Growthology

Getting Sotomayor Wrong

Even if you don't have a strong opinion about Judge Sonia Sotomayor's fitness to serve as a Justice on the Supreme Court, you should be disappointed with the tone of the discussion. She is incredibly competent with an excellent track record of professional, intellectual achievement. So why can't the country have a substantive discussion? Or do you really think it's fruitful for the republic to spend the week debating how racist it is to mention your ethnic heritage? Newt Gingrich can say what he wants - hyperbole is his way of making a point - but I would hope for more from White House spokesman Robert Gibbs dodging a substantive defense. Here's Dana Milbank's summary:

The questioning had drawn the interest of ABC News's Jake Tapper, who said he had read the entire speech but was still "wondering if you can explain what she meant."

Gibbs ducked again, telling the reporters that the speech was "about the unique experiences that she has" and again recommending people "look at her whole record" in its "totality."

"You're not spinning us," Tapper complained. "We're asking you, spin us! Explain what you think she meant."

My suggested spin: It would seem her personal success is a testament to meritocracy, and we should be pleased and hopeful she will carefully guard America's meritocracy more than someone without that experience, frankly. Her success in life based on merit speaks more powerfully to the advantage of her subjective experience than accusations of her gender and ethnicity.

The slippery issue here is subjectivity versus the ideal of blind (objective) justice. The question Senators should be asking is whether any nominee's subjective experience taints their perspective in way that reinforces the core values of the Constitution or clashes with those values. Of course subjective experience matters! Now tell us why. Seems to me ethnic or gender favoritism is a pretty clear violation of basic Constitutional law. But I doubt that's the outcome of Sotomayor's experience, or what she has ever tried to convey. Do you really think she never met any poor white kids in public housing? No isolated, alienated boys? Being on guard for alienation is exactly what we want in blindly just society.

Sadly, too many smart folks are defaulting to the circular logic of subjectivity supreme. Objectivity is impossible, an illusion, an excuse for neo-imperialism, blah blah blah. Even a smart guy like Joel Achenbach, self-declared uber-geek, rational scientisticy guy, has fallen into this gaudy trap. Read this:

You can argue these things round or square, but it seems to me that, in most instances, interpreting the Constitution is not like interpreting a mathematical equation. The Constitution says nothing of stem cells, affirmative action, sexting, gay marriage. The cases that reach the Supreme Court are the hardest ones to solve, where there's no indisputable answer, and where even the sharpest legal minds, sworn to uphold the Constitution, will split 5-4 on what should be the law of the land. A justice's personal background shouldn't dominate the analysis, but neither should it be irrelevant.

Whoa! Flip this argument around and realize how silly it is ... Imagine if we lived in some bizarre alternate universe and we were discussing a nominee to head NASA, and Joel had written this:

... it seems to me that, normally, commanding astronautic exploration is not like the rigorous rules of grammar and spelling. The numbers 0 through 9 say nothing about gravity, radiation, alien life, or the creation of the universe. The decisions facing the nation's top astronaut are beyond mere logic, let alone cost-benefit analysis. The bravery and confidence-inspiring square jaw of the NASA Administrator matter far more than egghead reasoning.

Let's stop pretending the Constitution is just words. We need to care about what any nominee's reasoning is on the existence of a privacy penumbra. Hard objective argument. How about intellectual property rights, monopoly, contract law, federalism, commerce clause ...? Talk to me about the 10th amendment.

Yawn. "How do you feel, Sonia?"

Caplan's Bet: Europe stays different

Bryan Caplan is willing to bet ("one meeelion dollars") that the U.S. unemployment rate will recover and remain significantly lower than the European average over the next ten years. I'm tempted to agree. 

Normally, this would be a no brainer, if all we were doing was betting whether U.S. labor policy is superior to European policy at employing its labor force near capacity. But what Bryan is really gambling is that the U.S. policy will remain superior. That's a political bet, not an economic bet. (He, author of the Myth of the Rational Voter, should know better!)

What are the odds that the U.S. raises its minimum wage again?  What are the odds that a bailout of California happens? And if so, that other states become more reckless? What are the odds of card-check legislation that chills entrepreneurship? What are the odds that technology allows entrepreneurs to circumvent labor law by building up virtual companies of independent contractors?  What are the odds that Justice Sotomayer casts the deciding Supreme Court vote ruling virtual business forms unconstitutional?

Either Bryan has more faith in American democracy than I do (unlikely), or he's much more risk loving than I am (surprisingly likely).

Entrepreneurial Experiments -- Research and Questions

This post is to share some original research I have in process with readers of this blog. For the last few months, I've been preparing to conduct some new economic experiments, and would love to engage in a discussion with you & get your advice. Dan Houser, a professor at George Mason University, and a graduate student, Xiaofei Pan, are helping me prepare to conduct the experiments at the GMU ICES labs, hopefully this summer.

The experiments are for the study of work and entrepreneurial behavior under different policy regimes, including taxation, welfare, and social insurance. I'll share a link to the preliminary literature review / experimental design working paper in a future post. Questions on my mind are:

1. Will higher federal taxes reduce entrepreneurship and growth, or are those fears overblown?

2. What's the best way to design an experiment for work under different policy regimes? Once we nail that down, what is the best way to design the choice of riskless versus risky (entrepreneurial) work?

3. Is there research already in existence informing this topic?

I was inspired by Vernon Smith (wikipedia entry here) after I spoke with him at Chapman University during last November's Global Entrepreneurship Week (hat tip to the Leatherby Center there). I was surprised to learn that experimental economics hasn't pushed very deeply into growth policy questions. According to a 2003 paper by Sutter and Weck-Hanemann (2003), “Experimental studies on issues of taxation abound.” However, these generally explore tax evasion, whereas “studies on the effects of tax laws on labor supply are very rare." Tax evasion is really just a subset of income shifting in response to taxes, related to the subset that naturally interests the Kauffman Foundation, which is the degree to which higher taxes are a barrier to entrepreneurial risk-taking.

The study of labor supply's elasticity has evolved in recent years. A consensus exists, holding that the number hours worked (i.e. labor supply) is inelastic with respect to tax rates, especially for males (primary earners). However, Larry Lindsey suggested in a 1987 paper that the key elasticity is not labor per se, but income. Martin Feldstein explored the idea of "elasticity of taxable income" (ETI) thoroughly in the late 1990s. Clearly, this is where my interest in entrepreneurship comes in. If higher taxes act as a job-lock by keeping more workers tied to their riskless salaried job (with untaxed fringe benefits) instead of a risky startup, then there is a short-term loss, measurable in terms of deadweight loss, and also a long-term loss, the immeasurable reduction in potentially innovative activity.

So what does the ETI literature tell us about entrepreneurship? Glenn Hubbard, Austan Goolsbee, and Doug Holtz-Eakin have written on this, including chapters in the 2000 tome, Does Atlas Shrug?, edited by Joel Slemrod. Goolsbee describes the "new tax responsiveness" (NTR) literature in terms of a methodology using econometric analysis of empirical data from natural experiments. The term confused me when I first heard it, because these are not really experiments in the proper usage of the term. But economists are able to assess activity before and after an unanticipated (exogenous) event such as a major tax reform, they call it a natural experiment. In any case, the early estimates of ETI were above 1, meaning that income was highly sensitive to taxation to the extent that an X percent increase in the marginal tax rate led to an equal or greater than X percent reduction in taxable income.

There may be more detailed papers about ETI and entrepreneurship, but the most useful survey of ETI I have found is a recent chapter (ungated here) by Seth Giertz in the 2009 AEI book Tax Policy: Lessons from the 2000s. Giertz reports that "recent studies report [ETI] estimates closer to 0.4." Estimates are narrowing, while at the same time we are learning that the ETI is not constant over time nor across earners. It seems the ETI rises with income itself -- the rich are so sensitive. Some studies that are able to focus on higher-income earners find estimated ETI slightly over 1.

Nonetheless, the NTR literature is limited to empirical econometrics, with all the pros and cons it entails. Giertz identifies a handful of issues that complicate ETI estimation: exogenous shifts in income distribution, mean reversion, endogeneity of the tax rate, institution factors in the tax system (shifting base, enforcement), transitory responses and income shifting, and transfers between economic agents. I know enough econometrics to worry that the empirical ETI debate is unlikely to be resolved since the results will be so sensitive to the inclusion or exclusion of other variables. It is worth noting that Giertz' paper makes no mention of insights made by experimental econ. But it seems to me that experiments can isolate ETI behavior and control for all the noise that muddies the signal in empirical work. It sure can't hurt.

Experiments and Taxes. A pioneering study was published by C.W. Swenson in 1988, updated and improved by M.A. Sillamaa in 1999, which confirmed Lindbeck’s theorem that higher marginal labor taxes will depress work effort even when all income is redistributed. Sillamaa reports that a marginal labor tax rate rising from 12 to 87 percent (across five discrete rates) - with revenue fully redistributed as a demogrant - is associated with a decline in total work intensity of 21 participants, from 7734 tasks to 6824. But by focusing narrowly on the Lindbeck theorem, this research sheds little light on richer, and more realistic, aspects of fiscal policy. Full revenue redistribution, in particular, is a very strong assumption.

And yet, the Sillamaa study establishes a firm foundation for future research using an experimental framework that includes (1) tedious work, (2) real money payments based directly on work effort, and (3) leisure opportunities as a valid participant activity. This framework could be extended to richer policy environments which would yield valuable insights into work behavior.

More recent experimental studies have explored the Laffer curve (Sutter and Weck-Hanemann 2003; Levy-Garboua, Mascalet, and Montmarquette 2008). But these studies use a 2-player game design where one player is the worker and the other is the tax authority. The results inform psychological motivations and rules of fairness, showing for example that a “veil of ignorance” about which player will fill role A or B leads to a greater sense of work obligation and a subsequently lower work elasticity. These papers treat tax revenue as a total loss to the worker, an assumption of zero redistribution. This is also a very strong assumption, but in the extreme opposite direction of the earlier papers.

The experimental framework I am planning on uses elements from both of these branches. The innovation I have in mind is structuring games so that all players are worker-taxpayers facing an identical environment, a faceless governing authority that can set taxes and welfare policies exogenously. A big question on my mind is whether work effort will change when the redistribution rate changes. If we redistribute a portion of tax revenues equally (so that all players get the same split), then I assume the free rider problem will loom larger as the rate of redistribution rises from 0 to 100 percent of tax revenues. But maybe social pressure in small groups will cause work to intensify with high redistribution rates.

Well, that's a pretty long preview. I'm excited about the research, and really happy to use the blog to share it with you. My hope is that experiments will offer a clean room approach to identifying ETI, which the empirical approach will have difficulty resolving alone. I can only imagine one topic of greater importance for economics, which is the precarious state of the global financial system (though I'm confident Bob Litan has that covered). The decades ahead will see developed countries struggling with the limits of taxation (here, here), and the more light we can shed on that topic, the better.

The Ascent (and Hopeful Descent) of Cash

(The title of this piece comes from a play on words of economic historian Niall Ferguson's book and PBS series, The Ascent of Money, which the Kauffman Foundation helped fund.)

By automating the checkout process at the Foundation lunchroom (where the food is incredible, by the way) the machines don't accept cash, only credit cards. What happens to unlucky staff like this author (lost card) and his research assistant (stolen identity, so he says)? It makes one wonder, will there ever come a day when we do not have cash? When money exists in 1s and 0s and nowhere else? 

Here's a bold prediction (from Atlas, the wunderRA): That day will arrive by 2025, if not sooner.

True, there have been stabs at moving us closer to that day, but none of them have really ignited. For those looking for a really good read, I recommend the book, The PayPal Wars: Battles with eBay, the Media, the Mafia, and the Rest of Planet Earth. The book is written by Eric M. Jackson, who was one of the first employees of PayPal and is reviewed at Reason Magazine by Radley Balko. 

Balko describse my favorite chapter in the book, 

Jackson recalls a speech Thiel gave to Confinnity employees, just a few days after he began work, in which he described his hopes for PayPal to become a borderless private currency. He saw PayPal facilitating trade in currency for anyone with an Internet connection by enabling an instant transfer of funds from insecure currencies to more stable ones, such as U.S. dollars. Thiel explained to his young staff how governments had historically robbed their own citizens through inflation and currency devaluation. The very rich could always protect themselves by investing offshore. It's the poor and middle class, Thiel explained, who get screwed. "PayPal will give citizens worldwide more direct control over their currencies than they ever had before," Thiel predicted. "It will be nearly impossible for corrupt governments to steal wealth from their people through their old means because if they try the people will switch to dollars or pounds or yen, in effect dumping the worthless local currency for something more secure."

Sadly, it seems that the libertarians in the room may have been too optimistic and that the only full scale innovation we will see is if the government exits the currency market a la Hayek's theory of competitive and therefore stable, currencies.

 

If history is any indication, privatized money can work. See economist George Selgin's great book, Good Money: Birmingham Button Makers, the Royal Mint, and the Beginning of Modern Coinage, 1775-1821, which documents the coinage entrepreneurship of Matthew Boulton, who built one of the best mints in existence after he landed a government contract to mint coins for Britain. People loved his coins and so use of the Royal Mint's coinage fell. Of course the British government's Royal Mint wasn't pleased about decline of their coinage and so it reasserted control and gave it back to the initial monopoly.

We all know the dangers that printing excess money can do to an economy. Milton Friedman's restatement of the quantity theory of money -- and subsequent Nobel Prize for Economics -- leaves little doubt. And yet, in light of the recent economic downturn, I think we must ask ourselves, Can we afford paper currency? 

A recent Wired Magazine article makes the point that minting them coins ain't cheap and that it cost in excess of 848 million dollars in 2008 alone, just to print things we'd just as soon not have. Here's the essential paragraph: 

To maintain our stock of hard currency, the US Treasury creates hundreds of billions of dollars worth of new bills and coins each year. And that ain't money for nothing: The cost to taxpayers in 2008 alone was $848 million, more than two-thirds of which was spent minting coins that many people regard as a nuisance. (The process also used up more than 14,823 tons of zinc, 23,879 tons of copper, and 2,514 tons of nickel.) In an era when books, movies, music, and newsprint are transmuting from atoms to bits, money remains irritatingly analog. Physical currency is a bulky, germ-smeared, carbon-intensive, expensive medium of exchange. Let's dump it.

Wow, talk about wasted resources. Fortunately, companies like PayPal, are leading the way to a cash- (and check-)less future. 

Between 2003 and 2006, noncash payments in the US increased 4.6 percent annually, while the percentage of payments made using checks dropped 13.2 percent. Two years ago, card-based payments exceeded paper-based ones—cash, checks, food stamps—for the first time. Nearly 15 percent of all US online commerce goes through PayPal. Smartcard technologies like EagleCash and FreedomPay allow military personnel and college students to ignore paper money, and the institutions that run dining halls and PXs save a bundle by not having to manage bills and coins or pay transaction fees for credit cards.

Hmm... avoiding cons and bills... maybe Kauffman's dining hall was on to something, after all.  But not so fast! MIT economist, Amy Finkelstein, has found that when EZ-passes are installed on road high ways, the charges to the tolls become less noticeable and therefore become subject to higher increases. Might that hold true for services or goods that are sold in non-competitive markets as well? I guess, we'll just have to wait and see.

Up From Poverty (Schramm on Economic Development)

I'd like to recommend this essay by Carl Schramm, published recently in the Claremont Review of Books and freely available at RealClearMarkets.

Formal development theory can be said to have rested on three assertions—all of which should have discredited it. One was that ethno-cultural characteristics limited the likely spread of modern capitalism. The leading books of the time clearly show that the academic establishment was certain that (say) Hinduism and Confucianism operated as impenetrable bars to economic growth. At best, India and China (if even mentioned!) could hope for subsistence futures, though social disintegration was held to be more likely. The second was an unswerving focus on natural resources as the key to growth. This unreconstructed colonialist worldview—extract what you can and send it home, or at least abroad—drove the construction of massive public infrastructure (in large part to move material to port), littering poor countries with projects that to this day look like incongruent artifacts of western economies that never emerged. Finally, and most tellingly, development theory aggressively argued that economic growth was possible only in the absence of population growth; raising indigenous agricultural production to levels high enough to sustain high birth rates was assumed to be impossible. This tenet above all should have been suspect even at the time. It was already well known that, between 1820 and 1920, the population of Europe increased at an unprecedented rate—while Europe enjoyed rapid economic expansion.

...

The principles of liberal democracy have made sustainable economic development a possibility for the whole world going forward. The application of creative talent by the individual in the context of commerce—once found only in liberal democracies—is now seen as necessary even inside socialist regimes. The rediscovered insight that entrepreneurs bring forth expanding welfare for all is so powerful that growth has regained its rightful place as a legitimate goal of economic theory.

Grey Shoots

I've started referring to myself as a "Depressed Bull."  I still have faith in the long-term growth prospects of America and the world. I still believe that entrepreneurial capitalism will prove itself the fairest, most propserous system of economic organization. Yet every day, I see more signs of the unprecedented severity of the current recession. And the mainstream/political media seems relentless in its quest for green shoots. Just contrast the top story in today's WSJ ("World Economies Plummet ") with today's WaPo ("Wider Confidence Lifts Economy From Winter's Deep, Dark Freeze"). Gag. The political cheerleading is embarassing to journalism. The financial reality is sad and serious.

Here's why the mainstream press probably can't get a grip on the economic story.  It's too slow.  I can hear the editors talking over drinks, "It's already been half a year since the Wall Street meltdown, right? Madoff's in jail, right? Can't we find a new angle on this?"

Imagine if the world's economies were a Hollywood special effects chase scene which ends in a fiery pileup. The globalized interesection of trade and finance and banks and people (think cars and trucks and semis and pedestrians) is going through a multi-year slow-motion crash. Naturally, the press wants to know when things get better. But how can we know when whole vehicles are still skidding across the pavement?

Can the U.S. learn from California?

The bankruptcy of California's government, and how it heals itself, will foreshadow how the federal government faces its own looming debt crisis.  Both state and federal legislators have been overspending, running large budget deficits, and tilting tax rates towards higher progressivity.  I worry that the national crisis is on the way to becoming just as bad as the California crisis. The question is when. Ten years?  Twenty? It all depends when investors lose faith in the ability to repay debt, right?

If the Congress decides to bail out California, it will be the most significant policy disruption of the recession. Yes, I know, there have already been profound shifts in policy -- the Federal Reserve's aggressive tactics, the bankruptcy of Chrysler and ongoing circuitous nationalization of the auto industry. But the fabric of America is its federalism: independence of the 50 states.

I find it very hard to imagine that voters in the other 49 states will tolerate their elected representatives raising THEIR taxes to pay for California. The Constitution was designed specifically for each state to make its own decisions and reap its own consequences, and for that independence to serve as a learning laboratory of democracy. The Founders also designed Congress so that representation was based on geography, not ideology. So if the Congress bails out California (in any way: guarantees for more debt, outright grants, whatever) it means that partisanship trumps the nature of our Republic. It will send a signal that state legislators can act with the utmost irresponsibility. And it will probably be the death of federalism.

As we witness the crisis, remember the populist political reforms of the 1990s. Term limits were adopted when Prop 140 passed in 1990. The result, unfortunately, is much like what happened to Wall Street firms. Short-term gains became the rule, and creating a leagacy of any kind was no longer possible. Legislators focused their energies on big new spending projects, congratulatory celebrations, while passing the buck to the next crop. Note also that California's term limits (6 total years for Assembly representatives and 8 for state Senators) are the lowest among the 50 states, matched only by Michigan. I'm pretty sure those are not the states to emulate this year, as their citizens would attest.

Add in the infamous 2002 political gerrymandering in California (great wiki article here) -- which both parties preferred and the Supreme Court did not overturn -- and you get something worse than gridlock. You get self-destruction. Who wants to bail out that?

Entitlements and Growth

I don't want to bury the lede, so here's a link and quote from one of the finer essays I have read in years. Andrew Biggs' essay in The American titled "The Straw Men of Social Security" actually makes Social Security reform and wonky debates about entitlement math seem sexy:

Due to the recession and to faster-than-expected increases in life expectancies, the long-term 75-year deficit increased by 18 percent, from 1.7 percent of payroll to 2.0 percent of payroll. This implies that if the 12.4 percent payroll tax were immediately and permanently increased by 2.0 percentage points (or benefits were cut across the board by 13 percent), the system would remain solvent through 75 years. In the 76th year, however, it would once again become insolvent. This means that workers who paid a full career of tax increases would not receive their promised benefits. To make the system sustainably solvent would require an immediate increase in the payroll tax of 3.4 percentage points, to 15.6 percent of wages. ...

Faster economic growth is great, but a) no one has any clear idea how to produce it over the long term; and b) its effects on Social Security are limited because benefits are indexed to wage growth. That is, higher taxes today equal higher benefits tomorrow. Even doubling the rate of wage growth would erase only about half the Social Security deficit. (Calculate it yourself from this table.) And there is no way any policy is going to double the rate of wage growth. (For those who like math, click here for a technical paper showing that faster growth could actually hurt solvency over the long term.)

Biggs is responding to the latest annual Trustees report, but also partly, to this pre-emptive and somewhat hostile but eloquent rant from the New America Foundation's Michael Lind. A week later (today), Lind published this follow-up piece, "The Right's Social Security Scare Tactics,"

The "generational equity" theme is used by opponents of Social Security to imply that future generations will stagger under the burden of paying taxes for Social Security alone (and not just in conjunction with Medicare). But according to the trustees, even when the trust fund runs out (in 2037 or 2041 or whenever) and Social Security becomes a pure pay-as-you-go system, in which working-age Americans finance retirees, Social Security minus other changes would pay about three-quarters of what it owes. Lifting the cap on the amount of income subject to the payroll tax would eliminate that problem forever. So would an extra 1 or 2 percent of GDP decades from now, obtained by diverting revenues from other programs, like a more modest defense budget, or raising new revenues -- say, from a modest national consumption tax. Whether the new revenue came from a payroll tax without a cap, diverted revenues or new taxes, the burden would fall disproportionately on the affluent, who overall will be much more affluent half a century from now, assuming even low economic growth. In other words, the contract between elderly Americans and the rest can be honored in half a century by slightly higher taxes that would fall chiefly on much richer Americans in a much richer America.

And The Winner Is ...

In his first essay, Lind makes a good point that fixing Medicare is much more daunting than Social Security, and he provoked my interest by noting that economic growth can fix the problem without cutting retiree benefits or raising taxes. He's absolutely right. But he's wrong to suggest economic growth alone can do this, which Biggs carefully observes, because Social Security is very oddly structured to give each new crop of retirees a better deal than the year before. For purposes of the debate, we see Lind change his tone in the second article by suggesting that a new tax on consumption or the rich will be necessary to siphon off some of that growth.

To summarize, growth alone can't solve the entitlement crisis because the entitlement programs are either indexed to growth (SS) or have costs outpacing growth and inflation, take your pick (MC).

What I think sinks Lind are two things.  First, in an article that goes after people by name for being crafty, it would seem he should be brutally honest. But suggesting that all deficit hawks are creatures of the Right is absurd. If it were true, then conservatives would actually have some credibility. The fact is that concern about the rising deficits in America, especially the broken entitlement programs, is one of the few genuinely non-partisan issues in Washington. Offhand, I would suggest that only opposition to racism has similarly wide support. Entitlement reform is a classic case of good policy versus bad politics, and the politics have been winning for decades. The second problem for Lind is his suggestion that a new tax can solve things. The math may work, but only by breaking Roosevelt's promise.  The noble promise of Social Security is a special contract between a worker and the state where the insurance provided was paid for by the worker himself. Modify that contract into an uncapped tax on the rich, and you have a very different program, philosophically. 

Naturally, one could argue that the program has changed over time. And it has. But the roots of the system should not be violated by another reform, they should be restored. A good place to start would be to let economic growth work its magic, and by that, I mean Congress should fix automatic raise each new generation of retirees gets. It seems to me a very strong argument for politicians to make that tomorrow's retirees should not be getting a better deal than today's, a system that becomes bankrupt for retirees the day after tomorrow. It's not fair in both directions.

Online Discussion: Today at Noon (washingtonpost.com)

Please join me at 12 noon for an online discussion at the Washington Post.  It is a Q&A session, so who knows what will come up? The topic is small business and the economy.

Dust . . . Wind . . . Dude*

Blogging can often be a low-return activity: you invest time and energy in a post yet have only a rough idea of how many people actually read it, let alone enjoy it. And, quite frequently, the only readers who bother to comment are those with negative reactions.

My long-agonized-over post from last Friday was a rare exception to this last characteristic. Regular readers Michael Martin and Derek Ozkal posted extremely thoughtful comments and Robin Hanson, whose musings started the whole thing, offered a quick riposte to my long-windedness. I must confess that I have little to add to their comments; Robin has established an entirely new research project with regard to how feedback cycles close themselves.

So here's my next question: what is the relationship between the long run and short run in economic growth? Robin's growth mode concept brings the former to the fore, but surely short-term policies and innovation matter in the maintenance of long-run economic growth. I cited this recent NBER paper in support of this proposition.

Or do they? If we look at aggregate statistics, the short-term doesn't really seem to matter much at all: the massive R&D investments after World War Two, for example, did little to bump up the long-term U.S. growth rate. We assume they maintained it, of course, and can cite plenty of innovations that came out of such investments. And it doesn't seem clear to me that extremely short-term things like tax rates matter as much as they're said to matter.

One of the thing that endlessly confuses me about the urban economics literature is that "smart" cities (higher levels of college degrees) are time and again proven to grow faster than their counterparts. But this cannot have always been the case--either such human capital didn't matter to the previously dominant industrial cities or it was a different type of human capital. Yet, at least according to Robin's concept, we have remained in the same growth mode for two centuries.

The longue duree perspective can be quite humbling. Unnecessarily so, perhaps?

*A classic.

Recession = Weak Job Creation

Viewing the economy as a dynamic rather than a static system yields paradigm-shifting insights. The most spectacular in my experience has been understanding that the rate of job losses is much less important than the static perspective can understand. So, the fact that that media trumpets "job loss" stories during downturns emphasizes exactly the wrong thing. What causes a net decline in employment is not, in fact, job losses but a collapse in hiring.

David Leonhardt pulls down some of the latest data to make this point. But Leonhardt doesn't go any further with this line of analysis, concluding instead, "Why? How should the government respond? How should the country’s long-term economic policies be changed to reverse this long-term decline in hiring? All are good, hard questions."

Let's not pull punches here. The answers are not elusive, and point directly toward policies that encourage job creation and job creators, and sharply away from policies that aim to save jobs. On that note, the Obama administration's language about "creating or saving" 2-4 million jobs is unhelpful. More talk among the political class about spurring job creation and new venture creation would be a good first step towards actual policies along these lines. Payroll tax cut, anyone? 

And help me out here, but why does California have an $800 fee to start a new LLC? Oh wait, maybe they don't (because this court seems to have ruled it an unconstitutional tax.  We'll see ...)

Will Economics Imitate Life?

I had the privilege of attending last week a seminar organized around Matt Ridley's forthcoming book on human progress across time. Clive Crook briefly summarized it, and Robin Hanson did an interesting post based on his comments at the seminar. Robin implores that if we are going to theorize about humanity's history of technological progress and economic growth (to the extent we can measure it), we need to be precise about things. We cannot ascribe a central causative role to, say, the invention of writing if it doesn't fit the timeline of facts. 

The facts Robin has assembled--mentioned in his post and developed in this paper--tell a story of three primary "growth modes" in human history. These correspond with the advent of hunter-gathering, agriculture, and the industrial revolution, with each new mode being characterizied by a much faster rate of the doubling of world product than before. This is an enormous topic (and one, Robin pointed out to me, that should naturally be considered by a blog devoted to economic growth) and won't be resolved in one post, one essay, or one book (as the voluminous literature devoted to economic growth demonstrates).

But, Robin's provocative puzzle and the discussion around Ridley's new book made me wonder about the relationship between economic thought and human nature. Much commentary of late has attacked the conventional economic assumption of rationality, with a corresponding celebration of behavioral economics and its emphasis on irrationality. Yet each of these basically assumes that human thought defaults to deductive and inductive reasoning. People have a generalized principle (self-interest, rational expectations) that they naturally apply to every situation. Or, people encounter facts A and B and our hunter-gatherer brains irreversibly induce C.

Do our brains really work that way? Actually, no. As Ridley remarked in an earlier book in reference to the human brain: "No general-purpose induction here." We are rational, to be sure, but abductively so. What does "abductive" mean? I don't claim to be an expert, but the term itself originated with American philosopher Charles Sanders Peirce in his analysis of Aristotle and has variously been described as "inference to the best explanation" or the formation of explanatory hypotheses. It was also adumbrated by William Whewell and his "philosophy of induction" and has been explained as the method of reasoning used by Sherlock Holmes.

To greatly simplify, abductive reasoning is the constant creation of hypotheses to explain a set of facts or observation, usually precipitated by a new or surprising fact that does not fit the conclusion that deduction or induction would draw. This isn't confined to scientific investigation--it's how our brains function. Neuroscience keeps confirming that perception is inference, that our brains are theory-generating machines and, not surprisingly, some of the best work in this area has been done in the field of artificial intelligence, where researchers must figure out how the human brain works. In terms of vision, for example, there is a hole in the middle of every person's sight line, but our brains fill it by inferring from the surrounding images. In terms of daily life, we constantly draw inferences that seem to explain new or surprising situations and freely revise those inferences in the face of new information. (I suppose from this you could proceed to some sort of neuro-ontological hierarchy but I have neither the capacity nor inclination to pursue that.) Even economics has been touched by the revival of interest in abductive reasoning.

So what does this have to do with economics, economic growth, and human progress? Economics is the study of human behavior, which naturally implicates human thought processes--the closer one can get to how we think, the closer you get to more relevant theory. But Robin's questions about growth prompt larger issues: the question of the causes of growth and progress is really one of the most important that economists and social scientists can consider.

When people talk about economic growth, innovation usually appears on everyone's list as a causal factor. So what is innovation and what causes it? In exploring the causes of human progress, the brilliant economist Nathan Rosenbergn advanced the idea that the freedom to experiment lay at the core: "freedom to conduct experiments is essential to any society that has a serious commitment to technological innovation or to improved productive efficiency." Experimentation with ideas, tools, and modes of organization matters because "there are many things that cannot be known in advance or deduced from some set of first principles."

If abductive reasoning means anything, it does not mean knowing something in advance (the eventual logic of induction) or from first principles (the essence of deduction). In fact, Rosenberg's observations are reminiscent of both abductive reasoning and Donald Campbell's evolutionary model of how new knowledge develops: blind variation and selective retention (BVSR). Every idea or innovation begins as a variation, and they are blind in the sense that a true innovation is one whose consequences cannot be known or foreseen (or induced) in advance. The way it propagates is that it is selected from among other variations and is somehow retained. Perhaps abductive reasoning was missing or implicit in Campbell's thinking.

So if we're thinking about reasons for why human progress became so rapid in the last two hundred years, or relatively rapid around 10,000 years ago, is there any weight to be given to abductive reasoning? On its face, it sounds silly. As a matter of explanation, if the human brain works abductively, we cannot ascribe to it a unique role in growth. Is there a manner by which abductive reasoning could be externally institutionalized? I suppose the market might be such a mechanism because its development over several millennia worked to channel experimentation and provided selective retention.

I'm left at a seemingly dead end, it appears. The explanations for human progress and its increases must be endogenous to humans and human society (unless we're prepared to admit truly exogenous causes like alien visits into our analysis). The timing must be right, so an innate feature of the human brain likely cannot serve as an exclusive cause in 1800. Experimentation is attractive, but surely the human capacity for wonder is timeless? Institutions seem to be coming to serve as a default explanation for growth differentials, but an intriguing recent paper raises some questions on this front.

Part of me is tempted to find solace in circular explanations like feedback cycles. Robin's growth grooves post struck me as leaving options open only for discrete, one-way explanations. I could be misreading it, but it was only later (reading Ridley's Red Queen, by chance) that circular explanation occurred to me as an answer to Robin. That is, can we seek answers in the interaction among many different factors and the associated positive feedback effects they would generate, causes becoming effects becoming causes in turn? I realize that's far from a new idea in economics, but I seem to have been led there inexorably by my own semi-logical reasoning.

Want a job? Get a license.

Would it surprise you to know that 29 percent of the U.S. workforce has a job requiring a license, up from 5 percent in the 1950s? Would it further surprise you to know that the economic consensus is that licensing raises prices, restricts job opportunities from the less privileged, and offers little or no quality improvement in service rendered?  And would it surprise you to know, lastly, that the ivory tower has essentially turned a blind eye to this research?

Let me recommend this tremendous and readable paper by E. Frank Stephenson and Erin E. Wendt in the May '09 EJW:

Consider the textbook by George Borjas. There are 11 pages covering the minimum wage. If he devoted pages in proportion to workers covered, then 11 pages on the minimum wage would correspond to 99 pages on licensing. Ehrenberg and Smith would give 72 pages to licensing. Hyclak, Johnes, and Thornton would give 135 pages to licensing. Instead, in each case, there is zero.

That this is terrible policy is hopefully self-evident. But are we surprised that its use is rampant? In a world where fear sells protectionism, not so much. In states that really care about fighting poverty, you will see lower licensing regulations.

Is there an entrepreneurship gene?

Professor Bryan Caplan says yes. 

Caplan has been dancing around the nature-nurture debate for many moons on his blog, but I get the feeling he is leaning to one side of the fence with this statement ... "The rest is noise; nurture once again fails to rear its hopeful head."

As a personal friend, Caplan should know that my family will not abide such sentiments. Seriously. We invest our time pretty intensively in our children, and we don't want to hear that all our time was wasted. It's too late for that. To be even more scientific about, twins run in our family. I'm pretty sure that proves something.

The Empirical Wrath of Harold Bradley

Pity the wealthy patrons of the National Venture Capital Association: they have called upon themselves the wrath of our very own Harold Bradley, who has now concluded his three-part crusade for empirical truth, economic justice, and the non-venture-backed way of entrepreneurial success.

Picturing Unemployment: Time to Call a Depression?

The business media have been on the lookout for "green shoots" amid the constant signs of recession, and this morning's release of the government's April Employment Situation report is inspiring some bizarre adjective pairings (David Leonhardt calls it "Dreadful, Yet Encouraging" ... imagine if he was describing your health). It reminds one of Ronald Reagan's favorite joke: Is there a pony in all this manure?

A more honest question is whether (or when) it will be time to call the current recession an outright depression. With another monthly half-point spike in the unemployment rate, I am afraid it is a close call and poised to become an easy call in 60 days. Here are three charts to make the case.

The first chart should be familiar, the unemployment rate from January 1948 to April 2009. The unemployment rate, which stands at 8.9 percent as of this morning's Labor Department announcement, is a ratio of the number of unemployed people (13,724,000) to the number of civilians in the labor force (154,731,000). As you can see, only three times in postwar America has the unemployment rate risen above 8 percent -- in May 1975 when it peaked at 8.982 percent and in December 1982 when peaked at 10.849 percent.

Two Aprils ago, the unemployment rate was 4.5 percent. One April ago, it had risen to 5.0 percent, which was considered a mildly alarming harbinger. This April, the rate is 8.9 percent, essentially double what it was two years ago, but representing an acceleration that is historic. For anyone who thinks this recession is comparable to '91 or '01, realize that the spike in unemployment is twice as bad. This second chart shows the net change in the unemployment rate, benchmarked from the first month of the recession in each case. There are two surprises. The last two recessions look like twins: intensity for 9 months, peaking around +2 percent 24 months after the start, and declining gradually for the next 24 months. In contrast, this recession is still in the intensity phase (with monthly increases of 0.2 to 0.4 percent), and we are 16 months in. 

Economists have recognized for some time that this recession is qualitatively worse than any downturn of recent vintage. The proper comparison is to the double-dip 1980-82 recession and the 1974 recession. So here is the third and final chart, again comparing the net change in the unemployment rate of the current downturn to 1980 and 1974. Note that the peak change.

 

In this chart alone, it is clear that the current peak of 3.9 is arguably the worst post-war employment experience. While the 1974 recession peaked at 4.2, its downturn (also 16 months) was preceded by a year of growth. In contrast, the 12 months preceding the official recession start in December 2007 were marked by job losses and decline. As for the 1980 recession, it has been my long practice to count the double-dip as one downturn. Official accounts say these were two distinct events, so the 4.5 peak is actually not an official peak. In other words, this recession is already the worst postwar downturn.

The length of a recession must also be considered. Every post-Great Depression downturn has lasted 16 months or less. As of April, the current recession is 16 months long, so next month will arguably mark this as the longest since the 1930s. Duration matters because past experience suggest that each month of downturn requires roughly a quarter of recovery. The rule of thumb: each monthly unemployment spike which average 0.3 percentage points is balanced by 3 months of 0.1 point improvements. My crude rule implies that even if a turnaround arrives in May, it will be 4 years for the economy to return to full employment.

So is it a depression or a recession? I do not know if the 21st Century Depression will happen, but I am sure that talk of green shoots is foolish. If the net unemployment rate change is higher than 4.5 (i.e. a 9.5 percent level or higher), then the media will emphasize that it is the worst downturn in 80 years. Worse yet, 3-4 more months of severe job losses will indicate the government efforts to arrest the downturn have failed, which will be reflected in ugly public attitudes. It could be a very depressing summer.

New Asymmetry: Robots in the U.S. Military

Economic growth has some perverse implications. Not only does new technology allow for enhanced weaponry, but it also implies a reluctance for humans to tolerate casualties. One could argue that the collapse in human mortality and frailty in modern societies has stoked a rising intolerance for the bloodshed of war. An interesting result is that American attitudes towards was seem less sensitive to the carnage of war, so long as our side is relatively unscathed.

Regardless of other causes, the basic fact is that robotic war-fighting is extraordinarily effective in terms of costs and benefits. For surveillance alone, a small robot can see bad guys or sniff our roadside bombs in a mortally costless fashion that defies imagination and traditional concepts of war. Once you expand imagination to the offensive realm, the impact of robotics is obviously revolutionary. Consider these facts, quoted from P.W. Singer's article in Wilson Quarterly:

• When U.S. forces went into Iraq in 2003, they had zero robotic units on the ground. By the end of 2004, the number was up to 150.  By the end of 2005 it was 2,400, and it more than doubled the next year. By the end of 2008, it was projected to reach as high as 12,000.

• All told, some 22 different robot systems are now operating on the ground.

• The amount spent on ground robots, for example, has roughly doubled each year since 2001.

• In addition to the Predator and Reaper [two large robotic air drones], a veritable menagerie of drones now circle in the skies over war zones. Small UAVs such as the Raven, which is just over three feet long, or the even smaller Wasp (which carries a camera the size of a peanut) are tossed into the air by individual soldiers and fly just above the rooftops, transmitting video images ....

• As new prototypes of aerial drones hit the battlefield, the trend will be for the size extremes to be pushed in two directions ... The military's estimation of what is possible with micro air vehicles is illustrated by a contract let by DARPA in 2006.  it sought an insect-sized drone that weighed under 10 grams (roughly a third of an ounce), was 7.5 centimeters long, has a speed of 10 meters per second and a range of 1000 meters, and could hover in place for at least minute.

The big idea in military strategy is "asymmetric warfare" where conventional forces face an enemy that is smaller, lighter, and qualitatively different. While that asymmetry poses difficult problems, the rise of robotic warfare is in the process of turning asymmetry upside down. The power of force stemming from greater financial resources, traditionally manifested in heavy conventional arms, is being supplemented by robotic forces that are smaller, lighter, and qualitatively different than revolutionaries and guerillas.

Peace on Earth?  It would be nice to think so. While I am convinced the battlefield is changing faster than most soliders, let alone policymakers, can anticipate, the path to peace is on the other side. Strategic counterinsurgency requires transformative construction, not transformative weaponry. I'm certainly not the first to say so. I wouldn't put it past the brightest minds in the Pentagon to already have worked on robots that build roads, schools and hospitals.

The yawning chasm

“There is no making sense of the world we now inhabit until we confront the yawning chasm that separates our age from the vast bulk of human experience.”

- Brink Lindsey, The Age of Abundance (2007)

This book was less economic and more sociohistorical than I expected, but very enjoyable overall and in places extraordinary. Plus, Lindsey is a wonderful wordsmith. I notice this peculiar trend in some thinkers with which I have a deep affinity -- they are Marxist Capitalists.  It may sound like an oxymoron, but I think if you are honest about intellectual history, by which I mean having the internal courage to assess the rightness and wrongness of ideas and events and people, then you can't help but admire the real Karl Marx and his insights while acknolwedging his deep, almost unforgivable, errors. And I think Lindsey achieves this perfectly. Marx saw what so many modern Marxists do not: there is progress in the human condition, and furthermore that progress is essentially capitalist. The reconciliation of old capitalism's contradictions will be (and now has been) resolved by empowering labor.

 

The Information Economy, Huh?

Automation at factories means that there are simply fewer and fewer manufacturing jobs. And this is a good thing. Machinery does most of the work growing the food we eat, and producing the goods we use (durable and nondurable). What's left is information, hence the moniker "The Information Age."

But if this is the great era of data, then what's with the demise of so many information companies? Newspapers, Record Labels, Encyclopedias, all heading south.

The now-familiar struggles of the newspaper industry is in the news again with the brinksmanship in labor negotiations at the Boston Globe, as well-told by David Warsh in this week's economicprincipals.com essay. David is more optimistic than I about the business of newspapering, but I'd like to think I'm more optimistic about the future of journalism. He concludes,

Never mind Warren Buffett’s admonition over the weekend that there is no price at which he would consider a newspaper an attractive investment (he still has positions in two, the Buffalo News and the Washington Post). Repair work has never been his passion. With a little luck, the best regional papers – The Boston Globe, the Chicago Tribune, the Baltimore Sun, the Los Angeles Times – will wind up back in the hands of people who know how to run them.  If so, the newspaper industry will return to a scaled-down semblance of its former self – a profitable and stable group of companies in the first-draft-of-history business. But then, I am a congenital optimist. I have sometimes been wrong.

Yet I find the story of Encarta even more interesting.  Encarta, as you may recall, was the revolutionary Microsoft product that put an encyclopedia on a CD-ROM in 1993 which was the creatively destructive force that assaulted Encyclopedia Brittanica, first published around 1768. Now it is Encarta that will be shuttering -- this year, even refunding existing users rather than continue into 2010 -- signaling the acceleration of technology cycles in the new century. In this NYT piece, Randall Stross describes how the destroyer became the destroyee:

It’s hard to look at the end of the Encarta experiment without the free and much larger Wikipedia springing immediately to mind. But Encarta arguably would have failed even without that competition. The Google-indexed Web forms a virtual encyclopedia that Encarta never had a chance of competing against.

Encarta was conceived pre-Web and had a long gestation. In 1985, Bill Gates envisioned a CD-ROM encyclopedia as a “high-price, high-demand” product with the potential of becoming as profitable to Microsoft as Word or Excel.

Pragmatism = Ideology

From the front page of today's New York Times: "In Classroom, a Pragmatic View of the Supreme Court."

Regular Growthology readers might not expect us to comment on the impending Supreme Court nomination battle, but given the profile of the institution, its recent trend to hear business and regulatory cases, and its broader impact on areas touching growth and entrepreneurship, we feel we should contribute to the dialogue.

Much has been made, as in today's Times story, of President Obama's generally pragmatic approach to governing. "Pragmatic" has probably been the most frequently repeated word since news of Justice Souter's retirement broke, usually defined against ideology. From today's story:

"And more than anything else, he is a pragmatist who urged those around him to be more keenly attuned to the real-life impact of decisions. This may be his most distinguishing quality as a legal thinker: an unwillingness to deal in abstraction, a constant desire to know how court decisions affect people's lives."

The persistent juxtaposition of pragmatism and ideology raises several issues. First, can we please retire the trope that these two concepts are opposites? Ideology has gained a bad name, but really, who is bereft of ideology? It's simply the way one sees and interprets the world. Even increasing evidence from neuroscience research confirms that, as one writer put it, perception is inference. Your "pragmatic" approach is always filtered through your interpretative view of the world, that is, your ideology. (Even the Pragmatism school of philosophy is itself a distinct school of thought, not an anti-school.)

Second, reading the Times story carefully belies the now-established media narrative of pragmatic justice: "Mr. Obama believes the court must never get too far ahead of or behind public sentiment." Nothing earth-shattering there. Later, however, we read that "Mr. Obama often expressed concern that 'democracy could be dangerous' . . . that the majority can be 'unempathetic.'" In other words, the President views the Court as the Founders did, and as probably most people do: as a bulwark of democracy. Because it controls neither the purse nor the sword, the Court can rarely run far astray of public opinion even if wanted to; the Justices know this, by the way--they are as much interested in the preservation of their influence as normal humans. At times, however, President Obama sees the need for the Court to stand against the tides of public opinion. This is how it's supposed to work and few would dispute it. 

Third, the pragmatism-ideology debate is framed as concern "about legal consequences" versus "formalism," supposedly blind to those consequences. Last time I checked, justice was still blind, and a common mistake in any discussion of justice is to conflate justice and fairness. Justice means the consistent applications of established and accepted rules; fairness is a subjective determination. (Forgive me: I grossly oversimplify for space considerations. There is an entire discussion to be had about the foundations of those rules, for example, and Martin Luther King, Jr., probably rendered one of the most eloquent discussions of this in legal history.)

Two threads of justice have long run through Supreme Court jurisprudence: procedural and substantive due process. Procedural due process is justice as equal application of the law. Substantive due process is, as one of my law professors put it, the filling of an empty vessel with one's own beliefs and norms. The Times story--and every media narrative concerned with the Court--tries to make the case that President Obama will favor substantive due process. He doesn't deal in legal abstractions, we are told. 

There are indications, however, that the President tilts toward procedural due process--that is, justice and not fairness. 

"In Mr. Obama's due process and voting rights classes, he showed students the broad failures of Reconstruction-era amendments that tried to establish equality for blacks."

And who would the President most like to argue before? Judge Richard Posner, quite possibly the best legal mind and writer of the last half-century and a leading exponent of Law and Economics. Why? Because Posner "was smart enough to know when you were right, Mr. Obama told the class." In fact, if I try to think of an approach to the law that has as its lodestar the consideration of the real-world consequences of legal decisions, Law and Economics is the best example that comes to mind. And I assume that many people would consider Law and Economics to be ideological, not pragmatic. Yet it may turn out, and it certainly seems to be the implicit message of the Times story, that President Obama views Law and Economics as the way courts are supposed to approach the law. (The Rehnquist Court disappointed many conservatives because it wouldn't deal greatly in the broad-brush generalizations of prior Courts. This may have been a function of the types of cases it saw and their social context.)

Now, this is all just speculation on my part, but it appears that President Obama has a deep respect for Supreme Court jurisprudence. Our media-soaked interest group political culture makes the nomination process an Armageddon-type battle over ideology and the supposed substance of Court cases. Yet the President, unlike many in the media and many of his supporters and opponents, has actually read Supreme Court opinions, has studied the careful reasoning every Justice employs. It takes far more thought, analysis, and, frankly, willpower to weigh the process and substance of the law and resist the easy temptations of shallow "pragmatism." President Obama, thankfully, seems to know this.