Confusion about the New Deal

Steven Colbert interviews Jonathan Chait of the New Republic about the New Deal:

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People tend to talk about the "New Deal" as if it were one policy, when in reality it was a hodgepodge policies, regulations, and spending - some of which worked, some of which didn't. Many of the regulations did create serious market distortions, which impeded recovery, as Harold Cole and Lee Ohanian note:

"The most damaging policies were those at the heart of the recovery plan, including The National Industrial Recovery Act (NIRA), which tossed aside the nation's antitrust acts and permitted industries to collusively raise prices provided that they shared their newfound monopoly rents with workers by substantially raising wages well above underlying productivity growth. The NIRA covered over 500 industries, ranging from autos and steel, to ladies hosiery and poultry production. Each industry created a code of "fair competition" which spelled out what producers could and could not do, and which were designed to eliminate "excessive competition" that FDR believed to be the source of the Depression.

These codes distorted the economy by artificially raising wages and prices, restricting output, and reducing productive capacity by placing quotas on industry investment in new plants and equipment. Following government approval of each industry code, industry prices and wages increased substantially, while prices and wages in sectors that weren't covered by the NIRA, such as agriculture, did not. We have calculated that manufacturing wages were as much as 25% above the level that would have prevailed without the New Deal. And while the artificially high wages created by the NIRA benefited the few that were fortunate to have a job in those industries, they significantly depressed production and employment, as the growth in wage costs far exceeded productivity growth."

Further, economist Robert Higgs provides evidence that the uncertainty created by the Roosevelt administration spooked businessmen, stifling investment.

Of course, that's not what the commentators in the clip are harping on. Their concern is the spending in the new stimulus plan; and on that, they have things mixed up. Both George Will and Sean Hannity are shown arguing that it was World War II, not the New Deal, that brought us out of the Depression. But how could a war bring the country out of the Depression? Through large-scale expansion of government spending! Bruce Bartlett explains:

"The [Great Depression] didn't really end until both monetary and fiscal policy became expansive with the onset of World War II. At that point, no one worried any more about budget deficits, and the Fed pegged interest rates to ensure that they stayed low, increasing the money supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly ended. As a consequence, economists concluded that an expansive monetary and fiscal policy, which had been advocated by economist John Maynard Keynes throughout the 1930s, was the key to getting out of a depression."

So if you're arguing against the stimulus, you don't want to say that the War got us out of the Depression; if you do, you'll kind of undermine your entire argument.

An ode to Paul Krugman

I just started a new job, so I haven't had a lot of time to post. But this definitely caught my attention:

For what it's worth, I think Tim Geithner is a very nice looking man.

Conservatives have a lot of Galt

John Galt, that is.

As Stephen Colbert explains, wealthy Americans are turning to Ayn Rand's "Atlas Shrugged" in response to the Obama administration's recent taxation and spending plans:

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Galt's character, disgusted by a government that heavily taxes the wealth producers in society only to waste their money on "moochers", calls for a general strike on behalf of the rich and talented.

Of course, it's tempting to draw comparisons to today. Barack "spread the wealth around" Obama is planning on increasing marginal tax rates on the wealthiest 2% in order to fund more generous social welfare programs and public goods.

But will this plan lead us to a Galtian world where the rich go on strike? In a word: no. Labor economists look at a measure known as the "labor supply elasticity of income", which is simply how much more people are willing to work if their income goes up (and conversely, how much less people are willing to work if their income goes down). The argument espoused by Michelle Malkin, Sean Hannity and other conservative pundits shown in the Colbert clip, is that this elasticity is high - if you increase taxes on the rich, they will decrease their labor by a lot, which will hurt us all. If high wage workers deprive the economy of their labor, then who will create wealth?

Empirically, this case is tenuous. For example, economist Robert Frank cites work by Fran Blau and Larry Kahn, who find that:

"the labor supply curve for men has been essentially vertical [which means a low elasticity] for many decades. The clear implication is that higher taxes on top earners, most of whom are men, will not significantly reduce work effort."

Similarly, Bruce Kaufman and Julie Hotchkiss, in their widely read text book The Economics of Labor Markets, survey the research and conclude that changes in tax rates during the 1980s did not cause large changes in labor supply, despite the theoretical evidence that it might.

Rand's novel is something of a libertarian version of The Communist Manifesto. The idea that high-wage workers will withdraw from society and form their own utopia is no less fanciful than the idea that low-wage workers will unite and create a socialist paradise.

Further, Atlas Shrugged may not be the best metaphor for our current situation. The popping of a $6-trillion housing bubble showed us that a great deal of wealth "created" by the John Galts on Wall Street was nothing more than an illusion. When financial assets were over-valued, so were the value of people who produce those products.

Ultimately, the lesson here should be one of humility. Consider what Will Wilkinson takes from the book:

"In the individual case, “going Galt” smacks of a kind self-aggrandizement in the same way that climate smuggery does. Because, really, your marginal contribution doesn’t matter that much...

By the way, Atlas buffs, the point of Atlas Shrugged is not that you are John Galt. The point is that you are not John Galt. The point is that you are, at your best, Eddie Willers. You’re smart, hardworking, productive, and true. But you’re no creative genius and you take innovation — John Galt — for granted. You don’t even know who he is! And this eventually leaves you weeping on abandoned train tracks."

Then again, if Michelle Malkin and Sean Hannity go on strike, you won't hear me complaining.

Michelle Obama's got two tickets to the gun show

Sometimes it's hard to believe how asinine the news media really is. Take the recent kerfuffle over Michelle Obama's affinity for sleeveless tops, which brandish her pythons, "Lady" and "Liberty" (those may not be their actual names).

Fortunately Kristen Schaal is there to guide us through these heady times:

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Are there more important things to talk about? You bet. But there's also the danger of reducing a strong female public figure into a department store mannequin. Then again, the media was never good with issues of gender... or race, or economics, or well, you get the point.

Stuck in the middle

Harold Mayerson is a Washington Post columnist and an actual, real-live socialist. Russ Roberts is a George Mason University economist and an actual, real-live libertarian. These two recently took part in a discussion on the use and abuse of the term "socialist" in politics today (here's the Windows Media Player file and here's the Real Player file).

Many interesting points come out of this talk, but here's the takeaway:

• Despite all the talk about socialism, the Obama administration is committed to private ownership of industry (see their resistance to nationalizing/re-privatizing the banks)
• Despite all the talk about free markets, George W. Bush was not a libertarian (see his steel tariffs, budget expansion, Medicare Part D, No Child Left Behind, etc)

Other democracies around the world support multitudes of parties (Israel, a country of 5 million people has 12 different parties currently represented in the Knesset. Another 21 ran but didn't meet the electoral threshold). This often means that a wide range of opinions are represented in government. Most European countries have socialist (and even communist) parties in governing coalitions. By contrast, American politics is mostly about the center right vs. the center left. Real socialist ideas, like government ownership of major industries, are not really on the table; neither, for that matter are real libertarian ideas, like privatizing schools.

For better or for worse, our politics is stuck in the middle. If you want real socialists (or real libertarians) in the mainstream, go somewhere else.

What does the income distribution really look like?

This great animation shows what it looks like to earn $100,000,000 - as opposed to, say $45,000 per year, which is the median US income:



It's from the election season and it's biased toward the Democrats. But when we talk about increasing taxes on the richest 1%, it's hard to wrap you head around some of the income figures being thrown around. This is what they would look like in 3 dimensions.

Who are you calling Socialist?

If I didn't watch Fox News, I'd have no idea that we were in the midst of an American-version of the Russian Revolution. Didn't you hear? The new administration is looking to turn our country into a worker's paradise! As Mike Huckabee lamented to the Conservative Political Action Conference, “Lenin and Stalin would love this stuff.”

In the interest of fairness, moderate conservative David Brooks gave the Obama administration space to respond to these accusations. Here's Brooks' recap of what they said:

"In the first place, they do not see themselves as a group of liberal crusaders. They see themselves as pragmatists who inherited a government and an economy that have been thrown out of whack. They’re not engaged in an ideological project to overturn the Reagan Revolution, a fight that was over long ago. They’re trying to restore balance: nurture an economy so that productivity gains are shared by the middle class and correct the irresponsible habits that developed during the Bush era.

The budget, they continue, isn’t some grand transformation of America. It raises taxes on energy and offsets them with tax cuts for the middle class. It raises taxes on the rich to a level slightly above where they were in the Clinton years and then uses the money as a down payment on health care reform. That’s what the budget does. It’s not the Russian Revolution.

Second, they argue, the Obama administration will not usher in an era of big government. Federal spending over the last generation has been about 20 percent of G.D.P. This year, it has surged to about 27 percent. But they aim to bring spending down to 22 percent of G.D.P. in a few years. And most of the increase, they insist, is caused by the aging of the population and the rise of mandatory entitlement spending. It’s not caused by big increases in the welfare state."

I think it's time for conservatives to take a deep breath. Whether or not you like the Obama economic agenda, this is hardly a revolution. If the budget projections are correct, we'll soon be back to levels of government spending, budget deficits and marginal tax rates in line with the past 30 years.

Of course, there has been a lot of hand-wringing over the plan to raise the top marginal tax rate. But people forget that as recently as the Reagan presidency, the top marginal rate was 50%, 10 percentage points higher than what Obama is proposing. We've come a long way on taxes, baby.

What can you buy at a 99 cent store?

Stock, apparently:

"Citigroup shares dip below $1"

Did math fail us?

By and large, mainstream economists didn't expect the events of the past 6 months. Many missed the housing bubble; many thought the losses would be contained. In diagnosing this failure, some have focused on the role of "simplistic" or "unrealistic" mathematical models used by economists and financiers to understand how markets work. This month's issue of Wired Magazine, for example, talks about David Li's "Gaussian Copula" function, ominously described as "The Formula That Killed Wall Street":

"His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."

But was it really the math that let us down? While there are many reasons to doubt the usefulness of the Gaussian Copla, the real failing was one of implementation. After all, math--as used in economics--is just a tool, to be used or misused as people see fit.

Mario Livio, the noted astrophysicist and author of "Is G-d a Mathematician?", argues that while not everything in economics can be successfully modeled with math, there is no reason to stop using it altogether:

"One major reason for the difficulty in making predictions in economics is the fact that many variables of the world of economics — the psychology of the masses, to name one — do not naturally lend themselves to quantitative analysis. Consequently, some crucial aspects cannot be, at least at present, adequately represented in any model.

A second problem arises from the fact that the predictive value of any theory relies on the constancy of the underlying relationships among the different variables. In other words, one needs some assurance that under repeated, completely specified states of, say, consumers, employers, banks, trade unions and so on, the same probability for a given outcome is guaranteed to follow. In the absence of such guarantees, as one critic of mathematical economics has put it, "resembling a science is different from being a science."

Does this mean that we should give up on mathematical economics? In my very humble opinion, absolutely not. Recall that physics, also, was not considered mathematical in Aristotle's time. Yet physics advanced to the point where mathematics is at its very core. The fact that at the moment success in economic forecasts is limited should not impede research in mathematical economics any more than the failure to predict the precise number of spots on the skin of a person with measles should limit medical research into vaccines."

Mathematical models provide useful abstractions that help isolate the effect of specific variables. These models can help clarify our thinking about economic phenomena and provides the field with a consistent vocabulary for debating important questions.

The real story, suggested toward the end of the Wired article, is that when we have a lack of respect for what the models can and can't tell us--when we confuse the model with reality--the whole thing can blow up in our faces.

And that's why they call them "marginal" tax rates

Media Matters highlights a baffling bit of nonsense in an ABC News report on Obama's plan to raise taxes on individuals making over $250,000:

"According to ABC, one attorney "plans to cut back on her business to get her annual income under the quarter million mark should the Obama tax plan be passed by Congress and become law." According to the attorney: "We are going to try to figure out how to make our income $249,999.00." ABC also quotes a dentist who is trying to figure out how to reduce her income.

This is stunningly wrong.

The ABC article is based on the premise that an individual's entire income is taxed at the same rate. If that were the case, it would be possible for a family earning $249,999 to have a higher after-tax income than a family earning $255,000, because the family earning $249,999 would pay a lower tax rate.

But that isn't actually how income tax works.

In reality, a family earning $255,000 will pay the higher tax rate only on its last $5,001 in income; the first $249,999 will continue to be taxed at the old rate. So intentionally lowering your income from $255,000 to $249,999 is counter-productive; it will result in a lower after-tax income.

The people ABC quoted don't seem to understand that. Worse, ABC doesn't seem to understand it, either."

According to standard economic theory (in fact, it's principle #3), people make decisions at the margins. So if the marginal income tax rate goes up for income above $250,000, I might decide that it's not worth it for me to work an extra hour if my wage for that hour is taxed beyond a certain point. But if all the other marginal rates stay the same, why would I try to bring my income down below the threshold?

I think the real question is how people this dumb can make $250,000 per year?

(HT: Paul Krugman)

Keynesian questioning of the stimulus

Arnold Kling has a terrific essay on the stimulus bill. The essay provides background on the different traditions in macroeconomics (Classical, Keynesian, Monetarist) and how they view the current crisis. He also gives some reasons why Keynesians themselves might not like the stimulus bill as is:

"Another group of skeptics is concerned about the timing of the fiscal stimulus. Even some economists on the left, including Alice Rivlin and Jeffrey Sachs, have made the point that the long-term spending in the stimulus bill is inappropriate and even counterproductive from a stimulus perspective. I share this concern. President Obama said that his goal is to have 75 percent of the stimulus take effect before the end of 2010. Instead, I would argue that we should have 100 percent take effect by then, and 75 percent take effect by the end of 2009...

Textbook Keynesian economics says that a spending increase will stimulate more powerfully than a tax cut, because part of a tax cut will be saved rather than spent. However, this same textbook analysis says that a stimulus now is more powerful than a stimulus that kicks in two years from now. Even though the multiplier for a spending increase may be higher than that for a tax cut that is enacted at the same time, we can be certain that the “multiplier” for a tax cut in 2009 is greater than the multiplier for a spending increase in 2011."

There's an old joke about how using government spending to stimulate the economy is like notifying the Fire Department of a fire via the mail. It's really hard to spend that much money that quickly and it's even harder to spend it well. Kling notes that there are other ways to do fiscal stimulus beyond digging ditches:

"A traditional stimulus proposal, going back to the 1960s, is a temporary investment tax credit. With such a credit, the government in effect provides matching funds for firms that undertake investment while the tax credit is in effect (say, through March of 2010). This would lead to spending increases that are a multiple of what the government contributes.

Another proposal, which George Mason University’s Bryan Caplan has suggested, is a cut in the employer portion of the payroll tax. The extra kicker here is that it reduces the employer’s cost of labor, thereby stimulating hiring. I think an additional kicker is that this would restore profitability in the nonfinancial sector, helping to boost investment."

I personally agree with the need for government provided fiscal stimulus. I think many parts of the stimulus bill are good and worthwhile--unlike Louisiana governor Bobby Jindal, I think that volcano monitoring is a legitimate government function. But if more stimulus is needed--and many people think that it will be--something like Caplan's payroll tax cut is worth trying. The payroll tax is a 13% tax shared by employers and employees. If you cut the employer portion, you make firms more profitable and encourage hiring by making labor less expensive; if you cut the employee portion, you have substantial a tax cut on a regressive tax paid by all working Americans, no matter how poor. If you cut both, you can support employment and consumer spending.

Where I disagree with Kling is on his dislike for aid to state and local governments. While he is right to argue that the private sector has seen much more layoffs than the public sector, I don't think that means that money spent on the public sector is wasted. First, aid to state and local governments will prevent layoffs, and jobs saved are good no matter what sector they're in; and second, the aid will help support Medicaid, food stamps and other programs for the poor.

Gluttonous Americans?

Paul Krugman has an interesting column today looking at the roots of the financial crisis.

The simple story is that people borrowed too much: to buy big houses, fancy electronics and other entrapments of the American dream. But why would people all of a sudden start borrowing so much? The answer is a global savings glut:

"In the mid-1990s... the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

The result was a world awash in cheap money, looking for somewhere to go."

Currency crises like the one in Asia are frightening experiences, and governments who have gone through them are concerned about having enough cash on hand in case something goes wrong. So these East Asian countries took the money they earned by selling exports and amassed it in case of a rainy day. But, of course, that money had to go somewhere, so it went into the US and other economies and fueled an era of cheap borrowing.

This is not a wholly unique story. In the 1970s, oil exporting countries were awash with cash as the price of oil spiked. That money had to go somewhere and it ended up going to projects in Latin American, which helped cause their debt crisis in the 1980s.

The simple answer for our current predicament is that American consumerism compelled people to borrow more. But something real had to happen in order to set this off, like lots of cheap cash flowing into the country.

Is Robert Shiller writing for 30 Rock?

In his new book Animal Spirits, Yale economist and noted behavioral finance expert Robert Shiller looks at the role of human psychology in driving financial markets. Clearly someone at "30 Rock" has read his work:

This is a terrific episode that takes a satirical look at how a financial panic can spread--in this case, by the semi-literate, profoundly crazy character Tracy Jordan.

I recently attended a panel discussion with Shiller at the New School for Social Research, which focused on the current crisis and the degree to which markets became "irrational". Shiller has been challenging the efficiency of financial markets for most of his career, and is likely to gain more prominence in the coming years.

For a non-fictional (but still entertaining) account of the current financial crisis, check out this PBS Frontline documentary posted at Freakonomics.