Our fiscal policies should also be guided by the objectives of maximizing freedom of choice and freedom of action, while minimizing market distortions. Spending programs and tax policy should be geared to the goals of economic security and individual empowerment. I have made the argument that these goals are best achieved through enabling capital accumulation and broad equity participation in the production process. With the substitute of self-insurance that wealth provides, tax policy can help us achieve these objectives in ways that reduce the budget-busting provision of entitlements. If we accumulate adequate retirement or health savings funds, there is less dependence on Social Security and Medicare, which would make means-testing and the modernization of benefit calculations more politically palatable.
There are certain market failures inherent to capitalism that require policy remedies. The most critical of these are moral hazard, maldistributions of wealth and income, and principal-agent problems. Moral hazard is minimized through effective and appropriate insurance pooling. Principal-agent failures are mitigated by open competition, transparency, fiduciary laws, and credible sanctions for criminal violations. Bernie Madoff and Kenneth Lay are the poster boys for criminal behavior in this respect and there’s not much more we can do except enforce sanctions that ensure crime does not pay, especially white collar crime. Corporate governance policy reforms should be focused on eliminating the conflict of interest between corporate management and the boards of directors. This may require new rules for corporate governance that seek to empower all stakeholders, especially labor, to exercise their interests over the ownership of the firm.
The Curse of the Market
This brings us to what I argue is the greatest policy challenge we face as a free society: the growing maldistribution of wealth and income, which ultimately determines the distribution of our resources. This is the dark side of a market mechanism that is both efficient and ruthlessly amoral when it comes to final outcomes. In certain aspects, inequality is a natural phenomenon. We all have different talents and innate skills that the market will reward disproportionately. Life is not fair and passing laws to redistribute wealth and income won’t necessarily make it fairer. Our traditional market approach is to strive for equal opportunity and let the chips fall where they may. This leads economists and politicians to focus on education as the great equalizer. Equal access to education is tremendously important, but it is not enough.
The true source of income and wealth disparities is the ownership and control of financial capital. To understand this, one need only look at the following graphs of the growing disparity of incomes in the U.S. over time.
We see here the changes in income from 1979-2007 separated out by income strata—quintiles from the top 20% to the bottom 20% contrasted against the top 1%. The maldistribution is obvious, with the most remarkable gains going to the top 1%. We should note the volatile swings in income for this group from year to year. There is no way these swings can logically be accounted for by education, changes in wages or salaries, or short-term income mobility. What is fueling these swings, and the widening income and wealth divide, is the ownership of financial assets. We can confirm this by tracing the periodic declines in top tier incomes to their direct causes: the financial market contractions in 1987, 1990-91 and 2000-01. We know that the crash of 2008 will display the same contraction of top tier incomes, and the same rebound immediately afterwards, due to the remedial policies that have been enacted since then. The policy “fixes” after each crash have only managed to restore and increase top-tier wealth.
We saw, in our macroeconomic model, that sustainable economic growth relies on a balance between consumption, savings, and investment over time. As a smaller group garners more and more of the resources of the economy, how will the funds be reallocated? Naturally, wealth is shifted from consumption to investment, as the rich can only consume so much. But excess investment with declining consumption demand means that investment will be channeled into less productive activities. We see this reflected in the “chase for yield” as markets reach new price highs and investment yields decline. The search for yield entails the assumption of larger risks with higher potential losses for miscalculation.
The timeworn correction for this situation is a market crash, when prices of risky investment assets plunge. This allows for prices to reset as unprofitable investments are liquidated and consumption demand contracts, putting downward pressure on all goods prices and incomes, affecting wages and employment levels. After prices have bottomed out, resources become reallocated to more productive uses as determined by renewed consumption demand that is based on more realistic price levels. Like a phoenix, trade once again rises from the ashes.[71]
My key point is that the gap in incomes widens when financial markets boom and closes during financial crises. One might surmise that the cure for inequality is a good market crash, but we cannot solve the problem of inequality by equalizing poverty. (I hope that sounds like a bad idea, but it was tried by the former communist states of the USSR, China, and even Cuba.) The danger we face now is that Fed policy has attempted to short circuit the normal market adjustment process by reflating financial and real asset prices. This has been a deliberate goal of Chairman Bernanke and it can be seen in his attempts to prop up asset prices, from houses to bonds to equities, with low interest rates and quantitative easing. One wonders how prices will ever find their accurate levels under this continued distortion. The political and social costs of this policy are reflected in the growing disparities in income, wealth, and political influence as the incomes, wealth, and political influence of top 20% rises while the fortunes of the middle and lower income strata fall. This is no way to run a free market economy or a free society.
There is another interesting point to note in the interaction between financial markets and macroeconomic policy. We have noted several times that financial capital is valued according to the fundamental value of earnings cash flows magnified by the perception of confidence in the future trend of those earnings. In the stock market we can easily distinguish between the value assigned to real earnings and the value assigned to future expectations by comparing the fundamental value of the firm’s earnings to the price/earnings multiple (called the P/E ratio). A P/E ratio of 10 means that investors are willing to pay $100 for $10 of annual earnings from an investment in a particular company. If investors are confident those earnings will go up, they may be willing to pay even more for those earnings in the short term, say $120 for $10 of present earnings yielding a P/E of 12 with the expectation that earnings will go up to $12 or more. Using these relationships as a rough gauge, we can see how much of the market valuation is being inflated by expectations and also determine whether those expectations reflect warranted confidence in the future. In the headiest days of the dot.com boom, many stocks had infinite P/E ratios because there were no earnings to speak of—all the valuations of these companies were in the eyes of the (be)holder.
Confidence is a matter of individual perception and one is free to gamble on hot air. However, if economic policy is inflating that confidence with easy credit and implicit guarantees—a serious violation of our macroeconomic policy model—then market instability will increase, as will the risks of crippling losses. Excess liquidity in the capital markets is often reflected in inflated stock prices that are not matched by real earnings growth. Mr. Bernanke seems to hope that higher asset values, which, as the basis of loan collateral, will shore up bank capital. Then, increased lending to business will fund productive investment and employment growth, causing business earnings to rise. But this puts the cart before the horse. Rising P/E ratios reflect growing confidence driven by real productivity gains. In other words, earnings rise, pushing up prices and P/E ratios. Rising prices do not pull up earnings. Confidence not confirmed by rising earnings and employment is not sustainable. We’ve already seen where that leads.
Excess leverage based on easy credit should be a central bank’s nemesis. Regrettably, I bel
ieve our current policy direction not only increases systemic risks, but also is likely to lead to greater inequality, more asset bubbles and crashes, insufficient savings, high persistent unemployment, anemic growth, and declining opportunities for new entrants into the economy. If and when we run out of policy options, the consequences (such as a deep, persistent, crippling deflation) will be cruelly exacted by the market, largely hurting the poor and aggravating inequality. I believe it is up to us, as citizens and voters, to hold our government and politicians accountable and to steer the nation back toward a more stable and rational course.
Our politics does not exist in a theoretical vacuum. It too is subject to the forces of change, uncertainty, and loss aversion. American politics is conservative by design—the nature of the elective process reinforces loss aversion and the reticence to tackle problems proactively. This is why most of our policymaking is crisis driven, which explains why much of it is half-baked. As seasoned voters, we should all know by now that when a politician makes campaign promises to deliver a chicken in every pot and a Mercedes in every garage upon election, he, or she, is not to be believed.
We should be equally skeptical of promises on entitlements that avoid tough economic trade-offs. For the past century the preferred political solution to inequality in developed democracies has been tax and redistributionist policies, mostly through social insurance and welfare entitlement programs. These have been justified in terms of fairness, but are also conceived as a way to stimulate inadequate consumption demand during economic slowdowns. (When the economy slows down and unemployment increases, public expenditures on entitlement programs help take up the slack.) A concomitant to this ‘social welfare state’ has been a strong, organized, union labor movement. All of these rationales to address the problem of inequality are legitimate, but none are sufficient to insure a sustainable growing economy, nor a lasting solution to the inequality problem. Why?
Taxes intended to help redistribute income are targeted on income-producing activity, and thus changing the incentives that risk-takers face when making their investment decisions. The tax take raises the threshold level for investment and reduces the international competitiveness of U.S. business. Eventually, we get less and less tax revenues to redistribute and more jobs get outsourced. Unions have served several important functions in the past, but as the industrial economy transitions to an information and service economy, their functions have in many cases become obsolete or counter-productive to their members’ goals. This is reflected in the decline of private union membership across all developed democracies, which has been offset by increased membership in public unions. Private unions are subject to the discipline of profits generated in the market, public unions are not. Public employee unions have only increased the deadweight costs of public sector spending, which depresses economic growth and distribution.
Some policy experts have advocated for a return to Roosevelt’s New Deal from the 1940s. FDR’s New Deal promised to provide public solutions to private problems with universal social insurance programs and the strong defense of organized labor. Because globalization and technology have created a different playing field for democratic capitalism, it may be time to rethink this model. A New “New Deal” modeled on this ‘Old Deal’ makes little sense going forward into the 21st century. If we all, as individuals, don't prudently spend, save, and invest over our lifetimes, there will be little to tax and redistribute through the public sector.
Some readers may conclude this guide is too ideologically biased in one form or another. A leftist, liberal perspective will see it as too pro-market and anti-government, while a rightist conservative one as too pliant on income and wealth inequalities. These criticisms appear contradictory based upon the simple dichotomy of the two these economic ideologies. The position I take is more complex and nuanced. I see the question of free markets vs. government regulation as one of looking at the glass as 90% full or 10% empty. [72] Market critics usually see the free market glass as 10% empty and desire more regulation. But the wrong regulation is often worse than no regulation.
Although this guide’s ideological stance is pro-market—I would argue this is the only intellectually and empirically defensible position—it also recognizes the failures of orthodox macroeconomy theory to account for the ways financial markets misbehave and how this reality affects the macroeconomy. These failures are inherent to a misspecified macroeconomic orthodoxy (see Appendix B).[73] Managing the tensions between the two interpretations of free markets and market failures leaves adequate room for politics and a necessary role for government. But given that my position challenges both ends of the ideological spectrum, one shouldn’t expect to find too many friends out in no-man’s land. My aim has been, however, to overturn a few apple carts, rock a few boats, challenge conventional wisdom, incite controversy, and provoke more critical thinking.
To judge by the level of consensus reached in the profession, we can make a generalized short list of what economists know and don’t know when it comes to the macroeconomy. First, what we do know:
1. Market competition works. Market liberalization has led to the unequaled creation of wealth around the world in the past century. This growth may be uneven and may foster societal externalities, such as inequality, pollution, and environmental degradation, but all societal problems are more easily managed by expanding the level of available resources.
2. Sustainable growth is the primary objective of economic policy. Long-term labor productivity and capital accumulation are the sources of real growth.
3. Open trade is a net gain to national economy, and globalization leverages the benefits of market liberalization and competition around the world.
4. Macro and micro economics have unresolved contradictions.
Here are the things we don’t know, or can’t agree upon:
1. How to use economic policy to ensure sustainable economic growth with the correct balance between consumption, savings, and investment over time.
2. How to analyze distributional processes that defy the standard modeling techniques of economic orthodoxy (see Appendix B); how to manage business cycles and maldistributions such as winner-take-all.
3. How to think outside the box with regard to:
a. The design of policy to manage uncertainty.
b. Policies to constrain crony capitalism and casino capitalism.
In this guide I have taken what we do know as a starting point and made some intuitive conjectures about how to proceed with what we don’t know. The various ideas include:
1. Incorporating a more developed understanding of economic behavior under uncertainty and loss aversion as applied to policy analysis.
2. Greater incorporation of finance and capital markets into macroeconomic analysis.
3. Addressing the problem of income and wealth inequality as a distributional problem. This will require new modeling techniques to address the weaknesses of general equilibrium modeling (A discussion of promising new approaches goes far beyond this introductory guide, but the basic discussion is presented in Appendix B).
At the beginning of this book, in the Author’s Note, I stated that, “The economy is the fine art of managing change through exchange.” Change is what happens to us, and exchange is how we manage economic trade-offs in order to adapt to that change. The change and exchange to which we refer in economics is measured in terms of material well-being. In monetary terms it is reflected in incomes, profits, goods produced and consumed, prices, etc. There is a legitimate criticism that markets reinforce the configuration of power within a capitalist society. Success breeds success; the rich get richer while the poor subsist. But this criticism disregards the fact that when markets adhere to the principles of openness, transparency, and competition, they also break up concentrations of power. We may feel pessimistic and cynical about the inequalities of this world, the poverty and the injustice, the abuse of power and the fickleness of fortune, but I believe there is a more positive take-away
from this discussion.
In a footnote to Chapter One, I alluded to the concept of Time. In a world of inequality, time is the great equalizer. Neither the rich nor poor know how much time they have and nothing can buy them more in the end. It is time, not money or material goods, that is the truly the scarcest resource in our lives. By the economic law of scarcity value, this makes time the most valuable economic resource we must manage. Though the rich man may be able to buy more free time with his money, global technological progress is helping us all leverage our own time in the same way. Consider how much money and resources it took to influence politics—to advertise, to promote through the mainstream media, to print and mail voter pamphlets. Now it is conceivable that it might only take a little time with a cost-free social network website. Technology is a great equalizer that raises the value of time relative to money and helps balance the inequalities of wealth and power with information and communication.
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