The Becker-Posner Blog

The High Unemployment Rate and its Social Cost-Becker

The Bureau of Labor Statistics (BLS) on Friday released its report on employment and unemployment in October. Although greeted by most of the media as signaling pretty good news, it is “good” only in the sense that the labor market did not get any worse. Employment and unemployment remain very far from full employment levels fully 4 years after the financial crisis erupted in September 2008, and 3 years after the Great Recession officially ended (as defined by the NBER). In fact, this is the slowest recovery from a recession during the past half century in both employment and unemployment.

 

The unemployment rate remains stuck at slightly below 8%, and about 12 million men and women remain unemployed. Over 8.3 million persons still are employed part time because their hours were cut or they could not find a full-time job. Another 2.4 million persons are only marginally attached to the labor force, but are not counted as unemployed because they had not searched for work in the four weeks prior to the survey.

 

The major explanation for the very sluggish labor market is the slow recovery of GDP from the depths of the recession. When GDP is growing slowly-this growth has averaged about 2% during past 8 quarters- one can hardly expect employment to be growing rapidly or unemployment to be receding at a fast pace. In fact, the relation between GDP growth in the recovery from a recession and and the decline in unemployment is called Okun’s Law, named after the economist Arthur Okun who discovered this empirical regularity. One version of this law states that there is a 1% percentage point decrease in the unemployment rate for every 2% increase in GDP away from recession levels.

 

This law is far from exact, but it does bring out in a simple way that unemployment is unlikely to be decreasing rapidly from recession levels if GDP is recovering slowly. Okun’s Law was not operating in the early stages of the Great Recession because workers were being laid off at much faster rates relative to the decline in GDP than would be predicted by this Law. However, the connection between the recovery in unemployment and the growth in GDP during the past couple of years has been more in line with Okun’s observations (I am indebted to discussions with Edward Lazear on these issues).

 

The extension of unemployment benefits to 99 weeks, or almost 2 years, is a public policy change that has raised the unemployment rate (see Casey Mulligan’s recent book, The Redistribution Recession). When the government is helping to support unemployed persons for up to 99 weeks, some of the long-term unemployed will look less diligently for work.

 

This brings us to the most disturbing aspect of the high unemployment rate during the past 4 years; namely, the large number of the unemployed who have been out of work for at least 6 months. Last month 5 million men and women had been unemployed for at least 6 months, and they comprise about 40% of all the unemployed. This fraction has been stuck at a little over 40 percent since the first quarter of 2010. Moreover, a truer picture of the extent of long-term unemployment requires the inclusion also of most of the 2.4 million individuals who have given up looking for work.

 

During past recessions, the U.S. typically has had relatively low rates of long-term unemployment, especially in comparison to most Western European countries. But that is no longer the case. American long-term unemployment has been so high during past few years partly because of the extension of unemployment compensation to 99 weeks, and partly because of the slowness of the recovery during this recession compared to previous recessions. Another contributor is the decline in sectors, such as parts of manufacturing, which will never recover fully. Since workers who invested a lot of their human capital in declining sectors would have to take a big hit in earnings if they take jobs in most other sectors, they may continue to look for jobs in sectors where their human capital is more valuable.

 

Long-term unemployment creates several long run social costs in addition to the psychological and other damage from being unemployed for many months. Some of the long-term unemployed become discouraged and leave the labor force prematurely rather than continuing to look for the work that has eluded them for many months. This is especially likely for the older unemployed since they take much longer to find jobs. In addition, younger workers who have been unemployed for a long time and are not highly skilled may retire from the regular labor force to enter the informal labor market where they are only sporadically employed. Food stamps and other benefits help them supplement their occasional earnings from jobs.

 

Persons who have been out of work suffer some erosion in their job skills because they have not been using them. This is obviously a much bigger problem for the long-term unemployed. Most workers can probably manage up to six months of unemployment without much skill erosion, but after that it can become a problem, particularly for persons with skills in fields that are changing more rapidly.

 

Much cyclical unemployment involves a waste of time and productivity, but the social cost is especially severe for the long-term unemployed. Unfortunately, the past several years has seen a dramatic rise in this group, not only in absolute numbers, but also as a fraction of all unemployed workers. This social cost of long-term unemployment has received insufficient attention from the media and during this presidential campaign.

 

 

 

 

The Problem of the Long-Term Unemployed--Posner

It is straightforward to enumerate bad effects of being
unemployed for a long time, such as erosion of skills, loss of contacts, and
reluctance of employers to hire a person who has been unemployed for a long
time (this is because employers often use a person’s having been unemployed for
a long time as a signal of lack of commitment to or fitness for employment).
But it is difficult to make a precise estimate of the gravity of the problem. 

For one thing, there is no nonarbitrary definition of “long
term.” Is it six months? (Many women are out of the work force for longer
because they have young children, yet do find jobs when they return, albeit
often at a lower wage than if they had remained in the labor force continuously.)
A year? One would have to know the average rate at which job skills erode,
contacts diminish, or potential employers’ suspicions grow, to be able to determine
the economically meaningful cut off. 

And even if this hurdle could be surmounted, it is unclear
who actually is “unemployed” and who simply has left the work force (retired
early, become a housewife or house husband and thus substituted household
production for paid work, become disabled, or interrupted work to go to college
or to a professional school). The number of people who are unemployed in the
Bureau of Labor Statistics sense—not employed at present, but looking for
work—understates the number of long-term unemployed, because some of the
long-term unemployed have become discouraged, ceased looking for work, and thus
are no longer counted as unemployed. No one knows for sure how many such
discouraged workers there are, but the Bureau of Labor Statistics estimates
that there currently are 800,000 id rgwn. This actually is rather few relative
to the 5 million long-term unemployed, that is, unemployed who are still
looking for work. 

Notice too that people who leaves the labor force are not
necessarily unemployed in an economic sense. Household production is real.
Apart from the obvious examples, a person who retires early to help with
raising a grandchild, thus freeing up the parents to devote more time to paid
work, is productively though not formally employed. This is true even if the
person is still looking for a paid job, and regards his stint as a household
producer as temporary. The difficulty of valuing the household production of
the long-term unemployed makes the cost of long-term unemployment to the
economy difficult to assess, although it is certainly positive. 

A final problem in estimating the social costs of long-term
unemployment is measuring the long term. Here one should distinguish between
long-term unemployed in the BLS sense—unemployed for a long time but still
looking for work—and unemployed who have stopped looking for work, whom the BLS
as I said calls discouraged workers. The unemployment rate in the United States
was very high throughout the 1930s, and many of the unemployed must have been
unemployed for years, yet that doesn’t seem to have left a residue of discouraged,
prematurely retired workers. Eventually most of them must have found jobs, and
not just during the World War II labor shortage, since low unemployment
persisted after the war ended. Surprisingly, of the 5 million long-term
unemployed still looking for jobs today, 1.7 million have been unemployed for
more than 99 weeks—and they are still looking. As the economy continues to
recover, assuming it does so, more will look for—and find—jobs. According to
the latest BLS statistics, in the past year the number of discouraged workers
has dropped by 16 percent, from 967,000 to 813,000. That is a promising sign. 

Long-term unemployment may turn out not to have a long-term
effect on the economy. Or may—for even though the economy has improved over the
past year, the number of long-term unemployed (the 5 million) has not declined.
This may reflect a reduced demand for workers, because of automation and (as
Becker points out) decline of manufacturing, which are economic changes
independent, or largely so, of the depressed state of the U.S. economy as
a whole.

Is Banking Unusually Prone to Risky Practices? Posner

I think the answer is “yes,” and that this becomes apparent if we understand the Darwinian character of competition, though this is not to suggest that competition invariably, or even typically, leads to corrupt behavior. 

There are many analogies between biological evolution and commercial markets, and as a result words like “competition” and “equilibrium” are important both in evolutionary biology and in economics. In an article published in 1950 the economist Armen Alchian argued that standard economic results could be predicted as products of a struggle for survival among competitors, without need to assume conscious profit maximization by any of them. But the explicit analogizing of economic behavior to Darwinian theory is far older than 1950, and in fact reached its
apogee in the decades following the publication in 1859 of The Origin of Species—in the movement that came to be known as Social Darwinism. In its extreme form Social Darwinism advocated eugenic
breeding, to improve the human race, and the elimination of poor relief and other redistributive policies, viewed as interfering with the struggle for survival and hence with the survival of the fittest. 

But the Social Darwinists had committed a big, though common, error, which is to confuse fitness with goodness. The “fitness” in Darwinian theory is adaptation to the environment, not improvement—which brings me at last to banking, and economic competition more generally. A competitive environment favors firms that adapt to that environment; and so to determine whether a market is working well from an overall social standpoint, one has to understand the environment, and the business behavior that best enables a firm to survive and thrive in it.  An analysis so motivated is a fruitful application of Darwinian theory to competitive markets.  

“Banking” traditionally meant borrowing from persons who want by investing to defer production or consumption (in other words, to save but be compensated for saving, rather than just stuffing their savings under their mattress) and lending the borrowed money to persons who want to save less and produce or consume more. Increasingly the word “banking” is defined more broadly, as virtually any form of financial intermediation, in recognition of the greater variety of investments made by
what are still called banks in our still lightly regulated financial system. But the traditional form of financial intermediation is all I need to discuss in order to make my point. 

The obvious problem for a bank is how to earn a spread—that is, how to lend at a higher interest rate than it borrows, as otherwise it will not cover its costs. The standard answer is to borrow short and lend long. Short-term interest rates are lower than long-term rates because the risk of default is lower (there is no need to predict the borrower’s long-term health) and because the borrower retains liquidity, which is valued—in the traditional demand deposit the borrower can withdraw at a
moment’s notice the money that he’s lent the bank (a deposit is a loan). Because a long-term loan is riskier and the lender surrenders liquidity, long-term interest rates are higher, so by borrowing short and lending long the bank earns the spread it needs to survive and thrive.  

The shorter the term of the bank’s borrowed money, and the longer the term at which it lends, the bigger the spread but the greater the risk of default. If the lenders to the bank decide that the bank is making risky loans, they, or some of them, may decide to withdraw their money. The more who do, the riskier the position of the other short-term lenders to the bank is, and so they will follow suit--hence bank runs. Because the bank’s lending is long term, the bank can quickly find itself with
no liquid capital and with long-term assets consisting of loans that are risky (which is what precipitated the depositors to flee the bank) and hence may be likely to default. 

One might think that, cognizant of such risks, banks would be cautious borrowers and lenders; they would not borrow so short (and thus risk a run) or make such long-term (and therefore risky) loans. But that need not be true. Maximizing spread may be very risky in the long run, but in the short run it may generate very high profits that shareholders and managers may be able to pocket and may compensate them for the risk of a future disaster, the costs of which will be borne by others. Banks that follow a more cautious strategy and therefore have lower profits may have trouble attracting and retaining talented employees and may not be able to hold on to short-term capital (the demand deposits) against the competition of more profitable banks (profitable because less risk averse) for short-term capital. 

As we know from the global financial collapse of 2008 and the ensuing global economic depression (and there are numerous historical precursors), the collapse of a banking industry can create
large external costs. For, to repeat, Darwinian evolution is toward fitness rather than goodness. A high-risk industry with frequent bankruptcies may be optimally adapted to its economic environment, but its risks may create serious danger for the economy as a whole. That is the argument for federal deposit insurance and other traditional, though now largely dismantled, regulations of bank solvency. Other high-risk industries with frequent bankruptcies, such as the airline industry, do not pose macroeconomic risk because they are small and because the firms can continue operating in bankruptcy; they do not experience runs that leave them assetless. For such industries, deregulation may be optimal. But for banking it is not. 

In recent decades some influential conservative economists, notably Alan Greenspan, the long-term chairman of the Federal Reserve, committed a variant of the Social Darwinist fallacy. They deemed
markets, including financial markets, as “self-regulating,” in the sense of achieving socially optimal results without need for traditional regulatory controls. At the urging of these economists and under pressure from the financial industry itself, some regulatory controls were rescinded and others ceased
to be vigorously administered. The underlying assumption was that markets “work.” They do work, but in much the same way that biological evolution works. Biological evolution has produced a marvelous variety of life forms, and economic evolution has produced a marvelous variety of products and services that have greatly increased human well-being. But both types of evolution produce “good” results only as by-products to the struggle for survival. Unregulated all they can achieve is fitness in the sense of adaptation to the environment. That may be good enough in most industries, but it is not good enough, for the overall health of the economy, in banking. 

Lax regulation, particularly of nonbank banks like Bear Sterns, Lehman Brothers, and Merrill Lynch, encouraged sharp banking practices. Firms in a competitive market cannot afford to be very ethical, any more than a tiger or other predator can afford to be gentle or kind. The firms will be under heavy pressure to engage in any highly profitable practice they can get away with, even if the profits that the practice promises are short term, provided those profits are great enough to dispel or at least
greatly  lessen the concern of managers and other key employees and investors with the long term. The short-term orientation will influence the business decisions of the managers and other employees (loan officers, traders, etc.) who exercise discretion; they will try to make as much money for themselves and their firms as they can, as quickly as they can, to avoid economic extinction. 

The Darwinian analogy of markets to nature is apt—and it is a warning against a certain type of economic complacency that appears to have contributed decisively to the economic doldrums in which much of the world is languishing, as well as to the frauds and other corrupt practices in banking that have surfaced. When an industry’s structure and centrality to the economy pushes it toward assuming macroeconomic risk, the need for careful regulation is acute.

Government Regulation, Competition, and Corruption-Becker

A widely accepted definition of corruption by businessmen is that their behavior violates laws or widely accepted ethical norms. Using this definition I would claim that the banking industry is more corrupt than the typical industry not because it is reasonably competitive, but partly because it is a highly regulated industry, and partly because it is an industry trusted with large amounts of money of customers. I will consider in turn the effects of competition, regulation, and trust.

Many believe that competition leads to a race to the bottom, where cheating of customers and other forms of corrupt behavior prevail because of competitive pressures. However, if repeat business is important for a company’s profitability, and if customers are aware of when they are cheated or are the victims of other unethical behavior by companies, competition tends to eliminate corrupt companies and promotes companies that behave honestly toward consumers. The reason is that corrupt companies will have little repeat business, and by assumption that would crush their profit prospects.

When repeat business is of little importance, as in many tourist centers, corrupt businessmen have much better chances of surviving and even thriving. It is in these cases that honest businessmen have trouble doing well because they are outcompeted by corrupt businessmen. Tourists do not have sufficient incentives to invest in knowledge of the reputations of local businessmen since they usually do not return to the same locality. In that case, their unhappy experience with cheaters would not affect their future behavior very much.

Unfortunately, the empirical evidence is limited on the relation between the degree of competition in an industry and its degree of corruption. Part of the reason for the scarcity of reliable information is that empirical studies of competitiveness do not tend to account for how important repeat business is, and the interaction between regulation and competitiveness.

One widely cited study on international corruption is Transparency International’s annual ranking of countries by the degree of corruption among government officials (its Corruption Perception Index). New Zealand, Denmark, Finland, Sweden, and Singapore head the list, while Sudan, Turkestan, North Korea, and Somalia are at the bottom. Some countries at the top have large governments, such as Norway and Sweden, but all the top countries have rather competitive economies, certainly much more competitive than countries at the bottom. These international comparisons do not indicate that competition leads to greater corruption, when corruption is measured by corruption of government officials.

While these indexes show that government officials are more corrupted in some countries than in others countries, greater regulation and government control in an industry often induces more corrupt practices in that industry. Companies that are successful at bribing or otherwise influencing officials to gain extra business or other advantages clearly are more likely to survive such competition. Of course, the advantage to corrupt business behavior would be eliminated if all officials and lawmakers were completely honest, but that is far from always the case.

Numerous examples are available of the advantages to businesses from corrupting regulators and other government officials. Fannie Mae and Freddie Mac, quesi-private companies, engaged in various corrupt practices during the housing boom in order to gain added business (see the expose of these companies in “Reckless Endangerment” by Morgenson and Rossner). Chinese government officials are accused of widespread corrupt practices as they allocate valuableland and capital to different companies.

From this perspective, the banking industry may well be more corrupt than the average industry not because it is reasonably competitive, but partly because it is highly regulated. Banks gain financially if they can induce regulators and others officials to give them advantages in the enforcement of the many complicated regulations that govern modern banking.

Corruption in the banking industry is also induced by the large quantities of money that that they receive in trust from depositors and others. Some regulations have undoubtedly protected lenders to banks from corrupt practices by bankers, although not sufficiently to prevent various highly suspect banking practices during the run up to the financial crisis. Still, an expansion of certain rules-based regulations of the banking industry has been warranted, such as greater capital requirements relative to bank assets.

In any case, my discussion indicates that the corruption of businessmen depends mainly on the importance of repeat business in a competitive environment, the ability of companies to influence the decisions of lawmakers and regulators, and the magnitude of the liquid assets of customers that are entrusted to companies.

 

What Limits to Using Money Prices to Buy and Sell? Becker

Perhaps partly due to the severity of the Great Recession, in recent years more books, articles, and blog postings than usual have argued against the use of markets to organize different parts of the economy. A subset of this type of literature is opposed not to markets in general, but to the purchase and sale of particular goods and services. One example is the 2012 book by the well-known philosopher Michael Sandel, “What Money Can’t Buy: The Moral Limits of Markets”. Another example is the opposition to a market in kidneys and other organs to be used in transplantation surgeries. Alvin Roth, the latest and highly merited winner of the Nobel Prize in economics, has argued that virtually no country allows such a market because most people feel  “repugnant” toward allowing organs to be bought and sold in an open market.

 

A general criterion that should be used in determining when money prices should be allowed to help bring demand into balance with supply is whether the private and social gains of using prices exceed the private and social costs. One major advantage of allowing money prices is that the cost to buyers equals the revenue to sellers, so that no resources are lost in the process of equating supply and demand. By contrast, when markets are cleared by queues, the waiting time is a cost or price to consumers, but sellers do not receive revenue from this cost imposed on consumers.

 

Another advantage of prices is that the limited supply of goods will be allocated to consumers who are willing to pay the most for the goods. This is an attractive result when dealing with individuals of similar incomes, but rationing by money price may be a disadvantage if richer persons get most of the medical care or other goods considered necessary for a decent life. However, the way to meet this problem is not by eliminating money prices as a way of rationing supply, but instead by redistributing income to poorer individuals, and sometimes perhaps by directly subsidizing the consumption of goods by the poor, as with Medicaid.

 

To show how these and other principles work out in practice I will discuss a few examples where the use of markets and prices has been criticized. I start with transplanting of organs since not only Roth and Sandel, but many doctors and others have expressed their opposition to allowing organs to be bought and sold. I concentrate on kidneys since kidney transplants are the most common, and individuals can donate one kidney while they are living as well as allowing their kidneys to be used after they die. The reasons given for opposing buying and selling kidneys are varied, but include Roth’s discussion of “repugnance”, and a claim that many poor persons would either be tricked into giving organs or would give because they were desperate for money.

 

These and other reasons for opposing using money prices to increase the supply of organs for transplant are not completely without merit, although the vast majority of individuals who need a kidney transplant or have relatives who need transplants want to increase organ supply by buying them and other means. Moreover, there are great costs to the present system that forbids the purchase and sale of organs. In the United States, about 90,000 individuals are waiting for a kidney transplant, and the average wait is about 6 years. The great majority of those waiting are on dialysis, and life expectancy while on dialysis is short. For this reason, about 4,000 individuals die each year while in the queue to get a kidney. Kidney exchanges, introduced in 2005, and other efforts to greatly reduce the waiting time have produced little overall benefit. In fact, the average waiting time rose from 4 years in 2005 to the 6 years wait at present.

 

Allowing kidneys to be purchased for transplant use would reduce the typical wait for a kidney to no more than a few months, and would eliminate all the deaths because of the time consuming queue to get a kidney. Since in the US and many other countries, governments largely finance transplants, access to transplants under a system when they can be purchased would not greatly depend on a person’s income. In light of these considerations, I do not understand how anyone who is knowledgeable of the great cost imposed by the present system on the many individuals who need kidneys could oppose allowing kidneys to be purchased and sold, even after taking full account of  “repugnance” and the other alleged costs of allowing a market in kidneys (for a more detailed discussion of allowing a market in organs, see Becker and Elias, The Journal of Economic Perspectives, Summer 2007, pp 3-24, and my blog post on organ transplants on 1/01/06) .

 

I briefly discuss two other controversial examples. Traffic congestion is a big problem in most cities in the world, such as Beijing, Los Angeles, and Mexico City. Traffic congestion imposes major costs on drivers since it often greatly increases the time to go from one destination to another. Again, as with the transplant market, time spent in traffic is an inefficient “price” since it wastes the time of drivers without providing benefits to anyone else. Indeed, it harms others because the driving time of other drivers is increased when someone decides to drive during congested times.

 

One alternative to traffic jams is to place a charge on using roads and highways during congested time periods, as the city of London does by pricing admission to the central business district during prime week day times. This "congestion price" would reduce driving times by encouraging some people to shift their driving to less congested times, to use carpools, to take slower and more indirect routes to their destinations, or to reduce their driving.

 

Of course, people who place higher values on their time would be more likely to pay congestion fees and continue to use the main roads. Since richer individuals tend to have high values of time, poorer persons would be more likely to shift their driving patterns. However, a better way to help lower income drivers than by using congestion is to use the revenue collected from congestion tolls to help poorer individuals, such as by improving roads in poorer neighborhoods. Congestion is too inefficient a method to ration road use and help drivers who place less value on their time.

 

My final example deals with the voluntary army that uses pay instead of a forcible draft to get a sufficient number of men and women to serve in the armed forces. Most readers are too young to remember the opposition to eliminating the draft in the US prior to converting to a fully voluntary armed force in 1973. It was then claimed, among other things, that a voluntary army would be “mercenary” and reduce patriotism, that only the poor and minorities would enlist, that a voluntary army would not fight well in difficult wars, and so on.

 

The evidence from the past almost 30 years in the US and from other countries that use a voluntary army is just the opposite; namely that a voluntary army is very professional and fights hard under difficult circumstances (think of Afghanistan and Iraq), that many young men and women from middle class families, and even upper class families, do volunteer, and that instead of exploiting minorities it provides some of the best opportunities for their advancement (Colin Powell is just one prominent example).

 

I have not attempted to draw a sharp line between where prices and markets should be used and where they should not be. Nor do I deny that for some activities the cost of using money prices would exceed the gains. I do believe, however, that in the US and other economies, the bigger problem is not excessive use of prices and markets but insufficient use. The examples I discuss illustrate the reasoning behind this conclusion.

Sale of Body Parts—Posner

I agree with Becker that a market in kidneys should be permitted. The “repugnance” that the idea of selling body parts engenders in many people seems to me to have no rational basis; it would be otherwise if one were talking about the sale of one’s eyes, heart, etc. 

The only function of a second kidney is as a spare. A person who loses a kidney does not experience a loss of health as a result. What is true is that if you sell a kidney, you have no back up. It is sometimes suggested that the problem be solved by a rule providing that a donor seller of
a kidney goes to the head of the queue for a kidney transplant if his remaining kidney starts to fail and if necessary he is given the new kidney free of charge. But such a rule would be unnecessary, as I’ll point out. 

The present system, much like the ban (frequently evaded though it is) on “buying” a baby for adoption (that is, of compensating the mother for giving up her birth child for adoption), has created a serious shortage of kidneys for transplantation. As a result of this shortgage, the
average waiting time for a kidney transplant is six years in the United States,
during which time the prospective recipient of the transplant is likely to be
on dialysis. Dialysis usually takes at least 12 hours a week, and the death
rate of dialysis patients is high. If kidneys were salable, the waiting time
for a transplant would drop precipitately, probably to zero (which is why it’s
unnecessary to guarantee a donor that he’ll go to the head of the queue if his
remaining kidney fails—there will be no queue), because demand is fixed at the
number of people who have advanced kidney disease, while the supply would be
highly elastic since many of the world’s poor, who are in the billions, would
regard giving up a “spare” kidney as a low-cost way of earning some badly
needed money. The market would be worldwide because the cost of shipping
kidneys long distances is negligible. (Kidneys from cadavers would have to be
harvested quickly, but I don’t think cadavers would continue to be a major
source of kidneys for transplanation, as they are now.) The U.S. demand would be small; there are fewer than 20,000 kidney transplants per year in the United States, although there would
be more if there were a market in them, because there would be fewer deaths of
people awaiting transplants and hence more transplant candidates. 

I imagine that the equilibrium price of a kidney would be low, and the overall cost of treating kidney disease lower than today because there be so much less dialysis. Hence moving to a market would not increase overall U.S. health costs, and would in fact reduce them. Moreover, there would be attractive income-redistributive effects. The market solution would cause a modest shift
of income from physicians and other personnel of dialysis centers to poor people, assuming realistically that the poor would be the principal sellers of kidneys.

 

The financial collapse of 2008 and the ensuing economic depression that the United States is slowly crawling out of have created some second thoughts about the nation’s commitment to free markets. But there is an important distinction between the fallacy (associated particularly with
Alan Greenspan) that markets are self-regulating and a general skepticism about
the efficiency of markets. Markets are self-regulating only in the Darwinian
sense; competition weeds out losers, but the winners may be imposing heavy
costs on society that they do not bear (pollution, for example, or the kind of
macroeconomic damage that the highly competitive financial sector has caused
because of its competition-driven risk taking). A market in kidneys would have
to be regulated, but the regulatory challenge would be slight, given all the
experience we have in the regulation of physicians, hospitals, drugs, medical
devices, and surgical and other medical procedures.

 

Luck, Wealth, and Implications for Policy--Posner

Liberals and conservatives tend to disagree about the role of luck in financial success, the
former thinking it plays a very big role, the latter thinking it plays a small
role: that instead financial success is largely attributable to talent and hard
work. Taken to its extreme, the second position is the one that was espoused by
the radical libertarian Ayn Rand. 

The economic significance of the disagreement has mainly to do with taxation. Taxing success
that is attributable to pure luck does not have disincentive effects, and so is
a cheap away of financing government. Taxing success that is attributable to
hard work may induce a substitution toward leisure, reducing money incomes, and
taxing financial success attributable to talent may induce some talented people
to substitute activities that generate substantial nonpecuniary income (apart
from leisure), which may not be socially as productive as business. Beyond the
economic concern, however, is an ethical one that is particularly acute in a
society, such as ours has become, in which there is great inequality of income
and wealth. 

I don’t find any merit to the celebration of the tycoon by Ayn Rand and her followers. I think
that ultimately everything is attributable to luck, good or bad. Not just the
obvious things, like IQ, genes that predipose to health or sickliness, the historical
era and the country in which one is born, the wealth of one’s parents, whom one
happens to meet at critical stages of one’s life and career, one’s height and
looks and temperament, to the extent genetic, and one’s innate propensity to
risk or caution (that is an exceptionally important factor); but also the
characteristics that cause a person to make critical decisions that may turn
out well or badly, characteristics that really are derivative from some of the
previously noted “luck” characteristics. The decision-determining
characteristics include intelligence, imagination, attitude toward risk, and
personality characteristics such as aggressiveness, maladjustment, indolence,
and having a low or high personal discount rate (how future-regarding one is or
is not). Talent is luck but so is the propensity for working hard (often the
consequence of a compulsive personality) or not working hard. 

In short, I do not believe in free will. I think that everything that a person does is
caused by something. It is true, and is the basis of belief in free will, that
often we are conscious of considering pros and cons in deciding on a course of
action; “we” are deciding, rather than having the decision made by something
outside “us.” But calculation and decisionmaking are different. Deciding may
just mean calculating the balance of utility and disutility; the result of the
balance determines the decision. No doubt when a cat pounces on a mouse, it has
decided to do so; but the decision was compelled by circumstances—the feline
diet, the presence of the mouse, etc. A complete description of the incident
would not require positing free will. 

If this is right, a brilliant wealthy person like Bill Gates is not “entitled” to his
wealth in some moral, Ayn Randian sense. But it would be ridiculous to infer
from this that the government should take his wealth away from him and scatter
it among the poor, on the theory that the only difference between Gates and a
poor person is that one is lucky and the other is not. But the reason that it
would be ridiculous is that it would have terrible incentive effects, not that
it would violate some deep sense of human freedom. 

The effects of heavy taxation of wealth may depend in part on the kind of luck that generated the wealth that is now to be taken away and given to someone else. There may be different effects from taxing wealth that results primarily from personal qualities, such as IQ and ambition, and taxing
wealth that is unrelated to such qualities—inherited wealth, for example, or
wealth obtained by winning a lottery, or, a subtler and more important example,
wealth resulting from financial risk taking unguided by real insight (or, it
hardly needs noting, from antisocial activities such as crime). Heavy taxation
of earned wealth is likely to induce many able and energetic people to increase
their leisure activities relative to productive work—but to induce other such
people to increase their work effort relative to leisure in order to preserve
or augment their wealth in the face of the heavy taxation. Heavy taxation of
unearned wealth is more likely to have the second than the first effect,
because, lacking talent, such people will have to work hard (to work, period—maybe they were living off their inherited or otherwise bestowed wealth and not working at all) in order to maintain a decent
standard of living, lacking as they do the talent of the wealthy people who
earned their wealth rather than having it fall into their laps. 

I mentioned financial risk taking. Because of the uncertainty (in the Knight-Keynes
sense—that is, a probability that cannot be quantified) of speculation,
speculative profits, as by trading stocks and bonds, are mainly the result of
dumb luck rather than of skill or hard work. In fact many speculators work
hard, but the number who are consistently successful seems little if any
greater than one would expect as a result of mere luck. Speculative profits
tend to soar in rapidly rising markets and collapse when markets sour. Market
turns are hard to spot and fluctuations in the prices of particular stocks are
difficult to predict because, as Keynes famously pointed out, when you are
speculating on stock prices you are speculating not merely about the fortunes
of the company that issued the stock but about how other speculators assess
those fortunes and indeed how they assess your assessments. Although
speculation tends to generate information about underlying values and to that
extent is socially productive, the benefits of that information bear no
relation to the profits and losses that speculation generates. Those are
gamblers’ profits and losses and taxing the profits heavily would probably have
only a small negative effect on the generation of socially valuable
information. 

So there is in my view nothing “unfair” about heavy taxation of wealth, but there are
practical objections. One is that the wealthy have sufficient political
influence to pepper any new tax law with loopholes that will enable wealthy
persons to minimize their tax liability. Another is that the additional tax
money raised will be squandered on unproductive governmental activities,
including handouts that reduce recipients’ work incentives. This objection
would disappear, however, if the proceeds of additional taxes on the wealthy
were earmarked for reducing the federal deficit. 

There are complaints that already, though the maximum federal income rate is low (the top
marginal rate is 35 percent, and for capital gains, dividends, and interest is
only 15 percent), the very wealthy pay a very high proportion of total federal
income tax, and almost half the adult population pays no federal income tax at
all, though it pays federal payroll taxes and state taxes. I can’t see why
anyone should care that the wealthy pay a “disproportionate” share of federal
income tax, unless there is evidence (of which I’m unaware) that taxing the
wealthy at even lower rates than they are being taxed would elicit greater
productive effort. Indeed, I don’t even know what “disproportionate” should
mean in this context. Would it be “disproportionate” to require the
highest-earning 1 percent of the population to pay 1.5 percent of total federal
income tax? 

Federal tax law is riddled with deductions and exemptions that are loopholes in the sense
that they have no social product. An example is the mortgage-interest
deduction, which incentivizes people to own rather than rent their homes—and
why encourage home ownership? Another example is the exemption of employer-paid
employee health benefits from federal income tax, which encourages excessive
expenditures on health care. Some taxes, such as the corporate income tax,
cause distortions, as does treating dividends and interest differently by
allowing interest but not dividends to be deductible by corporations. Reform of
the tax code would be preferable to raising taxes on anyone, but the major
loopholes and deductions and exemptions are sacred cows, leaving changes in tax
rates and spending levels as the only feasible methods of achieving fiscal
discipline.

Luck and Taxation-Becker

 

I do not believe that differences in value judgments are the main source of the disagreement among economists over how much to tax individual with different levels of wealth and income. These value judgments include beliefs about how much of high incomes are due to good luck, whether high-income individuals “deserve” their incomes, or whether there is “free will”. Such considerations, however, may be more important among the general public since, for example, they may not want to tax heavily a Steve Jobs or Brad Pitt because they admire these (and some other) successful individuals and their accomplishments.

For economists, differences in views on what the tax structure should be and on other policies mainly come down to different beliefs about how taxes and other policies affect behavior. For example, economists who support much greater taxes on higher income individuals believe that higher taxes will not much affect how hard these individuals work, their propensity to start businesses, or other kinds of behavior. On the other hand, other economists, including me, believe that high marginal tax rates not only discourage effort and other choices by those being taxed, but also affect the form in which they take their incomes. These adjustments include increases in non-taxable perquisites, such as greater use of a company’s plane, hiring expensive accountants and lawyers to search for loopholes in the tax code, converting income into capital gains when these gains are taxed at lower rates, and investing abroad if the income earned there is taxed at lower rates.

Unfortunately, the empirical evidence accumulated so far does not conclusively support either approach. That is, it is unclear how large is the effect of higher income taxes on the behavior of richer individuals. The relevant evidence is growing, but so far different perceptions of these effects prevent the resolution of the sharp differences in opinions among even a-political economists on the damage done by high marginal income tax rates.

The important point for our discussion is that beliefs about the importance of good or bad luck in determining high or low incomes is not usually the decisive source of differences in attitudes about tax rates and other public policies. For example, one may correctly believe that luck has a major role in determining the genes, education, and other opportunities of highly successful individuals, and yet believe as well that high tax rates on their income and wealth would induce major changes in their behavior. Conversely, one can believe that luck is unimportant in determining success, and at the same time believe that high tax rates on rich individuals would little affect their behavior. And, of course, various other combinations are possible about the relation between the role of luck in achievement and induced responses to taxes and other policies.

A well-known illustration of the link between luck and behavior is the advocacy of a single tax on unimproved land proposed in the 19th century by the American economist Henry George. His argument was that the intrinsic quality of land was entirely due to the luck of its location with respect to soil, rainfall, sunshine, and other relevant determinants of land productivity. This led George to argue that taxing heavily the higher value of unimproved better land would raise considerable revenue, and yet cause no harm since the value of unimproved land is determined entirely by its good luck in location. Critics of this “single tax” proposal responded that while George deid not want to tax the value due to heavy use of fertilizers, machinery, and other agricultural investments, in practice it is impossible to separate accurately the unimproved value from the total value. As a result, some of the investments in land would also be taxed. These agricultural investments would surely be affected by taxes on land, even though the location of land with regard to sunshine, soil, etc. is entirely a matter of luck.

My conclusion is that even though luck plays a huge role in determining genes, family, education, and other determinants of success or failure, this does not imply very much about the desirable tax rates and other public policies.

Will Long-Term Growth Slow Down? Becker

Sustained long-term economic growth beginning in the near future would help greatly toward overcoming two major problems confronting the United States (and Europe and Japan). One is the high ratio of government debt to GDP that resulted from budget deficits due to the rapid increase in government spending during the past several years. GDP that continues to grow faster than outstanding debt is the surest way to reduce the burden of the debt. Sustained long-term growth would also allay the fears of many parents that their children would not be any better off than they are.

Improvements in productivity due in large measure to new technologies have been the major source of long-term economic growth in per capita incomes. From 1880 or so to the beginning of the financial crisis, American productivity advanced on average at a rate of a little less than 2% per year. This helped, along with capital accumulation, to produce a long-term growth in American per capita incomes of about 2% per year. Since growth continued at such a steady rate for such a long time, one might reasonably expect that the US would resume growing at a similar rate once it gets beyond the effects of the financial crisis and the Great Recession.

However, a recent study by Robert Gordon of Northwestern, one of the leading experts on productivity, puts a damper on these expectations (see his “ Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds”, NBER working paper 18315, August 2012). Gordon argues that advances in productivity were slowing even before the financial crisis hit because the innovations of the past several decades, including computers and the Internet, were less important than those at the end of the 19th century and beginning of the 20th century. He also argues that future growth in the U.S. is likely to be even slower than in recent decades because of six “headwinds” that he believes will reduce growth. If Gordon is right, Americans face an unprecedented and dismal future of basically stagnating incomes.

It is common during a long and deep recession or depression for economists and others to become pessimistic about the economic future. For example, at the end of the Great Depression in 1939, a leading American economist of that time, Alvin Hansen of Harvard University, argued that the U.S. and Europe were in for long-term (secular) stagnation, partly because he believed that technological progress would be much slower in the future. Of course, he turned out to be completely wrong. However, Gordon’s forecasts abstract from the financial crisis and resulting recession, and he bases his pessimism on how the situation looked to him prior to the crisis.

Gordon follows an established approach by dividing the past 200 years into periods of three Industrial Revolutions. The initial one occurred during the last half of the 18th century and the first several decades of the 19th century, with the steam engine and railroad being examples of the major new technologies from that revolution. The second, and what he considers the most important, industrial revolution occurred between 1870 and 1900. This revolution gave us, among other inventions, electricity, the automobile, the airplane, and the small engine. The third revolution started around 1960, and encompasses computers, the Internet, and genomics and biotech.

Gordon’s main reason for pessimism about future growth is the evidence he presents that American labor productivity (measured by output per unit of labor input) advanced much more slowly after 1970 than it did between 1890 and 1970. He also points out that throughout most of history- that is, until the first industrial revolution- annual growth in world per capita income was close to zero. Perhaps, according to Gordon, we should think of the 3 industrial revolutions not as the norm for the future, but as “temporary” exceptions that will not be repeated in the future.

Gordon makes a thoughtful case for his conclusion that future long-term growth for the U.S. will be much slower than past growth. Still, I do not find the case convincing. While growth during the past two centuries was radically different from the slight annual growth during the prior two thousand years, the reason is not luck or accident, but in good part was due to the development of science, and especially to the application of science to industrial progress. Knowledge builds on knowledge, and the available evidence does not indicate that the accumulation of knowledge is subject to diminishing returns. This suggests that future knowledge could very well grow at a rate comparable to its growth during the past century and a half.

Another difference between the past two centuries and previous history is the emergence of economies that relied on competition and private enterprise. This was the economic system in Great Britain when it led the world in productivity advances, and it describes the U.S. economy after it took over leadership from Britain. Advances in technology and productivity are likely to continue at a good rate if the U.S. and other leading countries continue to emphasize competition and the private sector, and do not use governments to try to determine future technology “winners”.

I also believe that Gordon underestimates the full impact of the third revolution based on computers and other modern technologies. As he shows, the effects on productivity of the 2nd revolution lasted for close to 100 years, while the 3rd revolution has been going on for no more than about 50 years. It is extremely difficult even for the most informed individuals to predict the long-run effects on productivity of new technologies. Gordon quotes someone working in 1876 for Western Union, the major telegraph company, who claimed, “The telephone has too many shortcomings to be considered as a serious means of communication” and Bill Gates who stated, “640 kilobytes ought to be enough for anyone”.

I will say little about the six headwinds that Gordon believes will also slow down future growth since his arguments are not convincing. To take a few of his headwinds, I believe globalization will add to, not subtract from, U.S. growth and real per capita incomes, that the effects of having fewer young persons working relative to the number of retired older persons will be partially overcome by considerable extensions of the ages at which workers typically retire, and that inequality will likely begin to decrease. Along with Gordon I am concerned about the effects of global warming on the economy, but I expect new technologies to go a long way toward solving that considerable problem, just as technological discoveries overcame many challenges in the past.

I agree with Gordon that sizable future growth in per capita incomes in a leading economy like the American one will not come automatically just because past growth was considerable. However, I do believe that the dividends from the 3rd industrial revolution are far from exhausted, and that future growth can be robust given the right economic environment. What I mean by the “right environment” has several components, but number 1 would be a continued reliance on competition and the private sector as the principal way to organize the economy, and number 2 would be to improve investments in education and other human capital.

Will U.S. Economic Growth Slow? Posner

It is good to be reminded that the rate of economic growth
is not constant, that it has varied a good deal in the past, and that it may
decline over the indefinite future, as feared by Robert Gordon in the study
discussed critically by Becker. I agree with the criticisms, of which the
central one is that the future is unpredictable, including not only the
technological future but also the political future and the future of personal
tastes and preferences. Moreover, almost all prediction is extrapolation from
current conditions, so pessimism is characteristic of economic predictions made
during a period of economic depression, such as the United States remains in.

The material standard of living of many Americans is very high; roughly 20 percent of American households have an annual income in excess of $100,000. At that level, desire for leisure (including early retirement), or for goods and services that are labor-intensive, making productivity gains (from capital substitution) difficult to achieve, may retard economic growth yet increase economic welfare. At the same time, growing inequality of income may reduce the demand for goods and services in lower household-income quintiles, with negative effects on economic growth. Although it seems unlikely, one can at least imagine a situation in which growing inequality of income produces a rich upper crust satiated with material possessions and a vast underclass unable to afford many such possessions, and this would be a pattern inimical to economic growth. 

For reasons explained by Keynes, consumption drives the economy (by stimulating supply and hence employment, which in turn provides income for further consumption), and so if the desire for consumption flags, the economy would grow very slowly, or not at all, or would decline, unless government picked up the slack. Yet if the flagging of desire for consumption represented simply a satiation with material possessions and a resulting preference for leisure, economic welfare might actually increase rather than decrease. Europeans, judging from the average length of the work week in Europe relative to the United   States, place a higher value on leisure than Americans, and maybe we will grow more like Europeans, once our economy recovers from its present doldrums. 

Of course we mustn’t press the idea of material satiation too far—as Keynes did in his 1930 essay “Economic Possibilities for Our Grandchildren.” It predicts that barring another world war or some comparable tragedy, a century hence per capita income would be four to eight times greater because of continued capital investment. So far, so good; despite another world war, GDP per capita in the United States has increased almost six-fold since 1930 (and Britain’s per capita income about the same), and we still have 18 years to go before the century is up. Keynes thought the increase in per capita production would lead to a dramatic fall in the hours of work; by 2030 a person would have to work only 15 hours a week to maintain his standard of living. The “economic problem” would have been solved and the challenge would be to fill up people’s leisure time with rewarding leisure activities. Unlikely! People in wealthy countries like the United States
and Britain are working fewer hours per week on average than in 1930: roughly 40 rather than 50. But Keynes thought that by 2010 the average would be 20. Material
satiation is not in the offing, but there is no iron law of economics that the
work week shall not fall below 40 hours; increased substitution of leisure for
work may continue as incomes continue to rise. 

Probably economic growth is not something to worry about,
but rather concern should focus on correcting inefficient practices, such as
reluctance to allow the immigration of highly qualified scientists and
engineers because of the competition they would offer to our citizens in
technical careers; or nepotism in higher education; or neglect of
infrastructure; or excessive criminalization; or our screwed-up tax system—the
list goes on and on. Correcting inefficiencies will enable more rapid economic
growth—or less, if people’s preferences are for goods, services, or activities
(or inactivity) in which productivity is difficult or impossible to increase.
Economic growth should be thought of not as a goal, but as a byproduct of an
efficient economy; the focus of policy should be on means rather than ends.