Matt Y tackles a tough problem. Many economists believe that lower taxes on the rich increase economic growth by a few tenths of a percent. We do not have much solid empirical evidence for this, but they still believe it. So of course, these people agitate for lower taxes on the rich – its a no brainer because it makes everyone better off.
But the most cursory investigation makes it obvious they care far more about low taxes than economic growth.
First, Nearly all the benefit from this .2% comes after the current generation is dead. The extra benefit is barely visible after 40 years.
Economic Growth after 40 years
The overall economy is 30% better off after 40 years. Thats great, but not exactly earthshaking extra growth.
Next, This is the total economic growth. It doesn’t account for distributional effects. If the entire economy is 328% better off, but the middle class is only 200% better off, the deal is much better for the middle class to go with taxing the rich.
Over the last 40 years, the middle class is closer to 0% better off than 200% better off. No wonder why the middle class wants to tax the rich more. They don’t get any growth otherwise.
Then, This thinking doesn’t account for increased economic volatility that results from wealth concentration. I pound the table about this - we need to think about risk adjusted returns when looking at economic growth.
Downside volatility is horrible for long term growth, because digging out of the hole takes a long time. Some people are waking up to the idea, but we need more focus on the risk and not just the return when thinking about long term GDP growth.
We’re in the beginning stages of what could be a gigantic economic boom. Just recently, we had knockout numbers in two different reports. These numbers weren’t good, they were great.
First, the Personal Income numbers were stupendous. The real personal income number was in the top 5% of the last 20 years. More importantly, it is clear from the personal income numbers that the 2% Payroll Tax reduction is a much greater tax reduction than the first round Obama tax cuts.
From the numbers, it appears that this tax cut added $44bn to personal income in January. Annualized, this is a remarkable $528bn to personal income! January is typically a large month for income, so we’re not going to see quite that much of an increase in PI.
But even rounded down significantly, this change is on the roughly 3% of GDP. That is a gigantic difference in personal income.
The estimated impact of the 2% payroll tax cut was supposed to be $120bn
Because PI is calculated as a change from last month, we’re not going to see the huge difference recur again and again. However, the benefit from this tax reduction will be ongoing and huge.
Then, the Chicago ISM crushed it like Frank Thomas used to back in 1995.
The Chicago ISM came out with its best reading in 23 years. New orders were the best since 1983. Order backlog highest since 1994. This report was really, really good.
I hate to write this about Tyler Cowen. He seems like a nice guy, and he is certainly very smart. But this article about inequality is a train wreck, and his real time record is nearly propagandistic. Cowen is part of the problem, like Hoenig is part of the problem. (Kudos to Matt to calling Hoening out – he has been wrong for 20 years)
He just wrote an article that has the blogging world aflutter, talking about the “inequality that matters”: Wall Street captured the political process, and does not fail when it loses all of its money. Wall Street rips off its customers. Wall Street plays short volatility. Wall Street deliberately exposes itselt to systemic risk. This is not news to anyone in 2010.
In real time, Cowen was MIA. This would have been a prescient article to write in 2003 or 2004. Or a strong article in 2005, 2006, 2007, or even 2008. But in December 2010, please. Don’t bother searching through his blog archives from those years. You’ll find interesting articles about food, but not much real time information on the greatest wealth transfer in human history.
And the remedy? “Throw up your hands, we are powerless against this system – we just have to pay the price, and let these rich financial institutions destroy our economy, over and over again.” I will call this Bullshit now, and get to the reasons why later.
Please, please remember: Nearly everything that went wrong in the most recent crisis happened in financial products specifically created to avoid the laws passed after the first Great Depression. The entire shadow banking system grew up to evade these laws – that is the reason it is called the shadow banking system.
But lest we get lost, let’s examine the two different ideas, one, that Cowen was MIA when it counted, and two, he is totally wrong about the remedy.
Cowen: The real time record sucks
Look closely at his Slate review of Taleb’s Black Swan. Yes, The Black Swan is a flawed book – the author is full of himself, it dismisses all risk management as always useless, it claims that the Black Swan idea is nearly all Taleb’s.
But it is also a book that:
- devotes a significant number of pages to discussing how the banking system fails over and over again and gets bailed out by the government;
- shows how banking is designed to systemically fail;
- talks extensively about how short volatility strategies blow up financial institutions and enrich bankers – and the clean up is paid for by governments and ultimately taxpayers.
In addition, The Black Swan makes a startling claim about banks – that banks are not net profitable over our entire history of banking, but rather survive only because of repeated government bailouts.
Cowen does not mention these issues in his review. Cowen does mention finance. Choice quote from the June 2007 Slate review:
“Oddly, Taleb’s argument is weakest in the area he knows best, namely finance. Only on Wall Street do people seem to give proper credence—not too much, not too little—to very unlikely events.”
Just fifteen months later, the U.S. is handing $200bn to AIG. Treasury Secretary Hank Paulson issues a one page note asking for $1,000,000,000,000 to bailout Wall Street Banks, because they are all broke. “Proper Credence”, indeed.
Wall Street - and any bank - has a massive incentive to underprice the risks it faces. It can make more money when it does. This is why we passed the Securities Act of 1933, Glass-Steagall, and the Securities Exchange Act of 1934 – to prevent banks from underpricing risk and misleading their customers about that underpriced risk. Much of Minsky’s work is devoted to this idea: Banks face perverse incentives to pile on risk in good times, even if they know bad times – where they will not be able to suppor that risk – are just around the corner.
These ideas are well known, and were well known in June 2007.
On inequality, look through his blog archives. See if you can figure out what his opinion is on inequality. He doesn’t even think it really exists, but I could be wrong.
Short Volatility Strategies? Not mentioned as far as I can remember.
How about banking bailouts as a long term fact of the world financial system? Not mentioned on his blog, prior to 2009.
Overall – where was he in real time on what he seems to think are the most important issues facing us today. Nowhere to be found. In fact, he spent much of his time shilling for EMH, or maybe not – I cannot always figure out what side of an issue he is on. He has weak opinions, strongly held – the very reason why Harry S. Truman asked for a one-handed economist.
Despair, for Cowen does not understand risk adjusted returns
Currently, we run our economic system as though the natural path is the optimum path. But what does optimum mean? Does it mean highest returns?
Any trader worth their salt knows about risk adjusted returns. What are the risk adjusted returns of our current approach to banking? We do not seem to get much better returns, and the risks seem very, very high right now.
I think much of the despair of the article comes from this one line:
For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism.
He forgets that we had an excellent solution after the first great depression – make broad based rules that limit banks to specific functions. In this specific area of human existence, follow “rule of law” based regulations: everything not specifically allowed by the rules is banned.
We use this method with other extremely dangerous substances, like plutonium. We have laws like “reckless driving”, which essentially ban everything not specifically allowed by the rules.
Why not with something that has proven itself to be dangerous over and over again – unregulated banking? Remember the S&L crisis? That was “only” $200bn or so. Is it possible that some people looked to the S&L crisis as a trial run?
I find it odd that humans can: Put people on the moon; design, build, and program computers; improve traffic patterns; run profitable businesses; create and run the internet; raise ever more intelligent kids. But for many economists, their most sacred principle is that even the smallest deviation from unfettered natural systems reduces economic performance.
The idea of maximizing economic performance instead of maximizing the risk adjusted returns of our economy is probably flawed. Brad Delong points to an interesting chart that shows how much volatility we have taken out of our economy with active management. But the long term growth rate has remained largely the same – we’ve just cut off the lower tail.
This is similar to the return curve that most Long Term Trend Followers have, and why they insist on using the Sortino Ratio, instead of the Sharpe Ratio. Downside return volatility is far more devastating than upside volatility, even though you need to monitor both.
It does not make coherent sense, on some basic level. Either humans can figure stuff out to make it better, or they cannot. There isn’t some vast, cosmic, “un-figure-out-able” off-limits sign on economic activity, just the ones we put their ourselves. I am not claiming it is easy, only that the natural order isn’t likely to deliver what we want.
I find it even odder: We had a banking system that produced massive prosperity for most Americans, and then dismantled it. We can change the risk of our banking system.
Hoeing And Cowen do not deserve any accolades
Matt wrote this incredible article about how Hoenig has been wrong for the last 20 years, and doesn’t deserve any praise at all. Actually, it has been longer than that, but Matt is correct – Hoenig has been wrong for a vast majority of his career.
With Cowen, the problem is a bit more pernicious. It isn’t that he has been wrong, but that you cannot tell. What does Cowen strongly support? I think he does not like government meddling – ok that might be one. However, when I read his posts, I frequently cannot tell what his position might be on the topic. He is the reason Harry S. asked for a one handed economist.
Even worse is that this guy missed the worst economic debacle of our lifetime in real time, and his solution - well, he does not have a solution. Where is his wisdom? Where is his Strong Opinion, Weakly Held? Is it “we are powerless against the banks?”
It seems like it comes down to support and enable the status quo. He doesn’t see a way to change anything, because the markets have naturally evolved to put banks and financial companies at the top of the food chain. By his philosophy, he does not want to meddle, so he cannot do anything about it. Dude, it isn’t that we are powerless, it is that you tie your own hands behind your back. We’ve changed the laws dramatically to favor capital and financial firms – just look at the tax code on how hedge fund managers are taxed.
I however, remain unfettered.
Nearly the only spending that matters for the U.S. economy is upper income spending. Lower income spending just doesn’t have enough bang to be important to GDP. For example, the median household income was $46,326, but GDP per capita is $46,000.
In 2006, the median household size was roughly 2.5. So in a perfectly equal world, the total GDP per household should have been 46,000 * 2.5 = $115,000. I am not some communist saying “put the rich up against the wall”, but rather trying to determine what might impact the U.S. economy. So how can we make sense of the difference between $115,000 and $43,326 and what implications does it have for our trading.
It turns out to have a huge impact on trading. That extra $71,000 per household is being spent by someone, somewhere. And we know it cannot be anyone making under $71,000, or even $100,000 from simple logic.
Some level of income needs to spend much, much more to make up for the difference between these numbers to create our total GDP. It is pretty clear that the only people that can spend enough to make up this GDP is people in the top 10%, and the top 1% must contain the bulk of this spending.
So when I see charts like this showing true luxury products are flying off the shelves, I am not surprised. The super rich are spending:
I haven’t gone through the math yet, but follow the logic in this post, and just substitute “Spending” for “Savings”. The conclusion must be extremely similar: Upper Income spending is a massive driver of the U.S. economy.
Can we reconcile Hayek and Keynes? This Guardian Op-Ed says yes.
He makes it sound so easy. Maybe it is…
RE: Ideas in the article. Stamped money and mopping up savings – these are interesting ideas – and they would make a difference.
But, I know 50% of american wage earners make less than
$27,000 $26,300 a year. So a much simpler idea pops into my mind: The Payroll Tax Holiday.
50% of the U.S. population wouldn’t require any stamped money to spend it immediately.
But the Keynes-Hayek reconciliation! I think the Mises.org would rather burn themselves like a buddist monk than reconcile!
Did I mention that 50% of U.S. wage earners make less than $26,300?