Category: Economics

Irrational gloom, or Alex cheers me up

Alex remains worried about our future, but let us look more closely at his concerns. His biggest fear is our future demographic structure:

…the Bush policies are not the major problem. The major problem is that we are about to be hit by a tidal wave of old people (contra Tyler demographics are the problem not the solution).

Hey, I hope to be part of that wave, the problem will be if I am not!

Let’s redo Alex’s doctor example. In my version, the doctor suddenly tells Alex that he will live to the ripe old age of two hundred, most of those years in reasonable health. This is reason to celebrate, even though Alex would have to restructure his retirement plans. Something like this, albeit in less extreme form, is going on in America: a large baby boom cohort can be expected to live to older ages. Bravo, I say. Count up those extra years, including the implicit value of leisure, at their full economic value, and our “intergenerational accounts” will look much better. Note also that the elderly have a higher quality of life than ever before, for reasons ranging from cheap eye surgery to bypass operations to new drugs.

Two other issues:

First, contrary to what Alex suggests, “g>r” would solve the problem. Growing debt, which is a transfer, doesn’t change the fact that the intertemporal budget constraint has melted away, provided we can shift real resources into the present (if you’re not an economics nerd, the point would take too long to explain in non-technical language, read the link if you must).

Second, I am not convinced that Alex has put his money where his mouth is. He is conspicuously silent about whether he has gone short in bonds. Plus I bet he would have taken a tenured professorship, bought a house, and bought an internationally diversified portfolio anyway, I certainly did all of these and I am an optimist.

The bottom line? A growing population, combined with a bulge of old people, requires planning wisdom and creates some costly expenditure pressures. But overall longer lives are cause for rejoicing, not our economic doom. Love and time are what we are ultimately seeking to economize, and longer lives contribute toward both ends.

Rational gloom

Tyler is not as pessimistic as I am (see my earlier posts here and here) regarding our long-term budget problems. Unfortunately, he should be. Consider Tyler’s most gut-level response:

The United States remains a strong and prosperous country. Our infrastructure, national culture of innovation, human capital, and economic dynamism are unparalleled in world history.

Of course. Who would deny this? The problem is that the budget projections of Kotlikoff et al. already take these factors into account. Their projections assume that the economy will continue to grow, they assume that a nuclear weapon will not go off in Washington, they assume that we will not become bogged down at increasing expense in the Middle East for the next 50 years etc.

A doctor tells a man that he has just 6 months to live. The man replies but doctor I’m only 25, I’m in great shape and I’ve never been seriously sick before. Yes, the doctor says that’s why I gave you 6 months.

Tyler’s next comment reveals a misunderstanding. He says, “The Bush fiscal policies, whatever their irresponsibilities, costs, and drawbacks, haven’t changed those core facts.” But the Bush policies are not the major problem. The major problem is that we are about to be hit by a tidal wave of old people (contra Tyler demographics are the problem not the solution). The baby boom generation, born beginning in 1946, will begin to retire in 2008 and as they do so the demands on social security and Medicare are going to explode. By 2030 there will be 18.2 million people in the United States 85 years of age and older! In 2000, the 65 years and older crowd made up 12.4 percent of the population. By 2030 they will be 19.4 percent of the population.

Critically, combine baby boomers with rising life-expectancy and declining fertility and we have that by 2030 there will be only 2 workers per retiree (down from 16.5 workers per retiree in 1950).

Comparing today’s US budget deficit with that of Brazil or any other country misses the point. It’s the present value calculation over the future that is important. Put simply: Kotlikoff is applying Milton Friedman’s permanent income hypothesis to government accounting. (Kotlikoff is to Stone as Friedman is to Keynes).

Tyler’s most technical point, that g may be greater than r, also misses the mark. If g is greater than r then we can continually roll over our debt and eventually grow our way out of it. But this calculation is only relevant for a fixed debt – the problem is that our debt is rising very rapidly. If the debt were to stand still we could pay it but it ain’t standing still.

Tyler challenges me to put my money where my mouth is. In fact, I have. First, I got a job as a tenured professor! Second, I borrowed a lot of money at the lowest interest rate I expect to see in my lifetime and bought housing. The key problem in the future is going to be inflation and rising tax rates so you want to borrow at a fixed rate and put your wealth in hard to tax assets (Tyler, art may be an even better investment! You can always take it with you over the border.) I also own an internationally diversified portfolio (yes, even some in Brazil).

No, I’m not yet stocking up on cans of spam. We could get lucky. Kotlikoff could be wrong. The obvious facts of demography make me think that he is right enough, however, to warrant taking serious actions now rather than later. But like Kotlikoff, I don’t think our political system is ready.

Economic freedom in North America

The Fraser Institute has just put out its Economic Freedom of North America, 2004 report, here is the full and lengthy text, including all the data.

And how do the freedom rankings look? If you look at all sources of government intervention, the winners are:

1. Delaware
2. Colorado
3. Georgia
4. Nevada
5. New Hampshire

Louisiana comes in seventh, Alberta comes in ninth. Here is a short piece on enterprise culture in Alberta, here is a press release on possible declines in economic freedom in Alberta.

The eight biggest losers are all Canadian provinces, with Prince Edward Island as the least free. Here is a bureaucratic report on their current economic situation. Here is a summary of other Canadian results, including a recent upward freedom trend in Canada as a whole.

As for the States, West Virginia comes in last; for the full list go the linked report. If you look only at “sub-national” freedom (state-level regulations but not federal impacts), Colorado moves into first place, most of the other results do not change very much.

Economic freedom and prosperity are strongly correlated (Louisiana is an outlier), although the direction of causality of course can be debated. Here is a link to other Fraser data sources.

Why I am not as pessimistic as Alex

Alex, citing Larry Kotlikoff, despairs for our fiscal future, read his earlier post as well.

I agree with the Krugman-DeLong-A.Sullivan-Tabarrok (if I may call it that) critique of current fiscal policies. But I don’t agree that our government is “bankrupt,” or accept the cited claim by Kotlikoff that “our country is in worse long-term fiscal shape than Brazil.” Neither is close to being true, check out Brazil’s BB bond rating for a start.

What is the real cost of our fiscal irresponsibility? First, we could be using current resources more effectively. But productivity trends have been strongly positive for some time now. So while things could and should be better, current magnitudes are not themselves evidence of disaster.

Second, when the time comes to pay off the debts, we will require some combination of inflation, spending cuts, and tax increases. Since most of the debt is short-term, inflation won’t do it. The real problem has to be taxes. Spending cuts Alex probably favors, at least I get that feeling reading the guy’s blog. The danger is that we will end up with Western European levels of taxation, stifling our entrepreneurial culture.

So the real cost of our current fiscal irresponsibility is the increase in deadweight loss, resulting from the required increase in taxation, as will be needed to pay off all those trillions. The real cost is not equal to the number of trillions that need to be paid back. And most of the associated transfers are within a generation (tax some living people to pay off bondholders, other living people at the time), rather than across the generations. Let’s not confuse the size of the deficit, or the debt, with the size of the intergenerational transfer.

Keep two other things in mind as well. First, there is some chance that the growth rate of the economy will exceed the real rate of interest. In that case we can simply grow out of our debt, which over time will become small relative to the size of the economy. It is irresponsible for a government to take the risk of spending on this basis. Nonetheless it is at least possible that, in technical parlance, “g > r”.

Second, America will likely experience favorable demographics. Here is Nicholas Eberstadt:

…the United States is envisioned to grow from 285 million in 2000 to 358 million in 2025. In absolute terms, this would be by far the greatest increase projected for any industrialized society; in relative terms, this projected 26 percent increment would almost exactly match the proportional growth of the Asia/Eurasia region as a whole. Under these trajectories, the United States would remain the world’s third most populous country in 2025, and by the early 2020s, the U.S. population growth rate – a projected 0.7 percent per year – would in this scenario actually be higher than that of Indonesia, Thailand, or virtually any country in East Asia, China included.

No, that won’t solve the problem but it is a help.

I should note that Alex and I probably do not disagree about the economics of the matter (if we do, you will hear from him soon enough). But I think he is neglecting the importance of the following:

The United States remains a strong and prosperous country. Our infrastructure, national culture of innovation, human capital, and economic dynamism are unparalelled in world history. The Bush fiscal policies, whatever their irresponsibilities, costs, and drawbacks, haven’t changed those core facts.

So I walked down to Alex’s office and issued him the following challenge: if you think I am wrong, sell all your stocks and go short on U.S. Treasury securities (and long on Brazil, if you wish!). With all the money you will make, you can buy out my half of this blog.

A Rose by Any Other Name?

Years ago, the possibility of adopting a 28% “flat” tax on income (generally no deductions allowed) was seen as the solution for fixing the complex tax system. Today, there is outcry over a tax calculation that preserves a preferential 15% tax rate for dividends and capital gains, allows deductions for home interest and charitable contributions, but generally taxes income at 28%. A modified version of the flat tax? No, it’s called the AMT.

That is Kenneth Barkoff’s letter in the March 8 issue of Business Week, Barkoff is a tax specialist.

Some people complaining about the Alternative Minimum Tax may be objecting to its unfairness, as not everyone falls under its rubric. People with high deductions, as might arise from a second home, are the most likely victims. Other objections cite the height of the rate. Yet other critics may not like the process through which the AMT became so binding, namely the so-called Bush tax cuts, which made more people eligible for AMT status.

Gary Becker’s analysis suggests that a flat tax, if it is efficient, also will make government larger in size. Efficient taxation will make it easier to afford large government.

My take: I’ve never understood the conservative/right-wing obsession with flat taxation. I don’t favor arbitrary taxation per se, but we already have something resembling a flat tax right under our noses, and no one is very happy with it.

Buy one get one free

Washington Post consumer columnist Margaret Webb Pressler writes:

I also got a huge response about the growing use of buy-one-get-one-free promotions, or BOGOs, as they’re called in the industry….Shoppers don’t understand why retailers offer this kind of promotion when it’s no better for customers and no more profitable for stores than a half-price sale.

On the contrary, BOGOs can be much more profitable for stores than a half-price sale. To see why, assume that you value your first pizza of the night at $15.01 and the second at $5.01 and let’s say it costs the store $2 to make each pizza. If the pizza store has a buy-one-get-one-free offer at $20 then you will buy two pizzas and the store will have profits of $16 ($20-$2-$2). But if the store sells pizzas for half price, $10 each, you will buy just one pizza and the store will have profits of just $8 ($10-$2). The BOGO doubles the store’s profits!

Carefully designed BOGOs increase profits because they let the firm price more flexibly, what economists unfortunately call “price discrimination.” At $20, the BOGO is equivalent to charging $15 for the first pizza and $5 for the second. Notice that these prices are ideal for the firm since they are the maximum the consumer will pay – any more and the consumer won’t buy.

Although BOGOs may make consumers worse off they generally increase total welfare because the price on the last unit sold is pushed closer to marginal cost and because of this output expands. Even if the efficiency gain from price discrimination goes mostly to firms don’t forget that firms are owned by people too!

For more on price discrimination see Hal Varian’s classic, Differential Pricing and Welfare.

Children masquerading as adults

Laurence Kotlikoff, whose work I mentioned in my post, The U.S. Government is Bankrupt, had some very strong words in response to Greenspan’s recent testimony on social security.

It’s nice that Alan Greenspan is finally prodding our politicians to address the nation’s long-term fiscal problems. But he’s using a feather, when a cattle prod is what’s needed. Whether or not Greenspan knows it, our country is in worse long-term fiscal shape than Brazil. Once financial markets absorb this fact, interest and inflation rates will soar and there will be economic hell to pay. Greenspan’s proposed cuts in Social Security are trivial relative to what’s needed and perpetuate the myth that we can finance the baby boomers’ retirement with minor fiscal adjustments.

Senators Kerry and Edwards — along with President Bush — are fixated on the next election and ducking their responsibilities to the next generation. Like previous politicians who’ve failed to address our long-term Social Security, Medicare, and Medicaid problems, they are simply children masquerading as adults. What’s needed are real statesmen to propose and enact the radical and extremely painful reforms required to ensure our nation’s fiscal solvency.

For more, see Kotlikoff’s forthcoming book with Scott Burns, The Coming Generational Storm (prologue here, chapter 1 here)

Hat tip to Greg Ransom of PrestoPundit.

Markets in everything, continued…

…Maybe it’s a sign of the times — or just a gimmick — but celebrities, athletes and high-powered business executives who want protection from potential rape or other sexual charges can now obtain consent forms for their would-be partner to sign, acknowledging the pair is about to engage in consensual sex.

“This really is for someone you don’t know,” said attorney Evan Spencer, who wrote the one-page, “pre-sexual agreement” form for Colorado-based Protect Condoms Inc. “If you’re a professional athlete on the road, and you encounter someone you don’t know, certainly a person who is a man of means will want to be protected by something like this.”

The company has sold more than 4,000 forms at $7.99 each, according to president Nelson Banes. The standard consent forms are one-page documents to be signed by two parties, both of whom agree “to engage in any and all sexual acts legally permissible under state and federal law with consentee,” according to the Protect Condoms form, which includes two condoms in its package.

Here is the story. This link will bring you back to previous installments of Markets in Everything.

The economics of Internet phone calls

A new essay from Clay Shirky is almost always blogworthy. Recently he offered up his treatment of VOIP. Here is his entree into the topic:

“When” could still be a very long time, however. The incumbent local phone companies — Verizon, SBC, BellSouth and Qwest — have various degrees of interest in VoIP, but are loathe to embrace it quickly or completely, because doing so means admitting to everyone — shareholders, regulators, customers — that both monopoly control and artificially high voice revenues are going away. (The fact that this is true does not much lessen the pain of saying so.) As a result, they will likely try to convince regulatory agencies, both the FCC and the states’, to burden competitive VoIP firms like Vonage with additional costs and rules, while delaying their own offerings.

Complicating this de facto Plan A, however, is the fact that VoIP isn’t a service, it’s just a set of protocols, meaning that competitors don’t have to set themselves up as upstart phone companies to deploy VoIP. If Plan A is “Replace the phone system slowly and from within,” Plan B is far more radical: “Replace the phone system. Period.”

Here are two excellent paragraphs:

The official tradeoff in current telecom regulation is service guarantees in return for monopoly control. Over the decades, though, a third part of the bargain has arisen. Phone companies tolerated high taxation as well, in part because it guaranteed continued freedom from competition. As a result, telephony is treated as a vice instead of an essential service — the taxes and surcharges on a phone bill are more in line with the markup on alcohol and tobacco than with gas or air travel.

However, monopoly control, essential for the current bargain, is ending. The cumulative threats of competitive local phone companies, the decrease of second lines due to DSL and cellphone use, and now VoIP have made the old deal unsustainable. The rise of a competitive market seems conceptually simple, but most parts of the US have had a phone monopoly for longer than they’ve had indoor plumbing, so the possibility of phone service without the incumbent phone company is hard for many observers to understand.

The bottom line:

I can’t do better than to quote Clay:

With railroad bankruptcies in the 1940s, no one thought that the tracks would be ripped up and sold for scrap. Similarly, the question of whether the incumbent phone companies can survive if VoIP pops the bubble of voice revenues is separate from the question of whether the wires in the ground will continue to exist. Someone will sell data transmission over copper wires, but there’s no reason it has to be the existing phone companies, in the same way that someone still runs trains from St. Louis to Chicago, but it isn’t the B&O Railroad anymore.

Clay makes blogging easy, though arguably less fun. Just quote him and say yup, yup, and yup.

The U.S. Government is Bankrupt

“…the U.S. government [is] effectively bankrupt”

“…when rational gloom sets in, the U.S. economy will likely ‘go critical.'”

“…the decline and fall of America’s undeclared empire will be due not to terrorists at our gates nor to the rogue regimes that sponsor them, but to a fiscal crisis of the welfare state.”

Who is making these wild statements? Is it a “not-to-be-trusted”, liberal economist like Paul Krugman or Brad DeLong each of whom have warned of an impending “fiscal train wreck” and “fiscal catastrophe”? No. The statements are from Laurence Kotlikoff, one of the world’s most prominent economists, and Niall Ferguson, one of the world’s most prominent historians – both are whom are considered to be conservatives (more on that shortly).

Kotlikoff and Ferguson base their gloomy forecast on a study commissioned by Paul O’Neill before he was booted out of the administration. The study says the following: we know that there will be a deficit this year and one next year and probably one after that – suppose we add up all the future deficits and surpluses for as far as we can see and discount these to present value. What do we get? The answer: 45 trillion dollars of debt.

We do not have 45 trillion dollars. What then can we do? Here is why conservatives should not ignore the warnings of Kotlikoff and Ferguson, even when they deride similar pronouncements from Krugman and DeLong, because Kotlikoff and Ferguson argue that taxing ourselves out of this mess is not a desirable option. Instead, they argue that we must a) “discipline Medicare spending” (this was written before the prescription drug plan passed!) by eliminating “entirely the traditional fee-for-service option and giv[ing] all Medicare participants a voucher to purchase private health insurance.” and b) “privatize social security.”

Kotlikoff and Ferguson are not optimistic about the political viability of these actions, hence the opening quotes.

I worry when intelligent people on both the right and left start to talk about the U.S. “going critical.”

Good news: our senators are really, really smart

US senators’ personal stock portfolios outperformed the market by an average of 12 per cent a year in the five years to 1998, according to a new study.

“The results clearly support the notion that members of the Senate trade with a substantial informational advantage over ordinary investors,” says the author of the report, Professor Alan Ziobrowski of the Robinson College of Business at Georgia State University.

He admits to being “very surprised” by his findings, which were based on 6,000 financial disclosure filings and are due to be published in the Journal of Financial and Quantitative Analysis.

“The results suggest that senators knew when to buy their common stocks and when to sell.”

First-time Senators did especially well, with their stocks outperforming by 20 per cent a year on average – a result that very few professional fund managers would be able to achieve.

“It could be argued that the junior senators most recently came out of private industry, so may have better connections. Seniority was definitely a factor in returns,” says Prof Ziobrowski.

There was no difference in performance between Democrats and Republicans.

A separate study in 2000, covering 66,465 US households from 1991 to 1996 showed that the average household’s portfolio underperformed the market by 1.44 per cent a year, on average. Corporate insiders (defined as senior executives) usually outperform by about 5 per cent.

The Ziobrowski study notes that the politicians’ timing of transactions is uncanny. Most stocks bought by senators had shown little movement before the purchase. But after the stock was bought, it outperformed the market by 28.6 per cent on average in the following calender year.

Returns on sell transactions are equally intriguing. Stocks sold by senators performed in line with the market the year following the sale.

When adjusted by the size of stocks, the total portfolio returns outperformed by 12 per cent a year on average. The study used a total market index as the benchmark for comparison.

Here is the full story. Here is the home page of the researcher, Alan Ziobrowski. I haven’t scrutinized or even read the original study, but right now I will bet this is true.

Thanks to Jane Galt, who is just back from Mexico, for the pointer.

Facts about downsizing

Downsizing occurs when a firm lays off workers to economize on costs. So what do economists know about this phenomenon?

1. About half of all downsizing firms end up with at least as many laborers within a few years’ time. Downsizing is often a matter of restructuring a labor force, not just getting rid of dead wood. In other cases downsizing may be purely temporary, and is reversed once the firm has some extra cash.

2. Downsizing in manufacturing is nothing new and has been going on since 1967. That being said, the smaller manufacturing firms generally have been increasing employment. The notion of “regression toward a mean” describes the manufacturing sector better than the universal downsizing hypothesis.

3. Downsizing is positively correlated with the degree of foreign competition in a sector. So trade does encourage firms to cut their costs.

4. Manufacturing is fifteen percent of the U.S. labor force and thus only a small part of the downsizing story. Retailing and services have been upsizing considerably for many years.

5. Downsizing firms tend to increase their profits but not their productivity. Downsizing commonly leads to lower wages within the downsizing firm. There is evidence for the “wage squeeze” story.

From the recent Downsizing in America: Reality, Causes and Consequences, by William J. Baumol, Alan S. Blinder, and Edward N. Wolff.

The authors conclude the following:

…no special programs appear to be called for, aside from measures to ease the transition of downsized workers to other jobs…the evidence provides no support for the conjecture that the economy is undergoing widespread and protracted reductions in the size of the typical firm’s labor force.

Tom Friedman on outsourcing

…when I came to the 24/7 Customer call center in Bangalore to observe hundreds of Indian young people doing service jobs via long distance – answering the phones for U.S. firms, providing technical support for U.S. computer giants or selling credit cards for global banks – I was prepared to denounce the whole thing. “How can it be good for America to have all these Indians doing our white-collar jobs?” I asked 24/7’s founder, S. Nagarajan.

Well, he answered patiently, “look around this office.” All the computers are from Compaq. The basic software is from Microsoft. The phones are from Lucent. The air-conditioning is by Carrier, and even the bottled water is by Coke, because when it comes to drinking water in India, people want a trusted brand. On top of all this, says Mr. Nagarajan, 90 percent of the shares in 24/7 are owned by U.S. investors. This explains why, although the U.S. has lost some service jobs to India, total exports from U.S. companies to India have grown from $2.5 billion in 1990 to $4.1 billion in 2002. What goes around comes around, and also benefits Americans.

Read the whole column.

Addendum: Here is Virginia Postrel’s latest piece on trade.

Second addendum: How about this press release, India awarding a big contract to Hewlett-Packard, thanks to Kevin Bone for the pointer.