Too Few Jobs: Trade Is Not the Problem, Slow Growth Is

[Note:  This post originally appeared in American Thinker magazine on May, 27, 2016.]

The irrefutable evidence of economic history over several centuries is that the wealth of societies (later nation states) significantly increases as trade expands.  Scarce resources are conserved by being able to obtain goods from others who can produce those goods more cheaply.   The conserved resources then become available to be redeployed to other productive activities, thus adding to the total stock and diversity of a society’s wealth.

Notwithstanding this overwhelming evidence, however, expansion of trade is often singled out as detrimental to a society’s well-being.  Presumptive Republican presidential nominee, Donald Trump, for example, has made the alleged “costs” of trade a centerpiece of his campaign.  Mr. Trump cites current account deficits with China and Mexico as evidence that those nations are taking advantage of the U.S. and stealing U.S. jobs.  He says that, if elected, he will use his business skills to renegotiate existing international trade agreements so as to eliminate the deficits and bring jobs back home.

Regrettably, Mr. Trump sees the conservation of resources, especially labor, as a cost instead of a benefit to be exploited to the nation’s advantage.  This view is short-sighted, and it ignores the principal reason for the lack of new employment opportunities for resources that have been freed up because of trade, a near stagnant economy.

Economic systems are highly complex. In a market-based economy, all economic variables, including policy variables, are interconnected.  If you push on one variable, every other variable shifts — some imperceptibly, others measurably.  A consequence is that focusing on a specific perceived problem in isolation nearly always leads to a failure to grasp the actual causes of the problem.  Regrettably, politicians rarely learn this lesson.  As a result, they try to “fix” a specific problem that they can see with cocooned policy that does not account for other variables either unseen or incorrectly perceived to be unrelated.  In the end, the “corrective” policy more often than not does more harm than good.

Mr. Trump’s view about the “costs” of trade suffers from this short-sightedness. It focuses solely on what is visible, the displacement of resources (e.g., jobs) in those industries most affected by trade.  Such a restricted view has great emotional appeal because structural changes owing to trade can cause severe hardship to those whose lives are disrupted, and a compassionate nation should rightly address this result (I will come back to this).  Limiting one’s focus only to what is visible, however, excludes accounting for the benefit, on a macro level, of the nation’s enhanced capacity to grow by reallocating those conserved resources to other productive activities.

In this regard, a nation is no different from an individual. Most individuals find that it is cheaper to buy groceries at a supermarket than to produce their own food.  Because it is cheaper, money is conserved that then can be spent on other items that enrich one’s life.  Similarly, a nation that buys goods from abroad at a cost less than it would incur producing those goods at home can use those savings to expand output in other areas.  Moreover, when low-priced imports are intermediate goods, the gains extend to domestic industries using those goods, thus permitting, at the macro level, positive job creation.  Implementing restrictive policies (e.g., tariffs, quotas, duties, etc.) designed to “protect” jobs from being lost to trade (the visible problem) thus suppresses a nation’s wealth potential.

What’s more, this focus on the visible misdirects attention away from doing what is necessary to ensure that the wealth-enhancing gains from trade are fully realized and that trade-related structural change does not produce lasting localized hardships.  In other words, instead of forgoing resource savings and the gains to consumers (including industrial consumers) from low-priced imports in order to “protect” jobs, would it not be better to have a rapidly expanding domestic economy characterized by continuous new job creation?  It is no coincidence, I believe, that Mr. Trump’s pronouncements about the “costs” of trade come at a time when the U.S. has experienced an historically tepid recovery following a severe recession.  Had economic growth been anywhere close to historical norms since the 2008 crisis, it is doubtful that complaints about other nations “stealing” U.S. jobs would have nearly as much currency.

So, the real question to be asked is how do we restore economic growth. This is the problem to which Mr. Trump and others should direct their attention.  Undesired resource idleness does not occur in a vibrant economy with expanding job opportunities.  The goal should be to accrue all of the gains from low-cost imports while maintaining full employment at home.

Putting the economy back on a job-creating growth path will, in turn, require addressing the several significant self-imposed interconnected impediments to that path.  These include, among others, the massive and growing overlay of federal regulations on business; leviathan government spending that saps the economy of productive resources; and a tax system that hinders capital accumulation and is laden with special interest provisions that distort allocative efficiency.

Space here does not permit a full discussion of these yokes on growth and job creation, but a few facts illustrate the magnitude of the yokes.

Regulatory Costs:

According to estimates made by the Competitive Enterprise Institute (CEI), federal regulations imposed a $1.88 trillion cost on the U.S. economy in 2014.  Those costs include direct and indirect costs on businesses and higher prices on goods and services to consumers.  CEI estimates that, all told, the costs amount to nearly $15,000 per U.S. household.  This number would of course be even higher if state and municipal regulations are added in.

Of course, not all regulations are bad. Nonetheless, a $1.88 trillion burden on the economy certainly contains substantial overreach.   In turn, each dollar of unnecessary cost on businesses reduces the output rate at which a business maximizes its profit and thus reduces its demand for labor.  Moreover, the enormous compliance burden diverts resources away from more productive uses that would otherwise expand the size of the economy, and the higher prices on final goods mean that consumers’ real income is reduced.  The end result is stunted growth and fewer jobs.

Spending and Taxes:

Federal government spending for fiscal year 2015 was $3.7 trillion.  Total government spending (including state and local government) was $6.4 trillion. At the same time, the federal government took in $3.25 trillion in tax revenue.  State and local governments took in another estimated $3.1 trillion.  Such a huge diversion of resources away from private, productive uses robs the nation of both wealth and jobs.

In addition, the inefficiencies that spending and taxing policies impose on the economy hinder growth and job creation still more.  For example, special interest tax provisions and spending programs vitiate market-determined resource allocation.   The result is distortions throughout the economy.  Further, taxes on business income, capital gains, and income from savings reduce the returns on capital and make capital less desirable to accumulate.  Less capital accumulation means slower economic expansion and less demand for labor.

Summing Up:

Low-priced imports that American buyers find cost-effective and that provide the opportunity for expanding the total national wealth are a net benefit to the U.S., not a cost.  Restrictive trade policies that focus only on the visible hardships suffered by those most affected by trade misperceive the real problem, a near stagnant economy characterized by slow growth.  In the end, such polices will not only fail to stop inexorable structural change, but make the country poorer.  Far better would be to restore a vibrant, robustly growing economy in which there is continuous job creation that ensures an abundance of new opportunities for those otherwise displaced by expanded trade.  Of course, where short-term transition assistance is needed, that assistance should be provided, but long term unemployment need not be the norm. The next president will have a fresh opportunity to refocus on growth.  A good start toward this end is serious reduction in regulatory overreach, overhauling the tax system to remove anti-growth biases, and major cuts in the amount of national income that big government consumes. — The Chinese and the Mexicans are not the problem.  The problem is us.

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Paying One’s “Fair Share” of Taxes Redux

[Note:  This post is an update of an earlier one to take account of more recent developments, including President Obama’s news conference on May 6, 2016.]

In his news conference on Friday (May 6), President Obama reiterated his claim that, owing to tax loopholes, the wealthy do not pay their “fair share” of taxes, a claim he has made several times during his presidency.  Vermont Senator Bernie Sanders has made this same claim in most, if not all, of his presidential campaign speeches.  Former Secretary of State Hillary Clinton has also stated that, if elected president, she intends to institute a four percent “Fair Share Surcharge” on Americans who make more than $5 million a year.

I have always been puzzled when I hear politicians, particularly Democrats and others of the left, talking about people needing to pay their “fair share” of taxes.  What President Obama, Senator Sanders, and Mrs. Clinton mean by this idea is that those earning higher incomes owe society more in taxes than they already pay, notwithstanding that income tax rates are already progressive, i.e., marginal rates increase with income.  Rarely, however, do proponents of raising rates on high income earners say exactly what a “fair share” of taxes is or, more precisely, what the upper limit, if any, of a “fair share” of taxes is.  Even more vague is their philosophical basis, either in ethics or some other grounding, for what constitutes “fairness” in this context.

It seems to me that Obama, Sanders, Clinton, and others of similar views have the tables turned upside down.  In fact, rather good philosophical arguments can be made from both an ethics and an economics perspective that, if anything, high income earners are already paying well more than their fair share of taxes and that their absolute tax payments or marginal rates should therefore be reduced.

Taxes are the cost of financing government.  In our democracy, every qualified voter is afforded one vote, no more and no less.  Just as this political shareholding is allocated equally among citizens, it would seem intuitively fair that the burden of the cost of government should similarly be allocated equally.  That is, everyone should pay the same amount in taxes in the form of a simple per capita tax.  This way, each person contributes the same amount toward the cost of government, much like dues assessments in a club.  At the least, it would be interesting to ask President Obama, Senator Sanders, and Mrs. Clinton to explain, from an ethics standpoint, why their proposals to make taxes even more progressive, i.e., even more unequal, are fairer than an equal per capita tax.

Of course, as a practical matter, given the current size of government, an equal per capita tax would necessarily mean that many, if not most, taxpayers would owe more than they earn or have in savings and, in some cases, likely much more.  Such a tax thus would be unworkable unless government were shrunk substantially.  The cost of government would have to shrink at least to the point where the per capita tax would be affordable by each taxpayer, a goal unlikely to be shared by the political class, left or right.  Even so, the size of government and the practical ability to have fairness in the tax code would seem to be inextricably linked.

Admittedly, I am uneasy to render judgments on purely ethical grounds about whether the amount of taxes a particular taxpayer pays is fair for that taxpayer.  I do, however, claim some expertise in economic reasoning.  On that basis, I think an argument can be made that, in the alternative to a per capita tax, a regressive income tax is actually fairer than a progressive one.

The argument rests on the idea that whenever there is voluntary exchange, every transaction creates wealth.  A voluntary transaction will not take place unless each party becomes better off as a result of the transaction.  It follows therefore that, so long as high income earners obtain their income through voluntary exchange of their labor, services, or other resources, each dollar of that income is the product of a wealth-creating transaction.

Significantly, however, the high income earner does not keep all of the created wealth, but only a fraction.  The rest of the new wealth necessarily accrues to everyone else with whom the high income earner engaged in voluntary exchange, either directly or indirectly.  Thus, the higher the income of the high income earner, the greater the earner contributes to other people’s wealth.  It follows then that high income earners benefit society more than lower income earners before any taxes are taken out of those earnings.

Based on this reasoning, one possible way to measure tax fairness would be on the basis of relative additions to aggregate social wealth.  Under such a definition, people who contribute less to social wealth would be required to make up for the deficit by paying more in taxes, while those who contribute most to social wealth would be rewarded by lower taxes.  Put another way, fairness would require that high income earners be taxed less than low income earners.  The former have already made a disproportionate positive contribution to social welfare.

Of course, as with the per capita tax, a regressive income tax would require considerable downsizing of government.  Such a tax simply could not finance the current government.  Once again, the size of government and the practical ability to have tax fairness are inextricably linked.  But that practical consideration aside, a fairness argument for a regressive income tax that rests on economic reasoning, unlike the Obama, Sanders, and Clinton fairness arguments, at least has an analytical grounding.  It would be interesting to learn how they would respond to the argument.

In that regard, I will myself volunteer one necessary exception to the general conclusion.  The exception owes to the fact that many high income earners today derive their high incomes not from contributing to aggregate wealth but rather by using the machinery of government to expropriate the wealth created by others.  Rent seeking can be very lucrative.  Thus, if “paying one’s fair share” in taxes is inversely related to one’s contribution to social wealth, these high income rent seekers should be taxed at a 100% marginal rate.  Given that the Democratic left has its own set of favored rent seekers, however, I am not sure that Obama, Sanders, and Clinton could even agree to this exception.

To be sure, I write all of the above with a considerable amount of tongue in cheek.  I stand by the larger point, however, that tax “fairness” is hardly a known parameter, and that one can construct ethical and/or syllogistic arguments leading to completely opposite conclusions as to what is fair.  In view of this conundrum, it seems to me that we all would be better served if politicians and policy makers purged “fairness” from their thinking (and speeches) and simply focused on a tax system that finances essential government functions in the most efficient manner possible and impedes economic vitality and long-term growth as little as possible.  I suspect that, in a prosperous and growing economy, questions of “fairness” will lose much of their political cachet and recede to the academic lounges where they belong.

Demagoguery and the Minimum Wage

[This post was originally published by American Thinker magazine on April 2, 2016.]

On Monday (Mar. 28) California Governor Jerry Brown announced that he would sign a bill to raise the state’s minimum wage to $15/hr.  The increase from the current minimum of $10/hr. would be fully completed by 2022.  Last year, New York passed legislation raising the minimum wage for fast food workers to $15/hr.  At the local level, the city of Seattle has mandated a minimum wage of $15/hr. to be fully phased in by 2021.  In the presidential campaign, Hillary Clinton and Bernie Sanders have proposed raising the federal minimum wage from $7.25 to $12/hr. and to $15/hr. respectively.

Particularly among politicians of the left, raising the minimum wage has long been a staple as a campaign talking point.  Mrs. Clinton and Senator Sanders claim, for example, that raising the wage floor is necessary to help people to move into the middle class.  The argument rests on the idea that if incomes are too low for some people to reach the middle class, a law mandating higher incomes is justified.  Certainly, the argument has strong emotional appeal.  Regrettably, it is also subject to significant demagoguery.

As economists have taught for generations, price controls (wages are prices) never achieve their intended ends.  Simply put, there are irrefutable laws of economics that cannot be repealed by political action.  Demagoguery and emotional appeal may produce short-term political advantage, but ultimately claims based on unsound economics must disappoint those who put faith into those claims.  Minimum wage laws are an exemplar of political action that cannot live up to its claims.

A fundamental law of economics is the law of demand, which states that as the price of something rises, the quantity purchased decreases in a given time period, and vice versa.   The law rests on the fact that, in the real world, resources are scarce, and thus the process of satisfying human wants requires making choices among alternative uses of those scarce resources.  Relative prices determined in free markets facilitate this process by permitting persons to make spending decisions according to the incremental value they obtain per extra dollar spent on a good or service.  The lower the price, the higher is that ratio.  The higher the price, the less is the ratio.  Hence, if the price of something goes up – thus reducing the value per dollar spent – less will be purchased as substitutes become a better bargain.

Artificially controlling specific prices distorts this process and creates inefficiency in resource allocation, as relative prices no longer fully reflect market forces.  Wages are prices.  Hence, if wages for unskilled labor are artificially set above the market wage by means of legislation, less unskilled labor will necessarily be purchased per period of time.  Moreover, the structure of wages throughout labor markets – skilled as well as unskilled – will be distorted, and economic efficiency will be compromised.  These outcomes are givens, and economists have known about them for a long time.

Why then do minimum wage laws persist?  Are not the harmful effects sufficient for voters to reject politicians who push these laws?  The answer, I believe, is that, although the harmful effects are real, they are generally not immediately visible, while the superficial, demagogic appeal of minimum wages is easy to articulate.  For example, both Mrs. Clinton and Senator Sanders claim that raising the minimum wage will help to elevate people – particularly unskilled workers — into the middle class. Senator Sanders further claims that raising the minimum wage will have a desirable redistributive effect that will lessen income inequality.

Neither of these contentions, however, lives up to its full billing.  As for elevating lower income people permanently into the middle class, minimum wage laws are highly inefficient because they focus on symptoms and ignore causes.  In this regard, vast amounts of evidence indicate that rising incomes are best achieved by education, stable families, and cultural factors such as personal discipline and a strong work ethic.  Entry level jobs – even at low wages – help to foster the personal characteristics, especially among young people new to the workforce, necessary to succeed in a work environment and eventually advance into higher paying positions with greater responsibility.  Minimum wage laws that price these persons out of the labor market remove the opportunity to develop these traits.  In addition, in few households is the primary income earner a minimum wage worker. Hence, even for households where jobs are retained, raising the minimum wage will have little impact on household income.  A far better emphasis for public policy directed toward building the middle class would be on augmenting incentives for skills acquisition and maintaining stable families.

Raising the minimum wage is a similarly inefficient means to address income inequality. This is not controversial among economists.  Any income redistribution that raising the minimum wage achieves is likely temporary, as employers adjust to the higher wage rate over time by substituting to other inputs such as labor-saving technology.  In addition, the higher wage rate only raises the income of those who continue to keep their jobs.  For workers who, at the margin, lose their jobs, income falls to zero.  And, finally, the redistribution comes at the expense of distorting relative prices, which can be considerable depending on the size of the wage hike.  There are far better ways to achieve income redistribution (assuming that’s the goal) such as simple cash payouts or a negative income tax.  Either of these measures ensures that the incomes of the entire targeted group increase, and both mitigate against compromising efficiency because of price distortion.

Regrettably, demagoguery on the minimum wage is not limited to political candidates seeking electoral advantage. Minimum wage laws also receive strong support from organized labor under the guise of helping out all workers.  The California legislation, for example, was backed strongly by unions.  At first glance, such support would seem odd as union jobs, after all, are typically at hourly wages much higher than the minimum wage.  Even so, there are at least two reasons why unions can be counted on to advocate for higher minimum wages.  First, many union contracts contain clauses that structure union wages relative to the minimum wage.  That is, the union pay scale is set, in relative terms, to be some percentage above the lowest pay scale.  Hence, when minimum wages are hiked, the union pay scale is similarly adjusted upwards.  Second, even aside from contract terms, it is in the interest of skilled union workers to have the wage rates of unskilled workers continually increase.  The higher the wage of the unskilled worker, the less that worker competes for the same job as the more productive skilled worker.  In the end, despite contrary rhetoric, both of these factors work against greater employment of unskilled workers.  Once again, legislated wage floors produce perverse consequences for those intended to be helped.

To sum up, higher minimum wages cannot be justified in sound economics. Fundamental economic laws simply cannot be overridden by political action.  Unskilled labor in California, New York, and Seattle will, in the end, suffer the most from the economic demagoguery of their elected officials.  Moreover, if Mrs. Clinton or Senator Sanders succeeds in raising the federal minimum wage, the perverse consequences will be spread across the nation.  This result would be unfortunate because it need not be so.

Indeed, higher real wages for all workers (unskilled as well as skilled) and permanent rises in standards of living have been the historical norm in the U.S. The drivers of this experience have been ever-increasing labor productivity and an expanding economy in which competition for labor services remains intense.  The proven recipe to those ends is a vibrant and growing free-market private sector incentivized by low taxes and minimal regulation, and a culture that encourages skills enhancement and personal responsibility.  Demagoguery over the minimum wage is no substitute.

Donald Trump v. Adam Smith

[This post originally appeared in American Thinker magazine on March 1, 2016]

In the 1980s Reagan Republicans were fond of wearing Adam Smith neckties.  (I personally still have two hanging in my closet that hail from that era.)   Adam Smith, of course, was the 18th Century Scotsman who wrote An Inquiry into the Nature and Causes of the Wealth of Nations, a book considered by many to be the founding work of modern economics.  Wearing the Adam Smith neckties was intended to display fidelity to Smith’s ideas and, in particular, fidelity to free markets and free trade.

One does not see many Republicans wearing these neckties anymore.  Perhaps this loss of ubiquity is to the good, considering how far removed the Party’s front runner in the presidential race, Donald Trump, is from the free market ideas of Smith.  For example, in response to the announcement earlier this month by the air conditioning products manufacturer, Carrier Corporation, that it would be closing a U.S. production facility and relocating to Monterrey, Mexico, Mr. Trump stated on Sean Hannity’s Fox News Channel program that, if elected, he would impose a 35% tariff on Carrier products re-entering the United States.  In the same vein, Mr. Trump made a similar threat last year with regard to Ford Motor’s announcement that it will double its Mexican-based production capacity.  Mr. Trump asserts that the threat of high re-entry tariffs is necessary to discourage these and other American companies from seeking lower-cost production outside of the United States.

Mr. Trump also claims that the Chinese government engages in unfair trade practices by intentionally devaluing the yuan in order to impose a de facto tariff on all imported goods from the U.S., which he says is “costing millions of American jobs.”   He says that, unlike the “stupid politicians” in Washington, he will use his superior deal-making skills to stop this job loss by negotiating a U.S.-friendly trade agreement with China.  While those negotiations are taking place and to encourage the Chinese to come to the table, he will designate China a “currency manipulator” on day one of his presidency and impose countervailing duties on “cheap Chinese imports.”

Adam Smith would be alarmed by Mr. Trump’s retaliatory threats. The central thesis of The Wealth of Nations is that a nation’s economic well-being is measured not by its store of gold or currency, the amount of goods it exports, or the number of jobs that exist within its borders, but rather by the quantity of goods and services available for consumption by its populace.  Smith makes the point that the ultimate purpose of all economic activity is to satisfy human wants and needs.  The reason that economic activity takes place is so that people can consume.  Work and production are means to that end, but not ends in themselves.  In a world in which resources are scarce, employment of labor and other factors of production is the cost that a nation incurs in order to consume.

Thought of in this way, it becomes clear that if a nation can reduce the employment of any resource, including labor, required to yield a given rate of output of consumer goods, those freed up resources can then be used to produce even more goods, thus making the nation wealthier.  Such a result can come about because of several reasons, including the discovery and adoption of new technology that raises resource productivity, trade that derives from comparative advantage, and the free flow of capital to those uses and locations where it is employed most efficiently.

Thus, for example, American wealth stands to gain when Carrier can produce air conditioners at lower cost in Mexico and Ford can do the same with cars.  The gain comes about in two ways.  First, absent re-entry tariffs, as Mr. Trump proposes, more air conditioners and cars can be made available to American consumers at a lower price.  Second, the resources freed up in the U.S. become available for other output-expanding uses.

Trade also increases the wealth of nations by permitting them to take advantage of each other’s relative productive efficiencies.  So, for example, a nation’s wealth grows whenever it purchases goods from those nations that supply them most cheaply.  Hence, notwithstanding Mr. Trump’s outrage at “cheap Chinese imports,” American consumers are better off because of those imports.  By their own actions, consumers have revealed that they prefer spending their dollars on the Chinese goods to spending the dollars on anything else.  In addition, because the U.S. does not have to use up scarce resources to produce these goods, those resources are available to produce other goods that otherwise could not be produced.  Instead of harming the U.S., the “cheap Chinese imports” generate an increase in American wealth.

But what about the trade deficit that is created by importing all of these goods from China?  Isn’t Mr. Trump’s alarm justified on this ground?  The answer is “no.”

Of critical importance here is the fact that the dollars obtained by the Chinese sellers have value only because they represent a claim on American-produced goods and services. Because in the modern global economy, exchange does not take place by barter of goods for goods but by goods for currency, final settlements need not, and rarely do, occur instantly.  Rather, they take place over time, often many years.  Ultimately, however, the dollars in Chinese hands will find their way back to the U.S., either directly or through multinational trade, to be redeemed for real goods and services.

What Mr. Trump fails to grasp is that voluntary trade is always beneficial to both sides regardless of current account deficits or surpluses.  Moreover, he misses Adam Smith’s key insight, namely that exports are a cost to a nation; imports a benefit. When a nation imports, it is enjoying the consumption of goods produced from the scarce resources of some other nation. Although settlement may not occur immediately, ultimately a nation must pay for that enjoyment with exports of real goods and services produced out of its scarce resources.  In the end, trade allows each nation to obtain goods that yield greater consumer surplus than could be obtained if the goods were produced domestically.

The principal lesson here is that a nation that can become more efficient in supplying consumer goods to its people becomes wealthier.  The free flow of capital and international trade are two ways that increased efficiency can come about.  (There are others, of course.)  Tariffs and other policies that impede the potential gains in efficiency ultimately make a nation poorer.

Regrettably, Mr. Trump evinces no awareness of these principles from The Wealth of Nations.  His repeated promises to “be the greatest jobs president ever” and seek “fair trade, not free trade” are founded on long-discredited mercantilist ideas that confuse costs with benefits and focus solely on observable metrics while ignoring the less observable perverse consequences.

To be sure, international movement of capital and goods often has severe localized effects on individuals and communities. These are the observable costs that Mr. Trump sees and seeks to prevent.  For example, the lives of those individuals who will lose their jobs at Carrier and Ford will be disrupted, perhaps severely so.  Far better than Mr. Trump’s steep tariff penalties, however, would be policies that make it possible for these individuals to find other jobs quickly.  In the short term, taxpayer funded retraining and other transitional assistance are in order; in the longer term, free market policies that promote a more efficient and expanding economy will assure continuing employment opportunities for everyone.

By contrast, policies that focus directly on protecting and creating jobs, such as Mr. Trump’s tariff penalties and duties, will in the end fail to do either.  Although visibly protecting some jobs in the short term, these policies will diminish the efficiency of the economy, make American consumers poorer, and reduce the nation’s wealth.  Ultimately, they will cost jobs and harm American living standards.  Bearing out Adam Smith’s insights, economic history and experience show that job opportunities expand most when a society focuses first on increasing efficiency over time.  This is the recipe for a growing and ever wealthier economy.  More jobs are, in turn, the byproduct of this process.

I won’t be sending one of my Adam Smith ties to Mr. Trump.

The Democratic Presidential Debate, Economic Literacy, and the Minimum Wage

During last Saturday’s Democratic presidential debate Vermont Senator Bernie Sanders, Former Maryland Governor Martin O’Malley, and Former Secretary of State Hillary Clinton vigorously competed to display which one is most earnest in his or her support of raising the federal minimum wage.  In so many words, each claimed that it is necessary, as well as compassionate, to raise the minimum wage so that people can more easily rise to the middle class.  The argument is that if incomes are too low for some people, a law mandating higher incomes is justified.  Mrs. Clinton was a bit more nuanced, noting that the cost of living differs locally and thus, according to her reckoning, states and cities should implement minimum wages even above her proposed higher federal minimum wage of $12 an hour, if appropriate for a given locality.

Notwithstanding the substantial intrusion into economic affairs that governments at all levels undertake in contemporary times, I have long ago foregone any hope that political figures will take it upon themselves to obtain even a modicum of economic literacy before formulating their economic policy proposals.  Many, if not nearly all politicians, claim that reason and science should inform government policy, but few, if any, manifest any understanding that there are irrefutable laws of economics that cannot be repealed or altered by political action.  As a consequence, few areas of public policy are subject to more demagoguery than economic policy.  Minimum wage laws are a poster-boy-like example of such demagoguery.  Such was on great display in the presidential debate.

One of the most fundamental laws of economics is the law of demand, which states that as the price of something rises, the quantity purchased will decrease in a given time period, and vice versa.  The law rests on the fact that, in the real world, resources are scarce, and thus the process of satisfying human wants and desires requires making choices among alternative uses of those scarce resources.  Relative prices determined in free markets facilitate this process by permitting persons to make spending decisions out of a limited income according to the value they obtain per dollar spent on a good or service.  The lower the price, the higher is the value per dollar spent.  The higher the price, the less is the value per dollar spent.  Hence, if the price of something goes up – thus reducing the value per dollar spent – less will be purchased as other goods and services become a better bargain.

Artificially controlling specific prices in the economy distorts this process and creates inefficiency in resource allocation, as relative prices no longer fully reflect market forces driven by consumer preferences.  Wages are prices.  Hence, if wages for unskilled labor are artificially set above the market determined wage by means of minimum wage legislation, less unskilled labor will necessarily be purchased per period of time.  Moreover, the structure of wages throughout labor markets – skilled as well as unskilled – will be distorted, and economic efficiency will be compromised.  These outcomes are givens, and economists have known about them for a long time.

Why then do minimum wage laws persist?  Are not the harmful effects sufficient for voters to reject politicians who push these laws?  The answer, I believe, is that, although the harmful effects are real, they are generally not immediately visible, while the superficial, demagogic appeal of minimum wages is easy to articulate.  This appeal has several components, each of which was stated during the Democratic debate.  First, it is argued that raising the minimum wage will have a (politically) desired redistributive effect (Bernie Sanders).  Second, it is argued that raising the minimum wage will help to elevate people – particularly unskilled workers — into the middle class (Martin O’Malley and Hillary Clinton).  Third, it is contended that the empirical data show no significant adverse impact on employment because of raising the minimum wage, and therefore there is no downside to doing so (Hillary Clinton).

None of these claims, however, lives up to its full billing.  For example, even accepting a goal of income redistribution, minimum wage laws are a highly inefficient means to accomplish this end.  This is not controversial among economists.  Whatever income redistribution raising the minimum wage achieves, that redistribution is likely temporary at best, as employers adjust to the higher wage rate over time by substituting to other inputs such as new technology.  In addition, it only raises the income of those who continue to keep their jobs.  To the extent that the higher wage rate causes, at the margin, others to lose their jobs, their income falls to zero.  And, finally, the distribution comes at the expense of distorting relative prices, which can be considerable depending on the size of the wage hike.  In point of fact, there are far superior mechanisms to achieve income redistribution such as simple cash payouts or a negative income tax.  Either of these measures ensures that the incomes of the entire targeted group increase, and both avoid compromising efficiency because of price distortion.

As for elevating lower income people into the middle class, raising the minimum wage again is highly inefficient.  Vast amounts of evidence indicate that rising incomes are best achieved by education, stable families, and cultural factors such as personal discipline and a strong work ethic.  Entry level jobs – even at low wages – help to foster the personal characteristics, especially among young people brand new to the workforce, necessary to succeed in a work environment and eventually advance into higher paying positions with greater responsibility.   In addition, in few households is the primary income earner a minimum wage worker.  In fact, most minimum wage workers are younger than 24 years old.  (See here.)  Hence, although raising the minimum wage may have some impact on household income, the impact will be small.  A far better emphasis for public policy directed toward building the middle class would be on augmenting incentives for skills acquisition and maintaining stable families.

Mrs. Clinton’s assertion that the empirical evidence “shows” that there is little or no impact on employment following a hike in the minimum wage is similarly flawed.  It is indeed possible to construct studies that yield this result.  In so doing, the studies seemingly refute the basic law of demand.  In fact, however, they do not.  Rather, such studies rest on highly selective data (undisclosed by Mrs. Clinton) that severely cabins the contours of the analysis to exclude either one of two critical factors, or both, that otherwise explain the anomaly.  The first is that when the market wage for unskilled labor has risen above the existing minimum wage because of inflation the latter has no effect on employment rates.  The minimum wage is no longer a floor.  It serves no purpose.  Under these conditions, if the minimum wage is raised anywhere up to but not exceeding the market wage, it is perfectly consistent with the law of demand that there will be no significant employment effects.  Only when the minimum wage is hiked above the market wage, will employment effects take place.  Hence, data that selectively exclude wage hikes that actually exceed the market wage necessarily mislead on the question of employment impact.*

A second explanation for selective data showing little or no employment effects concerns the time frame considered.  In the immediate aftermath of an increase in the minimum wage, many, if not most, employers have capital equipment fixed in place.   In the short run, it will not be possible in many instances to substitute away from labor to a more capital-intensive production environment.  Thus, there may be little immediate job loss.  Over time, however, this will change as equipment wears out and is replaced, and as entry of new capital takes place.  For example, when I was growing up, most elevators required full-time human operators, engaging personally with bank tellers was the only way to withdraw funds from an account, and there were no self-checkout lines at grocery stores.  Today, none of these conditions is true.  Of course, one cannot claim that each of these changed conditions was solely caused by successive hikes in the minimum wage over the years, but undoubtedly those hikes contributed to the long run substitution away from low and unskilled labor in these occupations.  Moreover, this transition certainly took place in innumerable other sectors of the larger economy.

Finally, I want to close with a comment about union support for the minimum wage.  Although historically unions have been a strong Democratic Party constituent, it would seem odd, at least on the surface, that unions would much care about minimum wages.  Union jobs, after all, are typically at hourly wages much higher than the minimum wage.  There are at least two reasons, however, why unions can be counted on to advocate for higher minimum wages.  First, many union contracts contain clauses that structure union wages relative to the minimum wage.  That is, the union pay scale should always, in relative terms, be some percentage above the lowest pay scale.  Hence, when minimum wages are hiked, the union pay scale is similarly adjusted upwards.  Second, it is in the interest of skilled union workers to have the wage rates of unskilled workers continually increase.  Suppose for example that a particular task could be performed by two unskilled workers in an hour or one skilled union worker in an hour.  If the wage rate for unskilled work were $5 /hour and the wage rate for skilled work were $11/hour, the employer can be expected to employ two unskilled workers to do the task at a total of $10/hour.  Now suppose the minimum wage is hiked to $6/hour.  Under this circumstance, the employer will hire the skilled union worker at $11/hour, as the two unskilled workers would now cost $12/hour.  The higher minimum wage not only priced the unskilled workers out of the market, it also created a demand for union work.

In sum, the Democratic presidential debate on Saturday night revealed a great deal of departure from economic science among the three candidates.  This departure was especially apparent in the Q&As concerning the minimum wage.  Even more troubling is the possibility – and perhaps even probability as it concerns Mrs. Clinton – that the economic hokey pokey did not entirely owe to economic illiteracy, but rather owed simply to deliberate political demagoguery to gain votes at the expense of serious thought.

Addendum:   In watching the debate, I could not help but be reminded of the incessant cant from the political left about the alleged consensus among scientists concerning climate change and global warming.  On the basis of this alleged consensus, the science is supposedly settled, and outlying views are to be shunned and ridiculed.  Yet, as the basis for her assertions about the minimum wage, Mrs. Clinton solely cited former Obama White House adviser Alan Krueger, who co-authored a study of the impact on fast food employment in New Jersey and Pennsylvania following an increase in the minimum wage in those states.  The study, published in 1994 and using early 1990s data, claimed to find insignificant employment effects.  This study, however, is the poster boy of outlying studies concerning minimum wages, has often been criticized on methodological grounds, and runs contrary to the “consensus” among economists about the actual employment effects of minimum wage laws.  Mrs. Clinton’s hypocrisy on this score is stunning.

Notes:

* A simple example demonstrates the law of demand in this context.  Suppose the tasks performed by a worker earning $5/hour contribute $5.25/hour in incremental revenue to the employer.  Each hour thus generates $0.25 in accounting profit for the employer.  In fact, under this circumstance, it would pay the employer to pay the worker any wage up to $5.25/hour.  Now suppose the minimum wage is hiked to $5.50/hour.  Absent any concurrent increase in productivity on the part of the worker, it no longer pays the employer to keep the worker and the job is lost.  At the margin, all such workers will be let go.

Mrs. Clinton seems to understand this concept.  At Saturday night’s debate, she stated that she favored an increase in the federal minimum wage to $12/hour, but not to $15/hour.  But why?  From a worker’s standpoint, $15/hour is better than $12/hour, and will produce a higher annual income.  Indeed, why not increase the minimum wage to $100/hour and elevate everyone to the higher end of the middle class?  Implicit in Mrs. Clinton’s reluctance to go higher than $12/hour, at least at the present time, is surely a recognition of the adverse employment effects that the minimum wage produces.

Business Acumen and Economic Understanding

In a recent Wall Street Journal op-ed, Republican presidential candidate Donald Trump asserted that the Chinese government imposes a de facto tariff on all imported goods by intentionally devaluing the yuan.  (“Ending China’s Currency Manipulation,” Nov. 10, 2015)  According to Mr. Trump, the undervalued yuan makes international trade unfair and hurts China’s trading partners.  By Mr. Trump’s reckoning, it particularly hurts the United States by weakening American industry and costing millions of jobs.  He goes on to say that he will designate China a “currency manipulator” on day one of his presidency, if elected.  In addition, he will impose countervailing duties on “cheap Chinese imports” as retaliation for the unfair currency manipulation.

On the day after Mr. Trump’s op-ed, Mr. Doug Parker and Mr. Keith Wilson lament, also in a Wall Street Journal op-ed, that the United Arab Emirates and Qatar unfairly subsidize their respective airlines with massive cash infusions.  (“Rigging the Game on Open Skies,” Nov. 11, 2015)  Mr. Parker is the chairman of American Airlines Group and Mr. Wilson is president of the Allied Pilots Association.  Like Mr. Trump, Messrs. Parker and Wilson claim that these subsidies hurt the United States by costing hundreds of thousands of jobs in the American airline industry.

The views of Messrs. Trump, Parker, and Wilson are hardly unusual among business leaders and corporate executives.  A quick look at the International Trade Commission’s website reveals that the ITC currently has some 30 active “import injury” investigations open and another 12 active “anti-dumping and countervailing duty” investigations.  These investigations seek to determine if imports are priced “unfairly” and thereby cause injury to specific U.S. industries or companies.  The current investigations run across a wide range of products, including among others chemicals, various steel and iron products, bricks, sundry welded products, woven ribbons, plastic tape, copper products, sugar, uncoated paper, plastic bags, wooden bedroom furniture, and even tissue paper and ironing boards.  All of these investigations are responses to U.S. companies’ claims of injury owing to unfair import competition.

Each of the above-described contentions illustrates an important – yet, unfortunate — fact, namely that mercantilist views run strongly among business leaders and corporate executives.  This is particularly regrettable whenever such leaders and executives take to a public forum and mistakenly equate their knowledge of business with knowledge of sound economics.  In point of fact, business and economics focus on quite different matters.  The danger of equating business acumen with authority on economics is that the former’s narrow focus on business success leads to the promotion of policy prescriptions that, although beneficial to parochial interests, are often harmful to the general interest.  Protectionism is perhaps the most blatant and harmful example of this phenomenon.

Case in point are Messrs. Trump, Parker, and Wilson.  Although all three claim to be supporters of free trade so long as it is “fair trade” and promotes American prosperity, each defines success only in terms of mercantilist metrics.  Specifically, each looks to export growth and job creation as the measure of a successful trade policy.  This perspective, however, stands in direct contradiction to Adam Smith’s central point that the wealth of a nation is measured, not by the quantity of goods that it sends to other nations or by resource employment, but by the amount of goods and services available for consumption by its citizens.

In his seminal book, An Inquiry into the Nature and Causes of the Wealth of Nations, Smith explained (as I discussed in greater detail in an earlier post here) that the sole objective of economic activity in a world of scarcity is consumption.  If human beings did not need to consume or if there were no scarcity, there would be no need for economic activity, let alone trade or trade policy.  Under real world conditions, however, people not only need to consume to stay alive but also possess wants and desires for goods and services that go far beyond the basic necessities.  Scarce resources must therefore be constantly employed to produce those goods and services.

In terms of trade, Smith went on to explain that, rightly understood, exports are a cost to a nation and imports are a benefit.  Exports mean that a nation’s scarce resources, including human employment, are being used up for another nation’s consumption benefit.  By contrast, importing goods and services allows a nation to consume while conserving scarce resources for deployment in other productive activities, thus expanding domestic production of consumable goods and services and permitting even greater rates of consumption.  The result is an increase in the nation’s total wealth.  Exports, and the resources that go into those exports, are the price a nation must pay for its imports.  As with all exchanges, the lower the price the greater the surplus value to the buyer.

Given this central tenet of economics about the genuine wealth of a nation, whenever the United States can obtain goods and services more cheaply by means of importing them than by producing them domestically, it benefits.  U.S. consumers are made better off.  This benefit will accrue regardless of why the imported goods are cheap, i.e., even if they are cheap because of subsidies or so-called currency manipulation.  Indeed, if subsidies or artificially undervalued currency is the reason, the true harm falls on the citizens of the nations providing the subsidies or “manipulating” their currencies.  Not only are those nations using up their scarce resources for the benefit of American consumers, but their citizens are being taxed to fund the subsidies and are being exposed to higher domestic prices because of the undervalued currency.  It is a double whammy.

What is more, instead of a cost to the United States, the “jobs lost” that Mr. Trump and Messrs. Parker and Wilson claim occurs because of “unfair” trading practices are actually necessary to expanding domestic wealth. The freed up human and other resources are now available for new productive uses or for increasing the output rate of existing productive activities.  The available consumption pie is necessarily enlarged.  By contrast, the logical end of the Trump, Parker, and Wilson mercantilist argument is either autarky or at least significantly diminished trade, either of which must result in lower living standards for the American people.

To be sure, whether owing to market fundamentals or external foreign government policies, the vicissitudes of the international movement of goods and services, as well as capital, will result in certain industry-specific disruptions and transactional costs to individuals.  This inevitable consequence is by all means a basis for a compassionate nation to lend support to those who require retraining and other transitional assistance, but it is not a basis for protectionism and lower living standards.  To the contrary, every time that China devalues the yuan or another country subsidizes its export industries, we Americans should give a hearty thanks for the gift.

The House Freedom Caucus and Its Critics

Christopher DeMuth has long been one of the more distinguished leaders in the conservative intellectual movement.  As such, his views warrant a very high degree of respect.  In a recent Wall Street Journal op-ed, he contends that members of the House Freedom Caucus — a group of about 40 -50 highly conservative House Republicans elected with Tea Party support — are motivated more by opportunities for political theater and individual showmanship than by legislative accomplishments. (“The Decline and Fall of Congress,” Oct. 19, 2015)  In this case, Mr. DeMuth is wrong.

In making his argument, he offers the time worn idea that legislators must “go along to get along” and be willing to make trades and compromises in order to achieve desired legislative ends.  In Mr. DeMuth’s view, the process rewards those who are satisfied with incremental change.  Because the Freedom Caucus resists compromise, it must therefore hold political theater and showmanship more important than actual progress toward its ostensible long run goal to restore a limited federal government consistent with free people and free markets.

Although Mr. DeMuth’s argument may have some merit in the short run, it neglects the persistent failure of establishment Republicans to achieve real and permanent reversal of an ever growing federal government.  The fact is that establishment Republicans, notwithstanding campaigning to the contrary in election after election, have been fully complicit with Democrats in supporting anti-free-market and liberty-infringing legislation.  Examples include corporate welfare such as ethanol mandates, price controls such as federal minimum wages, uncritical support of a Federal Reserve that monetizes deficit spending, and an incomprehensible tax code.  Perhaps if just once establishment Republicans stood on the principles that they profess to hold, the Freedom Caucus might be more amenable to the kind of legislative compromise and incrementalism that Mr. DeMuth thinks more effective.  But the fact is that this show of principle never occurs.

Case in point is the current real opportunity to kill the Export Import Bank, which subsidizes foreign consumers by shifting credit risk onto U.S. taxpayers.  Authorization for the Bank ran out earlier this year, but Republican Leadership in the Senate — even though claiming to be opposed to reauthorizing the Bank — has used procedural gimmicks to provide still another vote on reauthorization in order to appease establishment Republicans as well as Democrats.  In the House, establishment Republicans have gone so far as to seek out and align with Democrats to force a vote that will give new life to the Bank.  Is it really any wonder that Freedom Caucus members distrust their establishment colleagues?    

Mrs. Clinton’s Repudiation of Scarcity

Imagine that you have all the ingredients to bake a twelve inch apple pie, including crust and filling.  Imagine further that the baked pie is initially cut into ten slices.  Under a new government program intended to ensure that everyone has access to quality pie, all citizens are required to buy pie insurance which, among other things, entitles each person to obtain one slice of pie each year at no out-of-pocket cost.  The pie provider bills the insurance company for each slice of pie it supplies to an insured. Assuming a population of eight citizens, after each person obtains one slice of pie, two slices remain.  These two slices might be provided, for example, at full cost or at least with a co-payment to two persons with special needs for additional pie.  Of course, once these last two pie slices are consumed, no pie remains until (1) additional ingredients are found or diverted from other uses, and (2) another pie production cycle ensues.

But wait.  There is a better solution to providing additional pie to everyone.  Specifically, the government could simply pass a law mandating that all citizens are entitled not to just one, but two slices of pie each year at no out-of-pocket cost.  Now each of the eight citizens can have two slices of pie each year.  Everyone is better off!

Of course, this solution is absurd, as there is no actual additional real pie to distribute.  There is still only one twelve inch pie cut into ten slices.  If each of eight citizens is entitled to two slices, all but two citizens would have to be denied a second slice.  In other words, there would be no pie left over to provide a second slice to six of the eight citizens.  Even this outcome assumes that a citizen is not entitled to a second slice until everyone has obtained at least one slice.  Without this rule, five citizens might consume all ten slices before three citizens consume any pie.

Alternatively, the pie might be cut into smaller slices so that there are sixteen.  In this case, there are now enough slices for each citizen to consume two slices.  No more total pie is being consumed, however, and the smaller slices may not adequately meet the needs of the insureds.

The point of this example is to illustrate that consumption must necessarily come out of real resources.  The using up of real resources is the true cost of consumption, and it is impossible to increase consumption in the absence of obtaining additional resources, which are scarce or otherwise deployed in other production activities.  It seems to me that this is not a complicated point, but it nonetheless appears to escape Hillary Clinton.

According to an article in today’s Wall Street Journal at A-4 (“Clinton Lays Out Plan to Cut Health Cost”), Mrs. Clinton, in her quest for the Democratic presidential nomination, has announced that, if elected, she will “improve” Obamacare by placing further limits on what insureds pay for healthcare.  Her goal, she says, is to reduce costs.  Her solution is to require insurance plans to permit three doctors’ visits a year before any deductible charges are made.  As quoted in the Wall Street Journal, Mrs. Clinton declared, “With deductibles rising so much faster than income, we must act to reduce the out-of-pocket costs families face.”

It is a shame that no one is asking Mrs. Clinton how this plan reduces the true costs of healthcare, namely the required resources to produce it.  She might also be asked where the additional resources are to be found or from what other productive activity they are to be diverted. If she favors more but shorter and less substantive doctors’ visits, she should explain how she has determined that such smaller but numerically more “slices” of the pie provide for superior quality healthcare.  Unless Mrs. Clinton magically discovers a means to eliminate scarcity – in which case there would be no need for any healthcare insurance – one should be highly skeptical of her pronouncements.

It Is Well Past Time to End the ZIRP

When I first began reading Federal Open Market Committee (FOMC) member Narayana Kocherlakota’s op-ed piece in the Wall Street Journal this morning, I thought that it had to be a deliberate parody on the Keynesian groupthink that characterizes the world’s central bankers.  (“Raising Rates Now Would Be a Mistake,” Aug. 19, 2015)  Then I realized that Mr. Kocherlakota is dead serious about wanting to continue the Fed’s zero interest rate policy (ZIRP) of the last six years, notwithstanding its failure to bring about anything close to a robust recovery from the 2008 financial collapse.

Mr. Locherlakota says that raising rates now would impede the Fed’s ability to achieve two goals: (1) raise inflation to its 2% target rate, and (2) stimulate spending via credit expansion and bank lending.  He fails to explain, however, how either of these goals arises from sound economic thinking.  In point of fact, both goals are highly questionable attributes of a growing and productive economy.

As for the first goal, Mr. Kocherlakota merely asserts that 2% inflation is how the Fed defines price stability.  No reason is given as to why 2% is superior to any other number, let alone superior to what most people outside of the FOMC would define as a stable price level — zero inflation.  In fact, a 2% inflation rate means that the purchasing power of a dollar will decline by almost a third over 20 years.  Not only is financial prudence on the part of households severely punished, saving is discouraged and debt-taking encouraged.  Diminished saving and increased debt, however, have never been shown to lead to sustained prosperity.

Mr. Kocherlakota’s second goal, increased spending, is similarly misguided.  A focus on spending neglects capital accumulation, which is essential to productivity gains and economic growth. Capital accumulation, moreover, requires saving to finance the new capital.  Hence, incentivized spending and debt-taking, buttressed by lower saving owing to an inflation tax, must result in a lower rate of capital accumulation and ultimately diminished growth prospects over the long haul.

In the end, price controls never work, and interest rate manipulation will be no exception.  Eventually, the massive distortions in asset pricing created by the six-year ZIRP must be corrected.  At that time, the tools that the Fed has in its bag will have been seriously depleted, and the correction will likely be long and deep.

Given six years of tepid recovery, it is well past time to jettison the ZIRP and return to free market principles in which interest rates are freely determined in the marketplace by peoples’ time preferences and an honest monetary policy.

Janet Yellen and the Power to Tax

Article I, Section 7 of the Constitution states, “All Bills for raising Revenue shall originate in the House of Representatives.” In other words, the Framers wanted to make sure that, when taxes are imposed on the people, the legislation giving rise to those taxes springs from the people’s House, the body closest to the nation’s citizens. No doubt the Framers thought that the taxing power of the federal government should not be taken lightly or at a distance from the people.

Janet Yellen, Chairwoman of the Federal Reserve Board, evidently has determined that she is a virtual member of the House of Representatives, and, in fact, holds a controlling position. She and the other members of the Federal Open Market Committee have publicly and repeatedly stated their desired intention to use monetary policy to achieve a continuous inflation rate of two percent a year. The targeted inflation is specifically in consumer prices. This means that Ms. Yellen has decided that income earners, savers, and holders of cash assets should be taxed annually an additional two percent. At this rate, the purchasing power of a dollar will decline by almost a third over 20 years.  As far as I know, no citizen voted for this tax, nor endorsed a member of the House of Representatives campaigning on such a tax.

The theory behind this inflation tax is grounded in modern monetary thinking, which is a synthesis of traditional Keynesianism and Monetarism (hereinafter, “modern Keynesianim”).* The theory holds that economic well-being and prosperity come about through spending. Therefore, spending, and especially consumer spending, must be encouraged. Indeed, saving is anathema to the theory.

One sure way to encourage spending is to punish financial prudence and frugality on the part of individual households. A positive inflation rate continuously maintained by design achieves this objective. People are incentivized to forego saving and spend now before the value of their income and cash assets decline even further.

A second way to encourage spending is to incentivize debt-taking. Continuous inflation, especially accompanied by artificially low interest rates, achieves this objective too. Debt-takers obtain relatively high value money to spend in the current period, and pay it back with relatively devalued money in a later period.

A key factor in this modern thinking is the idea that prices adjust faster than wages. Although a few prices may be fixed for a period by contract, most prices, especially consumer prices, can change quickly, if not immediately. By contrast, wages, more often fixed by contract, are usually slower to adjust to inflationary pressure. Even when not fixed by contract, burdens on both employees and employers can be severe with frequent turnover. Thus, even when higher wages might be had elsewhere, small gains in income may not be worth the burden of changing jobs.

Given this price/wage adjustment disparity, household incomes do not keep pace with price inflation, which creates still another incentive to accelerate spending.  In addition, business earnings increase because revenues are rising faster than costs (i.e., prices are going up, while wages remain sticky). Hence, stock values inflate. This asset inflation, according to the modern Keynesians, produces a wealth effect that also encourages spending. That is, stockholders see their investments rise in nominal value, feel richer, and spend more. In addition, the sticky nominal wages mean that real wages decline over time, thus creating more demand for labor by businesses. Taken together, all of these behaviors – households spending now rather than later, asset holders feeling wealthier and spending more, and businesses increasing demand for labor — bring about prosperity in the form of higher GDP and full employment. So goes the modern Keynesian story.

It is the story that continues to be taught in mainstream economics Ph.D. programs, and it is the story to which most prominent macroeconomists adhere. It is also the story most prevalent in the financial media. The core premises of the story survive despite the continuation of boom and bust cycles. Indeed, even the severity of the 2008 financial crisis and the historically slow recovery in its aftermath have done little to crack the edifice of modern Keynesianism.

Even so, there is a growing heterodox literature attacking this edifice and, in particular, the performance of the “Fed.” Much of this literature focuses on the period since the end of the Bretton Woods gold-exchange standard, which President Nixon jettisoned in 1971. Mr. Nixon’s decision made the dollar a full-fledged fiat currency and opened the door for the Fed to engage in wide ranging monetary discretion. This critical literature is too voluminous to discuss here. I will, however, set out a few reasons as to why I believe the prevailing paradigm should be abandoned.

First, even taking modern monetary theory as valid notwithstanding its failures, I am not aware of any explanation from Ms. Yellen, any of her fellow FOMC members, or any prominent macroeconomist as to why two percent is the appropriate inflation rate to target. Why not three percent? Or, one percent? Or, one and a half percent? As far as I know there is nothing in the analytics of the theory itself that determines this two percent. It seems to be nothing more than a preferred fancy of the monetary policy elites.** At a minimum, if the people are to be taxed an extra two percent a year, there should be a firmer foundation for that tax than simply the whims of unelected central bankers.

Second, the theory’s focus on consumer spending neglects capital accumulation. Capital accumulation is essential to economic growth. It is the basis for productivity gains in the economy. Capital accumulation, however, requires saving to finance the new capital. By making saving unattractive by means of the inflation tax, the rate of capital accumulation will be lower than what it otherwise would be. Although the inflation policy may give the illusion of stimulating economic activity in the short term, the longer term consequences of diminished growth prospects are a severe and lasting social cost.

Third, by most any measure, the Fed has historically performed poorly in taming the business cycle or making booms and busts less frequent. In fact, internal instability is built into modern monetary policy. Two factors, in this regard, are noteworthy. First, because the interest rate is one of the most important prices in any economy, its manipulation by the Fed creates massive price distortions and makes asset price discovery far more difficult. As a result, much malinvestment occurs. Such malinvestment ultimately has to be liquidated during a subsequent bust. Second, even if wages adjust more slowly than prices in the short term, they must eventually catch up to prices as pressures toward economy-wide equilibrium take hold. The boom therefore rests on an unstable platform. It can only persist if prices continue to outpace wages, an unlikely event.   The bust must inevitably follow.

Fourth, it is noteworthy that, in the 100 years since the Fed’s founding, the price level in the U.S. has increased by over 2300%, meaning that the value of the dollar has dropped by over 95%. (This information comes from the Bureau of Labor Statistics and can be viewed here.) That is hardly a record to be proud of. What is more, it shows just how severe an inflation tax can be over time.

Fifth, aside from economic and theoretical defects, an inflation tax that punishes prudence and thrift creates a culture that discourages personal responsibility. This comes about in two ways. First, prudent saving for a rainy day or for retirement requires a willingness to see those savings depleted in real terms every year. Certainly at the margin, fewer people will choose to save, or save as much, with this looming prospect. Second, the inflation tax encourages debt-taking. Debtors are rewarded by inflation by being able to pay back loans with cheaper money. As a cultural phenomenon, widespread debt-taking leads to irresponsible spending, especially as it relates to short term spending by “maxing” out one’s credit cards, which often have among the highest interest rates. With thrift and saving being irrational, instant gratification becomes the norm.

Where does this leave us?  Regrettably, Janet Yellen’s tax on the American people is unlikely to be unconstitutional, as it does not derive directly from a “Revenue Bill” within the meaning of Article I, Section 7. Moreover, the Federal Reserve System, although a creation of the government, does not itself operate as a government agency. Therefore, short of amending the Fed’s enabling legislation and taking away its independence to manage monetary policy, there is likely little the people can do to avoid the Yellen tax. Even so, I think it is important that people at least know that the tax exists.

______________________________________

* For simplicity, I will use the term, “modern Keynesianism” herein to mean this synthesis. In so doing, I neglect the fiscal policy side of Keynesianism, which is not relevant to my discussion.

** Incidentally, this whim is worldwide. Mario Draghi, the head of the European Central Bank, similarly has stated his determination to maintain a two percent inflation rate. Not uncoincidentally, Mr. Draghi was American-trained at MIT and is well ensconced in the modern monetary paradigm.

Adam Smith and the Republican Presidential Candidates

In the 1980s Reagan Republicans were fond of wearing Adam Smith neckties. (I personally still have two hanging in my closet that hail from that era.)   Adam Smith, of course, was the 18th Century Scotsman who wrote An Inquiry into the Nature and Causes of the Wealth of Nations, a book considered by many to be the founding work of modern economics. Wearing the Adam Smith neckties was intended to display fidelity to Smith’s ideas and, in particular, fidelity to free markets.

One does not see many Republicans wearing these neckties anymore. Perhaps this loss of ubiquity is to the good, however. After observing the large crop of Republican presidential candidates over the past several months, I can only conclude that none of them is particularly well informed by Smith’s ideas. Indeed, I suspect that few, if any, have ever read The Wealth of Nations. Some of the candidates indeed display an extraordinary degree of economic illiteracy.

The central thesis of The Wealth of Nations is that a nation’s economic well-being is measured not by its store of gold (or other financial assets), the amount of goods it exports, or the number of jobs that exist within its borders, but rather a nation’s economic well-being is determined by the quantity of goods and services available for consumption by its populace. In the book, Smith makes the point that the ultimate purpose of all economic activity is to satisfy human wants and needs. That is, the reason that economic activity takes place is so that people can consume. Work and production are means to that end, but not ends in themselves. They are properly considered costs, not benefits. Put another way, in a world in which resources are scarce, employment of human labor and other necessary factors of production are what a nation must give up in order to consume.

Thought of in this way it becomes clear that if a nation can reduce the number of labor hours (or the employment of any other resource) required to maintain a particular rate of output of consumer goods and services, those freed up resources can then be used to increase the output rate even further, thus allowing the nation to become wealthier. One way by which such an expansion of wealth might occur is through the adoption of new technology that increases productive efficiency. The efficiency is manifested in higher labor productivity and potentially an increase in the productivity of other resources as well. Technological innovation may also yield higher quality products, or the introduction of entirely new goods and services.

Another way by which a nation’s wealth can increase is by trade with another nation that has a comparative advantage in the production of certain goods. In this case, both nations gain by taking advantage of each other’s relative productive efficiencies. The trade consists of one nation giving up some of its wealth by exporting goods produced out of its scarce resources in exchange for imports of higher-valued goods from the other nation produced out of that nation’s scarce resources. Each nation sacrifices some of its wealth in order to obtain something in return that it values higher. The result is that each nation becomes wealthier.*

As Smith taught, exports then are a cost to a nation; imports a benefit. When a nation exports, it is using up its scarce resources for the benefit of another nation’s consumers. When a nation imports, it is enjoying the consumption of goods produced from the scarce resources of some other nation. Properly considered, exports are the goods that a nation must sacrifice to pay for its imports.

The principal lesson here is that a nation that can become more efficient in supplying consumer goods to its people becomes wealthier. Whether that efficiency comes about because of new technology or because of international trade, the savings in resource use, including labor, permits an expansion in the nation’s wealth through redeployment of those resources to the production of still other goods and services. **

Regrettably, none of the Republican candidates for president evinces much awareness of this basic lesson from The Wealth of Nations. What they say instead are repeated promises to “create” jobs and artificially promote exports, presumably beyond that rate required to pay for imports. In other words, they promise that, if elected, they would make America poorer.

To be sure, individuals want jobs because they know that they have to work in order to have income to obtain the consumer goods and services that they need and want. They must exchange their labor for those goods and services.  This necessity is a fact of life in a world of scarcity.

But political leaders who respond with promises to focus directly on creating jobs, including jobs derived from exports, will largely fail to keep those promises. Bearing out Smith’s ideas, economic history and experience show that job opportunities expand most when a society focuses first on increasing efficiency over time. The proven mixture is technological advancement, free trade, and minimal government-imposed burdens on entrepreneurship and other economic activity. These factors along with other necessary conditions such as the rule of law are the recipe for a growing and ever wealthier economy. More jobs are, in turn, the byproduct of this process of economic growth.***

It would be refreshing if at least one of the Republican candidates for president evinced an understanding of these tested principles and could articulate them in a compelling manner. Instead, we get empty promises to create jobs and pursue programs that hinder trade with other nations. It is indeed appropriate that none of them wears an Adam Smith tie.

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* In the modern global economy, trade of course takes place multinationally and is not goods for goods but rather is financed by means of international currencies and other monetary instruments. This permits nations to trade indirectly with each other. It also means that settlements need not occur instantly but can take place over time. So, for example, one nation may export in one period, but rather than import in the same period simply hold claims on another nation’s goods to be redeemed in a later period.   Nonetheless, the basic wealth-creating principles of trade as discussed above continue to hold.

** For a notable illustration of this principle, simply consider how technology has improved agriculture and thus permitted the expansion of non-agricultural production.   Were we still to employ the agriculture technology of 1900, many more people would still have to be working on farms instead of producing the variety of consumer goods that we enjoy today. In other words, advances in agricultural technology throughout the 20th Century freed up the resources, including labor, that permitted the development and supply of that century’s wide-ranging new industries, products, and services. Indeed, a politician who his dead set on “creating” jobs could ensure full employment simply by outlawing the use of tractors. It would not be a situation that most of us would want to endure, but it certainly would create full employment.

*** For example, over time new labor saving technology most often actually expands total labor employment. It does this in two ways. First, in that area where the new technology is applied, the increase in labor productivity reduces per unit costs, and thus consumer prices. With lower prices, quantity demanded increases and more output is sold. Although labor hours per unit of output are fewer as a consequence of the new technology, the higher output rate often means that total labor hour employment grows. Second, the increase in labor productivity in one area frees up resources for expanding output rates, and hence labor employment, in other areas, including new and developing industries where job opportunities may increase dramatically.

Paying One’s “Fair Share” of Taxes

I have always been puzzled when I hear politicians, particularly Democrats and others of the left, talking about people needing to pay their “fair share” of taxes.  Most recently, Vermont Senator Bernie Sanders, Independent Socialist and candidate for the Democratic presidential nomination, has made this claim in most, if not all, of his campaign speeches.  What he and others mean by this idea is that those earning higher incomes should pay more in taxes than they already are, notwithstanding that income tax rates are already progressive, i.e., marginal rates increase with income.  Rarely, however, do proponents of raising marginal rates on high income earners say exactly what a “fair share” of taxes is or, more precisely, what exactly those marginal rates should be.  Even more vague is their philosophical basis, either in ethics or economics, for what constitutes “fairness” in this context.

It seems to me that Senator Sanders and others of similar views have the tables turned upside down.  In fact, rather good philosophical arguments can be made from both an ethics and an economics perspective that, if anything, high income earners are already paying well more than their fair share of taxes and that their absolute tax payments or marginal rates should therefore be reduced.

Taxes are the cost of financing government.  In our democracy, every qualified voter is afforded one vote, no more and no less.  Just as this political shareholding is allocated equally among citizens, it would seem intuitively fair that the burden of the cost of government should similarly be allocated equally.  That is, everyone should pay the same amount in taxes in the form of a simple per capita tax.  This way, each person contributes the same amount toward the cost of government, much like dues assessments in a club.  At the least, it would be interesting to ask Senator Sanders to explain, from an ethics standpoint, why his income tax proposals are more fair than a per capita tax.

Of course, as a practical matter, given the current size of government, an equal per capita tax would necessarily mean that many, if not most, taxpayers would owe more than they earn or have in savings and, in some cases, likely much more.  Such a tax thus would be unworkable unless government were shrunk substantially.  The cost of government would have to shrink at least to the point where the per capita tax would be affordable by each taxpayer, a goal unlikely to be shared by Senator Sanders.  Even so, the size of government and the practical ability to have fairness in the tax code would seem to be inextricably linked.

Admittedly, I am uneasy to render judgments on purely ethical grounds about whether the amount of taxes a particular taxpayer pays is fair for that taxpayer.  I do, however, claim some expertise in economics.  Drawing on that expertise, I think that there is a reasonable argument on economic grounds that, in the alternative to a per capita tax, a regressive income tax is fairer than a progressive one.

The argument rests on the idea that whenever there is voluntary exchange, every transaction creates wealth.  A voluntary transaction will not take place unless each party becomes better off as a result of the transaction.  It follows therefore that, so long as high income earners obtain their income through voluntary exchange of their labor, services, or other resources, each dollar of that income is the product of a wealth-creating transaction.

Significantly, however, the high income earner does not keep all of the created wealth, but only a fraction.  The rest of the new wealth necessarily accrues to everyone else with whom the high income earner engaged in voluntary exchange, either directly or indirectly.  Thus, the higher the income of the high income earner, the greater the earner contributes to other people’s wealth.  It follows then that high income earners benefit society more than lower income earners before any taxes are taken out of those earnings.

Based on this reasoning, one possible way to measure tax fairness would be on the basis of relative additions to aggregate social wealth.  Under such a definition, people who contribute less to social wealth would be required to make up for the deficit by paying more in taxes, while those who contribute most to social wealth would be rewarded by lower taxes.  Put another way, fairness would require that high income earners be taxed less than low income earners.  The former have already made a disproportionate positive contribution to social welfare.

Of course, as with the per capita tax, a regressive income tax would require considerable downsizing of government.  Such a tax simply could not finance the current government.  Once again, the size of government and the practical ability to have tax fairness are inextricably linked.  But that practical consideration aside, a fairness argument for a regressive income tax that rests on economic reasoning, unlike Senator Sanders’ fairness arguments, at least has an analytical grounding.  It would be interesting to learn how Senator Sanders would respond to the argument.

In that regard, I will volunteer one glitch in the reasoning. Regrettably, many high income earners today derive their high incomes not from contributing to aggregate wealth but rather by using the machinery of government to expropriate the wealth created by others.  Rent seeking can be very lucrative.  Thus, if “paying one’s fair share” in taxes is inversely related to one’s contribution to social wealth, these high income rent seekers should be taxed at a 100% marginal rate.

Hillary Clinton and Trickle Down Economics

Few utterances in public life over the last 30 years annoy me more than the term, “trickle down economics.”  I know of no economics textbook, treatise, or journal article that even mentions TDE, let alone discusses it as a recognized economic theory or school of thought.  Yet, in her recent speech outlining her economic plan for the future (see here), Democratic presidential candidate and former Secretary of State, Hillary Rodham Clinton, invoked the term several times, asserting that she is not only opposed to TDE but, moreover, would most assuredly not return to that policy as president.  Mrs. Clinton’s opposition to TDE is not new.  It has been a theme in her public utterances for some time.  See here.

I wonder, however, just whom Mrs. Clinton has in mind when she implies that TDE is a policy that her political opponents, specifically the current crop of Republicans running for president, would implement if elected.  I know of none of these Republicans who has said “elect me and I will pursue a policy of trickle down economics.”  Nor, for that matter am I aware of a period in which TDE was the reigning policy of a Republican administration, a period of time to which Mrs. Clinton does not want to return.  Indeed, to my knowledge, only Democrats use the term.

Certainly some of the current Republican candidates have advocated for reductions in marginal tax rates and the elimination of unnecessary regulations on businesses in order to incentivize work, productivity, and saving.  Perhaps policies of this sort are what Mrs. Clinton has in mind.  Yet, the economic theory underlying such supply-side policies is quite different from the description that Mrs. Clinton and other Democrats give to TDE.  According to that description, TDE is about giving more money to the rich in the hope that the rich will immediately spend that additional money on yachts and the like, which eventually will stimulate economic activity that trickles down to the lower income classes.

Supply-side economics, however, is not based on spending.  Quite to the contrary, it is based on the idea – long observed in economic life — that encouraging more work, productivity, and savings results in both immediate increases in aggregate wealth and increases in future wealth.  Future wealth comes about because additional saving provides the means to expand the capital stock.  Economic growth is the end result.  All income classes share in that growth.  Whether or not there is more spending by the rich on yachts is wholly irrelevant.

Milton Friedman was fond of saying, “there are only two kinds of economics — good economics and bad economics.”  Good economics teaches that, if you want growth and rising incomes, the capital stock must increase over time in order to make resources, including labor, more productive.  Increasing the capital stock, in turn, requires saving by those in the best position to save and also that the government exact as little of that saving as possible.  It is not a particularly difficult concept to grasp.  Perhaps even Mrs. Clinton will grasp it someday.

Hello World!

Welcome to Liberty & Markets, my personal blog site.  I hope that you enjoy my commentary on legal, economic, and political issues of the day.  If you would like to know more about me and my background, please click on the About page on the opening screen.  Theodore A. Gebhard.