Fischer Black: Seeing Capital Everywhere

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After Tyler Cowen told me that my macro book needs more on Fischer Black, I ordered the 2010 edition of Exploring General Equilibrium, which includes a posthumous essay. I will probably have a number of posts on the book.

One way I think of Black is that he sees capital everywhere. In an extreme (and Black does not take things this far), think of the economy as nothing but different forms of capital producing utility. Take the concept of human capital really seriously, to the point (again Black does not take things this far) of looking at a human worker as just another machine.

From the point of view of a firm, the human worker-machine has some capabilities. However, in order to make it productive, you have to set it up, tune it, program it, and coordinated it with other machines. It becomes obsolete when the cost of maintaining and using it exceeds the value of what it produces.

When I ate a piece of toast this morning, I was getting utility out of various forms of capital. These included the refrigerator out of which I took the bread and the toaster oven. However, the bread itself resulted from roundabout production. Seeds were planted, grain was harvested, other ingredients were added, loaves were baked, etc. In order to know how to obtain the bread and operate the toaster oven, I had acquired human capital.

In a world where utility is produced almost entirely by capital, most economic decisions are risky. Any decision today represents a bet on how the world will look tomorrow.

Some remarks on this capital-centric point of view.

1. Standard national income accounting assigns a 2/3 weight to labor’s share of output. But perhaps this is highly misleading. The value comes from the capital embodied in the workers, which includes general human capital (skill usable everywhere) and specific human capital (skills usable on a particular job).

2. Standard national income accounting says that consumption is over 2/3 of output. However, very little output is immediately consumed. When I buy a loaf of bread, I do not consume it immediately. Instead, the bread is an input to consumption that takes place over subsequent days. Although Black does not take things this far, you can think of the bread as capital that, when used, depreciates rapidly and proportionately. This is in contrast to the toaster oven, which depreciates slowly and not exactly proportionately to its use.

3. The value of capital changes as events unfold. A desktop computer from 1987 is not worth much today. Houses in Las Vegas were not worth as much in 2009 as they were in 2005. The ability to shoe a horse is not worth much today. Arguably, a plain vanilla college degree was not worth as much in 2013 as it was in 2006.

4. Black points out that because of adverse selection and moral hazard, human capital investments are harder to diversify than physical capital investments. That is, I cannot sell shares in my future earnings without creating adverse-selection and moral-hazard problems, so I have to retain a large interest in my own human capital.

5. One of Black’s central points is that as events play out, some investments earn good returns and some investments earn bad returns. You will not always see equal amounts of good luck and bad luck. A lot of good luck is a boom. A lot of bad luck is a bust.

6. Black says several times that worker compensation consists of training as well as pay and benefits. When a lot investments do not pan out as hoped/expected, compensation for some humans has to fall. Black points out that if the compensation still includes a lot of training, then the firm may not be able to afford much in terms of wages and benefits. It made me think of unpaid internships as a market response to these circumstances. Of course, dropping out of the labor force is another natural response.

7. In thinking about the current situation, ask yourself which sorts of investments are no longer panning out. At the margin, does it no longer pay to take on a manual worker and train that worker? Health insurance costs are rising, and machines are getting smarter and more dexterous. At the margin, does it no longer pay to hire an American worker with a plain vanilla college education? A web site and a call center in India may be more efficient than an American sales force. Maybe financial institutions have had to cancel a lot of plans to hire plain vanilla college graduates to work in what was once thought to be an ever-expanding lending-securitization industry. Maybe when you factor in health care costs and the time it takes for a worker to get up to speed, the present value of investing in a new college-grad worker is no longer positive.

Laurence Kotlikoff on the U.S. Budget

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In a podcast with Russ Roberts, he says,

I think we are probably in worse fiscal shape and any developed country. The reason, Russ, is we’ve been piling up debts for over 6 decades; and when I say ‘we’ I’m referring to Republican and Democratic administrations and Congresses. And we’ve been hiding them. We’ve been keeping them off the books and using economic labels, words, to pretend that they are not real liabilities of the government…we have all these obligations to something like 30-40 million current retirees and close to 80 million baby boomers who are about to start collecting Social Security benefits if they haven’t already. All those obligations are not reported as part of the government’s debt, so we are missing those off-the-book obligations.

But the real economic emergency is inequality. Or austerity. Or something.

Models as Traps

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Tyler Cowen writes,

Enter DSGE models. There are plenty of good arguments against them. Still, they provide a useful discipline and they pinpoint rather ruthlessly what it is they we still do not understand. We can and should devalue them in a variety of ways, and for a variety of reasons, but still we should not dismiss them.

Models are simplifications. Sometimes they seem useful. For example, the AS-AD model often seems useful for explaining economic fluctuations. The production function often seems useful for explaining the distribution of income.

The DSGE model was never adopted for its usefulness in that sense. It was adopted in order to satisfy a methodological principle. That may be why I am tempted to dismiss it.

Any model can be described as valuable if you say that it shows us what we do not understand. To me, that is a low bar.

I think that a model is a trap if factors outside of the model constantly have to be invoked, to the point where they overwhelm the factors that are in the model.

Take the neoclassical production function. Recently, it has occurred to me that this may be a trap. Economists seem to need to add all sorts of types of capital to the model: human capital, social capital, network capital, brand-name capital, etc. It is hard enough dealing with heterogeneity in physical capital–how many forklifts equal one blast furnace? But when physical capital does such a poor job of explaining differences in performance across firms, across economies, and over time, at what point do you say that the neoclassical production function is a trap?

Radical Federalism Watch

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The Washington Times reports,

Venture capitalist Tim Draper of Silicon Valley has filed paperwork for a November ballot measure that would divide California into six states, calling the Golden State as presently constituted “too big and bloated.

I am mulling the idea for my next book (after the macro book). I am thinking of how to implement a radical form of federalism, so that the U.S. could be broken into states the size of Singapore or Norway.

My Case for Radical Federalism

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In this essay, I document the negative relationship between the population of a country and its economic freedom.

Overall, 43 percent of the small nations are in the highest group for economic freedom. Only 20 percent of the middle-sized nations are in that group. And just 17 percent of large nations have high levels of economic freedom.

After you read that essay, you might want to look at this version, where I use a controversial measure of national average IQ as an additional variable to predict economic freedom.

Think about what it might mean to have responsibility for something like Medicare or unemployment insurance devolved to the state level. Would someone who is born in Missouri and moves to Maryland be considered a citizen of Missouri who then is a guest worker in Maryland? When would that person become a citizen of Maryland? etc.

Gold-medal Misanthropy

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Jay P. Greene writes,

I hate the Olympics. I hate everything about them… their show-casing of murderous authoritarian regimes, their graft and corruption, their promotion of obscure sports that generate little genuine interest, their hypocritical claim of being non-commercial and non-political, their subordination of athletic excellence to soap-opera story-telling… everything.

Are there libertarians out there who love the Olympics? It occurs to me that anti-Olympics misanthropy might be correlated with anti-state misanthropy. It is true enough in my case.

Future Job Growth

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From the WSJ;

Personal-care aide will be the fastest growing job from 2012 to 2022, among categories with more than 25,000 positions, the Labor Department said in a new report. The field will grow by nearly 50% to 1.8 million jobs.

I could envision a scenario in which personal services of all sorts become more important. For example, here is an idea from IBM.

by next year, Watson will be your personal shopping assistant. Store associates will also have similar intelligent tech providing them instant product information, customer loyalty data, sales histories, user reviews, blogs and magazines, so that when you do need to talk with another human, they know exactly how to help.

IBM thinks in terms of technology it can sell to large enterprises. I tend to think in terms of disintermediation, in which large enterprises are no longer needed.

So IBM thinks about adding personalization to an existing classroom. I think about getting away from classrooms and going back to tutors. Imagine a world with tutors instead of schools.

Schools keep you kids around all day, and thereby waste most of the day. For parents, that is as much a feature as a bug, because they need schools to supervise their kids. But if you were to re-organize schooling into a day-care component and a tutoring component, you might find benefits in getting rid of the enterprise that we call a school.

So we might find that in the future there are fewer school administrators and fewer classroom teachers, but there are a lot more day-care supervisors and tutors.

Russ Roberts Asks an Easy Question

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He writes,

There are lots of claims about inequality and what is really going on. But this chart makes whatever explanation you believe in harder to explain. Chew on it.

Nick Schulz and I wrote about what we called the Sergey Brin Effect. We pointed out that the “game” of income distribution has been re-shaped by immigration, assortative mating, and technology.

The chart the Roberts refers to shows major differences in trends by education category. It also shows that, controlling for level of education, women have done better than men. My guess is that this is due to technology. We have seen an increase in the comparative advantage of people who can get into well-protected credentials cartels or who can help companies formulate and execute complex business strategies. I think that explains the education-income trend. We have seen a decline in the comparative advantage of workers who are good at lifting, shaping, and applying finishing to metal but who are not so good at interacting with customers and co-workers. That also explains the education-income trend, but I think it also helps explain the male-female trend.

The chart also shows more earnings growth at the top of the education ladder. That, along with assortative mating by education, should really drive household inequality.