The Becker-Posner Blog

Should the Minimum Wage Be Raised to $9?—Posner

The President in his State of the Union address last week proposed increasing the federal minimum wage from $7.25 an hour to $9, and then indexing it by the rate of inflation. The proposal will not commend itself to most economists who study the economic consequences of minimum wages. They make three principal arguments: minimum wage laws reduce employment (and efficient resource allocation) by pricing labor above its market rate; the laws do not reduce poverty, because most beneficiaries of minimum wage laws are not poor; and as a means of reducing economic inequality, such laws are inferior to the Earned Income Tax Credit (i.e., the negative income tax). I will try to assess these arguments. 

Although there is some disagreement among economists, the majority of those who actually study the
effects of minimum wage laws agree that they have a modest disemployment effect concentrated on young persons. But the issue is the effect of a 24 percent increase ($1.75 ÷ $7.25) from the current minimum wage; it could be immodest. The effect will vary from state to state, depending on each state’s minimum wage law. A few states set the minimum wage well above $7.25 and one (Washington) has set it above $9, though only slightly ($9.13). In Connecticut and Illinois the state minimum wage is $8.25, in Oregon $8.95, and in Vermont $8.60. But in most states it is at the federal level and in some states it is below it—and some southern states have no minimum wage at all. 

The majority of economists also believe that the minimum wage laws have no effect on the poverty level—except perhaps to increase it. A minimum wage law has no effect on poor people who don’t work, unless they belong to a family that has workers whom the law affects. And because the application of the law depends on the individual’s wage rate rather than on family income, a sizable fraction of those whose wages are affected by such a law are not poor, because they are members of families that are not poor, Many of these beneficiaries of minimum wage laws enjoy family incomes that are twice the poverty level (and thus about $40,000). It has been estimated that only 11 percent of workers paid the minimum wage are actually poor people. 

As for the Earned Income Tax Credit, because eligibility depends on family income rather than on the wages of individual family members, the payments do not benefit the nonpoor, except that, to avoid a sharp cliff, eligibility extends beyond the poverty level. A married couple with two children and annual income of $7000 is entitled to an Earned Income Tax Credit of $2810, rising to $5036 if the couple earns $15,000 and falling to $2179 if it earns $35,000. 

In analyzing the case for and against a hike in the federal minimum wage, one should bear in mind that a minimum wage law is really a form of redistributive taxation. It’s effectively an earmarked tax on employers. Income is redistributed from businesses, and their customers (because a business hit with higher costs, labor or otherwise, will, if its competitors likewise are hit, be able to pass on some of the cost hike to consumers in the form of higher prices), to workers; additional costs are borne by workers who lose their jobs (or can’t find a job) because they are not worth the minimum wage to any employer. With the minimum wage understood as a form of taxation, the objection to a hike in the minimum wage that it will cause a distortion in the labor market falls away; all taxes create distortions. If as some critics of the President’s proposal advocate, the Earned Income Tax Credit is expanded, this will require an increase in federal taxes or borrowing, measures that also distort markets. Furthermore, the Earned Income Tax Credit is limited to families who have minor children living with them, and so provides no redistribution to poor people who are childless, or whose children are grown. 

The fact that the minimum wage mainly benefits workers who are not poor, because they are members of nonpoor families, is a less forceful criticism of the President’s proposal than may appear. The reason is that the poverty line is extremely low. It is $11,170 for a single person and only $23,050 for a family of four. At $7.25 an hour, a minimum wage worker makes only $14,500 in a year if he works 2000 hours a year. That is below the poverty line unless he's single, and if he has minor children and no working spouse he is earning way below the poverty line, although his total income in real terms will be higher because of food stamps, Medicaid, and other benefits available to the poor and the near-poor (though not to all of them; Medicaid for example has quite restrictive eligibility criteria). To recall my earlier example, a worker who makes only $14,500 a year and has two minor children will be eligible for about $5,000 in Earned Income Tax Credit, but his total income will still be below the poverty line for a family of four of $23,050. 

As I have argued in previous posts, income inequality has become a serious problem in the United States. The median income in the United States--$50,000—though far above the poverty level, is too low to enable optimal investments in the human capital of children in families whose total incomes are at or below that level, even with the various governmental benefits available to them. Increasing the minimum wage is an inefficient response to the problem, but what is the alternative? What the advocates of increasing the minimum wage have going for them is a widespread sense that people who work full time at menial jobs (as most minimum wage jobs are) should be paid a decent wage, and that $7.25 an hour is no longer a reasonable estimate of a minimally decent wage for such work. 

Still, a 24 percent increase is a big jump. A prudent compromise might be to increase the federal minimum wage to $8.25 and study the results over a period of a couple of years.

And I don’t think indexing the minimum wage to inflation is a good idea; should inflation surge, which is always a possibility though not (it seems) an imminent one, an equal increase in the minimum wage might contribute to an inflationary spiral.

Is Raising the Minimum Wage a Good Idea? Becker

 

Serious economic debate over the wisdom of minimum wages has been going on for at lease 70 years, and the debate has been revived by President Obama’s proposal to raise the US’ federal minimum wage to $9 per hour. The two main issues debated are the effects of a higher minimum on employment of the low skilled, and its effects on the degree of poverty. both theory and evidence indicate that higher minimums reduce employment for teenagers and other workers with low productivity, and that it does little to alleviate poverty. Neither conclusion, however, is without controversy, especially the employment effect.

Federal minimums in the United States have never been higher than to affect a rather small fraction of the working population, such as teenagers, unskilled immigrants, and some others. The expectation from economic theory is that when the minimum wage is raised above the wages that these low skilled workers are receiving, some of them would become unemployed because they would be priced out of the labor market. The challenges to this conclusion have both theoretical and empirical aspects.

One old theoretical argument is that employment may not fall if firms hiring low skilled workers have monopoly power in the labor market. Yet the great majority of   low skilled workers are employed in fast food establishments and other retail and manufacturing sectors that face much competition even in local labor markets. Another claim is that higher minimums mainly reduce the profitability of the firms employing low skilled workers without have much effect on employment. Perhaps that claim would apply to highly profitable companies, but profit margins are generally thin in the typical firms employing the workers affected by higher minimums. Since there is not much room for these margins to go much lower without the firms going out of business, the firms affected try to preserve their thin margins by cutting costs, including reducing employment of low skilled workers.

Also argued is that higher wages shock firms into more efficient behavior that offsets the effects on costs of the higher wages. That claim too is not persuasive in the highly competitive sectors with much entry and exit of firms that employ the great majority of low skilled workers. The Economist in a recent article on minimum wages (issue of Feb. 6-23) refers to the claim that higher minimum wages are good for employers because they reduce worker turnover, which is costly to employers. But employers could raise wages on their own if they believed that this reduced turnover enough to raise their profits. In fact, the reduction in turnover is smaller, not larger, when higher minimums force competitor firms also to raise their wages. For then the gain to workers from staying with their jobs is lower, aside from the effects of higher minimums in reducing employment options.

The great majority of the literature during past couple of decades on the effects of higher minimum wages is empirical with little theoretical discussion. Two eminent economists, David Card and Allen Krueger, launched the first modern attack on the traditional conclusion that higher minimums significantly reduce the employment of the low skilled. They studied employment changes in fast food restaurants in adjacent states before and after one of the states raises its minimum wage. They found essentially no effect on employment, or sometimes even a slight positive effect. I wrote a Business Week article at the time (1995, reprinted in The Economics of Life) that was harshly critical of their study. In retrospect I believe my criticisms were too harsh, for their study was pioneering, and stimulated a large amount of serious empirical work using both time series changes in federal minimums, and state differences in minimum wages.

Some of the more recent studies have supported the Card-Krueger finding of little if any effects of “moderately” higher minimum wages on employment, although the “majority” has tended to confirm the older conclusion that a 10% increase in the minimum wage reduces teenage employment by about 1to 3 per cent. A very recent study by Neumark, Salas, and Wascher (January 2013] goes over a few recent studies challenging this conclusion. They conclude, as Neumark and Wascher did in their 2008 book, Minimum Wages, regarding earlier evidence, that the recent evidence does not overturn the conclusion that higher minimum wages do significantly reduce employment of vulnerable groups, like teenagers.

France has one of the highest minimum wages relative to average wages in the developed world, so its record is particularly interesting to analyze. Several studies by the French economists Guy Laroque and Bernard Salanie support the view that higher minimum wages significantly reduce employment of married women and young persons. Consistent with their analysis, France has the highest minimum in Europe, and also has unusually high unemployment rates of younger persons, especially Moslem males.

Some proponents of higher minimum wages indicate that while they believe that small to “moderate’ increases in minimum wages have negligible effects on unemployment and employment, they admit that sizable increases in the minimum wage would significantly reduce employment. Obviously small changes usually have small effects, but this view appears to be claiming that the employment effect per each one per cent increase in the minimum wage gets bigger as the overall increase in the minimum wage gets larger. This is not at all obvious, and depends on complex substitution and complementarity relations with skilled labor and other inputs.

Even if one accepts the conclusion, as I do, that higher minimum wages lowers employment significantly of vulnerable groups like teenagers, this conclusion does not imply that minimum wages are an ineffective way to fight poverty. Higher minimum wages might still increase the overall earnings of the poor because the higher earnings of those who manage to keep their jobs dominates the negative effects on the earnings of workers who lose their jobs.

That conclusion too is not justified because minimum wages are ill suited to raise the incomes of the poor, partly because it targets individual earnings rather than family incomes. Posner gives several reasons why low earnings of individuals and low family incomes are only loosely connected.

There is an additional reason why higher minimums may not help poor families. By raising the costs of employers, higher minimums induce competitive firms to raise their prices. I pointed out earlier that the principal employers of low skilled workers are fast food establishments and other producers of cheaper goods. Poorer families are also the main consumers of fast foods and other low-end goods and services that employ low skilled workers. As a result, low-income families are hit by two bullets: some of their members find it harder to get jobs, and they face a higher cost of the goods they consume.

 

Contrived Inequality and Equality-Becker

 

The media and many intellectuals have greatly criticized the large growth in inequality during past 30 years in countries as different as the United States, China, and Brazil. Yet people in all countries generally accept, and usually admire, differences in incomes and wealth that they believe result from abilities and hard work, and where the work done by the wealthy is considered socially valuable. For example, the great wealth of a Steve Jobs or Bill Gates is little criticized because they were brilliant at what they did, and they added a lot to social value. On the other hand, objections are raised when high incomes and wealth are considered to be undeserved. The distinction between deserving and undeserved wealth is crucial in the degree of acceptance and hostility to inequality.

Government policies that favor some individuals and discriminate against others are the biggest source of contrived inequality. For example, the Russian oligarchs are criticized because much of their wealth came from government favors when Russia privatized many industries after the collapse of Communism, and also from subsequent favors as the Russian government consolidated ownership in natural resource and other industries. Similar government help propelled the Mexican telecommunications giant, Carlos Slim, to become the wealthiest person in the world.

Until fairly recently, all countries simply gave spectrums for telephone services, radio and television transmission, and mineral and energy rights to politically powerful companies. Economists pointed out that this was granting enormous wealth to these companies without getting much in return. Their writings and other pressures finally forced the US and many other (but not all) governments to auction off such valuable and scarce property. Tariffs on goods like sugar and ethanol, and subsidies to the oil and other industries, artificially raise the incomes of capital and workers employed in the protected industries.

In labor markets, China’s sharp restrictions on rural migrants obtaining residency in urban areas has contributed greatly to China’s rapid growth in inequality during the past two decades. Minimum wage laws raise the incomes of low skilled workers who can find jobs, but they lower incomes of equally productive workers who are made unemployed because these laws price these workers out of employment.

I could give many other examples of government creation of undeserved inequality, but governments are not the only source of such inequality. Unions raise the wages of workers in the sectors unionized, but unions also lower the wages of equally productive workers who are forced out of these sectors into lower paying jobs elsewhere. In addition, unions artificially reduce inequality by suppressing earnings of more productive union members, so that the net effect of unions on inequality is not clear. One blatant example of unions suppressing earnings of more productive members is given by the teachers union’s opposition to merit pay for good teachers, even though good teachers have large positive effects on their students.

Private monopolies and cartels tend to raise the wealth of businessmen and workers who gain from the higher prices created by monopolies. The burden of these higher prices is borne by consumers, other businesses, and by the workers who must exit monopolized industries because of the cuts in output that create the higher prices.

Differences in education and other human capital are the cause of much of the earnings inequality within rich countries, such as the US and Japan. The boom in the returns to higher education during most of the past 30 years has widened earnings inequality greatly by sharply increasing the earnings of persons with at least a college education, and earnings also of other highly skilled individuals. Higher earnings of skilled persons is not a problem per se for most people, but they object to the fact that many young men and women with the talent to benefit from higher education are prevented from doing so. Their families and schools do not adequately prepare them for college, and they do not have the family resources that enable them to pay for a college education.

The effects on children of broken families and uninterested parents are considerable, yet much more can be done on other dimensions to reduce the inequality in opportunities to attend college. Preparation in schools attended by poorer children can be improved by increasing competition among schools, by paying very good teachers much more than average teachers, and by getting rid of the bad and uninterested teachers. Student loans might be made more effective by making the amount to be repaid contingent-up to a point- on the incomes of those who are repaying student loans. This would reduce the loan burden to those who turn out to earn relatively little, although this “tax” on high earnings does affect the type of occupations students with large loans choose, and may make student loans less attractive to students planning to go into high earning fields like business or medicine.

The huge earnings and great wealth accumulation of some members of the financial sector are often viewed with suspicion because they are considered more due to luck than to abilities. This suspicion is not universal since the billionaire Warren Buffett, the second wealthiest person in America, is very much admired, even though he made his enormous fortune from investments in companies. The vast wealth of some hedge fund managers, on the other hand, is often criticized in part because it is assumed to be due to good luck rather than great skill. Usually overlooked is the role of these funds and other investors in arbitraging prices and returns in different sectors. Hostility to high earnings in the financial sector has greatly increased during past few years because of the role of banks and other financial institutions (along with governments and other culprits) in generating the financial crisis that so damaged the world economy.

Since Rousseau, many intellectuals have been opposed to inequality per se. Most people, however, distinguish deserving from undeserving inequality. Clearly, much of the income and wealth inequality in any country would be considered deserving because it results from greater abilities and dedication. Yet a considerable fraction of the inequality in most countries would be considered undeserving. Governments are expected to reduce these obstacles, but unfortunately, governments also create many of the undeserved sources of inequality.

Contrived and Natural Inequality—Posner

Becker makes an important point: inequality of income and wealth is not entirely a product of differences in IQ, in other talents, and in luck; it is also contrived, in the sense of being produced by private or public actions that do not promote overall economic welfare. He gives a number of persuasive examples. His emphasis is on public actions, though he mentions cartels, which are private. Of course it must also be recognized that public actions frequently reduce inequality of income rather than increasing it, examples being the social security retirement and disability programs, the Medicare and Medicaid programs, the earned income tax credit (i.e., negative income tax), and food stamps. Probably (in my opinion) the net effect of government is to reduce income inequality, but that is no reason to defend programs that increase it. And it must be borne in mind that some programs that purport to reduce inequality, such as the federal student loan program, may well increase it, by imposing debt burdens disproportionate to the value of the education that they finance. 

I address a slightly different question: if public actions that create unjustified inequality of income were eliminated, and private action such as price fixing by competing sellers that do so were also eliminated, would there still be a “problem” of inequality, in the sense of a valid basis for government intervention to reduce inequality? And is there a valid basis, therefore, for the programs (some mentioned above) that redistribute income from the better off to the worse off? 

I think the answer is “yes.” With the median family income in the United States today only about $50,000 a year, a great many families cannot afford decent food, housing, child care, and education for their children, and job training for themselves, and cannot afford to move to areas of greater job or educational opportunity for themselves or their children. The result is to reduce the productivity and income prospects of parents and children alike. Since well-off people in the United States are lightly taxed by international standards, it may be possible to increase overall economic welfare by a modest increase in tax and spending programs designed to lift the life prospects of the lower half of the income distribution without killing the incentives of either the taxpayers or the recipients of public largesse. Subsidizing health insurance and school tuition (as distinct from providing loan money for tuition) and early-childhood education are examples of programs of income distribution that may promote overall welfare. 

I don’t endorse the argument of the philosopher John Rawls that no one is entitled to a high income because even characteristics that we think internal rather than external to a person, like IQ and leadership skills and athletic skills and energy and good health, are ultimately the product of luck. Therefore, Rawls argued, no one should be allowed to keep more of his earnings than necessary to “incentivize” him to exert himself in a way that will maximize the social product. That treats people like the cells of an animal’s body, or the ants in an ant heap. Rather my point is that, to the extent reducing income inequality increases overall social welfare, there is a case for programs, financed by the well to do, that increase overall welfare by more than the cost of the programs. There is no reason to think that the cost would impose a crushing burden on the well to do, a result that would be objectionable quite apart from the costs in diminished incentives, and related costs such as tax avoidance and emigration.

Rules versus Discretion in Financial and Other Regulation—Posner

There is an academic literatureon the choice between rules and discretion in regulation. Milton Friedman famously advocated that the Federal Reserve be required to increase the money supply by a fixed annual rate, rather than the Fed’s being allowed to exercise its traditional discretion over the money supply. But the choice between rules and discretion is not limited to the money supply, or indeed to financial regulation. 

It helps to distinguish not just between rules and discretion, but between rules, standards, and discretion. A posted speed limit is an example of a rule; liability for negligent operation of a vehicle is an example of a standard; and the President’s power of appointment of the members of the White House staff exemplifies the operation of discretion. In fact, though, the administration of rules and especially of standards typically involves a degree, often a large one, of discretion. Police officers don’t ticket all speeders, but only those who drive “too far” above the speed limit; and legal standards such as negligence tend to be vague and so operate to grant considerable discretion to judges and juries. So the real issue in choosing among rules, standards, and discretion is how tightly to rein in the exercise of discretion by persons exercising government authority (including pro tem. government officers such as jurors). 

The fact that discretion operates even in the enforcement of precise rules (such as speed limits) is a clue to the limitation of rules. Literal enforcement of rules is unworkable because rulemakers can’t anticipate the full range of circumstances to which the rules they promulgate will apply. For the essence of a rule is to abstract, in the interest of clarity and precision, from all relevant circumstances, a few circumstances to be determinative. Clarity and precision are important values. “65 m.p.h. speed limit” conveys more information (though not complete information, because the de facto speed limit may be considerably higher), more clearly and concisely, than “don’t drive faster than conditions permit” does. 

The choice among rules, standards, and discretion is especially controversial in the law. Rules limit judicial discretion and provide crisp guidance to persons subject to them, while when judges are exercising discretion, as when they “interpret” extremely vague constitutional or statutory provisions, they seem to be stepping out of the proper judicial role and acting as legislators. But really they have no choice. The first duty of a judge is to decide. He can’t refuse to decide a case on the ground that he lacks guidance in authoritative legal materials that are sufficiently clear to dictate the decision. 

The situation with respect to the role of discretion is similar when we switch focus from the judiciary to the regulatory process, as illustrated by the Federal Reserve. The Fed’s principal power is to alter short-term interest rates (though often with an effect on long-term rates) by buying and selling federal securities. If it sells, the cash it receives for the sale reduces the amount of money in the economy and so reduces interest rates, which ration the demand for money rise. If the Fed buys securities, it pours cash into the economy and interest rates fall. Lower interest rates stimulate borrowing and hence spending, unless the rates get so low that no one wants to lend. Also, the larger the money supply, the cheaper the currency is relative to foreign currency, which makes debt held by foreigners cheaper to repay and stimulates exports. Which is one example of the broader point that the larger the money supply is, the greater the risk of inflation (because the ratio of money to goods and services is higher). So creditors, who suffer from inflation, don’t want the Federal Reserve to increase the money supply, while debtors do. W the economy is depressed, cheap money encourages debtors to spend, by reducing their liabilities, and money borrowed because interest rates are low is largely spent, thus increasing consumption, production, and employment. 

Obviously there are huge political and economic stakes in actions by the Federal Reserve, and the Fed is little constrained by rules or standards (though I’ll give an example of where it is constrained), and so exercises very broad discretion. Its mandate requires it to pay attention to both inflation and employment; increasing the money supply can stimulate both, and reducing it depress both, and the economic consequences are very different. 

The Fed’s discretion leads to a concern, fed by the traditional hostility that many people feel toward banking in any form (banking is one of the few businesses which refuse to sell to people willing to pay its price, if they are not good credit risks, though lessors, such as rental car companies, unlike sellers, are often picky about whom they rent to, lest the rented property be damaged), that the Fed’s decisions on increasing or reducing the money supply are influenced by politics. If the Fed refuses to be influenced, the President or Congress may try to curtail its discretion and by doing so reduce its power and maybe harm the country in the long run; politicians typically have a short-run perspective because of their limited terms of office. Milton Friedman’s concern, however, was more with the unpredictability and doubful competence of the Fed’s money-supply decisions. 

Having learned from our recent, unhappy economic experience that depressions are not a thing of the past, I find it hard to accept the proposition that the Fed should be subjected to tight rules. Had it not been for the Fed’s massive purchases, which greatly increased the money supply, of mortgage-backed securities during the financial crisis that began in the fall of 2008, the banking industry might well have collapsed and credit been completely frozen, precipitating a 1930s-style deep depression. Of course this means that any Friedmanite rigid rule governing Fed actions would quickly have been lifted by Congress. 

Let me give an example that illustrates both the difference between a rule and a standard and the hazards of trying to limit the exercise of discretion by the Federal Reserve. It is widely believed (including by me) that the failure of the Fed, in September 2008, to bail out Lehman Brothers precipitated the world-wide financial crisis that ensued immediately. Fed Chairman Bernanke has said that the law forbade the Fed to bail out Lehman Brothers. I am dubious. Section 13(3) of the Federal Reserve Act authorizes the Fed to lend money to a nonbank (Lehman was a nonbank bank, which is to say a financial company that provided banking services but was not regulated as a bank) in “unusual and exigent circumstances,” provided that the loan is “secured to the satisfaction of the Federal reserve bank.” Lehman did not have good security for the large loan it would have needed in order to survive, but in the emergency circumstances created by a collapsing global financial system the Fed could have declared itself “satisfied” with whatever security Lehman could have offered. For section
13(3) establishes a standard rather than a rule, and standards (even rules, as I said) usually don’t extinguish discretion. But they cramp its exercise. It would have been better had the statute just said that the Fed could lend to a nonbank if unusual circumstances justified such a loan—a looser standard, allowing more play for discretion. 

Finally, rules do not really eliminate or even seriously constrain discretion, but rather merely shift the way in which, or the level at which, discretion is exercised. A regulatory agency, having issued a rule, will usually have discretion to amend or rescind it; and if Congress imposes a rule on an agency, Congress always has discretion to amend or rescind the rule.

Why I Favor Rules Over Discretion-Becker

Posner shows there is no absolute distinction between rules and discretion (and standards) because most sensible rules allow for discretion in extraordinary cases. Yet there is a difference under less than extraordinary circumstances, and rules are better in the great majority of circumstances when they are feasible.

One important advantage of regulatory rules partly stems from the nature of human behavior. When the great majority of businessmen and consumers are behaving in a particular way, such as the frenzied borrowing and lending on housing and other assets that preceded the financial collapse, it is extremely difficult for regulators to stick their necks out and shut down the party. As a result, SEC and other bank regulators took no extensive actions to rein in banks even though their asset to capital ratios had increased into dangerous levels before the financial bubble burst. Both Fed heads Alan Greenspan and Ben Bernanke in the early stage of the financial crisis said it posed little threat to the real economy (of course, Bernanke later radically changed his view).

Even when regulators can resist getting caught up in the enthusiasms of the businesses and consumers that they are regulating, they are still subject to enormous political pressures to go along with prevailing behavior. Many companies and industries have full time lobbyists who spend their time cultivating and trying to influence the officials who are regulating their clients. Consumers are not as well organized, but they have votes, and that makes regulators reluctant to take actions that reduce the availability of credit or goods and services that consumers want. To take one of many examples, Congressmen and lobbyists put tremendous pressure on Fannie Mae and Freddie Mac to continue to take on risky subprime loans up to the collapse of the mortgage market.

The pressure from interest groups on government officials has long been noted. Simon Newcomb, a 19^th century American astronomer and economist, wrote in 1885, “One cent per year out of each inhabitant would make an annual income of $500,000. By expending a fraction of {their} profit, the proposers of policy A could make the country respond with appeals in their favor…Thus year after year every man in public life would hear what would seem to be the unanimous voice of public opinion on the side opposed to the public interests”(Principles of Political Economy).

Rules set the tone for regulatory actions even though they must allow for discretion under unusual circumstances. If bank regulators had a rule requiring that the ratio of bank capital to bank assets had to be above a specified threshold, they very likely would have been forced to take actions that limited bank lending prior to the financial crash, even when they had misgivings about these actions or when subject to political pressures to let the financial party continue. This is why I favor such capital requirements, and even steeper ones for the banks that are “too big to fail”.

If the Fed had been following a rule that made its intervention dependent on some combination of inflation, output growth, and unemployment- as in Taylor rules- it probably would not have intervened before the crisis hit since all these measures were doing well. But a Fed following such a rule would have intervened quickly after unemployment began to rise sharply and output growth slowed dramatically.

The Dodd-Frank Wall Street Reform and Consumer Protection Act does require capital requirement rules for banks, and introduces other rules as well. However, it offsets these good rules with various new and dubious discretionary powers of regulators. These include the creation of a consumer protection agency with potentially considerable power over consumer actions. It also created the Financial Stability Oversight Council, a panel drawn from the Fed, SEC, and other government agencies, that monitors Wall Street’s largest companies and other market participants in order to respond to what they assess is excessive growth in the economy’s degree of systemic risk.

I am not arguing that rules alone are always sufficient to guide regulators and other government officials. Clearly, at times rules have to be supplemented to take account of circumstances that were not adequately covered by the rules. Also rules have to be adjusted periodically over time as new institutions and technologies develop, and as those being regulated devise ways to get around the rules. In addition, regulators subject to rules may manipulate the implementation of any rules. Nevertheless, we are likely to get far better policies if we begin with a widespread set of rules that guide officials, and then introduce discretion as supplements to this rule-based system of regulations, rather than supplementing a basically discretionary approach with some rules.

 

Why Has Competition to Get into Top Colleges Become Much Tougher? Becker

Children in the better secondary schools in Korea, Japan, China, Turkey, and other countries work very hard not only because of considerable school homework, but also through their parents spending considerable sums on private tutoring. In these countries, spending on tutoring is a sizable fraction of total spending on high school students; indeed, in Korea, spending on after-class tutoring has been estimated to be almost as large as spending by public high schools. The aim of the spending by parents on tutoring is to improve their children’s chances of getting into the top schools, such as Tokyo and Keio Universities in Japan, and Seoul National University in Korea.

 

With the worldwide boom in higher education and in the demand by business and governments for college graduates, the Korean and Japanese emphasis on hard work in secondary school has spread to other nations. For example, since enrollments in Chinese universities have increased manifold since 1995, the competition to get into the top schools, such as Beijing University, is fierce, even though the number of Chinese universities has also expanded rapidly. As a result, many Chinese parents are spending increasing amounts on the secondary education of their children, including private schooling and extra tutoring.

 

Although secondary school students work very hard in Japan, Korea, and many other countries, they tend to relax and take it much easier at universities. They often need a few years to recover their energies. So even at the best universities there, homework is not that extensive and much time is left for play.

 

The American education system had traditionally followed an approach that is the opposite of the Japan-Korean approach to education. High schools, even the better ones, did not give much homework, and relatively little money was spent on private tutoring. Of course, much learning occurred in the better high schools, but at a leisurely pace, with considerable time for athletics, theatre, school newspapers, and other school activities, and also for parties, watching television programs, listening to music, and other out of school pursuits. But once at a good university students had to buckle down to hard work, or at least much harder work than in high school.

 

This American approach to education is radically changing at the better public and private high schools because during the past couple of decades it has become much more difficult to get into the top colleges and universities. Teachers are giving greater amounts of homework, and families are also spending a lot more on private tutoring. The tutoring is partly in math and other subjects, and partly in direct preparation for the SAT exams that in good measure determine whether students get accepted into the better colleges and universities.

 

Presumably, parents, high school teachers, and students perceive that the students gain enough from attending the top colleges to justify the additional time, money, and energy put into trying to gain acceptance to these schools. It has long been known that graduates from top colleges and universities get better jobs and earn more than do graduates from lesser schools. What has been much less certain is whether these graduates do better because they are abler, and hence would have done better even if they had attended lower level schools. Recent econometric studies have more successfully separated out the performance of colleges from the selection of students. These studies examine the earnings of students who were rejected from and accepted into the top American schools when they have comparable SAT scores, high school grades, and other characteristics.

 

The studies find that students who attend harder to get into schools earn considerably more over their lifetimes than comparable students who attend schools that spend less per student and where average SAT scores are lower (a good summary is by Caroline Hoxby in “College Choices Have Consequences”, SIEPR Policy Brief, December, 2012). Most of the difference in earnings is apparently due not to the amount that schools spend per student, but to the quality of the other students attending the same schools.

 

Earnings of college graduates depend on how much their schools spent on their education, the various abilities and skills of the graduates, and the characteristics of the other students at the schools they attended. Hoxby shows that spending per student has grown much more rapidly since the 1960s at the top colleges than at lesser colleges, while at the same time tuition per student at the top schools has grown much more slowly than spending per student. It is also documented that earnings of college students per dollar spent on their education has risen substantially since 1980. As a result, the economic gains to graduates from the top schools have risen greatly during the past 40 years.

 

These three facts, that returns to college education have risen rapidly during the past several decades, that spending per student at the top colleges has also increased rapidly, and that the cost of attending these schools has grown much more slowly, can readily explain why students at the better high schools face a much more rigorous workload than in the past. They also explain why their parents spend a lot more on private tutoring. The gains from having better grades, higher SAT scores, and more extracurricular activities have risen considerably because that helps students get into the top schools.

 

These results do not answer the basic question of whether the extra effort by high school students is socially productive, or whether it is partly a social waste (an “arms race”) because efforts by different students partly just offset each other without producing socially valuable knowledge. The evidence I have discussed has a mixed message about this. On the one hand, the fact that the better colleges and universities ration entry rather than by raising tuition to the more marginal applicants suggests that these students fight it out for the limited and rationed slots at the top schools by becoming better “armed” with higher SAT scores and more extracurricular activities.

 

On the other hand, the fact that the quality of other students at the same university positively affects the subsequent earnings of all the graduates from that university suggests that too little is spent on higher scores and better preparation. The reason is that higher scores by any student improve the subsequent performance of other students at the same college. A further issue not fully resolved is how much of the benefits from attending universities like Harvard, Stanford, Chicago, Tokyo, Seoul National, and Beijing come from the reputation of these schools rather than from the valuable knowledge and skills (including networks) possessed by graduates from these schools.

 

Although the net result on the “arms race” aspect of the improved student preparation for college admission is not clear from the available evidence, the evidence cited explains why students in the better American high schools are working so much harder than they did several decades ago. I suspect that the greater earnings and other gains from attending top universities also applies, perhaps even more strongly, to Japan, Korea, and the other countries where the better high schools require so much work.

 

 

 

 

 

 

Competition to Get Into the Best Colleges—Posner

It makes sense, as Becker points out, that increased earnings of graduates of top colleges will attract more applicants to those colleges, enabling the colleges to be more selective. Furthermore, as colleges stopped discriminating against Jews and Asians, who tend to be the best students, the quality of the applicant pool rose. In addition, colleges want to have wealthy alumni, and if the financial return to IQ rises because of the increased complexity and sophistication of the economy, high IQ students become increasingly attractive as future alumni and therefore potential donors. 

Another causal factor may be the correlation between parental income and kids’ IQs. Obviously not all wealthy people are smart and have smart children, but in general there is a positive correlation between income and IQ and between parental IQ and children’s IQ. As the advantages of attending a top college became more apparent, well-to-do parents began investing more in tutoring for their kids and in sending their kids to top (and very expensive) private schools, and this further increased the quality of the college applicant pool. 

But this does not explain the relation between having attended a top college and having a higher income than students with similar intellectual promise who attended a lower-ranked college. The possibility explored by Becker, and by Caroline Hoxby, whose study he cites, is that a student benefits from the company of very bright students. One can learn from one’s fellow students as well as from one’s teachers, and moreover the presence of very bright students may stimulate the teacher to greater exertion in teaching. But at least three alternative possibilities should also be considered. The first is that potential employers consider graduation from a top college a certification of the graduate’s ability. The second is that what students mainly learn from their fellow students is social rather than intellectual—the students at these schools tend to come from prosperous, sophisticated households, which equips them to succeed in fields in which social sophistication (charm, poise, self-confidence, articulateness, etc.) is an employment asset, as it is in many fields. And third is that students at the top schools make valuable contacts—with their classmates who are marked for success. These contacts are business assets. 

Becker makes the interesting point that insofar as a student’s future earnings are bolstered by reason of his attending a college that has many bright students, the future earnings of those students are reduced because the students face more competition than they would if less-bright students were not admitted. But this effect could be offset by the external benefits generated by those students. The student whose employment prospects are enhanced from what he learns from his fellow students may turn out to be a highly successful entrepreneur who business activities generate lucrative employment or investment opportunities for other top-college graduates. 

Even though the greater selectivity of the top colleges increases the earnings of their graduates, and so, prima facie, their contribution to aggregate economic welfare, a question remains whether some alternative method of sorting applicants to colleges would be more productive. I am dubious. Suppose high-school graduates who passed a test designed to determine whether a student would benefit from a college education were assigned to colleges randomly. Parents would invest less in tutoring and other forms of college preparation for their children. Colleges would employ tracking to segregate the brighter students from the less bright ones, which would reduce the opportunities for the less bright students to learn from the brighter ones. Colleges would compete less vigorously for top-flight faculty, as better faculty would not attract better students. 

Moreover, if the benefits (for example in higher lifetime earnings) of association between bright students are multiplicative rather than additive, random assortment will reduce those benefits. (Becker has made a similar point with respect to assortative mating, in his work on the economics of the family.) Suppose that A is a 4 in intelligence or other attributes and B a 3, while C is a 2 and D a 1.5. If B studies, works, or converses with A, their total productivity will be 12 (3 x 4); then D will be assigned to C and their total productivity will be 3 (1.5 x 2). The grand total will thus be 15 (12 + 3). If instead D were assigned to A and C to B, the grand total would be only 12 (1.5 x 4 + 2 × 3). I think this is likely to be the case in the sorting of students. When there is a significant disparity in ability, communication will be difficult and neither will learn much from the other. 

I conclude that the current system is superior to one that would try to homogenize the quality of students accepted to different colleges.

Should There Be a Debt Ceiling?—Posner

The “debt ceiling” is a statutory cap on the amount of money the federal government is permitted to borrow. Introduced during World War I, the debt ceiling has been raised by vote of Congress dozens of times as federal debt has grown. A statute raising the debt ceiling must, like all federal statutes, be passed by both houses of Congress and signed by the President (unless his refusal to sign it—his veto—is overridden by a two-third vote of each house of Congress) before it can become law. The Republican members of the House of Representatives, who have a majority in the House and are preoccupied with federal debt and determined to reduce it solely through reductions in government spending, have lately taken to threatening to vote against raising the debt ceiling, as a lever to induce spending cuts. 

The concern with the size of the federal debt is legitimate but the debt ceiling is an illegitimate device for seeking to limit the debt. The reason is that the ceiling enables the requirement that I just mentioned that legislation to be valid be passed by both houses of Congress and signed by the President to be circumvented. The various programs that require federal spending—programs that range from defense expenditures and civil servants’ salaries and agricultural subsidies to Social Security benefits and Medicare benefits—were all enacted by Congress in the prescribed manner. If the government cannot fund the programs without borrowing, a refusal by Congress to raise the debt ceiling operates in effect as a partial repeal of the statute creating, and prescribing or authorizing funding for, the program. The repeal of a statute is governed by the same requirements as initial promulgation—passage by both houses of Congress and presidential signature. By refusing to vote to raise the debt ceiling, therefore, the House of Representatives would be effecting a partial repeal of many federal programs, all duly authorized, all by itself, without the concurrence of Senate and President. 

This strikes me as improper but also as reckless because of the possible economic consequences. It is true  that defaulting on bonds and other securities issued by the federal government could be averted simply by paying the holders of federal securities ahead of other persons entitled to money from the government, such as social security annuitants, civil servants, military personnel, and contractors who sell goods and services to the government and are owed payment. Debt service—interest on government securities—is actually only a small part of the federal budget. But because the federal deficit (the excess of revenue over expenditures) was $1 trillion this past year—though that was 20 percent below the deficit in 2011, a result of the economy’s improving—a reduction of the 2013 deficit to zero because the debt ceiling wasn’t raised would cause substantial economic dislocation, so substantial that the Republicans are now willing to raise the ceiling to avert a default, though only for three months. 

As I said, I think the use of the debt ceiling as a bargaining lever is improper because the debt ceiling is improper. But I also think that the conservative policy of reducing federal debt by cutting non-defense spending including entitlement spending while raising defense spending, rather than reducing federal debt by raising taxes, is a nonstarter. As Nate Silver pointed out in an article in the New York Times earlier this week (see http://fivethirtyeight.blogs.nytimes.com/), most types of federal expenditure have not grown faster than the economy in the last forty years and as a result have not contributed to a debt crisis. The big exception is the growth in entitlement spending, a growth due to a considerable extent (about half) to growth in outlays for medical expenses. Entitlement spending is very difficult to cut as a political matter. That would not be a problem if non-entitlement spending could be cut, but that is very difficult to do as well. Every federal expenditure program is walled and moated by the interest groups that benefit from the program. 

Some cutting is probably politically feasible, such as closing some tax loopholes and cutting some deductions, reducing social security and Medicare for people who have a high income, reducing (rather than increasing, as conservatives want) our enormous military budget, and laying off supernumerary civil servants. But the aggregate savings are likely to be smaller than the annual growth in Medicare and social security payments and the federal share of Medicaid payments. So the amount of federal debt will grow, and if it grows by more than 3 percent a year it will grow faster than the economy, though the annual deficit will continue to shrink as the economy improves and therefore tax collections increase while outlays for unemployment benefits and other “automatic stabilizers” (spending programs that expand during a recession or depression in order to reduce its adverse effects) decrease as an additional consequence of an improving economy. Rising debt will at some point result in higher interest rates, which will further increase the expenses of government and hence the debt. And those higher rates, which will spread to all borrowers, will reduce the capital available for business growth. If I am right that realistically government expenditures can’t be cut enough to offset growing entitlements expense, the only answer to the growing debt is higher taxes, though there are of course political obstacles to raising taxes. Assuming those obstacles can be overcome, the social costs of higher taxes would then have to be compared with the social costs of higher government debt to determine whether taxes should be raised or the debt increased. 

I want to close by returning for a moment to the issue of entitlement spending, to underscore my conviction that such spending will continue to grow faster than the economy. The term “entitlement”
is unfortunate, as it gives rise to phrases like “entitlement society.” To claim an “entitlement” sounds like something only a person who is spoiled would do. But we don’t speak of contracts in general, including health insurance policies, as creating “entitlements,” but rather as creating legally
enforceable rights. The “entitlement” programs are different only because they are forms of insurance that are highly subsidized. They are forms of redistribution. But all modern societies engage in redistribution, thus rejecting social Darwinism, and have been doing so for some time. Bismarck was the pioneer, pressing successfully for the enactment of publicly financed health, accident, and disability insurance, and retirement benefits—and he was no socialist! 

The elderly are a powerful political bloc (relative for example to children) in the United States and other wealthy countries, and, despite the nation’s wealth, because the wealth is very unevenly distributed most of them couldn’t enjoy a comfortable old age if they didn’t have Medicare and Social Security. As the population ages because of increased longevity attributable in significant part to advances in medical technology, outlays for Medicare and Social Security will increase. (While it is true that the growth in Medicare outlays has slowed since the recession began in 2008, this is because of falling incomes, which make co-pays and deductibles seem more costly, and thus reduce consumption of medical services. Rapid growth of medical outlays can be expected to resume as the economy improves; and feasible fiscal reforms—moderate and therefore politically acceptable economy measures—are unlikely to reduce the rate of growth enough to allow the government’s debt to be controlled without any increase in tax rates. Higher taxes or higher debt: those I think are the alternatives to focus on.

On the Debt Ceiling-Becker

Various attempts have been made to introduce rules that limit the aggregate level of federal spending, such as restricting the growth in spending over time to be no greater than the growth in GDP (aside from wartime and other emergencies). Balanced budget proposals do not limit spending per se, but require that enough taxes be raised to cover whatever level of spending passes the legislature and chief executive. However, neither spending limits nor balanced budget rules have ever received enough votes from Congress, although many states and local governments do require a (nominally) balanced budget.

The “debt ceiling” is much closer to balanced budget rules than to limits on federal spending since it tries to cap the budget deficits that are solely responsible for the growth in debt. As Posner shows, this so-called “ceiling” is not really a ceiling since it can be lifted by a majority vote in both houses of Congress combined with the support of the President. In fact, Congress has raised the ceiling more than 85 times since 1940, and 11 times since 2001.

More economically meaningful ceilings would relate debt to the level of GDP- and perhaps also to interest rates on the debt- since countries with higher incomes and lower interest rates can afford to carry higher debt levels. One good reason to have properly defined debt ceilings, even though the President and Congress must approve every piece of spending and taxing legislation, is to force politicians to discuss how this legislation aggregates to produce shortfalls or surpluses between total spending and total tax revenue. Budget deficits are far more common than surpluses in recent decades.

A further possible reason for a proper debt ceiling is to give “salience”, to use a term from psychology, to the deficit issue by requiring explicit consideration of deficits that push debt above its ceiling. Its salience is reinforced by media coverage of the debates over raising the ceiling, and of the different positions on raising the ceiling by Republicans and Democrats, or by different members within each Party. Studies in economics as well as psychology have shown that salience can affect behavior, such as how much people avoid flying after terrorist attacks on planes.

Unfortunately, the salience placed on raising the debt is somewhat misplaced since the effects of governments on economic and social life are mainly determined by the level and composition of government spending, not by deficits or debt per se. Raising sufficient taxes to cover large and excessive spending would be worse than keeping spending within reasonable bounds while financing some with debt.

Ultimately, the only way to evaluate debt ceilings is to determine how much they affect the level and composition of spending and taxation. That would not be easy to do in a credible way because of the difficulty in determining the counterfactual; that is, what would have been spending and taxation by the federal government in the absence of the debt ceilings? Perhaps that is why I have not found such a study.

While federal government spending in real terms has grown manyfold since the end of World War II, the ratio of debt subject to the debt limit to GDP was a manageable 57% in the year 2000. This ratio has grown rapidly since then, especially during the past four years, and it is now about 98%, higher than most other rich countries. Clearly, debt ceilings have not prevented spending and taxation from growing significantly over time. Nor would the present ratio of debt to GDP be a big problem as long as interest rates remain low.

I mentioned earlier that what counts most for an economy is not the ratio of debt to GDP, but that of government spending to GDP. This ratio will increase or decrease as GDP grows slower or faster than government spending. A decline in this ratio would be achieved if GDP resumes its long-term growth rate of a little over 3% per year, and if the growth in entitlement and other spending were kept under control. It remains to be seen whether the American economy will regain its long-term growth rate, and whether interest groups and politicians will resist the temptation to have government spendingcontinue to grow at a rapid rate.