## Corporate tax cuts, math, and intellectual swindles

Each dollar (per worker) of static tax losses raises wages by [more than one dollar] It’s always greater than one… A number greater than one does not mean you’re a moron, incapable of addition, a stooge of the corporate class, etc.

This is also a lovely little example for people who decry math in economics. At a verbal level, who knows? It seems plausible that a \$1 tax cut could never raise wages by more than \$1. Your head swims. A few lines of algebra later, and the argument is clear. You could never do this verbally.

For the other side of the controversy, see Mark Thoma.

Let me swindle you with the following example.

1. We have the GDP factory, with two workers, A and B.

2. Each worker faces a different tax rate on wages.

3. The pre-tax wage of worker A is fixed. It cannot change.

4. (a) Each worker stays fully employed. (b) That means that the ratio of the marginal product of worker A to the marginal product of worker B must remain constant.* (c) That means that the ratio of the after-tax wage of worker A to the after-tax wage of worker B must remain constant.

*That ratio is completely determined by the production function, which is given, and by the quantities used of the two workers, which are fixed at full employment.

OK, now we cut the tax rate for worker A. What happens to the pre-tax wage of worker B?

At the fixed pre-tax wage of worker A, the after-tax wage for worker A goes up. Because of 4(c), that means that the after-tax wage of worker B must go up. The only way that can happen is if the pre-tax wage of worker B goes up. And to get worker B’s after-tax wage to go up by, say \$1, you have to raise worker B’s pre-tax wage by more than \$1. So worker B gets a big raise.

Substitute “capital” for worker A, “the interest rate” for worker A’s wage, and the corporate income tax for worker A’s tax rate, and I think you have the story that everyone is talking about.

But this is a swindle. We have fixed both the quantity and price of worker A. Taking worker A to be capital, the fixed supply is plausible because you think “how can we instantly adjust the supply of capital?” The wage, er, interest rate is fixed because, well, we know that the world interest rate is given, right?

But it cannot be right. A fixed wage suggests a perfectly elastic supply. A fixed quantity suggests a perfectly inelastic supply. There is a contradiction between 3 and 4(a).

The larger issue is that the simple model of a GDP factory with two factors of production and full employment is just silly. And even though other models add enough complexity to require computers to solve, they are also just silly.

There are many types of capital, which is what creates all of the lobbying and infighting over corporate taxes to begin with. There are also many types of labor, which substitute for and complement with the various types of capital in different ways. Adjustment takes time, and not all types of capital and labor are continuously employed. Over time, there is innovation, some of which is exogenous and some of which is in response to the tax change. The supply of each type of capital and each type of labor is neither perfectly elastic nor perfectly inelastic (and certainly not both!).

The moral of the story, in my view, is that forecasting the impact of economic policy is not a science. We know that, but then people demand a forecast, and they turn to a CBO “score” as if it were the final word on the subject. I have a forthcoming essay on the mis-use of CBO scores.

| Tagged | 1 Comment

## The Schumpeterian lag

Michael Mandel writes (WSJ),

But does e-commerce destroy more jobs than it creates? So far the answer seems to be no. From the third quarter of 2015 to the third quarter of 2017, brick-and-mortar retail full-time-equivalent jobs fell by roughly 123,000, or about 1%, according to my think tank’s analysis of the latest Labor Department data.

Over the same two-year stretch, the e-commerce industry has added some 178,000 jobs in fulfillment centers and electronic shopping firms. In addition, express delivery companies and other local couriers boosted their full-time-equivalent workers by another 58,000.

If you take this on its face, then the retail industry as a whole is getting much less efficient. There has been a net increase in labor required to deliver goods from manufacturers to consumers.

I think what is happening is what might be called Schumpeterian lag. Schumpeter suggested that in the process of creative destruction, optimism over new methods combined with a reluctance to let go of old methods to create a boom. But eventually some firms realize that they are wrong, as they suffer losses. Then you get the bust. I expect that is the way it will play out in the case of retail.

1. The Captured Economy, by Brink Lindsey and Steve Teles. I don’t think I have much more to say about it than what I wrote here.

2. How to Think, by Alan Jacobs. The topic of political emotionalism is something of a well-squeezed orange these days, at least among people who are not too overcome with political emotionalism to be disturbed by it. Jacobs gets some juice out of the orange, and I have drafted an essay that uses his book as a jumping-off point. I particularly like his emphasis on thinking as a social phenomenon, and the way that he works through what that implies.

He emphasizes that that he straddles two separate worlds–religion and the academy, and he thinks that this helps with being able to empathize with different points of view. I can remember at a very early age feeling that I straddled two separate worlds. In 4th and 5th grade, my street in suburban St. Louis was white trash* (except for my college professor father), but some of the other streets that fed my elementary school were middle-class professional. The children were very different, and I was one of the few kids with friends of both types.

*You might think I’m exaggerating. But there was a lot of fighting and roughness among the kids, and even among the adults. The most dramatic incident was when Steve Stella’s mom grabbed a woman by her hair and banged her head against the curb. That’s not the sort of thing that middle-class kids encounter these days. (No, Steve Stella is not anyone famous, or anyone I’ve kept track of. I feel free to use his name on the theory that he did not grow up to be anyone you know.)

3. Economics for the Common Good, by Jean Tirole, a review copy of which was sent to me. At close to 500 pages of translated-from-French prose, this will not be an easy one to get through. So far, the main thing I have against it is the title. Something like “What economics can do for public policy” would go down more easily. I’ll let you know more when I am done–not necessarily finished–with the book.

4. The Second World Wars, by Victor Davis Hanson. This not for a WWII neophyte, since it offers no chronology. Nor does it offer the currently popular “how it looked to the ordinary grunt” perspective (at least so far–I am not finished reading). The book is primarily a vehicle for the author to offer his opinions about why things played out as they did.

He is unfashionably Anglophilic. Also, he emphasizes the industrial might of the United States and the Soviet Union. This in turn leads him to attribute the Axis defeat to the folly of Hitler’s choice to invade Russia, Japan’s attack on Pearl Harbor, and Hitler’s decision to declare war on the U.S. Interestingly, I skimmed through the chapter on Pearl Harbor in Churchill’s third volume, and it makes no mention of Hitler’s decision to declare war. It reads as if Pearl Harbor automatically put the U.S. in the war against Germany.

VDH provides provocative and credible evaluations of the cost-effectiveness of various military tools. American submarines and Soviet tanks receive high marks. Paratroops and battleships receive low marks. He argues that Britain and the U.S. learned from mistakes and improved tactics and machinery (such as faulty torpedoes on American submarines when the U.S. first entered the war) more quickly than did their enemies.

Recommended for World War II buffs. Also, after I wrote this post but before I scheduled it to appear, Tyler Cowen reviewed the book very enthusiastically.

## The Cowen-Cochrane dispute on banking

I don’t think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate.

As spelled out in Specialization and Trade, my simple account of financial intermediation is this.

1. We start with a risky investment, fruit trees, and it is costly to observe how the fruit trees are doing and how much skill and dedication the entrepreneur is contributing.

2. It helps to finance these fruit trees in part with debt. This is not because debt is easier to trade than equity, but because it is a less expensive way to align incentives.

3. It helps to have a bank buy the debt and issue short-term, risk-free liabilities. This is because people do want to hold and exchange short-term, risk-free liabilities. An intermediary that backs the fruit-tree debt with a combination of bank equity and demand deposits makes people better off.

So I am afraid that I am with Tyler on this one.

## What is the limit on firm size?

Given the replication argument, there is no scale of operation that is beyond efficient scale. There may be ample reason to make different plants or divisions quasi-independent so they do not interfere with one another’s operations. But that is not an argument against scale per se. There may even be reason to set up incentives so that different divisions are almost like separate firms, headed by someone in an entrepreneurlike position. But that still is not, properly speaking, an example of diseconomies of scale.

So what are we to make of this?

1. For the economy as a whole, the law of diminishing returns applies. You cannot grow all the world’s wheat in a single flower pot.

2. But the size of any one farm is not limited to a single flower pot. Any one farm can keep adding land (until it gets to be large relative to the earth’s arable land).

3. Kimball sees the assumption of diminishing returns at the firm level as a staple of standard pedagogy. But it is more than that. Dropping that assumption takes you away from the perfectly competitive equilibrium, as Kimball spells out in his important follow-up.

4. What about the notion that the entrepreneur’s time or skill is a fixed factor? This appears to be a way to show that firm size must be limited. But it also is like question-begging or hand-waving. If you start with a traditional production function, with output a function of the two factors of homogeneous labor and homogeneous capital, then you have a hard time rationalizing diseconomies of scale until the firm gets to be really big relative to the whole market. So you tack on a fixed factor, and call it “entrepreneur’s time.” But the original production function assumed away the entrepreneur to begin with, and you never did spell out the entrepreneur’s role in that context.

5. Kimball’s approach in the second post consists of postulating a demand curve and zero profits and solving for firm size. That also strikes me as hand-waving, with math. Call it math-waving.

6. Think of a real-world example of monopolistic competition. I like to use ethnic restaurants in Wheaton, Maryland, near where I live. What stops a single owner from taking over multiple restaurants under the auspices of one firm? What stops an owner from then expanding to other locations far away, where the local demand curve is not a limiting factor?

7. When you do this thought experiment, you realize that firm size is not determined by the tangible variables that are central to neoclassical economics. Instead, you have to turn to principal-agent problems and whatever else might help deal with the “boundary of the firm” problem that has been articulated but not necessarily solved in a satisfactory way by Coase, Williamson, and Alchian and Demsetz.

8. Why are farms in two different states separate businesses? I would say that it is because it is costly for the Iowa farmer to observe the Kansas farmer’s effort, giving rise to a principal-agent problem. This may turn out to be a testable hypothesis. It predicts that as the cost of monitoring goes down (because of cheaper surveillance technology), we will see mergers take place that would have been unthinkable until recently.

9. This year, Amazon bought Whole Foods. Where does it stop? Where are the diseconomies (of scope, if not of scale)? Suppose that in order not to incur management costs, Amazon leaves Whole Foods executives in place and adopts a hands-off approach. Then from the point of view of somebody who owned shares in both firms, the merger only changed the form of ownership. You used to own a sort of mutual fund, and it was your choice how to weight the shares of Amazon and the shares of Whole Foods in that fund. Now you own shares in a conglomerate, with the weight fixed–you can no longer simultaneously reduce your holdings of Whole Foods while increasing your holdings of Amazon.

10. From the foregoing, it would appear that shareholders always lose in a merger, because they lose the option to alter the weights of their holdings. In fact, mergers have other effects, but they involve those intangible “boundaries of the firm” phenomena.

11. Suppose that a major element in a corporate merger is ego. The CEO of the company being acquired gives up status but gains wealth for the firm’s shareholders. The CEO of the acquiring firm does the opposite. The ego hypothesis predicts that immediately after the merger the acquiring firm will not give the post of CEO to someone from the acquired firm. It also predicts that the merger will be positive for the shareholders of the acquired firm but not for those of the acquiring firm. I haven’t kept up with the literature, but it used to be that those predictions held up.

12. In conclusion, the attempt to rationalize diminishing returns at the level of a firm in neoclassical economics opens up a can of worms, and Kimball’s math-waving with the demand curve does not close it.

## The Richard Reeves recommendations

From a review of The Dream Hoarders:

Reeves is optimistic, however, that the correct policy agenda can reverse this trend. His policy background shines through in the clarity of his seven-point agenda. The first four focus on equalizing human capital development—reducing unintended pregnancies by expanding access to better contraception, narrowing the parenting skills gap by investing in home visits by nurses, paying the best teachers to work in poor schools, and making college funding more equal. The remaining three are aimed at reducing opportunity hoarding—curbing exclusionary housing zones, widening the doors into postsecondary education, and opening up internships through increasing regulatory oversight, expanding student aid to interns, and changing the norms of how internships are allocated.

The latest issue of Democracy is filled with articles about the pitfalls of progressive policies, which is refreshing. Of course, in many cases, but not all, they recommend alternatives that are further to the left.

## Complexity illustrated by the financial crisis

This IGM poll of leading economists on the importance of various factors in the financial crisis of 2008 provides interesting results. The poll lists 12 factors, and all of them receive at least some positive weight. In fact, this under-estimates the complexity of the causal mechanisms, because some of the factors are themselves multi-faceted. For example, the first factor, “flawed financial sector regulation and supervision,” could mean many different things to many different people. It could mean the repeal of Glass-Steagall (a favorite among non-economists on the left) or it could mean the Basel accords (one of my personal favorites).

Overall, I think it vindicates the broad, multi-causal approach that I took in Not What they Had in Mind.

## The Bretton Woods Consensual Hallucination

You might think it’s no big deal that exchange rates becomes more volatile after the end of Bretton Woods—after all, Bretton Woods was a fixed exchange rate regime. Actually, it’s a huge deal, as you’d expect the real exchange rate to be unaffected by a purely monetary change, like switching from a fixed to a floating exchange rate regime.

Read the whole post. Sumner makes his points powerfully. I am not sure that anyone has an easy explanation for this volatility change.

1. An old-fashioned pure monetarist view of the Mark/Dollar exchange rate is that its movements are inversely related to movements of the relative money supplies. Hold the supply of dollars constant and print 10 percent more marks, and the mark should depreciate by 10 percent. In that case, you in order to arrive at the volatility depicted in the chart in Sumner’s post you have to imagine the two central banks at their respective printing presses randomly alternating between flooring the accelerator and slamming on the brake.

2. A modern monetarist (Sumner?) might not focus on relative money supplies, but the inclination would still be to attribute the variation in exchange rates to the actions of central banks. But it is difficult to imagine a central bank policy reaction function that would generate the swings observable in the chart.

3. The Dornbusch overshooting model would tell you to keep your eye on relative interest rates. If the American interest rate in dollars is higher than the German interest rate in marks, then the dollar has to become overvalued relative to its long-term equilibrium rate, so that the expected depreciation of the dollar equates the expected return on German bonds and American bonds. My problem with that model is: what is this “long-term equilibrium rate” of which you speak? The model treats this as if it were some widely known and agreed-upon benchmark. In my view, there was no such thing, especially after Bretton Woods broke down.

4. My view of money and inflation is that they are consensual hallucinations. If that term bothers you, think of them as conventions. We explicitly agree to accept currency as payment, and then we tacitly agree on what other forms of payment are acceptable. We tacitly agree on how we expect prices to behave as measured in terms of currency.

The Bretton Woods agreement fostered the consensual hallucination that inflation would be gradual and that exchange rates would be stable. These beliefs were self-reinforcing up until the late 1960s. When the U.S. started losing too much of its gold reserve trying to maintain the Bretton Woods exchange rate, something had to give. In August of 1971, President Nixon took us off Bretton Woods and left the dollar unpegged. My interpretation of the chart is that for the next dozen years or so people did not have any consensus on where values belonged. Inflation rates started to vary widely across countries and over time. Exchange rates fluctuated wildly. People’s expectations had no anchor.

As Sumner points out, the end of that episode makes a great case for monetarists. Fed Chairman Paul Volcker said he was going to do something to restore sanity, and sure enough, sanity was eventually restored. I am left waving my hands and saying that somehow sanity was restored, and it was coincidental that it happened while Volcker was Fed Chairman.

Remember: I think that the Fed is just a bank. Yes, I know that the liabilities on its balance sheet are an accepted form of payment. But there are a lot of accepted forms of payment.

## Brink Lindsey and Steve Teles push liberaltarianism

the point of convergence is where anti-statism and egalitarianism meet

That is from their new book, The Captured Economy. They discuss four areas in which public policy exacerbates inequality: housing finance subsidies, intellectual property protection, occupational licensing, and urban land-use regulation. Thus, these are four areas in which a libertarian preference for less government and a progressive preference for less inequality can be served by the same policy changes–hence the “convergence.”

I found much to like in the book, particularly the discussion of the financial crisis, which puts more of the blame where I think it belongs and less on the places where I think it does not belong. In fact, I found the discussion so congenial that I did a search for “Kling” to see if I was in the footnotes somewhere, but I wasn’t.

I quibble when they write,

Of the four case studies we examined, only with respect to financial regulation do we see the usual left-right debate of bigger versus smaller government.

As an anecdote, early in the Trump Administration I attended a three-hour session on financial regulation at the Treasury Department, with about 50 economists in the room, predominantly on the right of course. At one point, the official running the session asked for a show of hands on the question of whether banks were required to hold too much capital, not enough capital, or the right amount. Overwhelmingly, our hands went up for “not enough capital.” So I think that Teles and Lindsey are wrong to imply that the reason that we are stuck with the financial policy we have is that the left and the right cannot agree.

Among economists, left and right agree that it would be good policy to require banks to be less levered. Just as we agree that it would be good policy to build more housing in high-income cities.

Lindsey and Teles are quite aware that on these issues where economists mostly agree, there are public-choice problems. That is what they mean by the title “captured economy.” In the latter part of the book, they talk about ways of getting around these public-choice problems. They reject both the libertarian solution (shrink government) and the progressive solution (regulate campaign finance).

I would describe their suggested alternative political approaches as scenarios rather than as solutions. I am not very optimistic that their scenarios can be realized.

| Tagged , | 8 Comments

## More thoughts on disciplined software development

Robert C. Martin described the single responsibility principle: “Gather together those things that change for the same reason. Separate those things that change for different reasons.” Clear separation of concerns, minimal coupling across domains of concern, and the potential for a higher rate of change lead to increased business agility and engineering velocity.

This is another characteristic of the disciplined approach to software development that Tim O’Reilly describes at Amazon. I didn’t include it in my previous post. Thanks to a reader for the pointer.

Thanks also to a commenter, who sends a link to a memo.

There are without question pros and cons to the SOA approach, and some of the cons are pretty long. But overall it’s the right thing because SOA-driven design enables Platforms.

SOA stands for “service-oriented architecture.”

O’Reilly explains SOA, as does Zack Kanter.

each piece of Amazon is being built with a service-oriented architecture, and Amazon is using that architecture to successively turn every single piece of the company into a separate platform — and thus opening each piece to outside competition.

Thanks yet again to another commenter for the link.

I reiterate my view that a firm’s software development can only be as disciplined as its business units. I have a hard time picturing Freddie Mac in the late 1980s and early 1990s (when I was there) having a culture to do SOA, even if you gave the IT department all of 2017-vintage technology to work with. The dependencies across business units were extremely tight, with decisions made by the people negotiating terms with loan originators having downstream effects on folks servicing defaulted loans years later as they tried to determine what recourse Freddie had, if any, back to the originator in order to compensate for losses. In practice, this was handled in an informal, ad hoc manner. To get to the point where you could have executed SOA, you would have needed business units to understand and buy into a much more explicitly documented business process. That is what I cannot picture happening.

Recently, some economists have been struck by the high degree of inequality across firms. I can imagine that one source of inequality would be in the ability of management teams to take advantage of highly disciplined processes for software development. The skill and culture of the management team might be more important, and more unequal across firms, than was the case a few decades ago.

Posted in books and book reviews, business economics | Tagged , | 3 Comments