of wedlock. Teenage pregnancy exploded in the 1960’s as welfare for unwed mothers was increased.
Is increased consumption at the expense of decreased investment worth more to society or less? All that matters is the direction of the trade-off at the margin. The strategic question is, with politicians directing more than 40% of the economy’s resources, are we better off letting politicians control more or less of those resources?
The political allocation process is not economically rational. Large numbers of voting consumers are arrayed against a very small number of investors. Numerous political factions demand increased consumption no matter the trade off in lost investment, innovation, and economic growth. These include special interest groups like municipal labor unions and a multiplicity of groups and corporations seeking special favors and subsidies, all of which work against logical outcomes from private markets. Proponents of redistribution have no perspective about where more redistribution becomes suboptimal and fail to realize that consumers and wage earners capture almost all of the value of investment. They are oblivious to the enormous disparity between the effectiveness of resource allocation through the private market versus the political allocation process. They take it as a given that large political interventions will work as planned.
We should do everything in our power, both with money and moral suasion, to recruit more investors and talented workers to take the risk and responsibility necessary to create more innovation.
What burdens future generations is government induced consumption whose increase comes at the expense of reduced investment. The reduction in investment and risk taking slows growth and diminishes the future for our children. Cutting back government induced consumption is one of the best steps we can take. All that matters is the incremental dollar of spending at the margin. Does an additional dollar of government spending and higher taxes, on either the rich or the middle class, benefit the middle class more than a dollar of spending cuts and lower taxes? Fiscal and monetary stimuli have only a temporary effect on the economy and small at that. The long term cost of the stimulus is greater than its short lived benefit. Unless we tax the middle class to pay for the increased spending, the resulting reduction in investment and risk taking costs far more than the benefit.
The U.S economy was on fire prior to the financial crisis. U.S. employment grew from a hundred million to a hundred and forty million between the 1980’s and 2007. Europe and Japan stagnated while U.S. growth pulled tens of millions of immigrants into the U.S. work force, many, young Hispanics without high school education and poor English skills. Median incomes increased substantially within every demographic of the work force but shifting demographics disguises this growth in median income. The U.S. also put tens of millions of offshore workers to work on our behalf. No other high wage economy has done more for the poor.
The U.S. put more investment into innovation than the rest of the world combined. Intangible business investment rose from about 7.5% of non-farm output in the mid 1970’s to 15% today. U.S. productivity soared as a result, while Europe’s and Japan’s stagnated. American standard of living rose relative to that of Europe and Japan despite a work force with lower academic test scores. American know-how and risk taking created many hugely successful businesses based on new technologies, the rest of the world next to nothing.
The U.S. would’ve grown faster had it not been for a shortage of talent. In the 1980’s, less than 25% of jobs were the most technical jobs at the top of the wage scale, but 50% of the 40 million jobs created since then were high skill jobs. The pay of talented innovators grew faster than the rest of the economy because of a growing universe of valuable investment opportunities, much of which went unrealized for want of supply of talent. The top 1% of workers is paid relatively more in the U.S. because they contribute far more to value creation than their counterparts in other counties. The shortage of talent exists because large numbers of college graduates refuse to take the risk and responsibility needed to bring unrealized investment opportunities to market. The rising price for successful business talent represents the incremental cost of motivating reluctant talent.
Companies like Google, Apple, Intel, Cisco, and Microsoft provide critical training that other economies cannot duplicate. The resulting accumulation of equity underwrites more risk taking. High payoffs for lucky innovators motivate others to duplicate their efforts. Rather than bemoaning the disparity in U.S. wages, we should recognize both their value and their necessity.
The trade deficit contributed to growth by eliminating capacity constraints. When we were running near full capacity we moved low wage value manufacturing offshore to cheaper labor and reemployed our high skilled workforce to innovation, and both our skilled and unskilled workers to relatively more valuable domestic services, jobs offshore companies can’t easily fill. These cheap imports freed our economy for increased investment which grew the economy.
Increased investment grew household assets faster than debt. Growths in the trade deficit, in household debt, and in assets are the mathematical outcome of the increased business investment in a capacity constrained economy. To maximize our growth relative to rest of the world we must continue to put the world’s unskilled labor and unused capital to work on our behalf. Making products for $17 an hour labor cost that we could have purchased for 75 cents an hour reduces U.S competiveness by wasting resources that could have been better used elsewhere. In a world full of unskilled labor we will not succeed by returning to the manufacturing based strategy that succeeded in the 1950’s. Competitive manufacturing in high wage economies requires so much automation it doesn’t employ many workers.
To avoid high unemployment we must put the world’s risk averse savings to work improving productivity, which requires pouring investment into innovation. As long as the return is greater than the cost of capital, we can continue to do so forever. For two decades innovation has proven so valuable it pulled 20 million immigrants into the U.S. workforce and put increasing distance between America and other high wage economies, all without reducing the unskilled wage rate despite a world awash in unskilled labor.
Innovation and the Internet have given the U.S. a unique window of opportunity to distance itself from the rest of the world. Uniquely American innovation will not succeed if we reduce the payoffs for successful risk taking. Rapidly changing U.S. demographics will make it harder and harder to pursue an investment based strategy. A demographic tsunami of retirees and voting age children of poor immigrants will soon wash over the United States demanding increased consumption through redistribution. The majority of voters already resent the rising return from successful risk taking and demand more income redistribution through stimulus spending, healthcare reform, and continued growth of government spending.
To recover quickly, we must increase risk taking per dollar of equity. It is a poor trade off to suffer permanently high unemployment to avoid periodic high unemployment during recessions.
Temporary withdrawals on the scale of 1929 and 2008 bankrupt the entire financial infrastructure. Letting the fire burn for the sake of market discipline destroys enormous value, especially given the relatively low cost of putting it out. Misguided housing policy exacerbated the risk of subprime defaults and triggered the bank run. Instead of reining in subprime lending, lawmakers demanded it and led Fannie Mae and Freddie Mac to raise low cost government guaranteed debt from offshore lenders to buy mortgage debt. Competition with government subsidized GSEs made it nearly impossible for banks to fund low risk conventional mortgages. Nowhere else in the world were subprime mortgages a substantial share of real estate loans.
Banks and regulators failed to see that defaults on subprime mortgages could trigger withdrawals large enough to cause bank runs despite capital buffers large enough to cover losses. The difficulty of foreseeing economic crises is confirmed by the fact that no serious economist believes asset prices are predictable beyond the price reflected by the market’s consensus. The Financial Crises was a by-product of logical economic policy that puts risk averse savings to work to maximize employment. The crisis revealed the enormous risk of damage from withdrawals and the impotence of implicit government guarantees to hold withdrawals in check. Prior to the crisis nobody considered the risk. Now risk averse short term savings sit unused which has contracted the economy. Risk averse investors won’t bare risk at nearly any price.
Financial crises stem from shocks that affect the entire economy, not just a select number of financial institutions. Limiting the size of banks will only reduce U.S. competiveness. To put short term savings back to work lawmakers must reduce the risk of damage from withdrawals, which means they need to strengthen government guarantees of liquidity and the Fed’s ability to act in a crisis to stem withdrawals by reducing the increased risk of misguided political interference made even more likely by Dodd-Frank. To reduce the increased risk of moral hazard, regulators need to charge banks for the government guarantees, with the charge based on the risk banks take. They need to increase visibility into the risks banks take so that markets can price that risk more accurately. They need to allow, rather than restrict, banks to take both long and short positions when pricing risk, and to increase capital adequacy reserves. We could encourage the use of credit default swaps to underwrite default risk, but not liquidity risk.
Proponents of subprime mortgages have successfully deflected blame for the crisis to banks, regulators, etc. Misled voters will never demand logical improvements that strengthen the recovery. Things that could be done to improve the economy are: more thoughtful immigration and trade policies, lower corporate tax rates, cut back on regulations, particularly Dodd – Frank and Obamacare, reduce unrealistic projections for long term entitlement promises like Social Security and Medicare, reduce fiscal stimulus, negotiate structural improvements in long-term spending – particularly reductions in runaway municipal union retirement benefits, and in health care usage ungoverned by cost. The Obama administration and the Democratic Party used its filibuster proof majority to do nearly the opposite of each of these at every turn. Commerce is the salvation of the poor, not charity. Successful risk takers put people to work, not government hand-outs. You’re either for investment and risk taking as a solution for what ails the economy or you’re against it. The real world offers no middle ground.
This summary largely consists of direct quotations from the book, (often without identifying them as such by quotation marks), and often shortened, paraphrased or otherwise changed.
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Copyright @ 2012 by Edward Conard
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