Naked Economics

by Wheelan, Charles

  One of the fallacies of poverty is that developing countries are poor because they have rapid population growth. In fact, the causal relationship is best understood going the other direction: Poor people have many children because the cost of bearing and raising children is low. Birth control, no matter how dependable, works only to the extent that families prefer fewer children. As a result, one of the most potent weapons for fighting population growth is creating better economic opportunities for women, which starts by educating girls. Taiwan doubled the number of girls graduating from high school between 1966 and 1975. Meanwhile, the fertility rate dropped by half. In the developed world, where women have enjoyed an extraordinary range of new economic opportunities for more than a half century, fertility rates have fallen near or below replacement level, which is 2.1 births per woman.

  We began this chapter with a discussion of Bill Gates’s home, which is, I am fairly certain, bigger than yours. At the dawn of the third millennium, America is a profoundly unequal place. Is the nation growing more unequal? That answer, by almost any measure, is yes. According to analysis by the Congressional Budget Office, American households in the bottom fifth of the income distribution were earning only 2 percent more in 2004 (adjusted for inflation) than they were in 1979. That’s a quarter century with no real income growth at all. Americans in the middle of the income distribution did better over the same stretch; their average household income grew 15 percent in real terms. Those in the top quintile—the top 20 percent—saw household income growth of 63 percent (adjusted for inflation).9

  As America’s longest economic boom in history unfolded, the rich got richer while the poor ran in place, or even got poorer. Wages for male high school dropouts have fallen by roughly a quarter compared to what their dads earned if they were also high school dropouts. The recession that began in 2007 has narrowed the gap between America’s rich and poor slightly (by destroying wealth at the top, not by making the typical worker better off). Most economists would agree that the long-term trend is a growing gap between America’s rich and poor. The most stunning action has been at the top of the top. In 1979, the wealthiest 1 percent of Americans earned 9 percent of the nation’s total income; now they get 16 percent of America’s annual collective paycheck.

  Why? Human capital offers the most insight into this social phenomenon. The last several decades have been a real-life version of Revenge of the Nerds. Skilled workers in America have always earned higher wages than unskilled workers; that difference has started to grow at a remarkable rate. In short, human capital has become more important, and therefore better rewarded, than ever before. One simple measure of the importance of human capital is the gap between the wages paid to high school graduates and the wages paid to college graduates. College graduates earned an average of 40 percent more than high school graduates at the beginning of the 1980s; now they earn 80 percent more. Individuals with graduate degrees do even better than that. The twenty-first century is an especially good time to be a rocket scientist.

  Our economy is evolving in ways that favor skilled workers. For example, the shift toward computers in nearly every industry favors workers who either have computer skills or are smart enough to learn them on the job. Technology makes smart workers more productive while making low-skilled workers redundant. ATMs replaced bank tellers; self-serve pumps replaced gas station attendants; automated assembly lines replaced workers doing mindless, repetitive tasks. Indeed, the assembly line at General Motors encapsulates the major trend in the American economy. Computers and sophisticated robots now assemble the major components of a car—which creates high-paying jobs for people who write software and design robots while reducing the demand for workers with no specialized skills other than a willingness to do an honest day’s work.

  Meanwhile, international trade puts low-skilled workers in greater competition with other low-skilled workers around the globe. In the long run, international trade is a powerful force for good; in the short run, it has victims. Trade, like technology, makes high-skilled workers better off because it provides new markets for our high-tech exports. Boeing sells aircraft to India, Microsoft sells software to Europe, McKinsey & Company sells consulting services to Latin America. Again, this is more good news for people who know how to design a fuel-efficient jet engine or explain total quality management in Spanish. On the other hand, it puts our low-tech workers in competition with low-priced laborers in Vietnam. Nike can pay workers $1 a day to make shoes in a Vietnamese sweatshop. You can’t make Boeing airplanes that way. Globalization creates more opportunities for skilled workers (Naked Economics is published in eleven languages!) and more competition for unskilled workers.

  There is still disagreement about the degree to which different causes are responsible for this shifting gap in wages. Unions have grown less powerful, giving blue-collar workers less clout at the bargaining table. Meanwhile, high-wage workers are logging more hours on the job than their low-wage counterparts, which exacerbates the total earnings gap.10 More and more industries are linking pay to performance, which increases wage gaps between those who are more and less productive. In any case, the rise in income inequality is real. Should we care? Economists have traditionally argued that we should not, for two basic reasons. First, income inequality sends important signals in the economy. The growing wage gap between high school and college graduates, for example, will motivate many students to get college degrees. Similarly, the spectacular wealth earned by entrepreneurs provides an incentive to take the risks necessary for leaps in innovation, many of which have huge payoffs for society. Economics is about incentives, and the prospect of getting rich is a big incentive.

  Second, many economists argue that we should not care about the gap between rich and poor as long as everybody is living better. In other words, we should care about how much pie the poor are getting, not how much pie they are getting relative to Bill Gates. In his 1999 presidential address to the American Economics Association, Robert Fogel, a Nobel Prize–winning economic historian, pointed out that our poorest citizens have amenities unknown even to royalty a hundred years ago. (More than 90 percent of public housing residents have a color television, for example.) Envy may be one of the seven deadly sins, but it is not something to which economists have traditionally paid much attention. My utility should depend on how much I like my car, not on whether or not my neighbor is driving a Jaguar.

  Of course, common sense suggests otherwise. H. L. Mencken once noted that a wealthy man is a man who earns $100 a year more than his wife’s sister’s husband. Some economists have belatedly begun to believe that he was on to something.11 David Neumark and Andrew Postlewaite looked at a large sample of American sisters in an effort to understand why some women choose to work outside of the home and others do not. When the researchers controlled for all the usual explanations—unemployment in the local labor market, a woman’s education and work experience, etc.—they found powerful evidence to support H. L. Mencken’s wry observation: A woman in their sample was significantly more likely to seek paid employment if her sister’s husband earned more than her own.

  Cornell economist Robert Frank, author of Luxury Fever, has made a persuasive case that relative wealth—the size of my pie compared to my neighbor’s—is an important determinant of our utility. He offered survey respondents a choice between two worlds: (A) You earn $110,000 and everyone else earns $200,000; or (B) you earn $100,000 and everyone else earns $85,000. As he explains, “The income figures represent real purchasing power. Your income in World A would command a house 10 percent larger than the one you could afford in World B, 10 percent more restaurant dinners and so on. By choosing World B, you’d give up a small amount of absolute income in return for a large increase in relative income.” You would be richer in World A; you would be less wealthy in World B but richer than everyone else. Which scenario would make you happier? Mr. Frank found that a majority of Americans would choose B. In other words, relative income does matter. Envy may be part o
f the explanation. It is also true, Mr. Frank points out, that in complex social environments we seek ways to evaluate our performance. Relative wealth is one of them.

  There is a second, more pragmatic concern about rising income inequality. Might the gap between rich and poor—ethics aside—become large enough that it begins to inhibit economic growth? Is there a point at which income inequality stops motivating us to work harder and becomes counterproductive? This might happen for all kinds of reasons. The poor might become disenfranchised to the point that they reject important political and economic institutions, such as property rights or the rule of law. A lopsided distribution of income may cause the rich to squander resources on increasingly frivolous luxuries (e.g., doggy birthday cakes) when other kinds of investments, such as human capital for the poor, would yield a higher return. Or class warfare may lead to measures that punish the rich without making the poor any better off.12 Some studies have indeed found a negative relationship between income inequality and economic growth; others have found just the opposite. Over time, data will inform this relationship. But the larger philosophical debate will rage on: If the pie is growing, how much should we care about the size of the pieces?

  The subject of human capital begs some final questions. Will the poor always be with us, as Jesus once admonished? Does our free market system make poverty inevitable? Must there be losers if there are huge economic winners? No, no, and no. Economic development is not a zero-sum game; the world does not need poor countries in order to have rich countries, nor must some people be poor in order for others to be rich. Families who live in public housing on the South Side of Chicago are not poor because Bill Gates lives in a big house. They are poor despite the fact that Bill Gates lives in a big house. For a complex array of reasons, America’s poor have not shared in the productivity gains spawned by Microsoft Windows. Bill Gates did not take their pie away; he did not stand in the way of their success or benefit from their misfortunes. Rather, his vision and talent created an enormous amount of wealth that not everybody got to share. There is a crucial distinction between a world in which Bill Gates gets rich by stealing other people’s crops and a world in which he gets rich by growing his own enormous food supply that he shares with some people and not others. The latter is a better representation of how a modern economy works.

  In theory, a world in which every individual was educated, healthy, and productive would be a world in which every person lived comfortably. Perhaps we will never cure the world of the assorted physical and mental illnesses that prevent some individuals from reaching their full potential. But that is biology, not economics. Economics tells us that there is no theoretical limit to how well we can live or how widely our wealth can be spread.

  Can that really be true? If we all had Ph.D.s, who would pass out the towels at the Four Seasons? Probably no one. As a population becomes more productive, we begin to substitute technology for labor. We use voice mail instead of secretaries, washing machines instead of maids, ATMs instead of bank tellers, databases instead of file clerks, vending machines instead of shopkeepers, backhoes instead of ditch diggers. The motivation for this development harks back to a concept from Chapter 1: opportunity cost. Highly skilled individuals can do all kinds of productive things with their time. Thus, it is fabulously expensive to hire an engineer to bag groceries. (How much would you have to be paid to pass out towels at the Four Seasons?) There are far fewer domestic servants in the United States than in India, even though the United States is a richer country. India is awash with low-skilled workers who have few other employment options; America is not, making domestic labor relatively expensive (as anyone with a nanny can attest). Who can afford a butler who would otherwise earn $50 an hour writing computer code?

  When we cannot automate menial tasks, we may relegate them to students and young people as a means for them to acquire human capital. I caddied for more than a decade (most famously for George W. Bush, long before he ascended to the presidency); my wife waited tables. These jobs provide work experience, which is an important component of human capital. But suppose there was some unpleasant task that could not be automated away, nor could it be done safely by young people at the beginning of their careers. Imagine, for example, a highly educated community that produces all kinds of valuable goods and services but generates a disgusting sludge as a by-product. Further imagine that collecting the sludge is horrible, mind-numbing work. Yet if the sludge is not collected, then the whole economy will grind to a halt. If everyone has a Harvard degree, who hauls away the sludge?

  The sludge hauler does. And he or she, incidentally, would be one of the best-paid workers in town. If the economy depends on hauling this stuff away, and no machine can do the task, then the community would have to induce someone to do the work. The way to induce people to do anything is to pay them a lot. The wage for hauling sludge would get bid up to the point that some individual—a doctor, or an engineer, or a writer—would be willing to leave a more pleasant job to haul sludge. Thus, a world rich in human capital may still have unpleasant tasks—proctologist springs to mind—but no one has to be poor. Conversely, many people may accept less money to do particularly enjoyable work—teaching college students comes to mind (especially with the summer off).

  Human capital creates opportunities. It makes us richer and healthier; it makes us more complete human beings; it enables us to live better while working less. Most important from a public policy perspective, human capital separates the haves from the have-nots. Marvin Zonis, a professor at the University of Chicago Graduate School of Business and a consultant to businesses and governments around the world, made this point wonderfully in a speech to the Chicago business community. “Complexity will be the hallmark of our age,” he noted. “The demand everywhere will be for ever higher levels of human capital. The countries that get that right, the companies that understand how to mobilize and apply that human capital, and the schools that produce it…will be the big winners of our age. For the rest, more backwardness and more misery for their own citizens and more problems for the rest of us.”13

  CHAPTER 7

  Financial Markets:

  What economics can tell us about getting rich quick (and losing weight, too!)

  W hen I was an undergraduate many years ago, a new diet swept through one of the sororities on campus. This was no ordinary diet; it was the grapefruit and ice cream diet. The premise, as the name would suggest, was that one could lose weight by eating large amounts of grapefruit and ice cream. The diet did not work, of course, but the incident has always stuck with me. I was fascinated that a very smart group of women had tossed aside common sense to embrace a diet that could not possibly work. No medical or dietary information suggested that eating grapefruit and ice cream would cause weight loss. Still, it was an appealing thought. Who wouldn’t want to lose weight by eating ice cream?

  I was reminded of the grapefruit and ice cream diet recently when one of my neighbors began to share his investment strategy. He had taken a big hit over the past year because his portfolio was laden with Internet and tech stocks, he explained, but he was plunging back into the market with a new and improved strategy. He was studying the charts of past market movements for shapes that would signal where the market was going next. I cannot remember the specific shapes he was looking for. I was distracted at the time, both because I was watering flowers and because my mind was screaming, “Grapefruit and ice cream!” My smart neighbor, who is both a doctor and a university faculty member, was venturing far from the halls of science with his investment strategy, and that is the broader lesson. When it comes to personal finance (and losing weight), intelligent people will toss good sense aside faster than you can say “miracle diet.” The rules for investing successfully are strikingly simple, but they require discipline and short-term sacrifice. The payoff is a slow, steady accumulation of wealth (with plenty of setbacks along the way) rather than a quick windfall. So, faced with the prospect of giving up consumption in the pre
sent for plodding success in the future, we eagerly embrace faster, easier methods—and are then shocked when they don’t work.

  This chapter is not a primer on personal finance. There are some excellent books on investment strategies. Burton Malkiel, who was kind enough to write the foreword for this book, has written one of the best: A Random Walk Down Wall Street. Rather, this chapter is about what a basic understanding of markets—the ideas covered in the first two chapters—can tell us about personal investing. Any investment strategy must obey the basic laws of economics, just as any diet is constrained by the realities of chemistry, biology, and physics. To borrow the title of Wally Lamb’s best-selling novel: I know this much is true.

  At first glance, the financial markets are remarkably complex. Stocks and bonds are complicated enough, but then there are options, futures, options on futures, interest rate swaps, government “strips,” and the now infamous credit default swaps. At the Chicago Mercantile Exchange, it is now possible to buy or sell a futures contract based on the average temperature in Los Angeles. At the Chicago Board of Trade, one can buy and sell the right to emit SO2. Yes, it’s actually possible to make (or lose) money by trading smog. The details of these contracts can be mind-numbing, yet at bottom, most of what is going on is fairly straightforward. Financial instruments, like every other good or service in a market economy, must create some value. Both the buyer and seller must perceive themselves as better off by entering into the deal. All the while, entrepreneurs seek to introduce financial products that are cheaper, faster, easier, or otherwise better than what already exists. Mutual funds were a financial innovation; so were the index funds that Burt Malkiel helped to make popular. At the height of the financial crisis in 2008, it became clear that even Wall Street executives did not fully understand some of the products that their firms were buying and selling. Still, all financial instruments—no matter how complex the bells and whistles—are based on four simple needs: