Friday, December 26, 2008

Economics Lessons, Part 2

In my last blog, I discussed popular misconceptions about economic policy of Democrats and Republicans -- mainly the fallacy of the popularly held belief that Republicans are anti-tax, anti-spending and that Democrats are pro-tax, pro-spending. To summarize the last post (which you can read in its entirety below), over the past 30 years, while Democrats have certainly been more willing to tax than Republicans, Republicans have actually increased spending at a far greater rate, hence the larger deficits during Republican presidencies.

Now that the history lesson is over, I think it makes sense in light of the economic crisis to examine beliefs about the marketplace. I'll start by discussing a few commonly expressed philosophies and what I find inherently wrong with them.

(1) Socialism
The basic Marxist principle "to each according to his need, from each according to his ability" sounds appealing...everybody does what they can and everyone gets what they need. The problem is, in developed societies, it doesn't work very well.

The fundamental flaw with this theory is the "from each according to his ability" part. People respond to incentive structures. If you are not going to be rewarded more for working hard, you are not going to work that hard, by and large. In socialist economies, where gains are shared equally, my individual effort does not impact my standard of living significantly. Hence, I don't work hard.

The exception to this is when you can build a small community of like-minded people and there is sufficient social pressure to drive individual accountability. Classic examples of this are the Jamestown settlement (yes, they were socialists, pooling their resources) or Monasteries, where monks share in all the work and the gains from the work. These systems work well because there actually is an incentive structure -- you are a social outcast if you do not contribute in these small communities. Such a set of social incentives is near impossible in a society as large as the US.

(2) Laize Fare Capitalism
Preached to a greater or lesser extent for most of the past 50 years by economic conservatives, the premise of this theory is that free markets are extremely efficient relative to government and therefore allowing free markets to work, completely unrestricted, is the best way to secure long-term economic growth.

This premise breaks down in several areas. First of all, the concept of monopolies negates the efficiency of a market. The efficiency of market economics is based on competition. If a company can establish a 100% share and raise barriers to entry so high that no competitor can enter, a free market becomes very inefficient. Say Wal-Mart takes over all retailing and then every time a competitor tries to enter, they cut their prices to next to nothing until that competitor is bankrupt. Wal-Mart is then free, once they've bankrupted their competitors to provide lousy service, raise prices, limit goods, etc. and there is very little recourse.

The second breakdown in this theory is that free markets are only extremely efficient with a very limited focus -- short-term profitability. Free markets have no concern for trying to provide national defense, build infrastructure that would benefit other companies, protect the environment, etc. And the short-term focus of capital markets actively punishes investment for the long-term. No major corporation in the US today invests in basic research. All of the key innovations of the last 100 years -- the micro chip, the television, the microwave, etc. where all derived from government-funded research (primarily military.)

(3) Supply-Side Economics
This is, essentially, a less extreme version of Laize Fare capitalism. Supply side economics, brought to promience by Ronald Reagan in the 1980s, holds the core belief that economic growth comes from investment capital. The theory holds that by cutting taxes on capital gains and high income earners, you provide an economic incentive for investment, which leads to innovation and economic growth which "trickles down" to provide a better lifestyle for everyone.

The problem with this theory is that it only addresses one side of the supply/demand curve. Today's economy is a prime example. There is tons of investment capital out there. The economy is still tanking because there is not sufficient buying power at the lower end to invest. Therefore, the money is going into very safe places like precious metals, government bonds, etc. It is not spurring innovation or growth, it is sitting on the sidelines.

Demand must exist in order for economic growth to take place. And if demand exists, investment will happen. Business don't hire more people if their tax rates are lower, they hire more people if they think there is demand for their products and that hiring more people will earn them more money. They do this regardless of the tax rates applied on those earnings. Anything else would be bad business.

(4) Demand Side Economics
This brand of economics, preached by liberals who are not quite socialists, has the premise that cutting taxes or providing social benefits ot middle and lower income individuals will spur demand that will cause economic growth.

There is some validity to this, but similar to #3, it addresses only 1 side of the supply-demand equation. You can't have growth without capital investment to support the existance of supply and you can't grow productivity (the long-term key to all economic growth) without available investment funds.

Also, oppressively high tax rates (like the US had in the 1950s) can dampen incentives for high-income individuals to produce. If I am being taxes at 90% on every marginal dollar I earn over $200K, I'm pretty much going to stop earning around $200K.

What Works
As with most things, what really works is somewhere in between. The best economic policies pursue social goals through government schemes, but do them in a way that takes advantage of what markets do best.

The role of the government is to provide a clear, transparent playing field, to set rules that incentivize behavior that we want as a society, to provide a safety net for lower income individuals and to provide focused investments that spur productivity growth.

Key investments for the government to secure productivity growth are education and basic research. In the medium-term, the level of educaiton of populace is directly linked to its productivity. Therefore, funding and raising performance standards for education is critical. College affordability is also key. These are very important roles for governemnt.

Secondly, to raise productivity in the long-term, the government must be making investments in basic research that will spur next generation technology investment. These are investments that businesses will not make, as they have a 30 or 40 year payback, not the 3 or 4 year payback that a business wil typically require. This can be accomplished through the military, NASA and other governmental agencies.

Thirdly, the government needs to regulate industry to guard against monopolies and to guard against policies that could undermine the economy as a whole. The mortage crisis is a classic example. When companies grow so large that they are "too large to fail", meaning an economic collapse will ensue if they go bankrupt, the government must aggressively regulate their activities. This would include, in the case of lending, restrictions on the standards banks can use to set loans, capitalization requirements, accountability for risk management, etc.

Fourthly, is the safety net. Irrespective of market efficiency, most people find it morally reprehensible to have children go hungry or without vaccinations in a wealthy society. The government has a clear role in ensuring that this does not happen.

Finally, the government needs to manage broad societal goals that businesses won't take on because there is not a profit motive. Protecting the environment. Building infrastructure. National security. Police. Etc.

In #4 and #5, solutions that leverage the benefits of the free market are vastly superior to solutions that are strictly government run.

For instance, if we want to reduce carbon emissions, we could, for instance, simply mandate that each company reduce carbon by 50%. This would likely have a devastating effect on the economy. A preferable solution, is a system by which the government sets a target for carbon emissions and then auctions off the rights to those emissions to the highest bidder. This provides a huge economic incentive -- some companies will reduce emissions by 25%, some will reduce by 75%, but the ones that reduce by 75% will have a huge economic advantage. It does not perscribe a solution, but it lets the markets optimize under a new economic paradigm.

Another example is health care. Let's assume for a minute that we agree that health care is something that should be provided for every American. One approach would be a government takeover of health care. This would likely lead to inefficiency and bad decision making as it essentially creates another monopoly. An alternative solution would be to mandate that all Americans have health insurance and provide tax dollars for uninsured individuals to buy insurance with. Then, private providers could develop coverage plans and consumers could choose the ones that best fit their needs with the coverage dollars they have.

So with all this said, what do I believe about things like taxation and government spending? Complicated questions, but I'll give it a shot:
A conservative friend of mine was speaking to me the other day about the benefits of the flat tax. I surprised him by saying that I agree with a flat tax....but, a real flat tax that encompasses all forms of income and covers all forms of taxes.

Let me explain -- there is a popular myth out there that rich pay the highest taxes. Not true. The middle class pay the highest taxes rate now. Sure the rich pay a marginal tax rate of 33% vs. a marginal tax rate for the middle class of 28%. But this excludes the impact of social security taxes, which amount to over 7% on the first $105K of income PLUS an additional 7% coming from your employer, meaning effectively that your check is reduced by 14% on the first $105K of income. This makes the REAL marginal tax rate for the middle class 42% vs. 33% for the wealthy. The poorest 30% pay nothing in income taxes, although they typically do pay the 14% in payroll taxes. Additionally, capital gains are taxes differently the earned income, with long-term capital gains taxes at only 15%.

This means that in effect, a rich person whose primary source of income is investments pays scarecely a third of the income tax that a middle-class working family does. It's not only economically inefficient, it's morally wrong.

Now some will argue that a lower capital gains tax is reasonable given that corporate earnings are taxes before transferrence to the investor. This is nonesense. All taxation occurs multiple times when money changes hands -- sales tax is collected at sale, corporate profits are then taxes and income for the worker is taxes again. It is no different with capital gains.

Also, some will argue that social security is different because you are paying into a system for which you get a benefit. But I could argue the same for any tax. Any notion that the dollars you pay into social security are the same ones that you take out later on is just mis-informed. The government is collecting a tax to pay a benefit, the same as any other tax.

So I do favor an all-encompassing flat tax, provided there is a sufficient standard deduction (say $20K per year) to exempt people below the poverty line. Applying taxes to people who can't afford rent and food is just cruel and it doesn't amount to much money. Secondly, we would need to wipe out ALL other deductions to prevent tax dodges. Yes, that includes charitable contributions. Charitable contribution deductions amount to nothing more than a government subsidy for churches and political groups -- how do you feel about religions you disagree with getting a government subsidy? Seems a little contrary to the constitution to me.

So what rate should be set? My basic answer is enough to cover government spending. The idea that taxes and spending are somehow two separate issues is just silly. We need to pay our bills. My one caveat to that is that during the next 2 years, as we battle a recession, a defecit is probably prudent. But Obama can't let 2 years become 4 years become 8 years. Not paying our bills is irresponsible, and for all you supply siders out there, it is soaking up investment capital that could be funding new innovations.

So is the level of government spending too high too low or just about right?

Ignoring the likely stimulus package (we will likely have to spend huge sums of money to get the economy going again, but that is not a part of core government spending), I'm entirely sure the answer...there are a lot of things I would like to invest more in but also a lot of government expenditures that are utter wastes.

Things to invest more in:
(1) Education and Job Training -- raising primary and secondary schools to world class must be a top priority to maintain or positoin as a world power. Providing access to post-secondary education for all children is also essentially. We don't spend nearly enough money federally to do this. Look at the horrible state of schools in places like Mississippi, Los Angeles, Camden, NJ, Gary, IN, etc. And look at the high percentage of kids who never make it to college.

(2) Basic Research -- we've given up our lead in science. There is not enough science or military spending right now inventing next generation technology. We are still flying Space Shuttles and F-15s, each 1950s and 60s technology. There is no microwave or microchip in the pipeline. This needs to be remedied. Basic Research funding could also do a lot to solve environmental problems.

(3) Health Care -- I do think it is a crime to see so many people without health care in the US. This is not an economic argument (the present system is probably more economically efficient than most) but a moral one. The government needs to design a system that improves health care.

(4) Infrastructure -- a big engine of our economy, it has been heavily neglected. Bridges, roads, rail, sure, but also upgraded air traffic control, an improved electrical grid and other enhancements. These are investments that will pay many-fold in the years to come.

(5) Troop Strength -- we do not have enough troops in the military to handle potential conflicts in the years to come. Again, not an economic need, but a national security need. The war in Iraq has demonstrated how undersized our military is -- can you imagine fighing a ground war against China or Russia if we have to tap reserves for multiple tours in Iraq? There is also a moral component to this, the sacrifices that we have asked of soliders with multiple deployments in combat zones and short breaks is wrong.

Investments that are a total waste of time:
(1) Farm Subsidies -- cut them all. 100% of them. They make our agricultural system economically inefficient and do nothing but line the pockets of big farmers.

(2) Earmarks -- John McCain had this one right. A process that lends itself to building bee hive museums and bridges to nowhere.

So, in total, I'd probably increase the size of government, but not by that much. And we'd have a tax code that made sense to pay for it.

I'm a free trader, bar none. Trade protections do nothing but make the system less economically efficient. If someone is willing to make it for us cheaper than we are willing to make it ourselves we should take it. And don't worry about them subsidizing industries -- if they want to sell to us at a loss, we should let them.

Yes, it will hurt specific industries, but overall it makes us more competitive.

We cannot avoid globalization, we need to capitalize on it.

Next Blog
Rating the Presidency of George W. Bush

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