The 85% Solution

It almost goes without saying that the health care reform (HCR) bill that is about to pass the Senate is extraordinarily bad policy. The perceived problem we have with health care in this country is exploding cost. Health care expenditures continue to rise much faster than the rate of inflation.

Now this is not on its face an unacceptable situation. As a country becomes wealthier, it might make sense for a larger and larger fraction of its GDP to be spent on health care. There is an easily approachable limit to how much food, shelter, and I-Phones a person can consume, but given the fact that we all grow old, get sick, and die, the limit to how much health care we can consume over our lifetime is high enough that we won't be bumping against it for quite some time.

But I think most people agree (although perhaps for the wrong reasons) that there is something horribly awry with our current system. Costs are rising much faster than they should, and there are probably some simple adjustments that could be made to contain costs and make health care more affordable.

Anyway, rising health care costs are perceived to be the problem. So, what does the HCR bill do? It subsidizes consumers and taxes providers and producers. That's right, it artificially stimulates demand for health care, and enacts new taxes and fees which artificially suppresses the supply of health care resources.

Brilliant! This ranks right up there with Cash for Clunkers as a textbook case of fallacious reasoning in economics.

That said, I wanted to focus on just one small part of the HCR bill which highlights the lack of thought that goes into the crafting of such legislation. The provision to which I refer requires, in the words of Senator Al Franken, "... health insurance companies to spend 85% of premiums on actual health services -- not administrative costs, TV ads, or gargantuan CEO bonuses..."

No doubt Harry Reid and his pals have put a lot of thought into that number 85% (sorry if i dripped sarcasm on the page here), but isn't it amazing that a government bureaucrat could come up with a single number like that which works for the whole country and for all large group insurance plans (of course, the states will be given the freedom to raise the bar even higher, although one hopes that 100% will be understood as a natural limit)?

Now, one might expect a somewhat more precise and legalistic definition of the phrase "actual health services" in the "actual" bill, and here it is:

(1) on reimbursement for clinical services provided to enrollees under such coverage; [and]
(2) for activities that improve health care quality;

Well that clears it up. Let's do something novel and try to put ourselves in the shoes of a rational human being for a minute, one that responds to incentives and tries to game the wording of vague regulations.

You're the CEO of a health insurance company, and Congress tells you that you have to spend at least 85% of your premium revenue on health care services or activities that improve health care quality. You can do math, so you quickly determine that the amount of money available for other expenses, salaries, and profits is at most (100%-85%)*(total premiums) = (100%-85%)*(total expenditures for health care servides)/85% = 17.65% * (total expenditures for health care services).

The amount of money available scales linearly with total health care expenditures, which is interesting. Now if you can just find a way to spend more on health care, without increasing your administrative and marketing expenses, you can pay yourself, your employees, and your stockholders more money. Hmmm.

Suppose you cut co-pays and deductibles and encourage your customers to get more health care. You could pay doctors more too, and even fund all kinds of ridiculous perquisites for doctors under the category "activities that improve health care quality."

Of course you would have to raise health care premiums for all this to work, and normally you would be constrained by competition from other health care insurance providers. But under the new law, all of the other providers would be thinking the same way. All the incentives are now skewed towards increasing health care benefits and costs, with commensurately higher premiums to pay for it all.

The intent of this language, I guess, was to provide an incentive to insurance companies to cut administrative expenses. But that incentive was always there. All this provision will manage to do is remove any incentive to cut costs for "actual" health care services. Perversely, it does the opposite.

Does Lack of Health Insurance Cause 45K Deaths Per Year in the US?

This paper has been cited by a lot of people recently, including Nicholas Kristof in his November 12th op-ed (I'll have more to say about Kristof later as he has been spreading health care falsehoods under the guise of countering health care myths).

The research has been interpreted as demonstrating that approximately 45K people die every year in the US because of lack of health insurance.

This is almost certainly wrong.

I note the following points to keep in mind about the paper:

1) the principal author is PNHP (Physicians for a National Health Plan) founder Dr. David Himmelstein;

2) in the paper itself the authors do not claim to have shown a causal relationship between lack of health insurance and higher mortality; they only claim to have shown that there is a positive correlation.

PNHP has an extreme agenda. The group was formed to promote socialized medicine in the US. In addition, PNHP recognizes that its goal of equal access to health care is undermined if a private market for medical services is allowed to develop in parallel with the government run network (such a 2-tier system exists in the UK). Therefore, PNHP wants essentially to ban private medical practice. Himmelstein et al want to make it impossible for someone to pay to see a doctor.

The fact that Himmelstein is the principal author of the paper does not necessarily mean that the paper is wrong (although one should probably be more skeptical than usual). Even if the paper is substantially correct, we should keep in mind that Himmelstein's political agenda may interfere in a number of ways. For example, data that undermines his political agenda may have been suppressed or at least not released publicly. Also, he may spin, or allow others to spin, the paper's results in a way which is not justified by the data.

I think the latter concern is clearly at play right now, and primarily with respect to the rather widespread confusion about causality vs correlation. That is, when sticking to the science, the paper only makes a claim about there being a positive correlation between lack of insurance and mortality rates (1.4x higher mortality rates for the uninsured vs the insured population when adjusted for a variety of factors). But correlation is not causation. Although the uninsured have a higher mortality rate, it may be due to some factor other than the lack of insurance. This is important because it might be that even if these people were given insurance for free, their mortality rates would remain high. I suspect this to be the case, at least in part.

Although not specifically mentioned in the Himmelstein paper (a surprising and telling omission I think), a reasonable hypothesis is that there is self-selection involved among people who are uninsured. People who are responsible about their health, who care about their health, and who therefore will go to the doctor when they are sick and then stick to a prescribed course of treatment, those people are more likely to care enough to go out and make sure they have insurance. It is the lazy, irresponsible people who will be skewed towards being uninsured.

I think that this effect is real, even in a system where most people get insurance through their employer. Remember, most honest economists would agree that health insurance is paid for out of employee wages, not out of company profits. All other things being equal, jobs which do not provide health insurance will pay higher wages than jobs that do. People who do not value health insurance will choose those jobs that do not provide health insurance because they will earn commensurately higher wages.

The authors of the paper try to normalize for various factors, including income, education, ethnicity, and current health status. But they cannot control for personal responsibility. In fact, their attempt to normalize for health status might exacerbate the effect they have captured (i.e. it makes the correlation between lack of insurance and mortality rates higher) because people who are already sick are probably focusing more on getting health insurance than people who are healthy. In other words, those who have good health status and are short-sighted about their health are more likely to be uninsured. So those without insurance are probably in a healthier pool after controlling for income, education, and ethnicity.

[To be fair, I should mention that the authors think that the effect of controlling for health status can go the other way because those who have poor health status at the start of the study might have already suffered from lack of health insurance.]

In any case, the paper only claims correlation, not causation. The researchers did not have access to cause of death data, and, accordingly, there was no way to know if lack of insurance played any role at all in the excess death rate for the "normalized" pool of uninsured.

Perhaps by design, however, the authors of the paper have created a perception in the media that causation has been proved and that 45K deaths per year could be prevented if we extended health insurance coverage to every US resident. I think that if you cornered Himmelstein himself, he would back off of that claim very quickly.

This paper finds that there is actually little correlation between excess mortality for the uninsured when mortality is restricted to "amenable" causes of death. Additionally, it finds that there is no change in the relative mortality rates for the uninsured pool of people once they become eligible for Medicare coverage at age 65. That is, giving the uninsured insurance does not improve their survival rates relative to the insured, at least once they've reached age 65.

Of course, as I've expressed before, even if the lack of health insurance causes excess mortality rates, we have to judge that effect relative to other wealth or income based factors that cause excess mortality. Eating cheap, starchy food, living in crime-ridden neighborhoods, driving unsafe cars, and working in dangerous jobs all cause excess deaths among the poor and are clearly direct consequences of being poor. If the money required to give out free health insurance could get better results in these other areas, then we shouldn't waste our limited resources on universal health insurance.

Minimum Wage Laws and Entry Level Jobs

It is interesting to compare Bob Herbert's article in the NY Times yesterday about unemployment among recent college graduates with a Wall Street Journal op-ed from earlier this month about the effect of the recent minimum wage hike.

Here's Herbert from October 30, 2009:

As jobs become increasingly scarce, more and more college graduates are working for free, at internships, which is great for employers but something of a handicap for a young man or woman who has to pay for food or a place to live.

"The whole idea of apprenticeships is coming back into vogue, as it was 100 years ago," said John Noble, director of the Office of Career Counseling at Williams College. "Certain industries, such as the media, TV, radio and so on, have always exploited recent graduates, giving them a chance to get into a very competitive field in exchange for making them work for no — or low — pay. But now this is spreading to many other industries."

Lonnie Dunlap, who heads the career services program at Northwestern University and has been advising young people on careers since the mid-70s, said today’s graduates are experiencing the worst employment market she’s ever seen.

...

Like Mr. Noble, she mentioned the growing use of interns versus paid employees and said she can see the value of such unpaid work for some recent graduates, "though, of course, not everyone can afford to do that."

Herbert concludes:

If we’re having trouble finding employment for even these kids, then we’re doing something profoundly wrong.

Ahh, but what could we be doing wrong?

From the WSJ article on October 3, 2009, aptly subtitled “The minimum wage hike has driven the wages of teen employees down to $0.00”:

Yesterday's September labor market report was lousy by any measure, with 263,000 lost jobs and the jobless rate climbing to 9.8%. But for one group of Americans it was especially awful: the least skilled, especially young workers. Washington will deny the reality, and the media won't make the connection, but one reason for these job losses is the rising minimum wage.

Earlier this year, economist David Neumark of the University of California, Irvine, wrote on these pages that the 70-cent-an-hour increase in the minimum wage would cost some 300,000 jobs. Sure enough, the mandated increase to $7.25 took effect in July, and right on cue the August and September jobless numbers confirm the rapid disappearance of jobs for teenagers.

The September teen unemployment rate hit 25.9%, the highest rate since World War II and up from 23.8% in July. Some 330,000 teen jobs have vanished in two months. Hardest hit of all: black male teens, whose unemployment rate shot up to a catastrophic 50.4%. It was merely a terrible 39.2% in July.

...

As the minimum wage has risen, the gap between the overall unemployment rate and the teen rate has widened, as it did again last month. (See nearby chart.) The current Congress has spent billions of dollars—including $1.5 billion in the stimulus bill—on summer youth employment programs and job training. Yet the jobless numbers suggest that the minimum wage destroyed far more jobs than the government programs helped to create.

Now, I don’t want to mislead you; Herbert is writing specifically about college graduates, and the numbers from the WSJ article are for teenagers. However, there is obviously a strong correlation. Recent college graduates are usually unskilled and trying to land their first real jobs, just like teenagers. And employers are not currently willing to pay $7.25/hour (plus the 7.65% employer portion of FICA taxes) for an on-the-job trainee of limited productivity.

The fact that zero wage internships are widely available means that the need for young, unskilled workers is there (after all, taking on interns is not exactly free – interns do require some supervision from paid employees), but that given the choice between paying zero (which is legal) and minimum wage, employers choose zero because the minimum wage does not make economic sense.

It is highly likely that there is some hourly wage between zero and $7.25/hour that could better clear the market for entry level labor and could match hundreds of thousands of additional entry level workers with entry level jobs. But the federal government, in its unbounded wisdom, has made that wage illegal.

I recently remarked to an economist friend of mine that economics must be a depressing field in which to be a researcher. In the hard sciences, new research is often translated into practical applications which benefit society. In economics, however, ideas that were worked out and widely accepted by practitioners centuries ago are not only not implemented, but are contradicted and disparaged by those who wield the most power over our society.

I suppose that we should feel fortunate that lawmakers don't try to repeal the law of gravity, even as they try again and again to repeal the law of supply and demand.

The Nobel Peace Prize and the Cause of World Peace

Although this post does not pertain to economics directly, I think there are general economic principles at work in every aspect of human life. As such, no topic is off-topic for this blog (isn't that convenient?).

Most observers are stunned by the announcement today that President Obama is the winner of the 2009 Nobel Peace Prize. I have to confess (brag really) that it was not so much a surprise to me. Before I was even out of bed this morning my wife turned on her laptop to check the news and immediately gasped and said "Guess who won the Peace Prize." I immediately said "Don't tell me it was Obama."

The Peace Prize, as well as the Literature Prize, are quite different from the science Nobel Prizes in that they are essentially political in nature. Although there are sometimes controversies about how important Nobel Prize winning scientific research is or whether the particular people who were awarded the prize actually deserved it more than others, there is rarely controversy about the work itself. The prize winning work is almost always already accepted as correct and already considered a significant contribution to human knowledge (although there was at least one prize given for erroneous research). Not so for the Peace and Literature Prizes.

I note in passing only that a Peace Prize, but not a scientific prize, has been awarded for global warming research.

The Peace Prize is unique in that the prize committee sees it as a vehicle for promoting world peace, rather than just recognizing important and completed work. And the committee clearly believes that it can promote world peace by enhancing the stature of the recipient and encouraging him to keep doing what he's doing.

Choosing Obama is logical in the sense that the committee wishes to encourage his recent overtures to the world, his professed commitment to peaceful diplomacy, and his apparent desire to reduce the military capacity of the United States. I think the timing in particular proved irresistible to the committee because the award could possibly influence Obama's pending decisions on escalating the war in Afghanistan and taking more aggressive measures against Iran.

But the choice is overtly political because it is not at all clear that Obama's professed peace-making strategy is correct. There are reasonable people (and I count myself as one of them) who believe that the current strategy is one of appeasement which actually does great harm to the cause of world peace.

The simple truth is that there are a lot of evil people in the world, and many of them accumulate vast powers through the apparatus of a state. I've seen references to medical studies which estimate that roughly 1% of humans are literally psychopaths. Probably a reasonable percentage of psychopaths are clever enough that they can play by society's rules in order to survive into adulthood unscathed and unjailed.

It is probably also true that a much larger percentage of people are capable of being trained to become psychopaths in practice. That is, they have moral consciences but can be indoctrinated to suppress them in order to achieve a greater good for their people, their cause, their country, or their religion.

Many of these psychopaths end up in control of states. In fact, in undemocratic states, there is probably a selection bias in favor of leaders who are violent psychopaths (whereas in democratic states there appears to be a selection bias in favor of narcissists).

Whatever the root cause, history is replete with examples of countries that start wars for no good reason except to accumulate power and wealth and to subjugate other people.

George Bush was widely derided for his Manichean world view -- which is that there are good people and bad people, and that the good people have to stand up to the bad people. But Winston Churchill had the same view, and he is generally recognized as an inspiring and brilliant leader. The main difference is that Winston Churchill was a lot better at speaking off the cuff (and was much more of a warmonger).

I'm beating around the bush (no pun intended), but my central point is one that Winston Churchill believed in and one that Ronald Reagan made into a campaign slogan -- that peace comes through military strength.

The US spends more than 4% of its GDP on defense. It is roughly equal to the total military spending of the rest of the world combined. Is this necessary? Is it overkill? I'm not sure of what the right number is, but the size and strength of the US military should be above the level at which other countries don't even think about challenging us.

You don't want a potential adversary to get even a glimmer of an idea that it is possible to initimidate the US militarily. Because if an adversary doesn't even think to try, we will have real and stable peace.

In financial terms, one might describe this idea thusly: the convenience yield of having a huge military capacity is equal to the potential cost of the devastating wars that such a capacity allows us to avoid. Given the shockingly high cost of war between modern countries in terms of human suffering and economic loss, that convenience yield may well be far in excess of 4% of GDP.

Now that might not be so comforting to a left-wing politician in Oslo who thinks that the United States is just as susceptible to being taken over by a psychopath as any other (especially since, in his view, it was ruled by a psychopath for the last eight years).

But the truth is the system of government we have in the US makes immoral military aggression extremely difficult and unlikely. Bush-haters hyperventiliate a lot about Iraq, but whether you think the Iraq war was smart or dumb, farsighted or rash, justified or not, it is necessary to ignore completely the prior 15 years of Iraq's history to judge the motivations for the Iraq war as immoral. According to any reasonable moral calculus, the 10 years of economic sanctions which preceded the Iraq war were far less moral than the war itself.

And given the surprising, suicidal hatred shown by some of our enemies on 9/11, it was not unreasonable to use our power to preempt a latent, albeit uncertain, threat. That this threat was hyped as more short-term than it really was (although perhaps not more than it was genuinely perceived to be) doesn't change the fact that it was a rational decision and not a psychopathic one.

Anyway, I think that what has kept the reasonably stable peace during the two decades since the end of the Cold War has been the United States' dominant military power, and the willingness to use it to maintain the peace on land and on the high seas.

The Nobel Peace Prize Committee disagrees and wishes to use the selection of Obama to promote its idea that global peace is attained by holding hands and singing kumbaya around campfires. Ten thousand years of human history says that the committee is wrong. Let's hope that Obama will come to see that before real damage is done.

What is a Waste of Resources?

Obama promises to cut $500B of waste, fraud, and abuse out of Medicare and Medicaid over 10 years. To say that this claim has been met with skepticism would be an understatement.

I am not nearly so skeptical because what Obama and the left wing are really demanding from Congress is more power to ration government provided health care, as well as to pay drug companies, medical equipment companies, doctors, and hospitals less for their products and services (which will of course lead to more rationing).

I think the savings in terms of money could easily materialize. The problem I have is that saving the government little green pieces of paper is not a worthy goal in and of itself. After all, the government can create little green pieces of paper almost for free.

If the government were to save $50B/yr in Medicare costs by cutting Medicare reimbursement rates and by raising the eligibility age from 65 to 67 years, would anybody think that is real savings? How about if the government mandated that no doctor be allowed to make more than $100K per year? Or that all drugs currently on the market are deemed no longer on patent? All of these changes would dramatically lower the cost of government provided health care, but would they actually prevent the waste of or increase the supply of health care resources?

Resources are tangible things -- valuable services, goods, products, information, trained people -- and not little green pieces of paper. Tackling waste means freeing up or increasing the amount, quality, and availability of resources. Paying people less doesn't do that.

Consider the following paired examples:

1.
(A) A drug company wins a patent extension which allows it to keep charging high prices for a successful and effective cancer drug;

(B) A drug company realizes that its new cancer drug provides essentially no benefit over existing ones, but decides to spend $1B developing and promoting it anyway because it calculates that it can capture a significant share of the market and generate a net profit;

2.
(A) a health insurance company CEO is granted a bonus that exceeds the industry average by $10MM even though by most measures he is doing a mediocre job;

(B) a health insurance company with an antiquated billing and reimbursement system spends $10MM more than it should this year on administration costs;


3.
(A) a doctor submits fraudulent claims to Medicare for services he never performed;

(B) a doctor orders unnecessary MRI tests for most of his patients because he has an equity interest in the MRI facility;

4.
(A) a doctor has to pay $150K/yr in malpractice insurance;

(B) a doctor orders a wide range of unnecessary tests for a patient, in order to protect himself from a potential malpractice suit in case of an adverse outcome;


I believe that to first order the (A) examples are merely (possibly unfair) transfers of money from one entity to another, but not a waste of resources.

The (B) examples represent true waste. Real (mostly human) resources are being used which could have been deployed better elsewhere.

It is not surprising that the focus of politicans is on the (A) examples. Perceived unfair transfers of money get people riled up, and being natural demogogues, our politicans cater to that anger.

Ironically, putting in place policies that curtail the (A) examples will, if anything, decrease the supply of health care resources (which is not necessarily a bad thing - see further down).

Reducing the amount of money transferred to the health care industry in the aggegate (even including outrageous examples of overpayment, abuse, and fraud) will not encourage an increase in supply.

When Obama and his speechwriters make the mistake of lumping corporate profits in with overhead (as they do repeatedly), it is clear that they don't understand any of this at all.

Now I am not claiming that we should tolerate overpayment and fraud. Far from it. A distortion in favor of the health care industry is just as bad as a distortion against it. As only one part of a complex economy, the health care industry should have no stronger claim on aggregate resources than any other area. Too many people becoming doctors, for instance, is as bad as too few. [How we could know how many is the right number is something that the free market is best at determining, by the way.]


Finally, here's a trio of hypothetical examples. Which of these represent a waste of resources?

5.
(A) a drug company spends $100MM on a public and doctor-focused advertising campaign to introduce its new product;

(B) a drug company spends $100MM in litigation defending itself against claims that its product causes serious problems in approximately 1% of patients;

(C) a drug company spends $2B developing a new cancer drug that gives terminal patients a 25% probability of living an extra 2 months;


I am inclined to believe that (A) and (B) are wasteful, but (C) is not.

Advertising is a complex subject. Some economists consider marketing expense a dead weight loss to the economy. I have always felt that it has some informational value for consumers, but it also appears to be necessary for free market competition.

The competition hypothesis seems less convincing in the case of drug companies, however, since they only compete directly in those rare instances when they have identical drugs on the market.

The benefits of litigation are difficult to quantify as well. Obviously, one way that the sanctity of contracts is upheld and consumers are protected is through litigation. But our system has gone awry, and you probably couldn't find one serious economist today who didn't think that the US is an overly litigious society and that the costs of litigation are excessive.

As for example 5.(C), the drug company would be wasting resources only if its prospects for making a profit depended upon the market price for the drug being anomalously high. It is in the nature of our 3rd party payer system for medical care to create such inefficiencies. Since consumers don't see the true cost, they make inefficient cost benefit decisions.

Still, my sense is that the medical community has generally made sound choices when it comes to approving expensive new drugs. My evidence is that hundreds of miraculous drugs have been invented over the last 30 years, and yet drug companies account for only about 1.5% of world GDP (in the US, it's about 2%). I would be willing to spend that fraction of my income on Claritin. Fortunately, it's much cheaper than that.

Health Care Rationing

There will be rationing under a government health insurance system. That is just simple economics. If you give away a valuable thing for free, then demand will exceed available supply. The government will have to allocate health care resources according to some formula, and I guarantee you, this will be extremely controversial and morally agonizing.

Proponents of a government health plan point out that in a free market rationing is also done, but it is done by price rather than by bureaucrats and lawmakers. The price rises until demand and supply are matched, and those unwilling or unable to pay that market clearing price will receive less health care.

This is certainly true, but rationing by price is more efficient and morally sound. Those that value health care a lot will be more likely to obtain it than those who don't value it very much. It is important to remember that health is not something everybody values equally. And pretty much everybody makes tradeoffs between health and money. That is why some people are willing to be coal miners or firefighters or football players, or are willing to work overtime with little vacation or even rest. It is also why some people don't eat healthy foods or exercise or stop smoking.

Some people care a lot about having (painful) surgery so they can continue to play tennis. Others not so much.

When you have rigid rules divvying up resources, you inevitably wind up giving something the government bureaucrats say is worth X to somebody who values it at X/10. Meanwhile, a person who values that thing at 10X must go without.

Perhaps most important of all, rationing by price will lead to more production of the health care services that are the highest price and therefore in the most demand versus available resources. In the long term, a market-based system will produce vastly more health care resources for everybody.

It's amazing that some people (read Barack Obama, Nancy Pelosi, Harry Reid, and other Democratic leaders) so easily forget the lessons of the Soviet Union and Communist China. Government control of the market stifles economic growth. It has been shown empirically that government bureaucrats simply can't do as good a job as the free market at pricing goods and services, providing incentives, and stimulating increases in productivity.

Some people want to believe health care is or should be exempt from market forces, but it isn’t, and it shouldn’t be.

Health Care Fundamentals

Health care is fundamentally no different from any other area of the economy. We live in a world of limited resources. Therefore, we need a mechanism to allocate those resources efficiently and fairly. Every individual decision about allocating a resource comes with a cost and a benefit, and neither benefits nor costs are the same across all individuals. As with every other area of the economy, a free market, in which individual consumers can make their cost-benefit decisions freely, and individual employees, employers, and companies can make their cost-benefit decisions freely, will provide a more efficient allocation of resources than a government controlled market. But perhaps not a fairer allocation.

Liberals are being disingenuous when they claim that giving the government more control will make the system more efficient. It will not. It cannot. I will get into the weeds on this later, but for now I think that most liberals want more government control over health care for one reason and one reason alone -- "fairness."

They have accepted to a certain degree that free markets lead to unequal outcomes in general consumption, in housing, in leisure time, and even in education. But they think that health care should not be treated as just another commodity. Poor people should not get worse health care than rich people. A person should not have to die early because he is poor. A corollary of course is that a rich person should not get better health care than a poor person, and a rich person should not be allowed to live longer because he is rich.

I have brought up the point about "fairness" and redistribution of wealth/income/consumption before, and I have basically accepted that there is no right answer. I have put "fairness" in quotes because there are many people who don't believe that unequal outcomes are necessarily unfair. Be that as it may, people value equality of outcomes differently, with liberals tending to value equality of outcomes higher than conservatives. I lean towards the conservative side. I believe there should be a safety net providing a floor on poverty, but I certainly don't believe in taking more than we are currently taking from the rich to provide for it. I cannot say that I am right, and those who are more liberal are wrong (and vice versa). We are just starting from different axioms.

The two claims I can make with confidence, however, are these:

1) treating consumption of health care as fundamentally different from other types of consumption is simplistic and wrong; and

2) a free market in health care in the US will lead to unequal outcomes but will make far more health care resources available for consumption by all (including the rest of the world, not just Americans).
　
To back up my claim in (1), I'll make two points. First, being poor is bad for health, regardless of the level of health care received. Poor people eat less nutritious food, they live in unhealthier places, they are exposed to more violence in their neighborhoods, they drive less safe cars, and they have more stress due to lack of money. There is a recent UK study that showed that low job status, which presumably leads to more stress, was a significant contributor to poor health. So to consider health care as having special moral implications is naive.

Second, we live in a world where many hard-working, smart people go into fields other than medicine. When somebody decides to become a financial analyst rather than a doctor, that decision reduces our aggregate health care resources, and therefore has consequences (probably negative) for the health of other people in the future. To the extent that such a career decision is largely an economic one, and it usually is, there is an entanglement between the economics of health care and the economics of all other fields, so that it is kind of meaningless to treat health care as an isolated area of the economy where the free market should not apply.
　
I will have more to say about (2) in later posts.

Cash for Clunkers -- The Final Phase

I've been obsessed with this topic because it is perhaps the most obviously and perfectly stupid government program I have ever seen. It's not all that important because it represents only a few billion dollars (as of this moment, $3B in total) of government waste and distortion in a $13T economy, but it does serve as a reminder that government can enact incredibly bad policy in a very short time. The forces of rationality and prudence take time to gather and gain critical mass, but by then it is often too late. Something to ponder as the Democrats try to ram health care reform through Congress without meaningful analysis and debate.

I predict that by the end of the year, you will see stories appear in the media which are highly critical of the results of the Cash for Clunkers program.

To wit:

1) the boost in GDP for the 3rd quarter was temporary -- this will be exacerbated by the way GDP is calculated; inventory drawdowns count towards GDP, but inventory builds do not [Update: Oops, I got this exactly backwards. Inventory builds count towards GDP and drawdowns do not. What I described would be correct for what is called the Final Sales number];

2) the boost to the auto industry was temporary; although domestic car sales had until recently been running at an unsustainably low level (9MM/yr, although there are over 200MM cars in the US), the Cash for Clunkers boost is unsustainable as well and has cannibalized future sales; in addition, Cash for Clunkers has induced many people to buy new cars who probably shouldn't have bought them, and those people will either be dumping them soon or going a good long time before buying another new car;

3) a detailed analysis shows the environmental/energy savings of the program (in terms of carbon emission or imported oil -- both questionable metrics in any case) was nil or negative because the mileage improvement was offset by the energy used to make new cars and destroy old ones, and the old cars weren't driven nearly as much on average as the new cars;

4) used car market prices rose making it harder for poor people to afford a car;

5) engine parts for older cars became scarce making it difficult for owners of clunkers to keep them running at an affordable price;

6) the lion's share of the government largesse actually went to car dealers rather than clunker owners because dealers raised prices on eligible new cars in the face of very high demand;

7) many clunker trade-in buyers ended up with buyer's remorse as they realized they traded in a $2,000 car for a $4,500 rebate but actually paid $2,500 more for a new car than they would have had to if the government hadn't distorted the market;

8) many clunker trade-in buyers were tricked into spending more than they could afford for a new car that they didn't really need or want;

9) new car buyers who didn't have a clunker to trade in had to pay far more than they would have had to just a couple of months before;

10) Cash for Clunkers was effectively a huge subsidy for car dealers as the program provided them with free cash, free advertising, and a huge distortion in customer preferences towards consuming new cars;

Keep in mind points (7) and (9) above as you read stories about auto inventories becoming depleted in the face of huge Cash for Clunkers demand. I suspect that clunker owners are getting no advantage out of the program at this point relative to the deals that existed in June. And yet they will keep buying anyway because human beings are susceptible to marketing schemes that make it look like a special deal is to be had. On top of that, they will be buying "eligible" new cars from depleted inventory, which means that they probably won't even be buying their first choice car (e.g. model, options, color).

Clunker trade-in buyers, regular car buyers, and taxpayers have become dupes of the auto industry.

More Cash for Clunkers

I admit it. I have a bug up my butt about this Cash For Clunkers program. I have a bug up my butt about health care reform too (at least all of the proposals currently on the table), but health care reform is ridiculously complex, and I don't feel I have my act together enough to opine (yet). Cash For Clunkers, however, is straightforward enough that it can perhaps be a teachable moment, as certain moral preeners like to say.

Positive news stories about Cash for Clunkers have dominated media coverage in the last week as the Senate ponders whether to join the House in adding $2B to the program. I see web video interviews with happy car buyers who just traded in their 15 year-old pickup truck to buy a hybrid SUV. I see Wall Street research papers about the positive effect on GDP -- upwards of 0.40% boost this quarter, and I see administration flacks talking up how good the program is for the economy and the environment. Most people believe that this government program is a smashing success (no pun intended).

I was gratified therefore to see Jonah Goldberg's article today. Jonah gets to the nub of the issue, which is Frederic Bastiat's main theme in his 1850 essay That Which is Seen and That Which is Unseen.

In this case, the government is managing to juice GDP this quarter by encouraging new car sales, but it will come at the expense of GDP in future quarters. What is unseen here is that many people made the decision to buy a new car only because the government was essentially giving them several thousand dollars off of the dealer price. Those who were planning to buy a new car anyway have done so earlier than they were planning but won't need another for quite a while. Those who weren't planning on buying a new car now have a lot less spending power to use for a new refrigerator or a new computer or for remodeling a bathroom. That is an unseen loss to GDP.

Then there is the unseen effect of removing cheap cars from the market. Perhaps a landscaper was getting ready to start a business, but he can only afford to purchase a clunker pickup for $3,000 to get started. Alas, they are not available anymore. The lowest price he can pay now is $5,000 because of the diminished supply.

The simplest analysis though focuses on what was destroyed. The government is paying people to destroy something of economic value. That something could have been used for recreation, or it could have been used to contribute to GDP. To make matters worse, resources were used to destroy those things (the car demolition and towing operators' resources), and even more resources (the car manufacturers' resources) were used to create expensive replacements for the things that were destroyed.

I hope Jonah's article is the beginning of some pushback from people who actually understand economics.

There is one other idiocy in the program. As my friend DJ pointed out with respect to the (admittedly stupid) CAFE standards, the government at least gets the math correct for CAFE by calculating the arithmetic average of the gallons per mile that cars get rather than miles per gallon. The reason is that all other things being equal, a 10mpg car uses twice as much gas as a 20mpg car, but a 20mpg car only uses 50% more gas than a 30mpg car.

The Cash for Clunkers program, of course, only looks to the arithmetic improvement (in the case of a new SUV/minivan/pickup truck, 2mpg-4mpg for the $3,500 rebate and 5+mpg for the $4,500 rebate). The improvement is 50% when you go from a 10 mpg SUV to a 15mpg SUV, but it is half as much in going from an 18mpg SUV to a 23mpg SUV. True to form, the government has a floor mpg on new SUVs of 18mpg, thereby ensuring that you are in the un-sweet part of the non-linear gas mileage improvement curve.

This brings me to yet another point in my rambling screed. The theory behind laws based on gas mileage (like CAFE and CARS) is that gas mileage is a good measure of how efficient a vehicle is. But it really isn't because gas mileage scales inversely with the weight and size of a car. Extra size and weight usually means extra passenger safety and extra carrying capacity. I have seen plenty of discussion about the tradeoff between passenger safety and higher CAFE standards, but I haven't seen much about the tradeoff between carrying capacity and higher CAFE standards.

The government obviously recognizes this tradeoff to some extent because it exempts larger trucks and buses from the CAFE standards, but I wonder why it doesn't distinguish between an 8-passenger minivan and a 4-passenger Ford Focus. A family with 3 kids in car seats isn't going to fit into most sedans, yet it fits comfortably into any minivan, with plenty of room for storage. Would the government rather the family drive two "fuel efficient" cars to its holiday destination or one gas-guzzling minivan?

Cash for Clunkers and the Broken Window Fallacy

The Consumer Assistance to Recycle and Save (CARS) Act (a.k.a. Cash for Clunkers) was passed and signed into law last month and can now be implemented thanks to the publication today of rules by the National Highway Traffic Safety Administration (NHTSA). I was going to write about this proposed (at the time) law a while ago, but I honestly didn't think such idiocy would actually pass the Congress. My bad.

The CARS program pays people up to $4,500 for buying a new car if they trade in an old car which gets 18mpg or less. This already sounds like a pretty dumb and pretty obvious government handout to the auto industry. Wouldn't it be nice if the government could just be honest and hand out cash to their favored industries and lobbyists? It would certainly save a lot of time and resources to pay off your political supporters in a straightforward way.

It gets worse, however, because some in Congress have actually convinced themselves (or at least their constituents) that the purpose of the CARS Act is to reduce fuel consumption and carbon dioxide emissions by getting cars with poor gas mileage off the road. Therefore, the old trade-ins must be destroyed. The following excerpt from the NHTSA's rules is practically Orwellian:

The agency has determined that a quick, inexpensive, and environmentally safe process exists to disable the engine of the trade-in vehicle while in the dealer’s possession. Removing the engine oil from the crankcase, replacing it with a 40 percent solution of sodium silicate (a substance used in similar concentrations in many common vehicle applications, including patching mufflers and radiators), and running the engine for a short period of time at low speeds renders the engine inoperable. Generally, this will require just two quarts of the sodium silicate solution. The retail price for two quarts of this solution (enough to disable the largest engine under the program) is under $7, and the time involved should not substantially exceed that of a typical oil change. The agency has tested this method at its Vehicle Research and Test Center and found it safe, quick, and effective. As with many materials used in the vehicle service area of a dealership, certain common precautions need to be taken when using sodium silicate. The same is true with regard to workers who may come in contact with the substance during the crushing or shredding of the engine block. We have discussed the matter with the EPA and the Occupational Safety and Health Administration (OSHA) and are aware of no detrimental effects related to the disposal of the engine block with this material in it.

I'm surprised that they don't require the cars to be buried and then the ground above sown with salt.

The CARS program has been variously described as an economic stimulus, as good for the environment, and as a way to reduce our dependence on foreign oil.

If one gives this even one minute of thought (something that Congress apparently did not), it becomes clear that, except for war, vengeance, and spite, no good could possibly come from destroying something of economic value. There is something called the broken window fallacy, introduced by Frederic Bastiat in 1850, and I refer you to the following link for a discussion.

Unfortunately, the CARS program is essentially a program to break windows. It encourages society to destroy all eligible clunkers with market values up to $4,500.

As we can infer from their market value, clunkers in fact have an important role to play in our economy and our society. They can actually move people and stuff from place to place at reasonably high speeds, and to the extent that a significant majority of people in this country can't actually afford to buy a new car, or even a slightly used one, clunkers allow those people to enjoy the fruits of a technology that has been around for the last hundred years.

This law is particularly annoying because the cutoff fuel efficiency for clunkers is 18mpg, and my 2000 Buick Regal gets 19mpg. The market value is probably barely higher than $4,500, but I figure I could have smashed a few things, collected the insurance money, and then traded it in.

Arthur Laffer's WSJ Op-Ed

I'm a fan of Art Laffer, and I think he is one of very few economists you see on TV who actually understands fiat currency economics.

However, his article today left me scratching my head. The following paragraph in particular makes no sense to me:

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

Let me try to parse it.

To start, the first sentence doesn't capture the complexity of how the crisis unfolded. "Demand" for money usually means a desire to borrow for the purpose of spending ("spending" includes investment in a business, by the way, and not just consumption). Money demand increases when the economy is growing, and prospects look rosy. And higher demand with fixed supply means higher interest rates.

However, this bears no relation to the crisis. People didn't want money so they could spend it. They just wanted to move it to a safe place. There was a collective loss of faith in the creditworthiness of the financial system. In September 2008, T-bill rates were effectively pinned at zero (there were even some scattered trades at negative yields). That shows just the opposite of a demand for a money. Yields on all risky fixed-income products sky-rocketed, but this wasn't because of a sudden spike in the demand to borrow. It was due to a belief that defaults were imminent. That's a big difference.

The Fed's response, of course, was to devise a number of programs to flood the market with money as a way to induce investors to buy the risky products again. The flood of money hasn't worked all that well actually. Other things have. What brought down the interbank lending rate (i.e. Libor) wasn't so much the flood of money but the government's increasingly explicit guarantee of all of the big banks. What brought down spreads in the agency debenture and agency mortgage market was the Fed's direct purchase program. What brought down credit spreads in the consumer loan market is the Term Asset-Backed Loan Facility (TALF) which basically grants a government subsidy to investors in the form of a free put option.

It's all pretty obvious when you think about it. If you don't want to loan Chrysler money because you think they'll default, you're not going to change your mind just because the Fed is willing to lend you $100MM interest-free to do it. You still have to pay back the Fed after all.

Laffer's second sentence is unobjectionable. A recession causes a reduction in the demand for money since business prospects look bleaker and people are more inclined to save money rather than spend it. I should point out that causality works the other way as well. An increase in the desire to save money means less consumption and investment and therefore less economic activity.

The third sentence is completely screwed up. Reduced demand for money is offset by the Fed's increase in the supply of money which lowers the price of money (i.e. the interest rate), which in turn raises the demand for money (since the price is lower). Yes, when the demand rises again (due to the lowered price), the cycle will renew itself. The economy will start growing again, and inflation will start to pick up, but interest rates will be wherever the Fed wants them to be.

Short-term interest rates will go up only if the Fed chooses to raise them (by reducing the money supply) in order to fight inflation. Intermediate-term rates will go up only if the market anticipates that the Fed will raise short-term interest rates. Long-term rates are driven by more complicated factors including risk premia, but let's just say that if the Fed maintains its inflation-fighting credibility, long-term rates will remain moderate.

The fourth sentence in our excerpt starts out ok, but then ends with a completely false statement. Yes, higher interest rates will reduce the demand for money (which had already been raised by lower interest rates and subsequently a growing economy), but this will serve to quash inflation, not stoke it. Higher interest rates do not exacerbate inflation; they do exactly the opposite. They discourage borrowing and spending and encourage saving. They reduce the aggregate demand for goods and services and therefore cause prices to rise less quickly (or even drop). Yes, some economists have theorized that there can be a small short-term cost-push effect on prices in which businesses try to pass on their higher borrowing costs to the consumer, but this isn't real inflation. It is at worst a very short-term and very small effect. At best, it doesn't exist.

Finally, I disagree with Laffer that the Fed is in a Catch-22. A better metaphor is that the Fed is trying to thread a needle. It must aggressively lower the price of money in order to boost aggregate demand for goods and services, but once the economy is safely back on track, it must move quickly to drain the excess liquidity from the system and raise interest rates. If the Fed moves too soon, the economy could be thrown back into recession (this was the Bank of Japan's mistake 10 years ago). If the Fed moves too late, then inflation could get out of hand.

What Does It Mean to Create a Job?

Obama claims that various government spending programs create or save jobs, but what does that really mean? Can the government prevent GM from going bankrupt and save hundreds of thousands of jobs? Can the government raise taxes on carbon and create jobs? Can the government stimulus package create jobs just by throwing money around willy-nilly?

It is important to define first what we mean by a job. The common definition is an activity which a person performs on a regular basis, which produces something of value, and for which that person receives compensation in the form of money and other benefits.

Under this definition, the government can create jobs by just hiring people to do something useful (e.g. picking up litter on the Washington Mall). It can also subsidize private sector employers in order to avoid layoffs of otherwise money-losing employees or to prevent the elimination of money-losing positions.

Finally, if you loosen the meaning of the word "value" in our definition of "job" above, the government can create jobs out of thin air by paying people to do whatever, e.g. see http://tinyurl.com/q6ljq2.

As a pseudo-economist, I prefer an alternative definition of the word "job." A job should be self-sustaining in the sense that the value produced by the employee exceeds the all-in cost of his employment (which includes compensation, benefits, taxes, insurance, and the marginal cost of maintaining and supervising that employee).

According to this definition, government subsidies and direct spending are unlikely to create jobs. They perhaps might save jobs if there is a temporary dislocation which could be mitigated through government action. Arguably, various government programs to stabilize the banking system have saved real jobs in the banking industry and throughout the economy.

But a job created by an artificial boost in demand for the goods and services produced by that job (i.e. through increased government spending) is, well, artificial. The value of the goods and services is inflated by arbitrary government action, and so the net benefit to society of that job is illusory.

My sense is that the private sector is much better than the government at finding profitable employment opportunities and thus creating real jobs. Even if a government bureaucrat were to think of a great new business opportunity which would gainfully and profitably employ dozens of people, you still wouldn't need the government to bring it to fruition. If such a business could create real jobs, then by definition it would be profitable and somebody in the private sector would be willing to seize the opportunity.

One way in which the government can create real jobs (under either definition) is by imposing new regulations. New regulations force businesses to hire people just to ensure compliance with those regulations. In the financial industry, the resources devoted to compliance with existing state and federal regulation is staggering, and the number of employees dedicated to compliance issues easily reaches into the tens of thousands. And of course even financial regulation pales in comparison to the income tax code in terms of complexity and cost and the number of workers who make their living from it (numbering in the millions). I suspect the coming tweaks to the income tax and banking regulation will directly create tens of thousands of jobs over the next two years.

Of course, there is an obvious problem with this method of job creation. New regulation creates new jobs, but not necessarily NET new jobs. Existing jobs may be lost at the same time if certain businesses become unprofitable under the new regulatory scheme.

The new Carbon Cap and Trade Plan is a case in point. Its implementation will certainly drive the creation of new jobs devoted to researching, implementing, and managing so-called green technologies, as well as managing the transition to the new cap and trade system itself, but there is no doubt that a great many current jobs will disappear as a direct result. Claims of the administration notwithstanding, nobody really knows what the final tally will be. And that's just for jobs. The tally in terms of our productivity and our standard of living is even more difficult to calculate, although I predict that it will be very large and negative.

Comparing the FairTax to the Income Tax -- Does the FairTax Depress Consumption?

The FairTax is a proposed national retail sales tax that would be designed to replace the income tax in the United States. It is explained quite well in the Wikipedia entry http://en.wikipedia.org/wiki/FairTax . FairTax proponents claim that a sales tax rate of 23% ($23 of every $100 spent) would be revenue neutral. Detractors claim that the 23% rate really amounts to a 30% sales tax (an increase of $23 in the after-tax cost for every $77 of goods and services).

A sales tax appropriately puts the tax burden on those who are using/consuming society's resources (whether natural or man-made), rather than on those who are creating value in society. You can probably guess that this blogger is a proponent of such a tax.

It's a good thing (or at least a fair thing) that such a tax hits those who consume the most, but we don't want to punish consumption too much. We want people to enjoy a high standard of living, and clearly too little consumption can cause near-term dislocations in the economy. Americans have historically not had a problem with being too frugal in the aggregate. The Japanese have, however, and perhaps a sudden jump to a very large sales tax could have negative consequences for the Japanese economy or a similar high savings rate, export-driven economy.

Does a sales tax really depress consumption more than the income tax, however? I think probably not. It is important to understand that under a primarily income tax-based system consumption is done with after-tax dollars.

Take the following example of a sole proprietor who has flexible work hours and finds himself in a situation where his marginal return for an extra hour of labor is $100. Under the income tax, he chooses to work an additional hour, makes an additional $100 and is taxed at a marginal rate of 25%. He will have $75 left after tax, and if he spends that money on dinner for four at a Chinese restaurant, he and his family will be well-fed for the night but will have no extra money left over from his hour of work. He has exchanged an hour of labor for some Chinese food.

Now let's consider the same situation under a sales tax similar to the proposed FairTax. We will assume a 25% tax rate using the FairTax definition of the tax rate (i.e. prices of goods and services are gross of taxes, and the amount of the tax is 25% of that gross price). Under the sales tax system, the proprietor will have $100 after tax. The Chinese dinner will cost him $100 ($75 price + $25 tax), and at the end of the day, he will be in the same situation as under the income tax.

FairTax proponents have come under criticism for claiming that the sales tax is only 25% in this example. Critics claim that the tax is really $25/$75 = 33.3%. I certainly agree with the critics that the sales tax is 33.3% and not 25%, but the FairTax people are also correct in pointing out that the income tax is never calculated this way. It is very easy to see in the example that a 33.3% rate of sales tax is equivalent to a 25% rate of income tax. It would be nice if we could get the government to admit that when somebody works to make $75 of after-tax income and pay $25 in tax that perhaps the real tax rate is 33.3% and not 25%.

One more example:

Let's suppose our businessman is also an amateur plumber, and he needs some plumbing work done in his house. He is more productive as a businessman than as a plumber, but he can hold his own against quality plumbers in the local area. Plumbers in the area make $75/hour, so it makes no sense for him actually to work as a plumber.

If he hires a plumber at $75/hour to do the required work in his house, he has to pay $100/hour under a 25% sales tax system. By doing the work himself he saves himself $100/hour, which is exactly what he would have been making doing his regular job. He is indifferent to doing the plumbing work himself at a 25% tax rate, but if the tax rate were higher, he would probably spend his time on the lower productivity plumbing job rather than on his higher productivity regular job.

Clearly, this is an inefficiency. It would be nice if the businessman did what he does best, and the professional plumber got to do more work doing what the plumber does best, but because there is no sales tax charged on work you do for yourself, there is an extra incentive to be a do-it-yourselfer.

If you do the same analysis under an income tax, however, the results are identical. In this case, there is no income tax charged on work you do for yourself, so there is the same incentive to be a do-it-yourselfer.

We see that the income tax discourages both production (because you get less money for your work) and consumption (because you're paying for your consumption with after-tax dollars). The sales tax/FairTax depresses consumption because it directly increases the cost of goods and services. But does it discourage work?

A blinkered economist might argue that it does. The utility of the dollars you earn is lower because their consumptive value is lower, so you would be getting less value for your labor. I think in practice, however, the decrease in the utility of dollars earned is mitigated by the fact that you earn more on your savings. If you can earn a high return on savings, it encourages you to go out and accumulate money with which to invest. People do tend to value having money in the bank, anyway, even if they have no plans to spend it. Overall, I think it is pretty clear that work is discouraged a lot less under a Fair Tax than under the current income tax.

An important side effect is that productivity will rise and the cost of goods and services will drop. So, even though the Fair Tax directly increases the cost of goods and services to the end consumer, the increase in productivity might very well go a long way towards offsetting that increase. There is no such offset under the income tax.

Why the Income Tax is Bad

As I've explained in previous posts and in comments to previous posts, the federal government doesn't impose a tax to raise revenue per se. It does so to remove dollar financial wealth from the private sector, thereby curbing aggregate demand for goods and services. This dampens inflation and maintains the value of the dollar, which is important for economic stability and growth.

When discussing the efficacy of various tax systems, however, it is easier to speak in terms of tax revenue, and that's what I'll do here.

The vast majority of federal government revenue comes from the personal and corporate income tax. There have been proposals over the years to replace the income tax partially or completely with other types of taxes or revenue raising schemes. Other taxes that have been considered and used at various times and in various jurisdictions include import and/or export tariffs, head taxes, real estate taxes, personal property taxes, intangible property taxes, sales taxes, and value added taxes.

Below, I'll quickly run through the problems with our current tax system, most of which are unique to the income tax:

1) Income is difficult, perhaps impossible to define. Most people would agree that reimbursement for expenses, compensation for damages, money borrowed, return of money lent, return of capital on an equity investment, and de minimus gifts of goods and services should not be considered income for tax purposes. But if you try to craft rigorous rules that tax transfers of items of value between two entities and yet exclude the things that should not be considered income, you find loopholes and unintended consequences everywhere.

2) Because of (1) above, the income tax code is horribly complex and the cost of compliance is outrageous; estimates as high as 5-10% of GDP have been posited for the annual burden/cost of compliance; when one thinks about the brainpower dedicated to finding loopholes in the tax code as well as trying to close them and litigating them, it almost makes one despair.

3) The complexity leads to law-abiding citizens running afoul of the law by accident or because of the malice of government officials; just as damaging, the complexity tempts normally law-abiding citizens to become scofflaws, a slippery slope which probably undermines respect for the law in general;

4) The income tax is necessarily very intrusive; citizens must divulge to the state very personal details about their businesses, their investments, their families, and their spending and giving habits; the income tax strengthens the state vis a vis the individual and makes oppression far more likely;

5) From a purely economic perspective, there can be nothing worse than discouraging work and production, but that's what the income tax does, particularly a progressive income tax;

6) In addition to (5) above, the tax code can also motivate an individual or company to enter into inefficient transactions in order to maximize after-tax income, rather than pre-tax income.

7) The income tax is relatively inefficient because it is very easy to hide income; also, it is hard to predict how much revenue will be raised from an increase in the tax rate because the incentive to hide or shield income (or not to work at all) increases as the tax rate increases.

8) Because of the intrusion of the income tax into all aspects of the economy, it is tempting for lawmakers to use the income tax to encourage socially desirable behavior and discourage socially harmful behavior; as pointed out in (1) above, however, the complexity of taxing income makes the risk of harmful unintended consequences very high.

9) Since the time of the New Deal, taxes have been used to redistribute wealth from rich to poor; whether or not one believes the government should be redistributing wealth, income taxes are a bad way to do it; income -- particularly, taxable income -- is not a good measure of a person's wealth; some rich people have low incomes, and some not so rich people have high incomes; an income tax just taxes those who are the most productive, not those who have the most wealth (a wealth tax would be better), or those who use the most resources (a sales tax would be better).

Hennessey's Blog and Netting of Govt Assets Against Debt

Keith Hennessey was a senior White House economic advisor to President Bush. He recently started a very interesting and informative blog. On Wednesday, he discussed (and disagreed with) Budget Director Peter Orszag's claim that the effective government debt is smaller than the reported number because the government owns a sizable amount of assets that should be netted against that debt.

http://keithhennessey.com/2009/04/08/dont-hide-the-debt/

I've enjoyed Hennessey's blog, but he appears to be confused about the way a fiat currency system works. I don't think he's alone among top government economists. For starters, Hennessey refers to Treasury bonds as IOUs which need to be redeemed in cash, which he seems to imply is something tangible.

It is not only Treasury bonds that are IOUs, of course, but money itself. A little green piece of paper with Benjamin Franklin's picture on it is nothing more and nothing less than a government IOU. When the government redeems Treasury bonds, it is simply replacing an interest-bearing IOU (barely interest-bearing, in the case of short-term T-bills today) with a non-interest bearing IOU.

In the UK they are somewhat more explicit about the credit-based, fiat monetary system there. The 5 pound notes read "I promise to pay the bearer on demand the sum of 5 pounds." The "I" refers to the Bank of England, and if you take the note to the Bank, they will indeed exchange it for 5 pounds -- either another 5 pound note or a handful of smaller notes and coins which add up to 5 pounds.

The point is that a dollar, whether it is green or electronic, is an IOU of the United States government, where the government is somewhat vague about what it in fact owes the holder. The IOU is imbued with value by two things: 1) the willingness of the government to provide some real goods and services in exchange for those IOUs ; and more importantly, 2) the government's demand that certain people pay IOUs back to the government in exchange for staying out of jail (i.e. taxation). These two things create demand for government IOUs and make them valuable.

The government, of course, can create as many IOUs as it wants. Sometimes it does it in the form of interest-bearing Treasury bills, notes, or bonds, and sometimes it does it in the form of non-interest bearing numbers in a reserve account at the Fed (i.e. cash). Actually, sometimes it does it in the form of a promise to pay pension and medical benefits in the future (e.g. Social Security and Medicare), but that is a discussion for another time.

Of course, there is a practical limitation on how many IOUs the government can create before inflation becomes a problem. Inflation can be mitigated by tempting people to exchange some of their non-interest bearing IOUs for interest-bearing ones (whether Treasury bonds or deposits at the Fed) which can't be spent easily. The Fed does this by offering a higher interest rate on overnight repurchase agreements, thus reducing aggregate demand for real goods and services by incentivizing people to save rather than spend. But if the government continues to create IOUs much faster than nominal GDP is growing, it is inevitable that the IOUs will depreciate against the value of real goods and services, and we will have destabilizing inflation.

With all of that said, I'll address two points that Hennessey made with which I strongly disagree. First, he disparages Orszag's idea of netting out assets of the government with the outstanding stock of IOUs. Looking at the assets of the government as being available to pay claims, i.e. to pay off and extinguish IOUs, netting is certainly appropriate to some degree because the assets help to maintain the value (real and perceived) of the IOUs backed by the government. In the case of financial assets, particularly relatively liquid, relatively short-term assets which actually spin off cash flows, the fungibility with IOUs is apparent. Financial assets should clearly be netted, although the financial assets do need to be valued appropriately (i.e. not anywhere near face value).

Second, Hennessey claims that when the government borrows to buy financial assets there is a "crowding out" effect. This is pure rubbish. There is no such thing as "crowding out" due to the issuance of Treasury bonds, whether it was done to offset government spending, investing, or tax cuts. For every dollar the Treasury receives from the issuance of Treasury bonds, a dollar is sent back to the private sector, by definition. Net IOUs remains the same.

The fallacy embedded in Hennessey's Alan I. Gorp example is that Alan would have the $100. Alan either spends that $100, pays down his own bank debt with it, or deposits it in a savings account at another bank. As long as Alan doesn't put the money under his mattress, it ends up at a bank. If the money did end up under a mattress, then the Fed could inject (i.e. create) an extra $100 into the banking system without spurring inflation.

Expanding the example back to the government level, we see that if the government issues $1T of bonds to pay for $1T of so-called toxic assets, the next effect is that the private sector in aggregate has received $1T of low-interest government IOUs in exchange for $1T of toxic assets. No doubt this would make the private sector a lot more confident about the creditworthiness of financial intermediaries and counterparties. It would also provide $1T of good assets that could be used to collateralize lending. I'm not saying such a swap is the right thing to do, but it certainly would spur investment and aggregate demand, rather than "crowd" it out.

The only way for the government to starve the private sector of investment funds is to run a budget surplus. This removes IOUs from the system, thus reducing aggregate net financial wealth. The reduction in aggregate net financial wealth would tend to reduce aggregate demand and be disinflationary/deflationary.

Government Spending and Other People's Money

A friend told me recently that Milton Friedman divided spending into four categories:

1) spending your own money on yourself;

2) spending your own money on other people (e.g. a gift);

3) spending other people's money on yourself (e.g. using a corporate expense account);

4) spending other people's money on other people (e.g. spending by government bureaucrats).

The first kind of spending is the most efficient. Since you are presumably aware of what you want, you will purchase goods and services which will make you happy. Since it is your own money you are spending, you will be careful about not over-paying.

The second kind of spending is certainly less efficient. To some extent you are guessing at what the needs of the "other people" are, and you are certainly not going to be privy to their utility function. It's your money you're spending, so you may try to spend wisely and not over-pay, but sometimes -- particularly if it's a gift -- paying above a certain amount of money is part of your goal. There is a lot of evidence that gift items (e.g. a bottle of perfume) will not sell at all if priced too cheaply. We've all had that experience. You see a great gift for $20, but decide not to get it because it's not expensive enough. If the same gift were $50, it would be perfect.

The third kind of spending is also less efficient than the first. You end up spending the money on things you need and desire, but you are less concerned with price. You end up buying things that you wouldn't if you had to use your own money. At least you know that the purchases will be enjoyed and thus not be a total waste. Furthermore, there is at least some incentive to keep costs down, since you will look greedy to other people if you spend too wildly.

The fourth kind of spending is the least efficient of all. You have all of the problems of both the second and third type of spending without any of the mitigating factors. Because you're spending money on other people and not yourself, you really don't have to worry about looking greedy if you spend too much.

Often there is a perverse incentive to overspend because a key metric used to gauge success is the amount of money allocated. How many times have you heard a politician boast about how much money he allocated for this or that project? You certainly never hear of a congressman boasting that he got $100MM for building a highway in his state but was able to cut costs and return $20MM to the federal government.

And the government bureaucracy is even more perversely incentivized. I've worked in a government research laboratory where at the end of the fiscal year we frantically spent any remaining money in our budget because if it wasn't all spent, we would be allocated less money the next year.

Milton Friedman's succinct categorization makes it clear why government spending should be minimized. If the solution to today's economic problems lies in the government getting more money into the private sector, it should be accomplished by tax cuts and/or transfer payments, not government projects.

Latest South Park episode is on the money

http://www.southparkstudios.com/episodes/220760/

Ironically, this is one of the clearest expositions of what ails the economy. The private sector -- particularly the consumer -- is overleveraged. The government has simply not been running large enough budget deficits to sustain sufficient private sector net financial wealth commensurate with the level of aggregate demand we had grown accustomed to. Aggregate demand was sustained instead through financial engineering and excessive leverage.

Now we are in the inevitable deleveraging stage, which is extremely disruptive and painful. The best and most effective way to shorten this stage is for the owner of the money printing press to fire it up and to disburse money as fast and as equitably as possible to the private sector. In the South Park episode, the owner of the printing press is Kyle with his no spending limit American Express platinum card. In the real world, it is the Federal government.

I am more optimistic about the economy in the intermediate term because of the automatic stabilizers built into the Federal budget. As the economy weakens, the budget deficit grows, and this works to correct the problem. So far, though, the government has done too little on the fiscal side. The stimulus in 2008 was done in a timely fashion, and it was the right idea, but it was far too small. The actions of the Obama administration so far have been a waste. They are more focused on seizing an opportunity to enact a long-term liberal agenda than they are in getting the economy going again.

Still, the economy will be well on its way to recovery in 12-18 months. The recovery could be faster and stronger if the right fiscal policies were enacted, but it appears we can never count on the government to do the right thing.

Money Market Fund Regulation

There is some talk of an overhaul of the regulatory scheme for our financial system. Quite frankly, that's wholly unnecessary, and I suspect it will turn out to be counterproductive. As I will discuss in future posts, the government is primarily responsible for the unfolding economic disaster -- both because its interference in the housing market inflated the bubble and because it has failed to inject sufficient money into the private sector in a timely manner to mitigate the bubble's collapse.

The near meltdown of money market funds after Lehman's bankruptcy last September did underscore a vulnerability in this area of the market. There is only one change that is needed, however, an obvious one that addresses one of my long-term pet peeves.

Money market funds should not be allowed to fix their NAV per share at $1. The NAV per share should accurately reflect the market value of the portfolio. It's insane that it has been otherwise for as long as money funds have been existence. I suppose it is a vestige of a time when mathematicians hadn't worked out long division to more than 3 decimal places.

Using a market value NAV is important for two reasons:

First, not using a fair NAV for redemptions and purchases allows arbitrageurs to take advantage of existing shareholders. To see this, consider a sudden drop in the short-term interest rate of 200bps (this has actually happened twice in the past year). An arbitrageur can invest the next day at $1/share and earn the legacy interest rate for several weeks or months (i.e. a rate 200bps higher than the prevailing rate) at the expense of existing shareholders, who will earn less interest than they would have. The reverse works as well. An invested arbitrageur can redeem at $1/share if short-term interest rates were to rise suddenly. The arbitrageur takes his money out and earns the higher prevailing rate, once again at the expense of shareholders who will earn the lower legacy interest rate (and even less than they would have thanks to the arbitrageur).

Second, and more importantly, runs on money market funds are less likely to get started and less likely to grow. The NAV problem is one of the reasons runs start. The smartest investors see the underlying assets going down in value and take their money out while the NAV is still $1/share and the getting is good. Once a run begins, however, the fair NAV method helps to nip it in the bud. The manager of the fund starts selling assets to meet the redemption requests. This lowers the price of the assets, leading to a lower NAV per share and a higher implied fund yield. By the basic law of supply and demand, a lower price discourages current investors from redeeming and encourages new investors to purchase shares. Stability.

Unfortunately, I doubt that the Feds are going to figure this out.

The AIG Bonus Outrage

The outrage here is that people are outraged. The government response is particularly outrageous.

I don't know the details of whether these bonuses were deserved in some moral sense, but the fact is these bonuses are contractually obligated and should be paid. If the government had a problem with paying large amounts of compensation to employees in order for them to stay and clean up the mess they created, it should have raised the issue when AIG was teetering on the edge of bankruptcy. After all, the bonuses would not be paid in the event of bankruptcy, so the government had some leverage to demand that employees take a pay cut. But it is too late for that now.

Personally, I don't even have a problem with paying smart, hard-working people a lot of money to try to mitigate the damage. It seems rational to pay them to stay if they can do a better job than their potential replacements. The fact that these same employees were responsible for losing a lot of money is irrelevant. I think the administration was getting a bad rap for this, and its initial instincts were correct.

Now, though, the administration and congress (and I include Republicans here) are acting like tyrants. It is completely unacceptable -- morally and constitutionally -- for them to try to pressure people to give up their contractual rights based on popular outrage, or worse, to pass taxes aimed at punishing them. The tax bill just passed by the House is essentially a bill of attainder, which is specifically proscribed by Article I of the constitution.

Any congressman who voted for this bill is guilty of a violation of his sacred oath to uphold and defend the constitution. We'll soon see if Obama also violates the oath he took just two short months ago.

The Employee Free Choice Act should be stopped

Once upon a time, perhaps 100 years ago, unions may have made sense. When the economy was industrialized and dominated by a handful of monopolies, when labor mobility was restricted, when communications were inefficient, labor might have been at such a large negotiating disadvantage that perhaps unions were needed to counter exploitation from the so-called "owners of capital."

But unions are an anachronism today. At any given time, even during a deep recession, there are millions of job opportunities, offered by hundreds of thousands of companies throughout the United States. Indeed, with the growth of the internet, it is possible to take a job on the other side of the country (or even outside the country) without having to move. Furthermore, the US government has zealously applied antitrust law to break up monopolies and prevent any one sector of the economy from becoming dominated by a single corporate entity.

From an economic perspective unions are bad for at least three reasons.

First, the union bureaucracy is a dead weight loss to the economy. That is, the time and effort spent operating unions, regulating them, defending them, and fighting them could be better spent producing real goods and services which improve our aggregate standard of living.

Second, unions extract higher compensation for low-productivity jobs, which (a) is an unfair transfer of wealth to union members, which inevitably comes at the expense of non-union workers in the form of uncompensated higher prices for goods and services; and (b) causes a misallocation of labor. For example, an auto worker producing $50/hour in value but being paid $45/hour will not do a different job in which he is capable of producing $60/hour in value but is paid only $40/hour.

Finally, unionized workers are not properly incentivized to work hard and do a good job because both their upside and their downside is limited. No matter how good an employee is, his compensation will be constrained by the union contract. No matter how bad an employee is, his firing will be fought by the union. In my view, the main problem we have with public education is that the powerful teachers' unions strip the teaching profession of any traces of a meritocracy.

As for the Employee Free Choice Act (EFCA), it is hard to overstate the deceit of its proponents.

Under current law, workplace union organization starts with a card check process, in which employees are asked by organizers to sign a card requesting representation by a union. If at least 30% of workers sign the cards, then the organizers can hold a secret ballot election which determines by majority vote whether or not a union will be formed. If at least 50% of workers sign the cards, the organizers generally will just present the cards to the National Labor Relations Board (NLRB) for union certification, but then the company can insist on a secret ballot election. Either way, there will almost always be a secret ballot election in which the will of the majority is expressed. If a majority votes against unionization, then a union will not be formed.

One of the changes the EFCA would make is the following: if more than 50% of the employees sign the authorization card, the union will be certified automatically. There will be no secret ballot election.

It's pretty obvious that the EFCA does the exact opposite of its name. Workers will have to decide out in the open, possibly under duress, whether or not to sign an authorization card. And if 1 out of 2 of their fellow workers sign the card, they won't be able to retract their decision to sign (i.e. their decision to support unionization publicly) in a secret ballot election.

I can't sugarcoat this. The EFCA is a desperate measure created to fight declining union membership by trying to force unionization on reluctant workers through intimidation. Its proponents who argue otherwise are malicious liars.

Paul Krugman award for Intellectual Dishonesty

Paul Krugman is a smart guy, and presumably he understands economics, having been a John Bates Clark Medal winner and a Nobel Prize winner. But he clearly lets his leftish political views shape his economic commentary.

The Economist has written the following: "... his past columns reveal[s] a growing tendency to attribute all the world's ills to George Bush ... Overall, the effect is to give lay readers the illusion that Mr. Krugman's ... personal political beliefs can somehow be derived empirically from economic theory."

If anything, this understates Krugman's bias. For shamelessly and dishonestly using his stature as a world-class economist to justify and promote his personal political beliefs, Krugman is, in my opinion, the most intellectually dishonest economic commentator alive today.

I have decided to shine some light on intellectually dishonest commentary from time to time by copying an idea that other bloggers have used, which is to offer an award dedicated to the most well-known offender.

The inaugural winner is Dorothy Brown, a professor of tax law at Emory University, for her op-ed in the NY Times today about the unfairness of the preferential tax rate on stock dividends and capital gains (p. A23 of Mar 9, 2009 print edition).

Dorothy writes nine paragraphs explaining that the tax rate on dividends and capital gains is only 15%, -- in contrast to the maximum rate of 35% on ordinary income -- and that this is some crazy aberration which benefits rich people and penalizes poor people. The reader is led to believe that there is simply no rational basis for a preferential capital gains tax rate and furthermore that there would be no negative consequences to equalizing the rate at the ordinary income tax rate.

Given that Dorothy is a professor of tax law, we can assume that she knows the real reason behind the preferential capital gains rate. To wit, the earnings on C corporations are already taxed at the corporate level (35% rate) before they are distributed. Until either the corporate level tax is repealed, a corporate tax deduction is allowed for dividends, or a tax credit (a.k.a franking credit) is passed along to stockholders, the United States will remain virtually the only country in the developed world that taxes stock investors twice. I figure the least our friendly, neighborhood tax collector can do is give a small discount when he comes around for the second time.

Ironically, the real aberration in our tax code was that stock dividends were taxed at a higher rate than capital gains, which fortunately the Bush administration remedied in 2003. The aberration was causing corporations to hoard excess cash, or at best use it for stock buybacks (which strikes me as rather inefficient and less than transparent) instead of paying it out to shareholders.

I am looking forward to Dorothy's next op-ed in which I expect she will decry the unfairness of municipal bonds. After all, the rich are paying zero tax on the interest! I'm sure that she can come up with a good solution, something along the lines of having an alternative minimum tax framework for people who have too much municipal bond interest income. Yeah, that's the ticket...

The Economic Hole -- What's the fastest way out?

I continue to believe that the fastest and best way out of the current economic crisis is for the government to put about $1.5T into the private sector immediately.

Government spending is NOT the right way to do it. It is extremely wasteful of human and natural resources. Resource allocation (i.e. spending) by politicians, lobbyists, and government bureaucrats is an economic evil. Sometimes a necessary evil, but an evil nonetheless. If it can be avoided, it should be avoided. In this case, most economists agree the goal is to put money into the private sector. Additional government spending is not necessary to do this -- all you need are net government transfers, which can be accomplished by cutting taxes or giving people checks.

I agree with Warren Mosler (http://www.moslereconomics.com) that the most efficient way to stimulate aggregate demand is to have a wage tax holiday. I think an income tax holiday may also be necessary to get enough money into the private sector. Cutting taxes on economic activity is obviously a good thing in general because it removes impediments to economic activity. Cutting taxes on wages and income is best of all because it incentivizes that very activity (i.e. production) which makes us all wealthier (in the standard of living sense).

Democrats won't accept an income tax cut, let alone an income tax holiday. For them it is a "giveaway" to the rich, as Democrats believe in redistribution of wealth as a desirable goal. I don't agree with them, but there is no right or wrong on the issue. It is an axiomatic difference between Republicans and Democrats, and right now the Democrats are in control.

The next best thing is to give every (and I mean "every") permanent American resident a check -- a big check. A check for $5,000. Bill Gates gets a check for $5,000. So does his wife and each of his kids. The President gets a check, as well as every member of congress. The CEO of GM gets a check and the CEO of Citigroup too. But also the elementary school teacher and every one of the kids in her class. The woman on welfare who hasn't worked in 5 years gets a check. The 100 year old great, great grandmother who has been on social security for 40 years. The newborn baby of illegal immigrants, as well as every newborn in the maternity ward in the poorest hospital in Alabama. Everybody serving in the armed forces, every college student, everybody. Even members of the Al Qaeda sleeper cell who have been here 5 years and have already earned their green cards.

Democrats should love this because it is redistribution of wealth in purest form. There is no so-called "taxpayer" who is paying for this. Whether or not you paid taxes in the past has nothing to do with whether this is on balance good or bad for you personally. In theory, this is on balance bad for people who have substantial net financial wealth (which includes foreign central banks holding lots of Treasuries) and good for people who have zero or negative net financial wealth. It diminishes the value of each dollar by creating more of them. It directly stokes inflation by driving aggregate demand higher while not directly increasing the capacity of the economy to produce goods and services. In normal times, it would be unfair and perhaps destabilizing to do this.

However, the problem we have today is deleveraging, deflation and falling aggregate demand. It is a vicious cycle that weakens creditworthiness and discourages investment and consumption, leading to more deleveraging and deflation. On balance, wealthy people too will benefit from an injection of money to fight deflation, spur aggregate demand and stabilize creditworthiness.

The beautiful thing about giving money directly back to the people is that there is no waste of resources whatsoever. No politician or lobbyist is directing thousands of workers to build schools in Milwaukee which nobody will use. No government bureaucrat is going to direct thousands of workers to toil away building a zero-emissions coal plant before the technology is ready. Those resources will be available to be allocated by the private sector -- by hundreds of millions of people making billions of economic decisions each year. This sounds like a novel idea, but it is called capitalism, and it is a distinctly more efficient economic system than what the Soviet Union created in the 20th century.

You may wonder, and the talking heads on CNBC will certainly ask, "How can the government pay for this huge handout? How can the government sell enough debt? Will the Chinese keep buying it? How can our children pay it back?"

The short answer is that the government owns a dollar printing press and doesn't need to borrow money from anybody. In fact, the bonds the government issues are no more debts than the dollars in which they are denominated. Government bonds are best thought of as liquidity sponges that soak up excess dollars and create a positive interest rate floor on savings. And if the Chinese want to hold their dollars, they have a choice between interest bearing Treasuries and non-interest bearing dollars at the Federal Reserve. If they don't want to hold their dollars, then they have to sell them to somebody else who will now have them.