Foundations of Real-World Economics: What Every Economics Student Needs to Know [2 ed.] 113829652X, 9781138296527

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FOUNDATIONS OF REAL-WORLD ECONOMICS

The 2008 financial crisis, the rise of Trumpism and the other populist movements which have followed in their wake have grown out of the frustrations of those hurt by the economic policies advocated by conventional economists for generations. Despite this, textbooks continue to praise conventional policies such as deregulation and hyperglobalization. This textbook demonstrates how misleading it can be to apply oversimplified models of perfect competition to the real world. The math works well on college blackboards but not so well on the Main Streets of America. This volume explores the realities of oligopolies, the real impact of the minimum wage, the double-edged sword of free trade, and other ways in which powerful institutions cause distortions in the mainstream models. Bringing together the work of key scholars, such as Kahneman, Minsky, and Schumpeter, this book demonstrates how we should take into account the inefficiencies that arise due to asymmetric information, mental biases, unequal distribution of wealth and power, and the manipulation of demand. This textbook offers students a valuable introductory text with insights into the workings of real markets not just imaginary ones formulated by blackboard economists. A must-have for students studying the principles of economics as well as micro- and macroeconomics, this textbook redresses the existing imbalance in economic teaching. Instead of clinging to an ideology that only enriched the 1%, Komlos sketches the outline of a capitalism with a human face, an economy in which people live contented lives with dignity instead of focusing on GNP. John Komlos is Professor Emeritus of Economics and of Economic History at the University of Munich, Germany. He has also taught at universities such as Harvard, Duke, UNC-Chapel Hill, University of Vienna, and Vienna School of Economics and Business. In 2003 Komlos founded the field of Economics & Human Biology with the journal of the same name, and through his research he has come to realize the limitations of conventional economic theory and has been an ardent advocate of humanistic economics.

FOUNDATIONS OF REAL-WORLD ECONOMICS What Every Economics Student Needs to Know SECOND EDITION

John Komlos

Second edition published 2019 by Routledge 52 Vanderbilt Avenue, New York, NY 10017 and by Routledge 2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN Routledge is an imprint of the Taylor & Francis Group, an informa business  2019 Taylor & Francis The right of John Komlos to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. First edition published by M.E. Sharpe 2014 First edition published by Routledge 2015 Library of Congress Cataloging-in-Publication Data A catalog record has been requested for this book ISBN: 978-1-138-29652-7 (hbk) ISBN: 978-1-138-29654-1 (pbk) ISBN: 978-1-315-09997-2 (ebk) Typeset in Interstate by Swales & Willis Ltd, Exeter, Devon, UK

CONTENTS

List of Figures List of Tables List of Illustrations

ix xii xiii

  1 Welcome to Real-World Economics My Credo Humanistic Economics A Primer on Blackboard Economics Toward a Paradigm Shift in Economics Real-World Economics Is Preferable Simple Is for Simple Minded “It’s Only a Model!”

1 3 5 6 8 10 11 13

  2 Markets Are Neither Omniscient Nor Omnipotent Markets Are Not Created by Divine Power The Downside of Free Markets Government Is an Essential Component of the Economy Markets Have Limitations The “Achilles Heel” of Markets Morality Should Take Precedence over Markets Economics Is a Social Science and Not a Natural Science Ideology Is Unavoidable

19 19 19 26 28 31 31 32 33

  3 The Nature of Demand 39 What Is Scarce? 39 Consumer Sovereignty and Endogenous Tastes 40 Wants and Basic Needs 45 The Metaphor of the Invisible Hand 49 The Magic of Competition 50 Consumerism 51

vi  Contents   4 Homo Oeconomicus Is Extinct: The Foundations of Behavioral Economics 57 Utility Maximization 57 Optimization Is Impossible for Finite Minds 58 Our Brain Is Imperfect 59 Neuroeconomics 60 Bounded Rationality 61 Satisficing Instead of Optimizing 62 Biases and Wonders of Intuition 64 Heuristics 65 Framing, Accessibility, and Anchoring 66 Prospect Theory 68 Behavioral Economics 74 Cognitive Endowment 76 Genetic Endowment 77   5 Taste Makers and Consumption 81 The Influence of Corporate Power 81 Interdependent Utility Functions 83 Society 85 Culture 86 Fairness 88 Efficiency vs. Equity 88 Self-Interest and Altruism 90 Positive and Normative Economics 91 Expected vs. Realized Utility 92 Imperfect Information 93 Signaling 94   6 Firms and Imperfect Competition 99 Firms 99 The Illusion of Perfect Competition 101 Imperfect Competition: Oligopolies and Monopolies 101 Prices 104 Equilibrium and Disequilibrium 106 Adverse Selection 107   7 Returns to the Factors of Production 109 Marginal Theory 109 Wages 110 The Returns on Capital 119 Profits 120 Institutions as Capital 121 Intangible Forms of Capital 121 Natural Resources 122

Contents  vii Income Distribution The Second Gilded Age Growth in Welfare Ethics and the Skewed Distribution of Income

122 125 132 133

  8 The Case for Oversight, Regulation, and Control of Markets 142 Principal-Agent Problem 142 Moral Hazard 144 Transaction Costs 144 Opportunistic Behavior 145 Regulation in the Public Interest 147 Regulatory Capture 148 Moral Constraints 149 Market Failures 150 Exploitation 151 Time and Space 152 Path Dependence 152 Limits and Standards 155   9 Microeconomic Applications on and off the Blackboard Minimum Wage Is Good Economics Price Controls Can Be Good Unions and Countervailing Power The American Medical Association Is a Cartel Discrimination Is Pernicious Redistribution Would Help

159 159 161 162 166 167 168

10 What Is Macroeconomics? Keynes the Savior Keynesian Fiscal Policy Monetary Policy The Liquidity Trap Neoclassical Synthesis The Monetarist Counterrevolution A Macroeconomic Policy Void GNP Is an Estimate of Production and Not of Welfare Production Possibilities Frontier

172 172 175 176 177 178 180 181 183 184

11 Macroeconomics Part II Unemployment and Underemployment The Natural Rate of Unemployment Economic Growth Economic Growth Does Not Increase Life Satisfaction Technological Change Is a Two-Edged Sword

189 189 193 194 194 196

viii  Contents Missing Markets 198 Environment 200 12 Macroeconomics Part III The Government Is Part of the Solution The Challenges of Keynesian Fiscal Policy Crowding Out The Threat of a Mushrooming National Debt Taxes Are Good for Us Savings or the Lack Thereof Inflation and Deflation Nominal vs. Real Wages The Obama Stimulus

205 205 205 206 207 208 213 214 215 215

13 International Trade: Open Economy Macroeconomics The Theory of Comparative Advantage The Effects of Tariffs on Welfare Are Complicated by Underemployment Free Trade Is Not an Engine of Growth The Protection of Infant Industries Unbalanced Trade Creates Underemployment Import Certificates Are the Only Safe Way to Eliminate the Trade Deficit New Trade Theory

219 219 220 223 224 224 226 227

14 The Financial Crisis of 2008 231 Preliminaries 232 Financial Innovations 234 Double Trouble: Greenspan’s Bubbles 236 Early Warnings Fell on Deaf Ears 238 The Minsky Moment: The Meltdown of 2008 241 Thirty-One Factors That Contributed to the Crisis 243 The Bailout: A Crisis Obama Wasted 253 Nationalization of the Banks as Pre-privatization 256 15 Conclusion: The Foundations of Real-World Economics Imaginary vs. Real Markets The Inconvenient Truth about the Current State of the U.S. Economy The U.S. Economy Is Facing 14 Headwinds, None of Which Is Fixable in the Foreseeable Future

265 265 266 269

Index 273

FIGURES

2.1 2.2 2.3

Poverty Rate among Children below Age 18 Cumulative Distribution of After Tax Income, U.S., 2014 Ratio of the Top 90% of the Disposable Income Distribution to the Bottom 10%, 2014 2.4 Health Care Expenditures, 2016 2.5 Life Expectancy at Birth 3.1 Conventional View of Consumer Sovereignty 3.2 In Reality Tastes Are Determined within the Economic System 4.1 Medicare Part D Options Confuse 4.2 What Is the Average Length of These Lines? 4.3a and b Context Matters a Lot in Case of Ambiguity 4.4 Concave Utility Function Implies Risk Aversion 4.5 Convex Utility Function Implies Risk Seeking 4.6 Changes in Utility and Wealth of Two Investors According to the Conventional Model 4.7 The Value Function Defined on Gains and Losses in Prospect Theory of Behavioral Economics 4.8 Comparison of Cathy’s and Susan’s Utility According to Prospect Theory 4.9 Conventional Comparison of Two Options 4.10 Experimental Results Conform to Prospect Theory: The Case of Two Options 4.11 Conventional Demand and Supply Analysis with Negative Feedback 4.12 Positive Feedback Loop Causes Asset Price Bubbles 6.1 Profit of a Monopolist (Without Fixed Costs) 7.1 Index of the Productivity-Wage Gap in the U.S. 7.2 Median Income by Gender in 2016 Dollars, 1955–2016 7.3 Share of Labor Income in GDP (%) 7.4 Distribution of Household Income by Ethnicity, U.S., 2009 7.5a and b Distribution of Household Income by Quintiles, U.S., 2016 7.6 Distribution of Earnings in 2016 Compared to Ford Workers of 1914

21 24 25 29 30 40 41 63 67 67 69 69 70 71 72 73 74 75 76 104 111 114 115 123 126 127

x  Figures 7.7 7.8 7.9 7.10 7.11 7.12 8.1 8.2 8.3 8.4 8.5 9.1 9.2 9.3 9.4 9.5 9.6 9.7 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 11.1 11.2 11.3 11.4 12.1 12.2 13.1 13.2 13.3 13.4

Trends in the Share of Total Income by Households, 1967–2016 127 Changes in the Share of Total Income in Three Epochs, by Quintiles 128 Growth of Income by Quintiles and Percentiles, 1979–2011 130 Ratio of Group’s Income to That of the Poor 131 Growth of Welfare by Quintiles, 1979–2011 133 Inequality Is Inversely Related to Happiness 137 The Optimum Level of Freedom in an Economy 147 Corporations Invest Heavily in Order to Tilt the Playing Field in Their Direction 149 Investment Decision with Perfect Foresight Two Periods Ahead Is Easy 153 Investment Decision with Perfect Foresight One Period Ahead Is Also Easy 154 With Sequential Decision, Optimum Technology “A” Is No Longer Feasible 154 Profit of a Quasi-Monopolist Without Fixed Costs 160 The Effect of a Price Ceiling on a Monopolist Without Fixed Costs 162 Profit of an Oligopolist Employing Seven Workers 163 Median Household Income by Education, 2016 Dollars 164 Physicians per 1,000 Population, 2016 166 The Supply and Demand for Doctors with Supply Constraint Brought About by the American Medical Association 167 Redistribution Increases Total Utility and Social Welfare 169 U.S. Consumer Confidence Index, 1996=100 173 Fluctuating Demand During the Great Depression 174 Automobile Production in the U.S., 1900–1970 174 Velocity of Circulation of M1 177 The Interest Rate Charged by the Federal Reserve 178 Quantitative Easing and GNP Per Capita 179 Capacity Utilization All Industries 185 Production Possibilities Frontier with Institutional Constraint 186 The Official Unemployment Rate and the Official Underemployment Rate 190 Official Underemployment Rate (U6) by Ethnicity 191 The “Natural” Rate of Unemployment Compared to the Official Unemployment Rate 193 Global Warming 199 U.S. National Debt as a Percentage of Gross Domestic Product 206 U.S. Personal Saving as a Percentage of Disposable Income 213 The Effect of Tariffs on Domestic Production and Consumption 221 Men’s Hourly Wages by Education 223 U.S. Trade Balance in Goods and Services 225 U.S. Cumulative Balance of Payments Deficit Is $15 Trillion in 2017 Prices 226

Figures  xi 14.1 14.2 14.3 14.4 14.5 14.6 15.1 15.2 15.3

Price to Earnings Ratio of S&P 500 Stocks 233 Ratio of U.S. House Prices to Rents and to Nominal Income, Index 1995=100 237 National Home Price Index, January 2000=100 239 Fed’s Interest Rates and GDP Growth 245 Real Median Household Income in the U.S. 255 Median Household Income by Ethnicity, 2016 Dollars 256 Average Annual Growth Rates of Real GDP Per Capita 266 Real GDP and Potential GDP, 2009 Prices 267 Women’s Hourly Wages by Education 268

TABLES

1.1 2.1 2.2 2.3 7.1 7.2 7.3 7.4 7.5 7.6 7.7 9.1 10.1 11.1 11.2 12.1 12.2 13.1

Electoral Votes Needed to Tip the 2016 Presidential Election in Favor of Hillary Clinton The U.S. Homicide Rate Per Capita as a Multiple of Those in These Countries Drug-Related Deaths Per Million Persons Aged 15–64 Share of Income and Wealth Distribution in the U.S., 2013 Growth in Productivity and Real Wages, U.S., 1947–2011 The Tax Returns of the Superrich Racial Gaps in Median Household Incomes in 2014, Dollars Share of U.S. Aggregate Income by Quintiles, 1967–2016 Real Disposable Income, 1979–2011, Thousands of 2011 Dollars International Comparison of CEO Compensation, 2015 International Comparison of Inequality, 2014 Change in Household Income Since the Year 2000 in 2016 Dollars Increase in Disposable Income of U.S. Households by Quintiles, 1979–2011 The Official and Real Unemployment Rate in the U.S., January 2018 Ranking of Happiness, 2012–2014 Happiness Rank and Average Tax Rates There Is No Relationship Between Economic Growth and the Top Tax Rates U.S. Average Annual Current Account Balance (Billions of 2017 Dollars)

13 20 21 26 111 124 125 129 130 135 136 164 184 190 195 208 210 224

ILLUSTRATIONS

2.1 2.2 3.1 3.2 3.3 3.4 5.1 7.1

The Market Treats Some Children Cruelly The Market Did Not Give Rosa Parks the Option to Ride the Bus Virginia Slims’ Successful Marketing Consumerism Overwhelms Drink to Contentment The Marlboro Man What Is One Without a Mansion and a Yacht? United, Labor Would Have Countervailing Power and Obtain a Bigger Share of the Pie 7.2 Life Would Just Not Be the Same If I Had to Travel on a Commercial Airline 8.1 Doctors for Camel Exploit the Gullibility of Consumers 11.1 You Did Not Bleed on Omaha Beach on June 6, 1944 14.1 Brooksley Born 14.2 No Less Than Eight Million Families Lost Their Homes as a Consequence of the Financial Crisis

23 32 42 43 47 48 95 113 124 151 199 238 254

1 Welcome to Real-World Economics

We must grant to markets what belongs to markets—and retain for people what rightfully belongs to them. The author

The financial crisis of 2008 illustrated vividly how markets often do go haywire, yet textbooks remain unchanged, failing to convey the fundamental flaws and systematic weaknesses of the free-market system. The recent election of Donald Trump was fueled by the frustrations that have been accumulating due to an economic system that skews its benefits to a select few and leaves too many people behind scrambling to eke out a bare existence. Yet, academics and politicians continue to sing the praises of abstract markets as if they had descended straight from heaven while maintaining a conspiracy of silence about the fact that without government help countless giant corporations would have landed in the dustbin of history.1 When the chips were down, only the Fed could print the trillions of dollars to prop up markets and save them from extinction. The doctrinaire approach to the teaching of economics is well illustrated by the oft repeated but rather arrogant assertion, “We know that markets work.” Instead, teachers of economics should admit at the outset that while markets do work well in some circumstances they only do so within an appropriate institutional framework, and they not only work inefficiently in others but often tip the stream of benefits toward a few insiders. Hence, our job is also to explore and delineate clearly the circumstances that prevent real markets from working as well as their theoretical counterparts and suggest remedies for their failings. The ideological commitment to “market fundamentalism,” which led to the excessive reliance on markets in the making of public policy, has brought us to our current, precarious situation. I hope the present volume can help rectify this misconception and improve the teaching of economics by presenting a real-world perspective as opposed to the fantasy world of mainstream textbooks. Alan Greenspan’s post-meltdown confession that he made a ghastly error in believing in— and aggressively preaching—market deregulation demonstrates vividly the miscalculations of the fundamentalist approach to economics. When asked by Congressman Henry Waxman, “You have been a staunch advocate of letting markets regulate themselves . . . Were you wrong?” Greenspan responded:

2  Welcome to Real-World Economics I made a mistake in presuming that the self-interest of organizations, specifically banks . . . were such that they were best capable of protecting their own shareholders and equity in the firms . . . The problem here is [that] something which looked to be a very solid edifice and indeed a critical pillar to market competition and free markets did break down and . . . that . . . shocked me. I still do not fully understand why it happened. History is, of course, replete with people wearing similar ideological blinders. Greenspan makes a number of serious mistakes in that short statement: banks are incapable of assessing the impact of their policies on the rest of the financial system. That is the role of the oversight authority. This is known as systemic effects. They just see their own balance sheets and not those of their rivals. The Fed is supposed to have the overview. Other problems with his statement were noted by the Nobel Prize winning founder of behavioural economics, Daniel Kahneman. Referring to the above statement as “Greenspan’s confession,” he was surprised by: [Greenspan’s] assumption that agents are fully rational, and there is a lot of evidence clearly that they’re not. The other is the idea that firms are actors; that firms are rational agents. But firms are really not actors . . . there are executives making decisions; the interest of those executives and the interest of that abstract idea that we call the firm are clearly not aligned and if we want to understand why firms are suicidal it is in part because the agents are . . . quite frequently not committing suicide. So, there is a mismatch between firms and the actors who act in their behalf.2 Waxman continued his query of Greenspan by asking, “You had an ideology . . . and this is your statement: ‘I do have an ideology, my judgment is that free competitive markets are by far the unrivaled way to organize economies.’” Greenspan answered by offering the congressman a philosophical lesson: “Remember . . . what an ideology is . . . [it] is a conceptual framework with the way people deal with reality. Everyone has one . . . Yes, I found a flaw . . . in the model that I perceived . . . how the world works.” Waxman: “In other words, you found that your view of the world, your ideology was not right.” Greenspan: “Precisely. That’s precisely the reason I was shocked.”3 Greenspan was right in this case: ideology is unavoidable in economics because one approaches it with some values and an organizing system of thought, that is, some preconceived notions of how the world works.4 This is unavoidable. Greenspan should not have been so shocked. There were plenty of warnings: Brooksley Born, Edward Gramlich, Paul Krugman, Raghuram Rajan, Nouriel Roubini, Peter Schiff, Robert Shiller, Joseph Stiglitz, Nassim Taleb, and John Taylor, to name but a few eminent proponents of opposing views. They were no strangers to Greenspan or to the establishment. They were not outsiders. They are mostly scholars who have held professorships at major universities or have distinguished themselves in other ways. All he would have had to do was to listen with care to their well-reasoned warnings with an open mind. Instead, Greenspan dismissed their ideas out of hand and cold-bloodedly thwarted Brooksley Born’s valiant efforts to regulate derivatives a decade before the meltdown.5

Welcome to Real-World Economics  3 One did not need a PhD to recognize that housing prices were off the charts. Yet, Greenspan and Benjamin Bernanke, his successor in 2006, ignored all the evidence because they were blinded by their ideology of the infallibility of markets. They were prisoners of their own ideology. If one does not subject that ideology to empirical evidence, the ideology becomes dogma. The notion that ideology plays a major role in the social sciences has a long history. Observers of human societies cannot be free of their preconceived notions “because the understanding of a ‘social’ experience itself is always fashioned by ideas that are in the researchers themselves.”6 One of the many limitations of mainstream economists is their reluctance to address the problem of ideology adequately and to acknowledge the need to understand its role in economic policy. Textbooks simply ignore the issue. Yet, as Greenspan suggested, we cannot help but begin to organize our thoughts without making some fundamental assumptions, and these assumptions are a function of our own mindset, worldview, and intellectual and emotional commitments and therefore influence greatly the rest of the ideas developed in the discipline. Hence, economics cannot be purged of ideology; our political, moral, and philosophical likes and dislikes—conscious and unconscious—are reflected in our assumptions and thus in how we structure our economic thinking and our understanding of the world around us. Much of that ideology is colored by our political philosophy. In other words, contrary to received wisdom, economics—despite the extensive use of mathematics—will not be a rigorous discipline until it is based essentially on verifiable empirical evidence. Our long-range goal should be to provide such an empirical foundation to the discipline. Our more immediate goal here is to present evidence to support the notion that the mainstream view is misleading. Our aim is to introduce the student to alternative perspectives, thereby providing a complement to standard presentations of the subject and widening the student’s understanding.

My Credo Perhaps I should first clarify my own credo—the assumptions that underlie my own worldview of economic matters. I consider my views to be progressive, democratic, and humanitarian.7 These values imply that I believe that we could restructure the economy so as to improve our lives by focusing on increasing our life satisfaction instead of on income growth. I am also convinced that we should begin our economic analysis with empirical evidence rather than on ivory-tower theorizing. Experiential evidence should be at the core of the discipline rather than assumptions. In the words of Deirdre McCloskey, a U.S. economics professor, “economics is supposed to be an inquiry into the world, not pure thinking.”8 In other words, I believe that economics should reduce its reliance on deductive logic and mathematics and become more of an inductive discipline.9 Human beings are not inanimate objects whose trajectory can be described accurately by a mathematical function of a handful of variables. Unlike planets, they can and do change direction. Economics should not attempt to be an axiomatic discipline like geometry. Sir Isaac Newton said as much: “I can calculate the movement of the stars, but not the madness of men.”10 To understand the world around us we need an economic theory based on empirical evidence, one that can hold its own when transferred from the blackboard11 to, say, the slums,

4  Welcome to Real-World Economics areas with a concentration of poverty in our big cities. The pieces of the economic puzzle do not fit together as smoothly in Bronx’s 10454 zip code area with a median household income of $20,210 as they do in Loudoun County, Virginia’s 20129 zip code district, with a median household income of $250,000—four times the national average.12 Moreover, we need a theory of economics that is not isolated from other social sciences but integrates insights derived from sociology, psychology, political science, and philosophy. Economists who focus on mathematics at the expense of these disciplines tend to neglect those issues that are not easily tractable mathematically and end up with a mechanistic view of the world. In addition, my economic principles are humanistic in that they focus on values that enhance the human experience and lead to mass flourishing. Pain also plays a major role in my thinking. I advocate its minimization. In contrast, the mainstream does not give pain much thought. But the current economic system treats some groups with an indifference that borders on cruelty. The groups include those children who are attending dysfunctional schools in dysfunctional neighborhoods, people who are unable to catch their bearings in the new economy created by the IT revolution and globalization, the working poor, or those who are trapped in a culture of poverty. They ought not be treated like machines without feelings. The quest for the good life is as old as philosophy itself. Aristotle was among the first to think about it systematically around 350 bc by arguing that the good life was about understanding the world around us.13 Much of this book is about just that: understanding the nature of today’s economy as it exists in reality rather than on academic blackboards. Change must start with understanding. My focus is on real human beings and how they actually live and feel, rather than inanimate objects such as money or abstract concepts such as output or gross national product, which economists often substitute for the human dimension. I do not believe that the level of money income translates automatically into life satisfaction. This is particularly the case for statistical averages, because these hide what is going on in the lower tail of the income distribution. This distribution is increasingly important insofar as it has become much more skewed and consequently its potent political force has been manipulated by the rise of Trumpism. Many economists are heard saying that “the economy is in good shape.”14 OK, but what about the people in it? Are most people doing well or are there segments of the population which are excluded from the good life? Hence, it seems to me that average growth of consumption, money income, or gross domestic product (GDP) should not be the exclusive focus of economics. As constituted, the current U.S. economic system has so many challenges and fault lines that it is incapable of providing a satisfactory life to about 44% of the population.15 That implies that 56% were doing just fine, but is that good enough for a $20 trillion economy that is supposedly the richest in the world? Furthermore, I believe that our starting point should not be Adam Smith’s Wealth of Nations, but his Theory of Moral Sentiments (1759), in which he asserted quite forcefully that we possess an innate empathy toward our fellow human beings.16 Morality and ethical principles of fairness are part of our nature. We ought not expunge these notions from the economics canon. Hence, I begin with the notion that economics ought to aspire to creating a just society and one in which compassion is as important as efficiency, if not more so. Admittedly, the meaning of justice is arguable, but that does not give us the license to disregard it completely. I think that an important aspect of it should be that the economy

Welcome to Real-World Economics  5 should minimize suffering, while enhancing human dignity and self-worth. I seek a commonsense Aristotelian “golden mean” which is situated between two extremes of advocating excessive changes at the one end and complacency at the other.

Humanistic Economics Humanistic economics need not be an oxymoron. It implies the vision that a kinder and more just economic system is possible, one that is embedded in a truly democratic society that not only empowers people but enables them to live their daily lives with less uncertainty, less manipulation, less taking advantage of people’s weaknesses, and less fear that their lives could collapse like a house of cards. This capitalism with a human face envisions an economy with zero unemployment, zero inflation, zero trade deficits, and zero government deficit over the business cycle. Humanistic approach to economics highlights that a meaningful life goes well beyond consumption and production. Since human beings are not simply “economic agents”—the values promulgated by the mainstream—the emphasis on money often conflicts with human values. Instead of advocating growth at any price, “Capitalism with a Human Face” would enable more people to live fulfilled, less harried, and ultimately more satisfied lives. John Maynard Keynes said as much: I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that in itself it is in many ways extremely objectionable. Our problem is to work out a social organization which shall be as efficient as possible without offending our notions of a satisfactory way of life.17 So, in contrast to the mainstream, in my view, the purpose of any economic system ought not be “growth” for its own sake, but the efficient allocation of resources. Foremost, it should be the provision of a decent life in which output is distributed equitably, people do not need to struggle to meet their basic needs, can avoid the rat race of fierce competition just to be able to stand still, and can realize their human potential. This means having sufficient leisure time to participate in the community’s social, cultural, and political life. People mistakenly equate economic growth with rising living standards. They harmonize with the politicians’ and economists’ pro-growth chorus. However, surveys contradict this perspective. In spite of all the growth in our lifetime, satisfaction eludes us in a big way. The growth-at-any-price perspective does not consider the decisive problem of distribution: economic growth will not help the destitute, the uneducated underclass, or the majority of those who are underemployed. In spite of all the growth since the Industrial Revolution a quarter millennium ago, there is much discontent with the economy as well as with the political system. Consider that in July 2017 in the country with aspirations to be the greatest in the world, 40% of the population evaluated their life as “struggling” and another 3% consider themselves “suffering.”18 That adds up to no less than 140 million people with dependents adding an extra 40 million. It seems like we ought to be able to generate more satisfaction with $20 trillion. The economy seems to be quite inefficient in producing wellbeing. The problem is that most of the discontented have yet to understand how the “free marketeers”—radicals who advocate free markets at any price—have led us astray.

6  Welcome to Real-World Economics De jure equal opportunity is insufficient for a just economy without de facto equal opportunity. Wealth is a privilege because it provides opportunities. Babies born into poor families have less chance of living a fulfilled life than those born into wealthy ones. Their future development will be on divergent paths determined by their initial endowments. Such random allocation at the start of life cannot possibly be the basis of a good society. Our goal ought to be to create an environment in which children have more equal opportunities, and those who are born at a disadvantage can be compensated by society for their initial bad luck.19 My aim in writing this book is to provide a critical framework that helps students understand the real economy—the actually existing one—and how the mistakes of conventional theorizing have landed us in our current predicament with rampant divisiveness and dissatisfaction. The book should also serve as a guidepost of the kind of economy to which we should aspire, and serve as a counterweight to conventional textbooks which claim to be above morality but conveniently disregard the untenable level of inequality the economy helped to create. As we have seen hundreds of times since the Industrial Revolution, and most vividly in 2008, free markets, being a human invention, often become dysfunctional; they do not deserve our blind faith. Furthermore, there are better ways to measure progress than in terms of money. One need not be a naive utopian to be appalled by a society in which one bumps—sometimes literally—into scenes of gross inequity around the corner. And there must be something wrong with an economics that fosters a system which leaves so many people stranded that they strike back at the establishment by voting for a leader such as Donald Trump. In this spirit, this book is dedicated to a new kind of economics that promotes Capitalism with a Human Face.

A Primer on Blackboard Economics “What do George Akerlof, Kenneth Arrow, Daniel Kahneman, Paul Krugman, Thomas Schelling, Herbert Simon, Robert Shiller, Joseph Stiglitz, Richard Thaler, and Oliver Williamson have in common?” would make a great Econ 101 question except for the fact that the contributions of these Nobel Prize winning economists to the Dismal Science are usually excluded from mainstream Econ 101 textbooks or relegated to obscure footnotes. Instead of including their critical ideas, introductory textbooks hype a free-market utopia which does not extend much beyond the edges of the blackboard. Hence, most textbooks do not help to understand the essentials of the real existing market economies in the hyper-globalized world of the twenty-first century. Rather, they present a caricature of the economy at a level of abstraction that creates a fantasy world and distorts the student’s vision: how inefficient! They perpetuate a stereotype that markets are efficient, thereby somehow automatically leading to a blissful life, and they continue to sing the praises of the immense achievements of the free-market system, keeping any demurrals muted. Super rationality reigns in this utopian kingdom inhabited by consumers with sufficient brain power to know every detail of the economy and are therefore not satisfied with anything less than doing the very best they can. They possess perfect understanding of all the nuances in small print, perfect foresight from the beginning to the end of their lives,

Welcome to Real-World Economics  7 and are not inhibited by the challenges of information overload insofar as information is free, available instantaneously, and a cinch to understand. They are neither manipulated nor tempted, so they have perfect control over their desires. They are not subject to bouts of irrational exuberance. Actually, this is a misguided view of human nature. Emotion and the unconscious mind play a big role in our decisions. In Freud’s view, the unconscious is not only the ultimate source of many of our desires, but they frequently come into conflict with our rational thoughts.20 Overlooking this leads economic policy makers astray. After all, if people are rational, there is no need to worry about banks giving predatory risky mortgages. Everyone knows what they’re doing. Moreover, in the mainstream’s fantasy world there are no brands, and goods have no quality dimension, so product choice is a no-brainer: two boxes of generic cereal, or three? There is no small print in contracts, no traps, no false promises, so buyers need not be on their guard. There are no regrets in this idyllic economy, no need for human judgment or intuition, no emotion, no real uncertainty hence no mistakes, and no need to worry about lawyers’ fees or other enforcement or transaction costs. Indeed, there is no society at all, no children, no gender, no glass ceilings, no class hence no underclass, no power hence no power imbalances, and neither space nor race, and hardly any time dimension. In this fictional world consumers are not influenced by advertisements or by other people’s consumption. Producers also inhabit this imaginary economy; they also know everything there is to know about consumers’ wants as well as their own firms, so they can maximize their profits with perfect ease. Actually, there are no firms at all in this economy, in the sense of a modern corporation, just simple entities like a Ma-And-Pa operation. There are no shareholders or boards of directors, no CEO who might maximize her own income rather than that of the far-away shareholders. This pseudo-firm does not need to advertise to persuade consumers to buy its products, much less collude with others, deceive, or game the system.21 Lobbyists are an extinct species, so there is no political process that can tilt the playing field in favor of the wealthy and influential.22 Problems are posed in terms of a single decision without antecedents and without uncertainty and without further implications in subsequent periods. In fact, time hardly plays a role in this static world: the past is passé and the future is obvious. So, there is only the right now, and no sequential decisions need to be pondered. Laws are in place so we do not need to discuss how they came to be or what advantages they provide to the powerful and the extent to which they disregard the dispossessed. If laws go unmentioned it is because they go unbroken, that is, people do not take advantage of each other’s lack of information or inaptitude and hence there are no enforcement costs. So, oversight would be a waste of effort and of brainpower. Everything runs smoothly—there are no chances to finagle, no conflicts, let alone wars. Basic needs have given way to benign wants. Free markets are efficient, hence above morality, so questioning their laissez-faire premise would be a waste of ethical scruples. (However, this is also a value judgment implying that efficiency is valuable rather than, say, sufficiency, or sustainability, or fairness, or minimizing risk, poverty, or pain.) Hence, it is alleged that laissez-faire does not need a moral basis, and ethics and aesthetics are superfluous. However, this overlooks the inconvenient fact that this in itself is also a value judgment. Well-being is measured by income in monetary terms, but there are no rich or poor so there is neither power nor hunger, therefore

8  Welcome to Real-World Economics the system is democratic: one dollar, one vote. The fact that some hold more dollars than others is their birthright, so there is no need to waste time discussing that de facto, they do have more votes. These are the basic elements of what is called positive economics, at least on the blackboard—that is to say, the way economics is taught at the undergraduate and especially at the introductory level. Furthermore, the conventional wisdom invariably emphasizes the perfectly competitive model, although a negligible segment of the economy can still be conceptualized as such in an economy full of too-big-to-fail banks and supranational corporations with global vision who operate above political oversight. The psychological world of the ultra-rational consumer is essentially pre-Freudian and pre-Pavlovian, that is to say, it lacks a sound psychological basis. It is rooted in the much simpler Smithian world of the eighteenth century without the moral fiber of that world. That is like trying to understand molecular motion using Newton’s laws instead of those of quantum mechanics; hence, the current state of the economics discipline is essentially inadequate for the post-meltdown world of the twenty-first century. However, an increasing number of economists believe that the above “ivory tower” economy, rooted in simplistic assumptions, is merely a product of our imagination.23 It is inhabited by implausible super-rational individuals, a race of Übermenschen, or supermen and superwomen devoid of emotion, living alone hence without any sense of community, whose only identity is that of being consumers, or producers with hardly any interaction with others.24

Toward a Paradigm Shift in Economics However, economics is far too important to be left to blackboard economics. In order for it to be useful it must bear some semblance to reality and it must work for the benefit of Every Man on Main Street not only for the few. Because it impacts our lives to such a great extent, it is arguably the most important academic discipline; no other has such direct and immediate impact on our daily lives in terms of employment, income, consumption, and investment as does economics. That is why the media is full of data, information, and reporting. That is why the government has institutionalized the role of economics in effective governing. The White House has the Council of Economic Advisers as well as the National Economic Council; the legislative branch’s Congressional Budget Office has 235 employees, the Department of Commerce has the Bureau of Economic Analysis with 500 employees; the Bureau of Labor Statistics employs 2,500; the Bureau of the Census also collects and analyzes some economic data and employs 5,600 people. So, lots of effort is expanded on getting the data right. It behoves us to get the theory right as well and not to delude ourselves with abstractions. The discipline should be about flesh and blood beings and not economic agents. This text is dedicated to this point of view. Mainstream economics steered us straight into the biggest economic crisis in 75 years, and political crisis was not far behind. Mainstream economics was also unable to create an inclusive economy in which most people felt good. Hence, it is time for a paradigm shift in economic theory. Instead of chasing the elusive “American Dream” in a “rat-race” economy with a few winners and many losers,25 we should focus on creating a more harmonious

Welcome to Real-World Economics  9 economy with a decent, sustainable, dignified, creative, secure, peaceful, satisfactory, and enjoyable life, one that is not based on excessive consumption and instant gratification—in short, one that is less materialistic.26 For the first time in history we have the possibility to achieve a quality of life that eluded our predecessors. However, in order to live comfortably, we do not need an ever-increasing quantity of goods. Materialism is insatiable and therefore cannot satisfy, because it always makes us want more. Rather, we need to rein in our appetite, our greed, and have a mindset that is less concerned with success measured by money and more concerned about the spiritual and social aspects of life.27 Instead of growing the economy, we need psychological, spiritual, and moral growth. However, for that we also need to rethink economic principles. That is what this book aims to foster. The Canadian Institute of Wellbeing defines well-being thus: The presence of the highest possible quality of life in its full breadth of expression, focused on but not necessarily exclusive to: good living standards, robust health, a sustainable environment, vital communities, an educated populace, balanced time use, high levels of civic participation, and access to and participation in dynamic arts, culture and recreation.28 In short, well-being is by no means identical with GDP or output or income.29 A satisfactory life in a capitalism with a human face should include the minimizing of poverty, pain, inequality, unemployment, stress, anxiety, and insecurity, and an increase in health, leisure time, social relationships, love, respect, ethics, intellectual satisfaction, and a moral life. President Jimmy Carter understood this when he said in 1979: [t]oo many of us now tend to worship self-indulgence and consumption. Human identity is no longer defined by what one does, but by what one owns. But we have discovered that owning things and consuming things does not satisfy our longing for meaning . . . It is the truth and it is a warning.30 However, his warning was not heeded any more than Eisenhower’s warning of the “grave implications” of the military-industrial complex.31 The reader should not misunderstand. I am not supporting abolishing markets or creating a leviathan of immense proportions, and I am resolute about protecting freedoms enunciated in the Universal Declaration of Human Rights. However, I have a wider conception of liberty than Milton Friedman or Ronald Reagan did. My conception is closer to Amartya Sen’s notion of capability. It includes the freedom from anxiety of an unrestrained form of capitalism that my pensions will disappear, free from the anxiety associated with our lives today: threat of crime, or becoming unemployed, or not knowing what happens if I become sick or unable to pay for my college tuition, as well as the freedom from seeing the suffering of the underclass, the unemployed, and homeless. This is congruent with the classical conception of liberty also echoed by Edmund Burke.32 My conception also includes the freedom to live without the hard-press sales pitches of intrusive advertisements, or being free from the feeling of relative deprivation from seeing the lifestyles of the profligate rich and famous. One should also be free to develop one’s personality from within rather than having

10  Welcome to Real-World Economics it imposed through the media. Developing one’s character autonomously without the interference of the profit motive of big business is an essential aspect of true freedom. We would then not be inculcated with the fundamental elements of consumerism. Furthermore, I also believe that many markets work well some of the time and a few markets work well most of the time, but we should verify if particular markets do what we expect from them. We need to think about improving their functioning so that we ourselves can function better in them. I am an enthusiastic supporter of those markets that enable people to exercise their creativity, autonomy, and individuality without being manipulated and without interference from trend setters and predatory lenders, but my support is contingent on empirical evidence. I refuse to disregard evidence that is contrary to the orthodox canon.33 If markets obviously do some of us harm, then we must retain the ultimate right to make alternative arrangements and take collective action to relieve the discomfort. This is the humanistic approach to economics: we should minimize suffering, mental and physical. Crucially, we should remain the masters of markets, and not vice versa. Furthermore, the benefits of markets should not accrue to a few members of the society, because that would be unfair and because that brings about relative deprivation. This was also at the root of the “Occupy Wall Street” movement. This is not a quixotic perspective. This is the approach of the Nordic countries, which usually are on top of all lists that measure the quality of life. Actually, there is a continuum of socioeconomic systems, ranging from market fundamentalism to socialism. I advocate finding that constellation of institutional arrangements at the golden mean between the two polar extremes that can provide most of us, as well as future generations, with a reasonably fulfilled life. I do not believe that we need to “grow the economy” to achieve this. Rather, we need to create a fairer economy that can sustain future generations and that produces less discontent and less insecurity than the current version does. As E.F. Schumacher put it, “The most striking thing about modern industry is that it requires so much and accomplishes so little. Modern industry seems to be inefficient to a degree that surpasses one’s ordinary powers of imagination.”34 By “accomplishing so little,” he meant that the economy provides so little life satisfaction despite high average incomes. In other words, we should not set ourselves the goal of producing as much as possible but to improve our sensibilities so that we can obtain more gratification with less: “the aim should be to obtain the maximum of well-being with the minimum of consumption.” Schumacher also insisted that work itself would yield much more satisfaction if the scale of enterprise were smaller so that workers would retain more of their autonomy. Thus, the politicians’ and economists’ admonition to “grow the economy” will not get us further.

Real-World Economics Is Preferable There is an increasing recognition that mainstream economics is in need of a paradigm change. There are many efforts underway to bring change to the discipline including “Rethinking Economics,” an international movement committed to “building a better economics in society and the classroom.”35 On the recent 500-year anniversary of Martin Luther’s The 95 Theses, it posted “33 Theses for an Economics Reformation” to the entrance of the London School of Economics, which starts with the assertion that “within economics,

Welcome to Real-World Economics  11 an unhealthy intellectual monopoly has developed.” The 33 theses include all of the points discussed in this book. The Institute for New Economic Thinking, The International Confe­ deration of Associations for Pluralism in Economics, have similar aims.37 The latter is made up of some 38 separate organizations. In short there are many efforts underway to reform the discipline. Thus, although many economists and students have rejected the simple mainstream models, their views have not been adequately represented in mainstream textbooks. For instance, W. Brian Arthur, a noted authority in complexity theory, explains: 36

[c]omplexity economics . . . assumes that the economy is not a perfectly balanced machine, but an evolving complex system. Actors in the economy do not necessarily face well-defined problems or use super-human rationality in making their decisions. They explore, try to make sense, and react and re-react to the outcomes they together create. Viewed this way, the economy is not in stasis, but always forming, always evolving . . . Bubbles and crashes happen, markets can be “gamed” or exploited, and history and institutions matter. The result is a rigorous but realistic picture of the economy.38 Moreover, under the heading “Aims and Scope,” the editors of the journal Capitalism and Society are explicit in their criticism of the mainstream: Today’s established economics—the economics dominant in classrooms, banks, and governments—misconceives the modern economy. This disconnect has consequences for how we understand history, how we make policy, and how we view capitalism. Its explanations fail and mislead at important junctures in modern history. Until economics is grounded on the basic character of modern economies—the ignorance, the uncertainty, and the new ideas for speculation and innovation—it limits and distorts our view.39 In short, we need to take a fresh look at the realities around us instead of accepting at face value dubious illusory notions conceived in the ivory tower, no matter how brilliant the theorems and how impressively sophisticated the mathematics seem to be. No less an authority than Nobel Prize winning economist, Joseph Stiglitz, declared—as it turns out prematurely—that “neoliberalism as a doctrine; market fundamentalism is dead.”40 Yet, you would not know it by reading the popular textbooks in the field, which influence a million students every single year. This is not a benign oversight. It has immense consequences insofar as it influences the media, political discourse, and the mindset of the voting public. No wonder, then, that many ask, “why economics is on the wrong track.”41, 42

Simple Is for Simple Minded The argument that a simple overview of the discipline suffices in Econ 101, because one must lay the foundations before students can learn more sophisticated aspects of the discipline, is utterly misguided.43 It sells the students far too short. The foundations ought

12  Welcome to Real-World Economics not to be such a caricature that distorts reality beyond recognition. I dare say that if the straight-­talking Nobel Prize winning physicist, Richard Feynman (1918–88), were still with us, he would concur with me. In his famous 1974 commencement address at the California Institute of Technology, he beseeched the graduating class to practice “scientific integrity,” “utter honesty,” and to “lean over backwards” so as not to “fool ourselves” (and of course others).44 I believe that this holds for us—teachers of economics as well. Economists should be held to professional ethics, like other professionals.45 From the very beginning, students must be made keenly aware of the limitations of real markets as opposed to theoretical ones for at least four crucial reasons: 1

2

3

4

Half-truths hardly belong in academia at any time, not any more in the beginning of one’s studies than at the end; omitting important aspects and new developments such as Herbert Simon’s theory of satisficing or Kahneman and Tversky’s prospect theory is hardly being “utterly honest.”46 It is much more efficient to learn a discipline correctly the first time than to have to unlearn it and correct it subsequently. It is extremely difficult to unlearn something once one is socialized into accepting the main tenets of the discipline without learning about their limitations in the real world. The human mind is not so flexible: once the neural networks are in place, they are extremely challenging to rewire.47 The more “sophisticated” ideas of imperfect markets are not so complicated and can be explained easily at the 101 level. Neglecting them and focusing on perfectly competitive markets distorts economic theory to such a degree that students leave the course with a fundamentally misleading caricature of the real existing economy. Most students of Econ 101 do not continue to study economics, so they are never even exposed to the more nuanced version of the discipline and are therefore indoctrinated for the rest of their lives with the idea that markets work perfectly well. This indoctrination played a substantial role in the political developments of the last half-century in forming an intellectual climate tilted heavily toward the free-market worldview that came to prevail. Thus, every statement one makes in the classroom ought to be true and the distinction between theoretical and actual markets clarified and stressed. This is the case although the instructor is expected to cover a lot of material in the introductory course. Nonetheless, unless the various perspectives on economics are presented in a balanced way, the student can only gain a biased perspective on the reliability of market processes. Quality ought not be sacrificed for quantity.

Many principles’ texts make the argument that one must simplify in order to begin to understand this complex system. However, finding the right balance between simplification and realism is crucial: oversimplification leads to distortion and to a fundamental misunderstanding of the application of economic principles to the real world. An example of the misapplication of economic principles is economists’ unconditional support of free trade without regard to those who are devastated by the foreign competition (Chapter 13). The benign neglect of the displaced workers especially in the Rust Belt, led to a level of frustration that helped elect a candidate who promised to bring those jobs back even if the promise was based on bait and switch tactics and will not lead to an

Welcome to Real-World Economics  13 Table 1.1  Electoral Votes Needed to Tip the 2016 Presidential Election in Favor of Hillary Clinton

PA MI WI Total

Trump Plurality

Electoral Votes

44,292 10,704 22,748 77,744

20 16 10 46

Source: U.S. Electoral College. “Historical Election Results, Election for the Fifty-Eight Term, 2017–2021.” www.archives. gov/federal-register/electoral-college/votes/2000_2005.html#2016.

improvement in their lives. Consequently, Dani Rodrik, an economist in Harvard’s Kennedy School, answered his question, “Are economists partly responsible for Donald Trump’s shocking victory in the US Presidential election?” in the affirmative.48 Hillary Clinton’s loss of three of the Rust Belt states—distressed by globalization—tipped the election in favor of Donald Trump (Table 1.1). His plurality in Pennsylvania, Michigan, and Wisconsin was just 77,744. Thus, if just 39,000 voters had switched their votes (0.6% of the votes cast in these states for Donald Trump), Hillary would have had a majority in the Electoral College. Yet, some economists argue that the models can be unrealistic as long as their predictions are correct. But mainstream economics comes up especially short on this account. On the basis of mainstream models, one would predict that our life satisfaction or happiness would have increased substantially since World War II. After all, per capita gross national product (GNP) in real terms increased in the U.S. in the meanwhile by a factor of 3.5. But that prediction is falsified by the fact that the share of people who report that they are either happy or very happy has not changed at all in the intervening half-century.49 If anything, it has fallen. Hence, obviously, the importance of money is overvalued by economists. Yet, another example in which predictions were completely false is that no mainstream economists predicted the crisis of 2008. Fed chairman Ben Bernanke expected the subprime mortgages not to destabilize the financial system.50 Geologists are better at predicting earthquakes than Ben Bernanke was in predicting the Meltdown of 2008. In other words, when it comes to the major challenges of our time, economic theory has misguided us. So the argument that economists can predict accurately even with unrealistic models has been falsified by the evidence.

“It’s Only a Model!” Economists think in terms of theoretical models expressed in equations or in geometric diagrams. Blackboard economics is based on assumptions and on conceptualizations of how the variables of the model interact. Although these appear rigorous, given the obvious limitations of the human mind, the number of variables must be restricted to a handful in order for the mathematics to be manageable. While these simple logical constructs can be quite useful, they are just as likely to be misleading and at times extremely so. And there is lots of evidence that simple models cannot possibly capture the true nature of our complex economy with thousands of variables and millions of interacting components, which

14  Welcome to Real-World Economics themselves are embedded in an even larger global framework. So, simplification can render models destructive, as we saw during the 2008 financial crisis and during the 2016 presidential election. Unfortunately, much too often the distinction between the world of the model and reality is not stressed sufficiently so that students and practitioners confuse the two. Teachers are doing their students a great disservice if they allow them to leave their classrooms with the differences between the two worlds blurred in their minds. The reason is that all too frequently, oversimplified blackboard models are applied to real-world situations erroneously so that instead of enhancing our understanding, they obscure, lead us astray, and ultimately become a powerful destructive force. Greenspan and Bernanke’s overlooking powerful systemic effects—negative externalities—in the financial sector prior to the run-up to the Great Meltdown is a recent vivid example of the damage of models applied inappropriately to actual circumstances that exist at street level.51 Similarly, economic models and policy makers overlooked completely the political storms that were unleashed by the hurricane-size forces of globalization. Politics was not part of their models and that was supposed to somehow take care of itself. How? Well, that was not part of the economists’ purview. Another example is the recurrent misguided application of models of perfect competition to unions, and to the minimum wage to markets that are far from perfectly competitive (Chapter 9); after all, today’s insignificant share of economic activity takes place in a perfectly competitive environment. Thus, an enormous intellectual problem arises in our culture because the theoretical models are misused every day and especially so in political discourse. This is hardly a minor phenomenon. Instead, it is at the root of the current economic, social, and political malaise—a watershed in U.S. history. Hence, the economics profession bears the responsibility that the public, the media, and politicians are ill informed about real-world economics. It has not followed the spirit of Feynman’s admonition, and did not bend over backwards to explain with sufficient clarity and ample emphasis the qualifications that accompany the blackboard models. It is insufficient to mention the assumptions at the beginning of the semester and assume that the students will remember them throughout the course. We have to be much more careful to delineate the circumstances under which the models are appropriate to apply to the real world. Without such clarification most textbooks fail to provide a nuanced understanding of flesh-and-blood economic processes. The failure to emphasize real-world economics has immense implications for the body politic and civil society. The fact that millions of students go on with their lives and years later choose among political candidates based partly on their economic policies, or become newspaper editors, radio commentators, small-town mayors, congressional aides, or political activists—in other words, their careers take them to responsible positions within the society—mistakenly think that they have understood the basics of economic theory, that markets are efficient if left alone. Thus, the deficiencies of Econ 101 become a powerful damaging force—students become vulnerable to, or perpetrators of, simplistic slogans particularly vitriolic in the current political climate: “Competition will lead to growth;” “the free market is efficient;” “lowering taxes will create jobs;” “government is not the solution to

Welcome to Real-World Economics  15 our problem, government is the problem;” “no consumer protection is needed as we all know what we are doing.” To avoid such stereotypical pitfalls, it is incumbent upon us in the academia to “lean over backwards” in the first course in economics to avoid half-truths at all costs before the students are socialized into thinking that competitive markets have the magic formula to provide the answer to all or even most of our actual economic problems. Examples abound, as most economic models are applied inappropriately. For instance, one finds such gobbledygook in a leading textbook as: “Health care is an economic commodity like shoes and gasoline.”53 This invidious contention disregards the essential differences between these markets. It has been known at least since a seminal article on the subject in 1963 that the standard economic model of perfect competition does not apply to health markets. This is because of the crucial role of asymmetric information between doctor and patient, because of the conflict of interest between the various counterparties in which very complicated decisions have to be made with a great deal of uncertainty, and because price competition is non-existent.54 These factors make the health market completely different from the shoe market. One does not usually purchase insurance for one’s shoes, for example. Moreover, doctors know much more biology than we do, and there is no practical way for us to ascertain the most prudent treatment. I have not heard of anyone wanting to get an MRI when it was unnecessary, but I have experienced doctors wanting to prescribe one to increase the profits of their employers. Another difference is that health is a necessity whereas shoes are often considered a luxury. “If a designer shoe goes up from $800 to $860, who notices?”55 Moreover, the quality of a shoe is much easier to ascertain than the quality of a health insurance contract. Gasoline is also entirely different from the other two products. It is produced from an exhaustible resource, pollutes, and therefore has major environmental effects. Thus, the essence of the three markets could not differ by more. To conflate them is to willfully defy common sense and confuse the student. Another example from the current political discourse is the oft-cited allegation that “taxing the rich is bad for economic growth,” which overlooks the inconvenient evidence that economic growth was quite robust in the 1950s and 1960s, when the tax rates were notably higher on top income earners than they are today. The proponents of the view also overlook empirical evidence that other countries—such as Germany, Switzerland, and Japan, to name just a few of the many—manage to invest just fine without having a U.S.-like abyss between rich and poor. Lowering tax rates on the rich is supposed to increase investments, again overlooking the obvious fact that a goodly share of their income is spent on conspicuous consumption or on overseas investments and does not help create U.S. jobs.56 Practically nothing trickled down below the 1% of income earners from the Reagan tax cuts.57 As Nobel Prize winning economist, Joseph Stiglitz, writes: “Lower [tax] rates have done nothing for growth”.58 Still the hype remains in the media and public consciousness that lower tax rates are good for growth. All they did, according to Stiglitz, is to fuel inequality. The question surely arises whether John Travolta really needed two jet airplanes sitting in his back yard for us to have a growing economy. Does Mitt Romney really need an elevator for his car at his La Jolla beach house in order to put people back to work?59 If the wealthy had to pay higher taxes, they would not be able to afford such frivolous 52

16  Welcome to Real-World Economics expenditures, and perhaps there would be more money available for mental health facilities so that the number of mass shootings might be reduced.60

Notes 1 Joseph Stiglitz observed that there is not much variation in the perspectives conveyed in introductory textbooks. See Stiglitz, “On the Market for Principles of Economics Textbooks: Innovation and Product Differentiation,” Journal of Economic Education 19 (1988) 2: 171–182; here, p. 172. 2 Fora.tv, Nassim Taleb and Daniel Kahneman, “Reflection on a Crisis,” @ 18 minutes. http://library.fora. tv/2009/01/27/Nassim_Taleb_and_Daniel_Kahneman_Reflection_on_a_Crisis 3 “Waxman to Greenspan: Were You Wrong?” YouTube video, 5:05, posted by “NancyPelosi,” October 23, 2008. www.youtube.com/watch?v=txw4GvEFGWs. 4 An ideology is a belief system without empirical foundation that justifies social, economic, or political aspirations and policy. As a consequence, it is not open to empirical refutation. 5 On Brooksley Born, see the outstanding PBS documentary, Frontline: The Warning. www.pbs.org/ wgbh/frontline/film/warning/ She received the John F. Kennedy Profiles in Courage Award in 2009 for her valiant efforts to regulate derivatives. 6 Wikipedia contributors, “Frankfurt School,” Wikipedia: The Free Encyclopedia. 7 Mark A. Lutz and Kenneth Lux, Humanistic Economics: The New Challenge (New York: Bootstrap Press, 1988); George P. Brockway, The End of Economic Man: An Introduction to Humanistic Economics (New York: W.W. Norton, 1991). 8 Deirdre McCloskey, The Secret Sins of Economics (Chicago, IL: Prickly Paradigm Press, 2002). 9 Donald N. McCloskey, “The Rhetoric of Economics,” Journal of Economic Literature 31 (1983) 2: 482–504. 10 Wikipedia contributors, “South Sea Company,” Wikipedia: The Free Encyclopedia. 11 The Nobel-Prize winning economist Ronald Coase first referred to theorizing models as “blackboard economics.” The Firm, The Market, and the Law (Chicago, IL: The University of Chicago Press, 1988), p. 19. 12 www.incomebyzipcode.com/ Loudoun County, VA is the richest county in the U.S. Most of the richest counties lie on the outskirts of Washington, DC, for obvious reasons. 13 Edmund Phelps, Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change (Princeton, NJ: Princeton University Press, 2013), p. 273. 14 Martin Feldstein, “The U.S. Economy is in Good Shape,” The Wall Street Journal, February 21, 2016. 15 40% think that they are “struggling” and 4% feel that they are “suffering.” www.gallup.com/ poll/151157/life-evaluation-weekly.aspx. 16 “How selfish . . . man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” Adam Smith, The Theory of Moral Sentiments I.I.1 (London: A. Millar, 1790 [first published in 1759], available at Library of Economics and Liberty). 17 John Maynard Keynes, The End of Laissez-Faire: The Economic Consequences of the Peace (London: Hogarth Press, 1926). 18 Gallup, Inc., “U.S. Life Evaluation.” www.gallup.com/poll/151157/life-evaluation-weekly.aspx. 19 Some people are luckier in the choice of their parents than others. John Komlos, “Income Inequality Begins at Birth and These Are the Stats that Prove It,” PBS Newshour. www.pbs.org/newshour/­ making-sense/plight-african-americans-u-s-2015/. 2 0 Sigmund Freud, The Unconscious (London: Penguin Classics 2005); First published as Das Unbewusste in 1915. 21 David Cay Johnston, Free Lunch: How the Wealthiest Americans Enrich Themselves at Government Expense and Stick You with the Bill (New York: Portfolio Books, 2007); David Cay Johnston, The Fine Print: How Big Companies Use “Plain English” to Rob You Blind (New York: Portfolio Books, 2012). 2 2 David Cay Johnston, Perfectly Legal: The Covert Campaign to Rig Our Tax System to Benefit the Super-Rich—and Cheat Everybody Else (New York: Portfolio Books, 2003). 23 See the journal Real-World Economics Review. 2 4 Stephen A. Marglin, The Dismal Science: How Thinking Like an Economist Undermines Community (Cambridge, MA: Harvard University Press, 2010). 25 Robert H. Frank and Philip J. Cook, Winner-Take-All Society (New York: Free Press, 1995).

Welcome to Real-World Economics  17 26 B.F. Skinner’s answer to “What is the Good Life?” in his Walden Two was: It is “a life of friendship, health, art, a healthy balance between work and leisure, a minimum of unpleasantness, and a feeling that one has made worthwhile contributions to one’s society.” Wikipedia contributors, “B.F. Skinner,” Wikipedia: The Free Encyclopedia. 27 In Pope John Paul II’s socioeconomic encyclical Centesimus annus (1991) both private property and the organization of labor unions are included among a variety of fundamental human rights. 28 “What Is Wellbeing?” Canadian Index of Wellbeing, available at https://uwaterloo.ca/canadian-indexwellbeing/wellbeing-canada/what-wellbeing. 29 Shortcomings of GNP accounting is in Joseph E. Stiglitz, Amartya Sen, and Jean-Paul Fitoussi, Mismeasuring Our Lives. Why the GDP Doesn’t Add Up (New York: New Books, 2010). 30 David Shi asserts that “[Carter] totally ignored the fact that the country’s dominant institutions— corporations, advertising, popular culture—were instrumental in promoting and sustaining the hedonistic ethic.” David Shi, The Simple Life: Plain Living and High Thinking in American Culture (Athens, GA: University of Georgia Press, 2007), p. 272. 31 “We must guard against the acquisition of unwarranted influence . . . by the military-industrial complex. The potential for the disastrous rise of misplaced power exists, and will persist. We must never let the weight of this combination endanger our liberties, our democratic processes.” “Eisenhower Warns Us of the Military Industrial Complex,” YouTube video, 2:31, posted by “RobUniv,” August 4, 2006. 32 “Society cannot exist, unless a controlling power upon will and appetite be placed somewhere; and the less of it there is within, the more there must be without. It is ordained in the eternal constitution of things, that men of intemperate minds cannot be free. Their passions forge their fetters.” Edmund Burke, Letter to a Member of the National Assembly (London: J. Dodsley, Pall-Mall, 1791), pp. 68–69. 33 George Akerlof and Robert Shiller, Phishing for Phools. The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press 2015). 34 Ernst F. Schumacher, Small Is Beautiful: Economics as If People Mattered (New York: Harper Torchbook, 1973). 35 www.rethinkeconomics.org/. 36 www.newweather.org/wp-content/uploads/2017/12/33-Theses-for-an-Economics-Reformation.pdf; www.newweather.org/category/projects/the-economics-reformation/; www.rethinkeconomics.org/. 37 www.ineteconomics.org/; https://icape.org/. 38 W. Brian Arthur, external professor, Santa Fe Institute, http://tuvalu.santafe.edu/~wbarthur/. 39 “Aims and Scope,” Capitalism and Society, A Journal of the Center on Capitalism and Society. www. degruyter.com/view/j/cas. 40 In a lecture in November 2008, Stiglitz declared, “This September has been to market fundamentalism what the fall of the Berlin Wall was to communism. We all knew that those ideas were flawed, that free market ideology didn’t work; we all knew that communism didn’t work, but these were defining moments that made it clear that it didn’t work . . . America really has a system . . . of corporatism corporate welfarism . . . under the guise of free market economics. And it is that mixture that was fundamentally flawed, incoherent, was intellectually bankrupt from the beginning, that has been shown not to work.” Joseph Stiglitz, “Market Fundamentalism Is Dead,” YouTube video, posted by “ForaTV,” November 10, 2008. www.youtube.com/watch?v=x_2-Tv2GPs0. 41 McCloskey charges the mainstream with “cultural barbarism,” and “historical ignorance.” McCloskey, Secret Sins. 42 Deirdre McCloskey, The Secret Sins of Economics (Chicago, IL: Prickly Paradigm Press, 2002). 43 Jeffrey Madrick, Seven Bad Ideas: How Mainstream Economists Have Damaged America and the World (New York: Knopf, 2014). 44 Richard Feynman, “Cargo Cult Science,” Engineering and Science 37 (1974) 7: 10–13. 45 George De Martino, The Economist’s Oath. On the Need for and Content of Professional Economic Ethics (Oxford, UK: Oxford University Press, 2011). 46 Herbert Simon, “Rationality in Psychology and Economics,” in Rational Choice: The Contrast Between Economics and Psychology, ed. Robin M. Hogarth and Melvin W. Reder (Chicago, IL: University of Chicago Press, 1986); Amos Tversky and Daniel Kahneman, “Judgment under Uncertainty: Heuristics and Biases,” Science, New Series 185 (1974) 4157: 1124–1131. 47 B.F. Skinner showed that it takes much more time to unlearn something than to learn it in the first place. See his Science and Human Behavior (New York: Free Press, 1965), pp. 62–71. 48 Dani Rodrik, “Straight Talk on Trade,” Project Syndicate, November 15, 2016. www.project-syndicate. org/commentary/trump-win-economists-responsible-by-dani-rodrik-2016-11?barrier=accessreg.

18  Welcome to Real-World Economics 4 9 Richard Easterlin, “The Economics of Happiness,” Daedalus 133 (2004) 2: 26–33. 50 YouTube Video, “Bernanke was Wrong.” www.youtube.com/watch?v=INmqvibv4UU&t=2s. 51 The role of economists in the financial crisis is highlighted in the Academy Award winning documentary Inside Job. 5 2 Ronald Reagan, Inaugural Address, January 20, 1981, The American Presidency Project. www.presidency. ucsb.edu/ws/?pid=43130. 5 3 Paul Samuelson and William Nordhaus, Economics, 19th ed. (New York: McGraw-Hill/Irwin, 2009), p. 221. 54 Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care,” American Economic Review 53 (1963) 5: 141–149. 5 5 Stephanie Clifford, “Even Marked Up, Luxury Goods Fly Off Shelves,” The New York Times, August 3, 2011. 56 Danny Yagan, “Capital Tax Reform and the Real Economy: The Effects of the 2003 Dividend Tax Cut,” American Economic Review, 105 (2015) 12: 3531–3563. 57 John Komlos, “Growth of Income and Welfare in the U.S., 1979–2011,” NBER working paper, 2016, no. 22211. www.nber.org/papers/w22211. 58 Joseph Stiglitz, Rewriting the Rules of the American Economy: An Agenda for Growth and Shared Prosperity (New York: W.W. Norton 2015). 59 Ashley Parker, “For Romney, a Four-Car Garage with Its Own Elevator,” The New York Times, March 27, 2012. 60 John Komlos, “How Raising Taxes on the Rich Could Prevent Mass Shootings,” PBS Newshour, September 2, 2015. www.pbs.org/newshour/making-sense/face-mass-murders-case-universal-­mentalhealth-insurance/.

2 Markets Are Neither Omniscient Nor Omnipotent

Markets Are Not Created by Divine Power According to conventional wisdom, free markets are practically flawless, acquiring an almost divine aura. However, we ought to resist the temptation to ascribe supernatural powers to them, for markets are created by human beings and not by a deity. They are not natural and do not emerge spontaneously out of disorder.1 Rather, they are man-made institutions and are only as good as the rules (moral and legal) that govern the behavior of market participants and the oversight of a higher authority that enforces the rules without which markets generally implode. Hence, markets can be formed and reformed to suit our purposes and improve our lives. They are not infallible and should not be idolized.2 They are a means to an end and not an end in themselves. The market system is with us, for better or for worse; a world without it is unimaginable but we should be vigilant and not become subservient to it. To be sure, after the Industrial Revolution, markets were increasingly used to unleash Prometheus, increase incomes, make a super-abundance of material goods, raise life expectancy, and create miracles in science, engineering, medicine, communication, and information technology. These achievements are obviously phenomenal. Yet, we should not become conceited, because in important aspects we have not progressed at all. This includes our psychology, our ability to cope with life’s stresses, our aggressiveness, our self-control, our habits, the persistence of poverty, or our ability to lead a virtuous life. So the emphasis on material progress is by no means the whole picture. There are some inconvenient facts to consider: an immense poverty and deprivation, both relative and absolute, remain and continue to haunt the U.S. society and others around the world.3

The Downside of Free Markets The common wisdom is that market capitalism “has been an enormous success.”4 However, this is only so if one deliberately overlooks the enormous set of challenges that stem directly from the current organization of the economy and the way it distributes the wealth it creates and the ways in which it disadvantages some from the very beginning of their lives.5 Markets are incapable of ameliorating such distortions and the social problems they create.6 To be sure, market aficionados argue that we should keep the social, political, and economic issues separate. However, that view is itself a value judgment and without much

20  Markets Are Neither Omniscient Nor Omnipotent merit, because they are intricately intertwined: economic processes have social and political consequences as we just witnessed with the election of Donald Trump.7 Thus, increasing inequality is not an epiphenomenon to be easily dismissed. It is the central problem of market economies, and its benign neglect by economists has disastrous consequences.8 Rampant and endemic social, political, and economic challenges face us as a consequence of the inequitable distribution of work, income, and wealth. In fact, there is no quality-of-life indicator for which the U.S. is ranked high in international comparison relative to other rich countries. Not in life expectancy, not in life satisfaction, not in educational attainment, children’s welfare, not in mass murder rate, and not in opioid overdose. Only using income per capita is the U.S. near the top of the list, but this is an indication of how misleading averages can be if the distribution is skewed. This is the case because super incomes have an extraordinary impact on the average.9 Members of the anxiety-ridden underclass, who see no way out of their hopeless predicament, far too often turn to acts of desperation out of sheer frustration. That is one reason why the homicide rate in the U.S. is three to eight times higher than in Western and Northern Europe, where the state-provided safety net reduces anxiety to bearable levels (Table 2.1).10 The high mass murder rate is not only an indication of the level of frustration with the system but also the inadequate availability of mental health services. There were 384 mass shooting incidents in 2016. Assassinations of police officers are similarly indicative of the amount of venom that has accumulated in people.11 Yet another indicator of the widespread malaise is the opioid epidemic. Per capita drug use in the U.S. is more than three times as high as in Western Europe,12 and drug related deaths are eight times as high (Table 2.2). Obviously, there are feedback effects and the level of crime increases the level of anxiety in the society, thereby diminishing the quality of life enormously. The incarceration rate is also a sign that people are unable to find their place in the legal labor market. There were no fewer than 6.7 million people (2.7% of the adult population) “supervised” in the U.S. in 2015; this includes people on parole, probation, and 2.2 million people incarcerated.13 This is the highest rate in the world: with 5% of the world’s population, the U.S. has 23% of its prisoners.14 The toleration of such levels of imprisonment shows the callousness of the economic system toward those who fail to find their niche in the economy and fall into a nebulous underclass, a problem that few economists are willing to acknowledge. The number of bankruptcies shows the difficulties people have to meet their obligations, mostly because of medical expenses.15 Bankruptcy filings peaked in 2005 at 2 million, but Table 2.1  The U.S. Homicide Rate Per Capita as a Multiple of Those in These Countries Norway Netherlands Ireland Spain Switzerland Italy

8.8 8.0 7.7 7.4 7.1 6.3

Note: Dates vary somewhat; most refer to 2014. Source: https://data.unodc.org/.

Germany U.K. Denmark Sweden France Finland

5.8 5.3 4.9 4.3 3.1 3.1

Markets Are Neither Omniscient Nor Omnipotent  21 Table 2.2  Drug-Related Deaths Per Million Persons Aged 15–64 U.S. Sweden U.K. Switzerland Germany Italy France Europe Average Global Average

234 96 91 23 19 8 4 29 44

Note: Dates vary somewhat; most refer to 2014. Europe pertains to Western and Central Europe. Source: https://data.unodc.org/.

then declined to 0.9 million in 2014. Still, on a per capita basis they doubled between 1980 and 2014.16 This challenges the notion of unmitigated progress in the course of the twentieth century. We might also consider the 9.3 million homeowners who lost their home between 2006 and 2014.17

Spain

21

U.S.

19.6

Italy

17.4

Japan

15.7

Canada

14.4

Australia

12.9

France

11.4

Belgium

11.4

Netherlands

10.7

Austria

10.4

UK

10.4

Ireland

8.7

Sweden

8.3

Czech Rep.

8.2

Korea

8

Switzerland

8

Germany

7.4

Norway

5.9

Finland

4.6

Denmark

2.7 0

2

4

6

8

10

12

14

16

18

20

22

Figure 2.1  Poverty Rate among Children below Age 18 Source: OECD Statistics, Social Protection and Well-Being, Income Distribution and Poverty by Country, Chapter 1 Table 1.A.1. Key indicators on the distribution of household disposable income and poverty 2013. www.keepeek.com/Digital-Asset-Management/oecd/employment/in-it-together-why-less-inequality-­ benefits-all/key-indicators-on-the-distribution-of-household-disposable-income-and-poverty-20072011-and-2013-or-most-recent-year_9789264235120-table12-en#.WWkPR_nysyU.

22  Markets Are Neither Omniscient Nor Omnipotent Persistent and endemic poverty indicates that the market economy leaves many people struggling. The poverty rate among U.S. children—at 19.6%—is about twice the mean rate prevailing in rich countries and seven times as high as in Denmark (Figure 2.1).18 One reason for this high rate is that the divorce rate has doubled,19 and the share of families with children headed by a female has quadrupled since 1950.20 In 2016 one-third of all children lived in single-parent households. This also means that it is more challenging for these 19 million children (29% of all U.S. children) to obtain a reasonable education with a path to the middle class.21 Generally U.S. children fare worse in international comparisons than adults, which does not bode well for the future of human capital formation. Too many of the poor children live in slums—concentrated areas of poverty—that do not provide them with an adequate start in life, particularly in education and in socialization that are so important for their future development.22 In other words, the free market does not provide a level playing field for those children who find themselves trapped in dysfunctional neighborhoods and school systems and the accompanying culture of poverty.23 No other rich country neglects the fate of future generations like that. UNICEF rated the welfare of U.S. children as being in 26th place compared to those of European countries and even below those of middle-income countries such as Hungary, Poland, Slovakia, and Estonia.24 Six million children are reported for maltreatment to U.S. agencies annually,25 and five children die daily due to abuse or neglect.26 U.S. pre-term birth rates are closer to those prevailing in Africa than in Europe.27 A teenager in Mississippi is 15 times more likely to give birth than her counterpart in Switzerland.28 These social problems are rooted in the nature of the economic system that increases the cost of their upbringing and yields few opportunities for advancement for a goodly share of children. Children, without agency, are by and large a disadvantaged group with the exception of those who are born on the right side of the tracks. The U.S. is the only industrialized nation without universal health insurance. Although the Affordable Care Act (2010) almost halved the number of uninsured, it still left some 28 million people without the security of health insurance. However, the Republican administration tried to reverse this trend, and the uninsured rate among the working-age population (ages 19 to 64) rose from 12.7% in 2016 to 15.5% in 2018, implying that some 4 million people lost coverage.29 The Congressional Budget Office estimated that some 23 million people are at risk of losing their insurance. The rate is much higher among the poor: 26%, and among Hispanics: 28%.30 Moreover, in 2015, many people in one of the richest countries in the world did not have enough money to meet even their basic needs: 13% of the population had to contend with food insecurity and among female headed households the rate was 30%, while 8% of all African Americans struggled with a very low level of food security that included hunger.31 Obviously, the above-mentioned anxiety has an effect on mental health. The number of people seeking outpatient care for depression in the U.S. increased from 0.7% of the population in 1987 to 2.3% in 1997 and then to 2.9% by 2007.32 The use of medication among these patients increased from 37% to 75% at the same time. In 2014, 16 million adults (6.7%) experienced at least one major episode of depression.33 The economic burden of depression increased from $173 billion per annum in 2005 to $210 billion in 2010.34 This is a never-beforeseen development that led to a decline in overall life expectancy at birth between 2014 and 2015, as depression often results in alcoholism, opioid poisoning, or suicide.35

Markets Are Neither Omniscient Nor Omnipotent  23

Illustration 2.1  The Market Treats Some Children Cruelly. How Will History Judge Us? Credit: iStock.com/AvailableLight.

These “deaths of despair” have risen enormously. Drug overdose deaths in the U.S. were about 6,000 in 1980 while by 2015 they rose to 52,000, i.e., an increase by an amazing factor of more than 8.36 Other deaths of hopelessness include alcohol poisonings, suicides, and chronic liver diseases from alcoholism. The upshot is a “shocking increase in midlife mortality” among white Americans. This has never happened before in a developed country in peacetime. The U.S. is the only rich country to experience an increase in mortality in recent times, in spite of medical advances. Most affected are middle-aged white men with a high school education or less. Their mortality rates have been increasing since the turn of the twenty-first century, while those with a college education are immune from this trend.37 Blacks and Hispanics were also unaffected: they did not experience the shocks of downward mobility as did lower-class whites. Does this society sound like a free-market nirvana? The answer is obvious, but there is more to consider: on a typical day in 2016 there were 374,000 homeless people in shelters and an additional 176,000 were in the open; about 22% were children (mostly in shelters).38 The number of children who were homeless at some time in 2011 reached 1.6 million.39 It is unconscionable to let children be treated in such a way in a rich society. All of this is tolerated as normal at a time when there are 540 billionaires in the U.S. with a combined net worth of an astronomical $2.4 trillion.40 In addition, there were 400,000 families who earned more than $1 million in 2014 (with an average income of $3 million);41 thus, 0.3% of households earned a total of $1.4 trillion or 14% of the total income generated in the U.S.42 The Gini coefficient is a standard metric of inequality. It is calculated using Figure 2.2 in which the diagonal line depicts the line of perfect equality. Along that line 10% of the population earn 10% of total income and 20% earn 20% of the income and so forth. Hence, the

24  Markets Are Neither Omniscient Nor Omnipotent

Percent of Income

100 90 80 70 60 50

A

40 30 20 10 0 0

10

20

30

40

50

60

70

80

90

100

Percent of Population

Figure 2.2  Cumulative Distribution of After Tax Income, U.S., 2014 Source: IRS, SOI (statistics of income) Tax Stats, Table 1.1 “All Returns: Selected Income and Tax Items, by Size and Accumulated Size of Adjusted Gross Income, Tax Year 2014 (Filing Year 2015),” www.irs. gov/uac/soi-tax-stats-individual-statistical-tables-by-size-of-adjusted-gross-income.

farther is the actual distribution from this diagonal, the more unequal it is. The Gini index is calculated by dividing the area between the diagonal and the Lorenz curve (A) by the total area of the triangle.43 The actual income distribution in the U.S., based on tax returns, shows how unequally income is distributed. People in the bottom 60% of the income distribution earned just 20% of the total income generated in the economy (after tax), which is as much as the top 1% earns. They also earn 20% of total income. In other words, 1.2 million taxpayers earned as much as the bottom 90 million (Figure 2.2). Checks written by these ultra-rich could go a very long way to alleviate the misery described earlier. Another metric of inequality shows the ratio of the disposable income of the top 90% of the income distribution to the bottom 10% among rich countries (Figure 2.3). The U.S. ratio, at 6.1, is well above the median ratio of 3.7. Furthermore, because of underfunded school systems, U.S. children are lagging well behind their counterparts around the globe: 15-year-olds placed 24th in reading, 25th in science, and 39th in mathematics.44 The U.S. ranked an embarrassing 48th out of 133 developed and developing nations in quality of math and science instruction.45 This depressing performance does not bode well for the U.S.’s ability to compete in the information age in the years to come.46 Ultimately, the middling quality of the U.S. education system is a result of the public’s anti-government disposition and its refusal to provide the government with sufficient funding. Depriving the federal government of revenue by cutting taxes is a conservative strategy referred to as “starving the beast.”47 Consequently, public goods such as adequate schools are especially in short supply. In this vein, John Kenneth Galbraith contrasted “private

Markets Are Neither Omniscient Nor Omnipotent  25 U.S.

6.1

Spain

5.5

Japan

5.1

S. Korea

4.8

Italy

4.6

Australia

4.3

Canada

4.2

UK

4.2

Ireland

3.7

Switzerland

3.7

Germany

3.7

France

3.5

Belgium

3.4

Netherlands

3.4

Austria

3.4

Sweden

3.3

Czech Rep.

3.1

Norway

3.1

Finland

3.1

Denmark

2.9 0

1

2

3

4

5

6

7

Figure 2.3  Ratio of the Top 90% of the Disposable Income Distribution to the Bottom 10%, 2014 Source: https://stats.oecd.org/Index.aspx?DataSetCode=IDD#. OECD Statistics, Social Protection and Well-Being, Income Distribution and Poverty Chapter 1 Table 1.A.1. Key indicators on the distribution of household disposable income and poverty.

affluence” with “public squalor”—a comparison that is as valid today as it was a couple of generations ago.48 There are many other problems with the current state of the economy: in a list of the best places to be a mother, the U.S. was ranked in 25th place.49 Consumer complaints are endemic. There were even scammers who offer “bogus” help to save homes from foreclosure.50 Some 17.6 million people in the U.S. experienced identity theft in 2014.51 Identity-theft insurance costs about $150 per annum. Infrastructure has been neglected, as evidenced by the collapse of a bridge in Minneapolis in 2007 that killed 13 people and injured 145.52 The breach in the Oroville Dam in California led to the evacuation of 200,000 people. The American Society of Civil Engineers gave a grade of D+ to the state of U.S. infrastructure that includes bridges, dams, drinking water (Flint, Michigan), hazardous waste, levees, and solid waste facilities. The U.S. has a several-trillion-dollar backlog in infrastructure investment. In other words, it has literally mortgaged the welfare of future generations by cutting taxes and neglecting to maintain the country’s infrastructure, which is the lifeblood of the economy. Moreover, we are continuing to degrade the environment to such a degree that global warming threatens the very survival of our civilization.

26  Markets Are Neither Omniscient Nor Omnipotent Table 2.3  Share of Income and Wealth Distribution in the U.S., 2013

Top 3% Next 7% Top 10% Bottom 90%

Income

Wealth

30% 17% 47% 53%

54% 21% 75% 25%

Source: Federal Reserve Bulletin, “Changes in U.S. Family Finances from 2010 to 2013: Evidence from the Survey of Consumer Finances,” September 2014, Vol 100, No. 4; www.federalreserve.gov/pubs/bulletin/2014/pdf/scf14.pdf.

After global warming, rampant inequality is the biggest challenge of our time. Ultimately it is behind all the social problems discussed here. The evidence is ubiquitous. Income is super concentrated and wealth even more so. The top 10% of families receive nearly half of annual income in the U.S. in any one year and own about 75% of total wealth (Table 2.3). In fact, income is more concentrated in the U.S. than in any other rich country. No wonder there is so much discontent, frustration, and suffering: the left tail of the income distribution has a disproportionate impact on the social and political system. The average income (after taxes and after transfer payments) of the lowest 20% of the income distribution—the poorest 64 million people—was just $18,000 in 2011, barely enough to keep body and soul together.53 In sum, the U.S. has an overwhelming set of problems and praising Capitalism’s “enormous success” ignores the “elephant in the room.” Actually, all rankings pertinent to measuring the quality of life register the U.S. performance as mediocre in those aspects of life that really matter: health, peace of mind, happiness, longevity, security, safety, education, social mobility, children’s welfare, and human development. The culprit is not the mean income but its skewed distribution, and economists have been silent for far too long on the chasm between average incomes and the quality of life it provides the population. In sum, progress has been much more tentative than most mainstream economists are willing to concede and, moreover, it has been limited to a small segment of the society. As a matter of fact, we could have done a much better job of improving the quality of life for the men and women on Main Street, given our immense wealth. Progress ought not be measured by growth in average income. Its distribution also matters—and it matters a lot; well-being is multifaceted and ought not be conflated with average income.

Government Is an Essential Component of the Economy Government does many things more efficiently than markets, including building the interstate network of roads, providing health care to senior citizens and veterans as well as guaranteeing Social Security, which has taken care of citizens effectively for decades. Government sponsored basic research brought about the IT revolution. So, it should not be constantly disparaged. Instead, we should emphasize that markets and governments are complementary. They need each other. Markets are incapable of creating their institutional structure, which includes the political system, ideology, law, and unwritten norms that govern the behavior of market participants. Markets would not function at all without sufficient

Markets Are Neither Omniscient Nor Omnipotent  27 laws and appropriate institutions that are created for the most part by government. In sum, government is indispensable. To be sure, it needs to be effective. But the colloquial slogan, “that government is best which governs the least” is patently false.54 That doctrine, according to Franklin D. Roosevelt, makes government seem indifferent to the plight of humankind.55 Put simply, government has to adjust to the size and complexity of the economy and the needs of the people which markets are incapable of adequately fulfilling. The government built dams and bridges, educated our children, stabilized the banking system, and spurred innovation in hundreds of ways by supporting basic research in medicine, IT, the Internet, and biotechnology. Moreover, one should acknowledge that there were crucial moments when markets would have imploded without sufficient government aid, or when GM and Chrysler desperately needed to be resuscitated with state funds. In short, there are very good reasons not to sing hymns to free markets unconditionally.56 Markets did not achieve our current level of wealth by themselves and could not have done so. It was a partnership of individual and community effort. Markets are institutions just like governments, and like governments they should also be under our control. Markets are not sovereign; we are. We, the people, retain the ultimate right in a democratic society to determine what our goals are and how to accomplish them. Some of those goals should be left to markets while others should be determined through our elected representatives or other nonmarket institutions. Although some people vilify it, the government is we. It represents our collective will—our collective interest—which we cannot adequately enforce as individuals. Admittedly, this power has eroded of late. Influential vested interests have co-opted government institutions.57 Otherwise it is difficult to comprehend the transfer of trillions of dollars from 99% of the population to the top 1%.58 The economic system as currently constituted has led to such concentration of wealth that our democracy (1 person, 1 vote) is being turned into a plutocracy.59 For example, the carbon industry has successfully generated a misguided effort to deny the existence of global warming,60 the National Rifle Association has prevented a ban on assault rifles, and Wall Street has resisted stringent financial regulation and has weakened the Consumer Financial Protection Bureau.61 Without government regulation, a functioning legal system, and effective enforcement mechanisms, most markets would implode quickly. Governments can do many things better than markets, such as providing public goods and guaranteeing our bank deposits. Markets are not good at providing protection of consumers, children, the environment, the weak, the poor, minority rights, or the interests of future generations. Markets would sell cigarettes and alcohol to children. It was not until government regulation that cigarette smoking was cut by half in the U.S. One of the roles of government is to maintain the balance of power within the economy. An unregulated market does not mean a free market if monopoly power exists, or where parties have markedly different access to information, or where one party can bear the transaction costs more easily than the counterparties because of income differences. Such markets would not be “free” for those who do not enjoy those advantages. So the lack of government intervention does not lead to free markets. Just the opposite is the case. Without government, power accumulates in the hands of the few and only government can prevent such imbalances.

28  Markets Are Neither Omniscient Nor Omnipotent In addition, governments must establish and continuously adjust the institutions within which the economy functions. Governments define property rights and the procedures by which such rights can be exercised and enforced. Should we forget that the government, not markets, guarantee civil rights to minorities?62 Providing safety nets also belong to essential government services; otherwise the political structure would be unstable, as Marie Antoinette found out, as did many other rulers who failed to make provisions for a rainy day. Hunger is a mighty political force. It can also take other forms of deprivation or relative deprivation, or a longing for the “American Dream,” as Hillary’s “deplorables” so forcefully demonstrated in 2016. Furthermore, we also need government institutions to be the lender of last resort in order to maintain the stability of the financial system. The laws enacted by Franklin Roosevelt served us well until they were repealed piece-by-piece under the Reagan, Bush Sr., Clinton, and Bush Jr. administrations. And, of course, we need government’s help in case of emergencies caused by natural disasters. In such cases, exactly as in the financial crisis, even those who otherwise espouse a deep-seated hatred of government turn unabashedly to it for bailouts without seeing the irony of it all.63 And what is the difference between a natural catastrophe and diseases which also strike randomly? Why can’t the same model of relief be applied to those who are struck by cancer or another debilitating disease? The government must also help those in dire need because they were left behind in the competition for jobs. There are simply not enough jobs for everyone looking for work. It is the collective responsibility of society to come to the aid of those who are unable to meet their basic needs through no fault of their own. Helping them is not only charitable but also ensures social stability. They just might not leave this world quietly.

Markets Have Limitations Markets characterized by asymmetric information or uncertainty, tend to be inefficient. For instance, as long ago as 1963 Kenneth Arrow pointed out that private health-care markets are inefficient because of the “existence of uncertainty in the incidence of disease and in the efficacy of treatment.”64 In addition, there is virtually no price competition as in other markets; it has more asymmetric information than other markets, and people have biased predictions of their future health needs. Furthermore, “adverse selection,” implies that those with the most health needs have a higher probability of insuring themselves than those who are healthy. Consequently, the price of health insurance increases so that fewer people are able to afford it (around 16% of the population in the U.S. before Obamacare). Besides, insurers can entrap customers with fine print that enables them to deny coverage just when it is most needed. No wonder that the U.S. population has less confidence in its health-care system in general than people in other advanced industrialized countries, because it is much more dependent on free-market principles than all other wealthy countries.65 The U.S. has the most inefficient medical system in the world! Here are two metrics to buttress this point: life expectancy at birth in the U.S. ranks 31st in the world, but healthcare expenditure is twice the median in rich countries (Figure 2.4). That is the definition of inefficiency. People are healthier and live longer in countries where the government plays

Markets Are Neither Omniscient Nor Omnipotent  29 U.S. Switzerland Norway Germany Sweden Netherlands Austria Denmark Canada Australia France Japan UK Finland New Zealand Italy Spain Israel South Korea 0

2000

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Figure 2.4   Health Care Expenditures, 2016 Source: Health Care Expenditures, 2016 OECD, Statistics, http://stats.oecd.org/Index.aspx?DataSet Code=SHA.

an important role in health care (and 100% of the population is fully insured, as in Western and Northern Europe). Consider, for example, Canada’s spending was just at the level of the median ($4,700). In contrast, the U.S. spent $9,900 for every man, woman, and child. That was more than twice Canada’s expenditure. If we had Canada’s system, we would save no less than $13,600 per household. How inefficient! The waste, therefore, is a walloping $1.7 trillion dollars, about as much as last year’s after tax profits of all U.S. corporations combined.66 The median life expectancy in the rich countries with a combined population of 670 million was 81.8 years. Canada was again close to the median and 2.9 years above that of the U.S. That means that Canadian babies can expect to live nearly three years longer than their counterparts born south of the 49th parallel. U.S. life expectancy at 79.2, is at the level of Cuba, Uruguay, and Costa Rica, whose incomes are miniscule compared to that of the U.S. Thus, the U.S. medical system, based on free-market principles, is the most inefficient in the world (Figures 2.4 and 2.5).67 Life expectancy among black males in the U.S. is at the level of men in Slovakia, Honduras, and Turkey, and below that of Algeria, Cuba, Tunisia, and China.68 Something must be awry with market principles if a service that is so expensive delivers such inferior outcomes.

30  Markets Are Neither Omniscient Nor Omnipotent Japan Switzerland Singapore Spain Australia Italy Israel Sweden France South Korea Canada Netherlands Norway New Zealand Austria Ireland UK Portugal Finland Belgium Greece Germany Denmark U.S. 76

77

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Figure 2.5  Life Expectancy at Birth Source: World Health Organization, “World Health Statistics 2016, Annex B,” www.who.int/gho/publications/ world_health_statistics/2016/Annex_B/en/.

Competition is not transparent enough for the free market to offer adequate health care at affordable prices without extensive government oversight. Moreover, markets are also extremely impatient institutions and hence are not good at long-range planning because the incentive structure is biased toward the present. Markets are also not efficient at producing an education policy that provides broad-based, quality education. Markets were not designed for that purpose. Markets are also ineffective at providing safe products, since safety is a difficult-to-­ ascertain, intangible attribute of the goods and because there is a psychological bias toward the present on the part of both producers and consumers. Hence, safety often does not seem to be worth it in the short run, and insofar as providing safe products in the long run is costly for the consumer and unprofitable for the producer, price competition gets in the way of provisioning safety. For example, seat belts in automobiles were hardly used until they were mandated in 1968.69 Now, of course, we are so used to them that most of us don’t even have to think about buckling up. Another example is providing safe baby cribs, which does not seem like a complex product to design. Yet, it was not until dozens of babies accidentally suffocated in cribs that the Consumer Product Safety Commission Agency, after years of

Markets Are Neither Omniscient Nor Omnipotent  31 wrangling with industry groups, finally mandated the safe design of cribs in 2011. Producers had decades to design and sell safe cribs but were incapable of doing so, because it required coordination that the market was incapable of providing.70 The incompetence of businesses at provisioning safety is also demonstrated by such disasters as Union Carbide’s deadly gas leak in Bhopal, India, the grounding of the Exxon Valdez in Alaska, and the explosion aboard the Deepwater Horizon in the Gulf of Mexico. Such disasters caused immense suffering and environmental degradation.

The “Achilles Heel” of Markets Markets have “Achilles heels” that interfere with their smooth functioning and detract from their ability to efficiently improve the quality of life. I call this inconvenient truth the “curses” of markets. These are intrinsic problems—such as bounded rationality (Chapter 4), imperfect and asymmetric information (Chapter 5), power imbalances (Chapter 5), social interactions (Chapter 5), conspicuous consumption (Chapter 5), monopolies and oligopolies (Chapter 6), transaction costs (Chapter 8), opportunistic behavior (Chapter 8), imperfect foresight (Chapter 8), pollution (Chapter 11), fragility of finance (Chapter 14)—that are associated with the workings of real existing markets as opposed to imaginary ones, preventing them from working as efficiently as they do on the blackboard. These Achilles heels are usually omitted from conventional courses at least at the beginning level even though many economists received a Nobel Prize for illuminating these issues decades ago. To be sure, volumes have been written on these curses, but excluding them from introductory textbooks implies that millions of students leave their basic economics course without having seriously reflected on the nuances of the default models. Of course, there are many practicing economists who disagree with the main thrust of the mainstream view and chide their colleagues for “intellectual malfeasance,” by not questioning their own assumptions more seriously.71 To be sure, conclusions reached by the process of deduction from assumptions as practiced by the mainstream are logically valid in theory and work well on the blackboards of academia but often turn out to be toxic at street level.72

Morality Should Take Precedence over Markets Being human inventions, markets ought not take precedence over our moral values. Markets are part of our ethical system, and we should organize them in such a way that they do not exploit or hurt people, and distribute the fruits of the economy in an equitable fashion. If markets do us harm or threaten us, then we, the people, ought to retain the right to make alternative arrangements and take collective action to stop the pain caused by market processes. Market outcomes ought by no means be above ethical considerations. When they do not lead to satisfactory outcomes or when they malfunction, they should be modified. Moreover, there are many valuable socioeconomic and moral goals that markets are incapable of achieving, such as providing for an equitable distribution of rewards, insofar as even a small early advantage can bring about substantial subsequent benefits. For instance, markets were not particularly helpful in enabling African American citizens to purchase coffee at a lunch counter of their choice or to sit where they liked on buses and trains. People

32  Markets Are Neither Omniscient Nor Omnipotent

Illustration 2.2  The Market Did Not Give Rosa Parks the Option to Ride the Bus Without Being Arrested if She Chose to Sit Where She Wanted to.

had to sacrifice their lives before the rights of a desegregated market were granted.73 Also, selling babies might well be efficient from an economic point of view, but we decided against such exchange out of moral considerations. So in principle we ought not to rely on markets to create a moral socioeconomic framework for us.

Economics Is a Social Science and Not a Natural Science Economics is not at all like the natural sciences. It is insensitive to evidence contradicting its basic assumptions. Alternative theories as well as facts from other disciplines are disregarded, which is not accepted scientific practice. Would chemists be allowed to overlook results from physics or mathematics? Certainly not! Yet economists regularly disregard findings from sister disciplines such as psychology, sociology, political science. Social psychology, for example, frames the problem of human action in terms of group dynamics. However, such group interactions are generally overlooked by economists, although economic activity obviously does take place in a society and within a political system and not between isolated individuals.74 Furthermore, economics is not based on controlled experiments in the same way as natural sciences are. The use of mathematics in model building does not make economics into a rigorous science.75 Essentially, economics is based on assumptions about people’s behavior and motivation from which principles can be derived using deductive logic. This is like the methodology of medieval philosophers who used to argue about “how many angels can dance on the head of a pin.” St. Thomas Aquinas, for example, assumed that God was perfect, infinite, and immutable.76 This is a reasonable starting point if one were to imagine the nature of God in the abstract; this is the way God would be, according to Aquinas. Similarly, economists imagine perfect markets in which there is an authority called the auctioneer who calls out prices in a similar fashion. Just as Aquinas supposed that there is a perfect God and

Markets Are Neither Omniscient Nor Omnipotent  33 theology followed from that, economists suppose that there is a perfect market with perfect competition without considering all its shortcomings in the real world. Such a methodology is faulty because intuitively plausible assumptions have not been borne out by experiment. It seemed obvious and logical for a couple of thousand years after Aristotle that heavier objects fall faster than lighter ones until it was disproved by Galileo. Hence, experiments and experience are a more reliable guide to economics than theorems based on logical deductions from basic premises, which themselves are a matter of controversy. Moreover, the results of experimental economics and behavioural economics—­ particularly the anomalous ones—are not integrated into mainstream thought and are treated as epiphenomena. Their inconvenient results, such as those that contradict the rationality assumption, are mainly disregarded; by doing so, economists deviate from the scientific approach. Furthermore, the lack of precision of economic predictions implies that the models used are rudimentary. Former Federal Reserve chairman Alan Greenspan’s version of economic theory implied that markets won’t crash, but that prediction was falsified. Yet, there is no rush to scrap old theories in order to avoid such mistakes in the future. When the results of laboratory experiments contradict the fundamental assumptions of the economics discipline, they are ignored, in the main, or rationalized away as being insufficiently realistic.77 Consider an experiment called the “ultimatum game” consisting of two players. Player 1 receives some money, say $100, under the condition that she should share it with another player. Player 1 can decide how much of it to give to Player 2. However, the catch is that if Player 2 refuses to accept the proposed share then neither player is allowed to keep any of the $100. If both players were rational, selfish, and maximizing, then Player 1 would give a small amount, say $1 to Player 2. The reason is that $1 is greater than zero so Player 2 should accept the $1. However, this is contradicted in experiments. Instead, Player 2 consistently rejects a share less than a third and often the split is closer to being even.78 The results of this experiment blatantly contradict the common assumption that Homo oeconomicus is selfish, guided by reason, and a utility maximizer. Instead, they reveal the importance of emotion, empathy for others, and the feeling of revulsion if we believe that we were treated unfairly. Decisions are also mediated by hormonal levels that trigger emotional responses, rather than pure reason. In other words, our feelings of justice enter our interaction with others and our willingness to cooperate. These results, replicated innumerable times, contradict the rational-agent model but have been censured from mainstream textbooks.

Ideology Is Unavoidable As Greenspan suggested, ideology is an integral part of economics and will continue to be so until it has a more substantial empirical foundation. Ideology stems from the judgments made about the appropriateness of initial assumptions. We are unable to organize our thoughts without making some initial assumptions, and these assumptions are necessarily a function of our own mindset, worldview, and intellectual and emotional commitments, and

34  Markets Are Neither Omniscient Nor Omnipotent therefore influence greatly the ideas deduced from them. Ideology is similar to a heuristic that enables us to get along in a complex world full of intractable uncertainties. It helps us when we have to make decisions with limited information and are unable to understand fully the intricate network of interconnectedness among numerous variables. It is our rule of thumb for action. Hence, economics cannot be purged of ideology; our political, moral, and philosophical sympathies are reflected in our fundamental assumptions and, thus, in how we structure our thinking and our understanding of the world around us. Its conclusions are largely derived from assumptions, intuition, introspection, opinion, and, yes, ideology.79 That is one of the reasons there are so many different schools of economics—Neo-Keynesian, post-Keynesian, neoclassical, monetarist, heterodox, feminist, Austrian,80 behavioral, institutional, evolutionary, socialist, Marxist, radical—and that is why economists do not have coherent advice on some of the most important issues of the day.81

Notes 1 “For the past quarter century we have worshiped the ‘free’ market as an ideology rather than for what it is—a natural product of human social evolution and a set of economic tools with which to construct a just and equitable society. Under the spell of this ideology and the false promise of instant riches the American’s immigrant values of thrift, prudence and community concern—traditionally the foundation of the Dream— have been hijacked by an all-consuming self-interest.” Peter C. Whybrow, “Dangerously Addictive: Why We Are Biologically Ill-Suited to the Riches of Modern America,” The Chronicle of Higher Education, March 13, 2009. 2 “We Must Not Make an Idol Out of the Market,” says political philosopher Robert George of Princeton University in a dialogue with Cornel West “Bloggingheads TV,” December 15, 2010. https://bloggingheads.tv/videos/2822?in=23:48&out=38:52 @32 minutes. 3 For a heartbreaking story of what it is like to live on a disability check in West Virginia read: Terrence McCoy, “After the Check is Gone,” The Washington Post October 6, 2017. 4 Lawrence Summers, “Why Isn’t Capitalism Working?” Reuters, January 9, 2012. Summers was the President of Harvard University, and Director of the National Economic Council under President Obama. 5 John Komlos, “Income Inequality Begins at Birth and These Are the Stats that Prove It,” PBS Newshour, May 4, 2015. www.pbs.org/newshour/making-sense/plight-african-americans-u-s-2015/. 6 Robert Reich, Aftershock: The Next Economy and America’s Future (New York: Knopf, 2010). 7 John Komlos, “How Reaganomics, Deregulation and Bailouts Led to the Rise of Trump,” PBS Newshour, April 25, 2016. www.pbs.org/newshour/making-sense/column-how-reaganomics-­ deregulation-andbailouts-led-to-the-rise-of-trump/. 8 Thomas Pikkety, Capital in the Twenty First Century (Cambridge, MA: Harvard University Press, 2014). 9 Consider a society of two people with incomes of 10 and 1, and then consider a society with incomes of 5 each. The former society has a higher average income, but which society do you think will have a higher quality of life? 10 United Nations Office on Drugs and Crime, Statistics. https://data.unodc.org/. 11 “HuffPost Graphics, “There Have Been 153 Mass Shootings in 2017,” https://twitter.com/ HuffPostGraphic/status/875019850061664258. 12 7.4 vs. 2.2 per thousand. 13 Bureau of Justice Statistics, “Correctional Populations in the United States,” www.bjs.gov/index. cfm?ty=pbdetail&iid=5870. 14 Christopher Hartney, “US Rates of Incarceration: A Global Perspective,” www.nccdglobal.org/sites/ default/files/publication_pdf/factsheet-us-incarceration.pdf. In many states, ex-felons are denied the right to vote. 15 Juliet B. Schor, The Overspent American: Why We Want What We Don’t Need (New York: Harper Perennial, 1999).

Markets Are Neither Omniscient Nor Omnipotent  35 1 6 BankruptcyAction.com. “Business and Non-Business Filings.” www.bankruptcyaction.com/ USbankstats.htm; Al Krulick, “Bankruptcy Statistics.” www.debt.org/bankruptcy/statistics/. 17 This number includes those who went through a foreclosure, surrendered their home to a lender, or sold their home via a distress sale according to the National Association of Realtors. Laura Kusisto, “Many Who Lost Homes to Foreclosure in Last Decade Won’t Return—NAR,” Wall Street Journal April 20, 2015. www.realtytrac.com/mapsearch/foreclosures as well as on the website of U.S. Courts www. uscourts.gov/sites/default/files/data_tables/bf_f_0331.2017.pdf. 18 Organization for Economic Cooperation and Development (OECD), Growing Unequal? Income Distribution and Poverty in OECD Countries (Paris: OECD, 2008); OECD, Divided We Stand: Why Inequality Keeps Rising (Paris: OECD, 2011). 19 National Center for Health Statistics, “Advance Report of Final Divorce Statistics, 1988,” Monthly Vital Statistics Report 39 (1991) 12, suppl. 2. 20 U.S. Census Bureau, Data, Historical Families Tables, Table FM-1, “Families by Presence of Own Children under 18: 1950 to Present.” www.census.gov/data/tables/time-series/demo/families/­ families.html. 21 U.S. Census Bureau, Data, Historical Families Tables, Table FM-3, “Average Number of Own Children Under 18 Per Family by Type of Family: 1955 To Present.” www.census.gov/data/tables/time-series/ demo/families/families.html. 2 2 In a dozen metropolitan areas such as New York, Chicago, and Cleveland, the average poor black child lives in neighborhoods in which one-third of the children are poor. Nancy McArdle, Theresa Osypuk, and Dolores Acevedo-Garcia, “Disparities in Neighborhood Poverty of Poor Black and White Children,” Diversity Data Briefs 1 (2007). 23 About one-half of black youth graduate from high school. Half of the dropouts end up in prison by the time they are in their mid-thirties. “Why Are 1 in 9 Black Men in Prison?” NAACP of Otero County, New Mexico, March 27, 2008. 2 4 UNICEF Innocenti Research Centre, Child Well-Being in Rich Countries. A Comparative Overview (Florence, Italy: The United Nations Children’s Fund, 2013), Report Card 11. 25 Childhelp, “National Child Abuse Statistics & Facts.” www.childhelp.org/child-abuse-statistics/. 26 Centers for Disease Control and Prevention, “Child Abuse and Neglect Prevention.” www.cdc.gov/ violenceprevention/childmaltreatment/index.html. 27 Christopher P. Howson, Mary V. Kinney, and Joy E. Lawn, eds., Born Too Soon: The Global Action Report on Preterm Birth (Geneva: WHO, 2012). 28 “Our view is that teen childbearing is so high in the United States because of underlying social and economic problems. It reflects a decision among a set of girls to ‘drop-out’ of the economic mainstream; they choose nonmarital motherhood at a young age instead of investing in their own economic progress because they feel they have little chance of advancement.” Melissa S. Kearney and Phillip B. Levine, “Why Is the Teen Birth Rate in the United States So High and Why Does It Matter?” Journal of Economic Perspectives 26 (2012) 2: 141–166. 29 “Commonwealth Fund Affordable Care Act Tracking Survey, February to March 2018.” www. commonwealthfund.org/publications/surveys/2018/may/commonwealth-fund-affordable-care-acttracking-survey-february-march. 30 Kelsay Avery, Kenneth Finegold, and Amelia Whitman, “Affordable Care Act Has Led to Historic, Widespread Increase in Health Insurance Coverage,” Issue Brief, Department of Health & Human Services, September 2016. https://aspe.hhs.gov/system/files/pdf/207951/ChartpackACA HistoricIncreaseCoverage.pdf. 31 Low food security is defined as “reduced quality, variety, or desirability of diet with little or no indication of reduced food intake.” Very low food security is defined as “multiple indications of disrupted eating patterns and reduced food intake.” U.S. Department of Agriculture, “Interactive Chart: Food Security Trends.” www.ers.usda.gov/data-products/food-security-in-the-united-states/ interactive-chart-food-security-trends/; “Definitions of Food Security” www.ers.usda.gov/topics/ food-nutrition-assistance/food-security-in-the-us/definitions-of-food-security. 32 Mark Olfson et al., “National Trends in the Outpatient Treatment of Depression,” Journal of the American Medical Association 287 (2002): 203–209; Steven C. Marcus and Mark Olfson, “National Trends in the Treatment for Depression from 1998 to 2007,” Archives of General Psychiatry 67 (2010): 1265–1273. 33 Anxiety and Depression Association of America, “Depression,” https://adaa.org/understandinganxiety/­depression.

36  Markets Are Neither Omniscient Nor Omnipotent 34 Paul E. Greenberg et al., “The Economic Burden of Adults with Major Depressive Disorder in the United States, 2005 and 2010,” Journal of Clinical Psychiatry, 76 (2015) 2: 155–162, here p. 159. 35 See the website of the organization Mental Health America. 36 Josh Katz, “Drug Deaths in America Are Rising Faster Than Ever,” The New York Times, June 5, 2017. 37 Anne Case and Angus Deaton, “Mortality and Morbidity in the 21st Century,” Brookings Papers on Economic Activity, March 23–24, 2017; 38 U.S. Department of Housing and Urban Development, “The 2016 Annual Homeless Assessment Report to Congress,” November 2016. www.hudexchange.info/resources/documents/2016-AHARPart-1.pdf. 39 Not all of them were living on the street, though. Some were living in shelters, motels, or with other families. Marisol Bello, “Child Homelessness Up 33% in 3 Years,” USA Today, December 13, 2011. Some 1.6 million people use shelters per annum. See U.S. Department of Housing and Urban Development, Press Release “Annual Homeless Assessment Report to Congress,” July 9, 2009, https://archives.hud. gov/news/2009/pr09-108.cfm; “About Homelessness,” The National Alliance to End Homelessness. The number of homeless families (parent[s] with child) living in shelters increased from 130,000 to 170,000 in 2010. See Michael Luo, “Number of Families in Shelters Rises,” The New York Times, September 11, 2010. 40 In other words, their net worth is more than a thousand million dollars. Katie Sola and Emily Canal, “Here Are the States with the Most Billionaires,” Forbes, March 5, 2016. 41 U.S. Internal Revenue Service, “SOI Tax Stats—Individual Statistical Tables by Size of Adjusted Gross Income, Tax Year 2014,” table 1.1, 2014. www.irs.gov/uac/soi-tax-stats-individual-statistical-tables-bysize-of-adjusted-gross-income#_grp1. 42 In addition, there were at least eight million households whose net worth exceeded $1 million. Wikipedia contributors, “Millionaire.” 43 World Bank, “Gini Index,” https://data.worldbank.org/indicator/SI.POV.GINI?locations=US. 44 The rankings declined since 2010. Wikipedia contributors, “Programme for International Student Assessment;” “An International Education Test,” The New York Times, December 7, 2010. 45 Editorial, “48th Is Not a Good Place,” The New York Times, October 26, 2010. 46 Secretary of Education Arne Duncan said that this should be a “wake-up call.” Sam Dillon, “Top Test Scores from Shanghai Stun Educators,” The New York Times, December 7, 2010. 47 “Beast” refers pejoratively to the federal U.S. government. The strategy is based on the idea that if taxes are reduced then the increasing deficits will put downward pressure on expenditures; the strategy was first articulated by Alan Greenspan in a congressional testimony in 1978, but the name for it originated later in the Reagan administration. The strategy was pernicious, because it failed to consider that the government may not be able to cut back on expenditures and therefore led to persistent government deficits. Bruce Bartlett, “Tax Cuts and ‘Starving the Beast’: The Most Pernicious Fiscal Doctrine in History,” Forbes, May 7, 2012. 48 John Kenneth Galbraith, The Affluent Society (New York: Houghton Mifflin, 1958); Lester C. Thurow, “Galbraith, John Kenneth (1908–2006),” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 4 9 It was up from 31st in the previous year. “The Best and Worst Places to Be a Mom,” PBS NewsHour video, May 8, 2012. 50 Jennifer Saranow Schultz, “Top Consumer Complaints in 2009,” The New York Times, July 27, 2010. 51 Bureau of Justice Statistics, “Press Release,” September 27, 2015. www.bjs.gov/content/pub/press/ vit14pr.cfm. 52 Wikipedia contributors, “I-35W Mississippi River Bridge,” Wikipedia: The Free Encyclopedia; Paul Krugman, “America Goes Dark,” The New York Times, August 8, 2010; Bob Herbert, “The Corrosion of America,” The New York Times, October 26, 2010; Walter Euken, The Foundations of Economics: History and Theory in the Analysis of Economic Reality (Berlin: Springer, 1950). 5 3 John Komlos, “Growth of Income and Welfare in the U.S., 1979–2011.” NBER working paper, 2016, no. 22211. www.nber.org/papers/w22211. 54 This phrase, attributed to Henry D. Thoreau, is a staple in Republican politicians’ slogans. Joshua Gillin, “Mike Pence Erroneously Credits Thomas Jefferson with Small Government Quote,” POLITIFACT, September 21, 2017. 5 5 “Franklin D. Roosevelt’s Address Announcing the Second New Deal,” http://docs.fdrlibrary.marist. edu/od2ndst.html.

Markets Are Neither Omniscient Nor Omnipotent  37 56 Joseph Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy (New York: W.W. Norton, 2010). 5 7 The financial sector spent $2.7 billion on lobbying from 1999 to 2008, while individuals and committees affiliated with the industry made more than $1 billion in campaign contributions. Sewell Chan, “Financial Crisis Was Avoidable, Inquiry Finds,” The New York Times, January 25, 2011. 58 Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009. 59 The Supreme Court has exacerbated this development by an incomprehensible twist of the English language conceptualizing money as speech in its 2010 Citizens United decision, in which it interpreted the First Amendment so as to imply that corporations can spend an unlimited amount of funds on political campaigns. The decision has allowed big money to play an even larger role in the electoral process. 60 Chris Mooney, The Republican War on Science (New York: Basic Books, 2005); Andrew C. Revkin, “Climate Expert Says NASA Tried to Silence Him,” The New York Times, January 29, 2006. 61 U.S. Department of the Treasury, “Bureau of Consumer Financial Protection.” 62 Some markets are just too repugnant from an ethical standpoint to allow. These are no less binding constraints as those imposed by technology. Alvin Roth, “Repugnance as a Constraint on Markets,” Journal of Economic Perspectives, 21 (2007) 3: 37–58. 63 “In responding to the hurricane [Harvey]—and in funding some of the repair—everyone turns to government, just as they did in the aftermath of the 2008 economic crisis. Again, it is ironic that this is now occurring in a part of the country where government and collective action are so frequently rebuked. It was no less ironic when the titans of US banking, having preached the neoliberal gospel of downsizing government and eliminating regulations that proscribed some of their most dangerous and anti-social activities, turned to government in their moment of need.” Joseph Stiglitz, “Learning from Harvey,” Project Syndicate, September 8, 2017. 64 Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care,” American Economic Review 53 (1963) 5: 141–149. 65 Angus Deaton, “Income, Health, and Well-Being Around the World: Evidence from the Gallup World Poll,” Journal of Economic Perspectives 22 (2008) 2: 53–72, p. 68. 66 Federal Reserve Bank of St. Louis, “Corporate Profits After Tax,” https://fred.stlouisfed.org/series/ CPATAX. 67 Israel’s system is even more efficient: Israelis live 3.2 years longer than Americans but spend just 28% as much on health care or $7,000 less per annum than the U.S. for every man, woman, and child. 68 See source in Figure 2.5 and Statista, “Average Life Expectancy in North America For Those Born in 2017, by Gender and Region (in Years)”. 69 Ralph Nader, Unsafe at Any Speed. The Designed-In Dangers of the American Automobile (New York: Grossman, 1965). 7 0 “Crib Information Center,” U.S. Consumer Product Safety Commission. 71 Jeffrey Madrick, Seven Bad Ideas: How Mainstream Economists Have Damaged America and the World (New York: Vintage, 2015); see also the “Heterodox Economics Newsletter.” McCloskey declares that “the progress of economic science has been seriously damaged” by ivory-tower economics; Deirdre McCloskey, Secret Sins. 7 2 “Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world.” John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), chapter 24. 73 For instance, three civil rights activists were brutally murdered in 1964 in Philadelphia. Mississippi Wikipedia contributors, “Murders of Chaney, Goodman, and Schwerner.” I highly recommend this article for its detailed description of cruelty. 74 Karl Polanyi, The Great Transformation: The Political and Economic Origins of Our Time (New York: Rinehart, 1944). 7 5 Ariel Rubinstein, “A Sceptic’s Comment on the Study of Economics,” The Economic Journal 116 (2006): C1–C9. 76 Wikipedia contributors, “Thomas Aquinas,” Wikipedia: The Free Encyclopedia. 77 Daniel Kahneman, “Maps of Bounded Rationality: Psychology for Behavioral Economics,” American Economic Review 93 (2003) 5: 1449–1475, here p. 1450.

38  Markets Are Neither Omniscient Nor Omnipotent 78 Nowak, M. A., Page, K. M., and Sigmund, K., “Fairness Versus Reason in the Ultimatum Game,” Science 289 (2000) 5485: 1773–1775. 79 Steven Rappaport, “Abstraction and Unrealistic Assumptions in Economics,” Journal of Economic Methodology 3 (1996) 2: 215–236. 80 The reference here is not to the nation but to a school of economic thought. 81 Nick Wilkinson, An Introduction to Behavioral Economics: A Guide for Students (London: Palgrave/ Macmillan, 2007); Binyamin Appelbaum, “Politicians Can’t Agree on Debt? Well, Neither Can Economists,” The New York Times, July 17, 2011.

3 The Nature of Demand

The impotence of man moderating and checking the emotions I name bondage, for, when a man who is prey to his emotions, he is not his own master . . . he is often compelled, while seeing that which is better for him, to follow that which is worse. Baruch Spinoza1

The issues discussed in this chapter are necessary to understand the workings of real markets as opposed to hypothetical ones. Chapter 2 provided evidence that the economy as currently constituted provides an inadequate quality of life to around 40% of the U.S. population. Here we suggest that the reason this is that mainstream economics creates a fantasy world that misleads, and this has dire consequences for the way the economy is constituted. We focus on the psychology of consumption, overlooked in standard introductory treatments of the subject, which is crucial to understanding the extensive frustration with the system. This chapter will provide an introduction to viewing demand from a behavioral perspective.

What Is Scarce? Among the first conventional assumptions is that we live in a world of scarcity, which implies that our desires are basically infinite. Yet, our desires are not innately endless and depend basically on external influences. In fact, most of our wants, except the obvious basic ones determined by genetics, are primarily culturally constructed. They are not fixed at birth. In other words, we are not born with a desire for iPhones. Thus, the demand for most of what we consume is not self-generated (exogenously given) except for such basic needs as food, clothing, shelter, and health care. On the contrary, these depend on influences generated within the economic system. Hence, they are endogenous to the economic system. To associate the overdeveloped part of the world, overflowing with goods, with a pervasive level of scarcity is a misapplication of the concept. On the contrary, the societies of the developed world are best characterized as one of abundance overflowing with supply. Our closets and garages are cluttered with things we do not use and never really needed. Our department stores are filled to the brim. In order to increase profits, firms induce a feeling of scarcity in us. In other words, scarcity is induced endogenously within the system of desire-creating advertisements. Actually, scarce today are stress-free leisure time with

40  The Nature of Demand our family and friends, decent jobs, trust, respect for one another, and public goods such as good schools and safe neighborhoods. If our desires are man-made and not natural, we should consider where they come from.

Consumer Sovereignty and Endogenous Tastes Consumer sovereignty is the mainstream doctrine that consumers dictate what businesses produce insofar as they “vote” with their dollars to channel production in such a way as to satisfy their desires (Figure 3.1). Tastes are supposedly determined outside of the economic system: they are assumed to be exogenous rather than endogenous. Insofar as they are predetermined, consumers’ tastes, expressed through their wants, supposedly induce corporations to produce the right amount and quality of goods to satisfy those wants. In the end, consumers are in charge as they determine what is being produced. If they do not demand stuff, firms would not produce stuff. So the conventional claim is that our wants are satisfied and everyone is happy. This is a convenient assumption because it makes it appear that we, the consumers, are in charge, as we should be. However, this model makes the unfounded assumption that tastes are exogenous, that is to say, that wants are determined before the individual enters the economy. This presupposes that corporations do not affect our desires; this is tantamount to asserting that consumers’ likes and dislikes are immutable by the time they make decisions in the marketplace and are

Figure 3.1  Conventional View of Consumer Sovereignty

The Nature of Demand  41 Basic Needs Children Youth

Adults

Pavlovian Conditioning

WANTS

Producers

$300 Billions for Persuasion Output

In the actual economy tastes are endogenous; so consumer sovereignty is captured by producers. The result is an economy that does not satisfy.

Consumption

Figure 3.2  In Reality Tastes Are Determined within the Economic System

guided by their innate desire for products, such as iPhones, and act accordingly. It is a completely erroneous assumption as it is all too obvious that the corporate world influences our desires in profound ways through their ubiquitous and overpowering advertisement campaigns. Therefore, our tastes are endogenous to the economic system: our wants beyond our basic needs are determined within the economy and corporations have a big role to play in that (Figure 3.2). Consequently, conventional economics is essentially adult economics: it disregards the crucial first 18 or so years of life during which our psyche and subconscious mind is formed. Hence, by the time we reach adulthood, we have gone through an extended and rigorous process of socialization inasmuch as Madison Avenue inundates us with symbols of sex, power, and cultural icons in order to sell its clients’ products. Through this socialization we assimilate the dominant culture in which we learn to mimic the tastes, values, and consumption habits of superstars and assorted other idolized celebrities projected across the media. Under such intense pressure, children are groomed to grow up to become reliable consumers and choice becomes a charade, a “pretence of individualism.”2 In other words, we learn to become American on Madison Avenue’s terms. As a consequence, it is self-deceptive to think that we are in control of our tastes, values, and choices. Hence, the theory of consumer sovereignty is essentially pre-Freudian and pre-Pavlovian (Figure 3.2). Sigmund Freud, the father of psychoanalysis, emphasized at the turn of the twentieth century that much of what we do is not under the control of the rational mind. Our decisions are often directed not by our prefrontal cortex but by emotions and by desires of which we are unaware, which originate in the unconscious mind and are not subject to the

42  The Nature of Demand

Illustration 3.1  Virginia Slims’ Successful Marketing Appealed to Feminists by Combining Imagery of Glamour, Freedom, Independence, Emancipation, Empowerment, Slimness, and Attractiveness. Increased Smoking among Teenage Girls and Killed Hundreds of Thousands of Women. Source: From the Collection of Stanford Research into the Impact of Tobacco Advertising (tobacco. stanford.edu).

laws of logic. These thought processes influence our actions in profound ways, motivate us, and induce feelings in us without our explicit awareness. Freud suggested that: Not only does the unconscious mind contain buried memories, but it is also the source of instinctive drives, particularly sexual and aggressive ones. Although the conscious mind has no direct access to the content of the unconscious mind, it is strongly affected by that content.3 The importance of the unconscious mind is a standard concept in cognitive psychology.4 It is important to realize that the unconscious is not open to introspection. For example, the manipulation of children’s unconscious by the media lays the foundation for a culture of consumerism and cannot be undone by rational processes once the child reaches adulthood.5 Hence, it would be important to create an environment in which the development of children’s unconscious mind is largely protected from business influence.

The Nature of Demand  43

Illustration 3.2  Consumerism Overwhelms. Madison Avenue Makes it Seem as Though It Leads to a Good Life. It Does Not. It Leads to Frustration and Indebtedness. Credit: iStock.com/tobiasjo.

Pavlovian conditioning is another important psychological/physiological principle prominent in marketing,6 though overlooked completely in economics. It is named after the Nobel Prize winning Russian physiologist who discovered the phenomenon that dogs learned to respond involuntarily to stimulus. The dogs in his experiment learned to salivate in response to hearing a bell: he found accidentally while feeding the dogs that if he added a simple stimulus by ringing a bell, they soon learned to associate the bell with the food. The dogs then began to salivate reflexively at the ringing of the bell, even without the food. Advertisers take advantage of this kind of response by depicting young good-looking men and women with wide smiles in fashionable attire having a good time drinking a particular brand of soft drink. After a while we involuntarily associate that soft drink with having a good time and purchase the product. This is classical conditioning. We may choose to buy a six-pack of coke without thinking about it, and yet to an outside observer the purchase could well appear as a choice based on a rational decision. Such marketing strategies are both demeaning and exploitative inasmuch as they appeal subliminally to our difficult-to-control primordial desires and illusions.7 Another kind of conditioning is reinforcing behavior by rewarding it. That is the reason why we have so many reward programs such as frequent-flyer miles, free gifts, and premiums. The conditioning starts with toddlers: fast-food chains give away toys to toddlers as a way of conditioning them to want to frequent those eateries even when they no longer

44  The Nature of Demand receive the toys,8 and cigarette companies give away samples to youth. “The firearms industry has poured millions of dollars into a broad campaign to ensure its future by getting guns into the hands of children.”9 Parents have not been successful in shielding their children from this multibillion-dollar effort at conditioning. Reward points for using credit cards have also been very effective means of enriching banks. They earn money at practically every purchase we make. In 2016 banks earned a walloping $100 billion in credit card fees and has left many consumers swimming in debt.10 The discoveries of Freud and Pavlov pose a substantial challenge to conventional economics. The reason why economics textbooks ignore these major thinkers of the twentieth century is that their discoveries undermine the assumption upon which all of neoclassical economics rests, namely the rational agent model, according to which homo oeconomicus is objective about her wants, is super rational, and is in perfect control of her taste, emotions, and desires. Thus, homo oeconomicus is pre-Freudian and pre-­Pavlovian, and mainstream economics overlooks the fact that we do not enter the economy as adults with fully developed tastes. Instead, we enter the economy at birth and develop mentally within that economy and therefore interact with it in critical ways from the very beginning of our lives (Figure 3.2). This is an essential oversight in conventional economics textbooks. Moreover, there are hardly any advertisements to teach us how to live a good life: to save for a rainy day, to practice frugality and moderation, to be circumspect, to appreciate self-control, to appreciate the free things in life, to read the classics in the public library, to be patient and humble, to relax with friends, not to be envious, not to imitate the rich and famous, to show self-restraint, to appreciate that we are healthy and not hungry, to be kind to the fellow travellers on this earth without being greedy.11 To grow up in such a culture with asymmetric power means that we are free to choose our cola drink, but we are deprived of a basic right to develop our own taste—utility function—without such overbearing corporate manipulation. However, we are unaware of this fact because we are so accustomed to it. Consumer sovereignty is captured by the business community using mass communication channels including social media. This is a major hindrance to our ability to develop healthy mental attitudes independently and to live fulfilled lives, because new desires are implanted in us as soon as the old ones are satisfied. Contentment is unprofitable. No wonder that the average American is overweight, indebted, and deeply discontented. We did not choose to become so. This culture and these attitudes were imposed upon us by powerful profit-seeking corporations. This state of unfreedom is an immense contradiction for a nation in which the popular culture stresses freedom above all else.12 In sum, consumer sovereignty is merely a mirage in the real existing economy (Figure 3.2). The result is an economy that fails to satisfy: [a] “yawning void, an insatiable hunger, an emptiness waiting to be filled,” that [Christopher] Lasch identified as animating the typical narcissist of the 1970s has grown only deeper with the passage of time. The Great Recession was supposed to portend a scaling back, a recalibration of our lifestyle, and usher in a new era of making more of less. But the pressures that drive the dysregulated American haven’t abated any since the fall of 2008. Wall Street is resurgent, and unemployment is still high.

The Nature of Demand  45 For too many people, the cycle of craving and debt that drives our treadmill existence simply can’t be broken.13 Consequently, we need to protect the individuality of our children from the conditioning of the corporate world. That can only be accomplished if we can limit the power of Madison Avenue from depicting an unrealistic fantasy of the American Dream as Aldous Huxley, best known for his prophetic nightmare-vision novel Brave New World of 1931 which warned of the dehumanizing forces of totalitarianism, warned us.14 E.F. Schumacher also argued a generation ago that less is more: “A Buddhist economist would consider . . . [the conventional] approach excessively irrational: since . . . the aim should be to obtain the maximum of well-being with the minimum of consumption” and the “essence of civilisation [is] not in a multiplication of wants but in the purification of human character.”15 We have not evolved to be able to handle today’s affluence gracefully. According to psychiatrist Peter Whybrow, “Human beings grew up under frugal circumstances. They don’t know how to manage affluence.”16 He shows that there is “a dangerous misfit emerging between our consumer-driven culture and the brain systems that evolved to deal with privation 200,000 years ago. Absent of any controls—cultural or economic constraints—we are easily hooked on our acquisitive pleasure seeking behaviors.” Whybrow shows how human biology is ill equipped to cope with the demands of “the 24/7, global, information-saturated, rapid-fire culture we . . . have come to crave.”17

Wants and Basic Needs Although the convention is to consider demand exclusively in terms of “wants,” it is essential to distinguish between three sources of demand depending on the type of goods involved (necessities, comforts and social necessities, and luxuries): (A) Necessities are goods that fulfill basic survival needs, such as food sufficient to avoid hunger, safe drinking water to relieve thirst, shelter that includes sanitation facilities, clothing appropriate for the weather conditions, and medical care to relieve pain and disease including mental health; we could not continue to live without these goods and services for long. Natural needs derived from the instincts of reproduction would also be in this category. (B) Comfort goods are considered socially necessary to live a dignified life in a particular society, such as an automobile in most areas in the U.S., because of the shortage of public transportation and the long distances that need to be traveled for work or daily needs. Access to education, computer, and telephone are also in this category, as we cannot function effectively without them in the society in which we live. (C) Luxuries are goods that are not necessary for life either biologically or socially but are demanded (i) because of an acquired taste; or (ii) because we are manipulated psychologically into wanting them; or (iii) in order to obtain social status by virtue of their being trendy or because of their exclusiveness. These are also called Veblen goods or positional goods. They differ from the goods in the two previous categories in that they confer social status and thereby create a negative externality on others: envy. The share of these types of goods in total expenditures has increased over time from 20% in 1901 to 32% in 1950 to 50% by 2003.18

46  The Nature of Demand These distinctions should not be considered carved in stone but should suffice to get us started thinking about the underlying source of demand and the key distinction between basic needs and other kinds of wants. Even if this is a fuzzy distinction, it is crucial to understanding the fundamental differences between the consumption of bread, health care, a used car, and a new BMW.19 To conflate these goods under the general rubric of consumption misses a number of crucial attributes of these products. The above typology is based on two characteristics of demand: the source of the need for the good and the consequences of being without it. The need for the goods in group (A) stems from natural sources and is inherent to existing as a human biological organism. These goods enable us to survive, and their lack is associated with pain, suffering, or even death, if they are not supplied in the right proportions. The need for goods in group (B) stems from the structure of the socioeconomic system, and these goods enhance one’s capability to function with self-respect within that society.20 Thus, access to the Internet facilitates communication necessary to work effectively in today’s developed world, while being capable of driving to work or dressing in a manner required by the job description is a precondition of holding a job. In 2016, a single person earning less than $12,486 was considered poor by the U.S. government, while for a family of four the poverty line was at $25,000.21 These amounts were deemed sufficient to meet basic needs (A) as well as minimum social needs in category (B). In contrast to the first two types of goods, the need for luxury and status goods in group (C) stems from external sources influencing us to “keep up with the Joneses” or wanting to attain a higher status in society, or to avoid the shame of being seen as inferior or as an outsider. The satisfaction obtained from these goods is due to their exclusive nature, or to habit, or to having our subconscious manipulated in such a way that we crave the good.22 People flaunt their wealth in order to attain social status, so these goods are highly visible. It is difficult to exhibit one’s savings deposit unless one carries the bank statement around, and that is not considered socially appropriate behavior. Flaunting has its cultural norms as well. In rich countries, the necessities of life make up a small share of total expenditures. Hence, the conventional assumption that “wants” are “unlimited” is by no means warranted for goods in groups (A) and (B), especially since storage of goods is costly. Our priority as a society ought to be to meet first the basic social and physical needs for all before we indulge in luxuries. In other words, goods in groups (A) and (B) ought to take precedence over goods in group (C). As the humanistic psychologist Erich Fromm affirmed, “the unconditional right of everyone to have a sufficient material basis to live a dignified human life, that is to say, that a man has the same right as a dog has to live and not to starve.”23 Basic needs are finite: the size of the stomach is limited as is the amount of clothing we can wear at any one time. One of the most important disadvantages of free-market economics is that the advertisement agencies on Madison Avenue have immense power to influence consumers in such a way that they feel a psychological dependence on consumption per se, without our conscious realization that we are being manipulated. Consequently, leaving consumption up to free-market processes cannot possibly lead to a good life inasmuch as the market is not content with producing goods to satisfy the needs in groups (A) and (B), and devotes considerable effort and resources to coax us into coveting goods in a capricious manner, subject to whim and impulse. It supports an excessive and insatiable desire for goods recommended

The Nature of Demand  47

Illustration 3.3  Drink to Contentment. Most People Who Drink Colas Do Not Look This Sophisticated. One Bottle Has 41 Grams of Sugar. For a Woman the Recommended Daily Intake of Non-Naturally Occurring Sugar Is Less Than That: 25 Grams! No Wonder That Two-Thirds of American Adults Are Overweight or Obese. Credit: iStock.com/travelif.

by the rich, famous, beautiful, and powerful. In this way, we are made to feel that goods in group (C) actually belong in group (A) or (B). For instance the market share of Virginia Slims’ cigarettes grew enormously by using an “aspirational image” which “co-opted women’s liberation slogans to build a modern female image.”24 In contrast, the Marlboro Man was a rugged individualist projecting an ultra-masculine image and became one of the most successful brands in any industry world-wide.25 “The Marlboro Man was strong, powerful. He never speaks. He’s so tough.”26 Its sales increased 300% after the ad debuted in 1955. Inconveniently, it killed some 2.3 million people by 2005 in the U.S. alone and probably another 1.6 million in the subsequent ten years.27 The management of shareholders of Phillip Morris Inc. earned billions as a consequence of the ad campaign. What price success! In sum, we develop a Pavlovian conditioned response to advertisements to such a degree that we are not even conscious of our dependence. Corporations have gained the upper hand by creating fads and exploiting our psychological weaknesses to induce us to buy their products. They succeed in imposing upon us their worldview through their full-court-press marketing strategies. We would be much more frugal and our wants would be much more modest otherwise. Our wants have become so extravagant through the influence of nearly $300-billion-per-annum expenditure tempting us to buy and consume today and not wait

48  The Nature of Demand

Illustration 3.4  The Marlboro Man Represents the Macho Rugged Individualism of the Dominant American Ideology. Marlboro’s Supposedly Transformative Experience Killed Millions of Men by Causing Cancer. Source: From the collection of Stanford Research into the Impact of Tobacco Advertising (tobacco. stanford.edu).

until tomorrow.28 That amount of money is a persuasion bombshell and almost four times as much as the amount spent on computers in 2016.29 In contrast, practically no one is telling us to be circumspect, frugal, or less impulsive shoppers.30 We should emancipate ourselves and become self-actualizing human beings according to Abraham Maslow’s hierarchy of needs: people who are able to enjoy more autonomy in personal development, who are rich in spirit, creative and wise enough not to have to depend on Hollywood stars to tell them how to arrange their lives.31 Until consumer sovereignty is restored de facto, free-market economics will not lead to a fulfilled life for the overwhelming majority of the population, because businesses profit from teaching us to be greedy, but as greed has no satiation we end up on a vicious circle of chasing desires incessantly implanted in us.32 Fixation on material needs cannot gratify, because we are blocked from further psychological and moral development. We are hindered from seeking meaning in life in intangibles rather than in material goods, although there is an unlimited supply of good feelings that can be generated from the beauty of nature, from friendships, from selfrespect, dignified relationships, love, spiritual connectedness, and other such intangibles.33

The Nature of Demand  49 Or consider that three of the eight Millennium Development Goals of the United Nations pertain to health: child health, maternal health, and combating diseases. Furthermore, Articles 23 and 25 of the UN’s Universal Declaration of Human Rights (adopted in 1948) state that: Everyone . . . has the right to social security [and] to a standard of living adequate for the health and well-being of himself and of his family, including food, clothing, housing and medical care and necessary social services, and the right to security in the event of unemployment, sickness, disability, widowhood, old age or other lack of livelihood in circumstances beyond his control.34 Mothers and children are singled out for being “entitled to special care and assistance.” Consequently, we need to make sure that distribution of income suffices to provide for the basic needs of the population that enables them to live a dignified life. However, the mainstream is oblivious to the distinction between basic needs and wants, thereby adopting a misleading framework. This omission is by no means benign. It has major consequences because it enables economists to tolerate deprivation and ill health among the poor, while the new elites are spending obscene amounts frivolously on conspicuous consumption with impunity, such as $2 million on a birthday party.35 If there is no distinction between needs and wants, then it is unnecessary to be concerned with such lopsided consumption: the health of a baby does not take priority over children’s playhouses costing $250,000.36 Yet, basic needs in the estimation of most of humankind have a different place in the scheme of consumption than a $300 million yacht,37 or the 310,000 breast augmentation procedures performed in the U.S. annually.38 Americans spent $15 billion on cosmetic surgery in 2016. Instead of being sovereigns, we have become willing executioners of business interests as we are socialized into the dominant ideology of consumption, instant gratification, and being oblivious to the extreme degree of income inequality.

The Metaphor of the Invisible Hand Adam Smith’s famous metaphor of the invisible hand is used as a shorthand for the selfregulating mechanism of the market; it implies that the actions of selfish individuals will benefit society. The coordination provided by competitive markets turns the self-interest of producers and consumers into an increase in social welfare. However, economists often fail to tell students that the invisible hand does not work in many circumstances, for instance with imperfect information.39 Stiglitz has repeatedly warned that the invisible hand metaphor ought not be taken at face value: “Adam Smith’s invisible hand—the idea that free markets lead to efficiency as if guided by unseen forces—is invisible, at least in part, because it is not there.”40 He continues: Markets by themselves do not lead to economic efficiency. If we look at examples of market successes and failures around the world, we see that many are understandable in terms of economic theories based on imperfect markets in which governments must play an important role.41

50  The Nature of Demand In sum, the invisible hand metaphor is not universal.42 Smith was describing an economy in which the quality of the products purchased was easily ascertained and information was easily available. Moreover, the butcher bought bread from the baker and the baker bought meat from the butcher year in and year out. Not only did they know one another but their parents did too. They attended the same church and were present at major life events: marriages, baptisms, and burials. Under such circumstances, the threat of opportunistic behavior was non-existent. Obviously, the butcher would not have gained by selling inferiorquality meat, neither would the baker have benefited by short-changing the butcher. They would have been discredited if they tried to deceive, overcharge, or otherwise entrap the customers of their small community. There was no small print, the products were simple, and transactions were based on repeated exchange within the confines of a village community with a sense of permanence. It is a folly to compare such a market to mortgage-backed securities at the turn of the twentyfirst century, for which none of the conditions of that Smithian world holds. Asymmetric information is crucial to the understanding of the modern economy and makes transacting business much more precarious than in Smith’s time. Besides, there was much stronger social pressure in the eighteenth century to check opportunistic behavior: cheaters, deceivers, and the greedy would have been ostracized. The impersonal nature of today’s economy implies, in contrast, that Dick Fuld, the CEO who bankrupted Lehman Brothers, will not be ostracized as his net worth at $250 million should suffice for him to maintain his extravagant lifestyle.43 Moreover, the participants in eighteenth-century markets were much more likely to believe in the Ten Commandments than today’s businessmen, and consequently would have been much less likely to want to engage in opportunistic behavior and take advantage of others as it could not be hidden from God. No sense in risking ending up in Purgatory or worse, in hell. Thus, the Smithian world is far from a reliable guide to the economy.44 Deception has become part of the business model. Goldman Sachs paid a $550 million penalty for getting caught misleading its investors on one of its collateralized debt obligations. A day later, AIG agreed to pay $725 million in a fraud case.45 These firms knew much more about the financial products they were selling than did the buyers, and they took advantage of the latter’s ignorance. They were fishing for fools. These are not isolated examples. Such mischief is reported regularly in the media. Thus, invoking Smith’s butchers and bakers as stand-ins for twenty-first-century turbo-capitalism is nothing less than bizarre. As Stiglitz suggests: “the invisible hand is often invisible because it is often not there.”46

The Magic of Competition Competition has a positive connotation in our culture. However, competition does not suffice for creating a good economy. For instance, it will neither create nor enforce safety standards, or if asymmetric information is present opportunistic behavior becomes a threat. So competition does not work well when these factors are present, and government has to provide oversight in order to ameliorate problems in the market.

The Nature of Demand  51 For instance, suppose a ground beef manufacturer put a label on the product stating “We guarantee that this beef has only 1 million E. Coli bacteria per pound. We’ll give you thousand dollars if you get sick.” Would people buy that package? I would not, because many of us do not know—and do not want to be reminded—that E. Coli invariably exist in ground beef, and we do not know what the FDA’s approved limit is. All we want to know is that the hamburger made of the ground beef is safe to eat if cooked properly, but the company could not convince us to trust it in a credible way. So labeling cannot be a competitive substitute for government inspection and regulation. Competition cannot solve all problems with complex transactions or when quality is difficult to ascertain. Competition also does not work well when the fees are in the future and contingent on uncertain conditions that the consumer is careless about. This is the major problem with the hidden penalties of credit cards. I was subject to a fee by my credit card company as I purchased something from Canada and did not anticipate that there would be a surcharge on foreign purchases.47 In fact, I am practically always surprised by hidden fees when I participate in a complex transaction, and the surprise is never in my favor. Competition can also lead to a race to the bottom especially when an intangible attribute such as risk is involved in the transaction. The reason is that risk is hard to measure and easy to hide. Hence, money managers who obtain a high return by taking excessive risks are at a competitive advantage vis-à-vis those who are more prudent and earn a lower return. Since risk is hard to ascertain, most investors flock to the high-return money manager putting the prudent one out of business. That process will then lead to high returns and excessive risktaking until the system implodes. In sum, competition is not sufficient for market outcomes to be efficient.

Consumerism The mainstream argument is that increasing the number of products raises welfare, because it increases consumers’ choices. However, the proposition overlooks the fact that choosing between products takes time, effort, and increases the probability of confusion. Therefore, increasing the number of options imposes search costs on the consumer, and these could exceed the value of the additional choice, thereby decreasing welfare. Thus, after a point, choice becomes a nuisance and leads to confusion or excessive transaction costs. A typical grocery store carries dozens of varieties of balsamic vinegar and olive oils.48 Shopping under such circumstances is challenging and confusing, thereby leading to inefficiencies. With increased choice comes increased possibility of misperception. Brand differences are usually minor: tests have revealed, for example, no difference among gasoline brands.49 Shopping has become our national pastime and hunting for bargains has become an addictive mania.50 Consumerism weighs heavily upon society insofar as we sacrifice personal relationships in the process of obtaining material goods, and we subject ourselves to longer work hours in order to acquire things we are persuaded to buy.51 In addition, we mortgage the living standards of future generations in the process. The outcome is a stressed existence.

52  The Nature of Demand Under normal circumstances, the emotional, reward-seeking, selfish, “myopic” part of our brain is checked and balanced in its desirous cravings by our powers of cognition—­ our awareness of the consequences, say, of eating too much or spending too much. But after decades of never-before-seen levels of affluence and endless messages promoting immediate gratification, Whybrow says, this self-regulatory system has been knocked out of whack. The “orgy of self-indulgence” that spread in our land of no-money-down mortgages . . . has disturbed the “ancient mechanisms that sustain our physical and mental balance.”52 Our guards are down. Our brain and nervous system have been rewired by Madison Avenue. We want to belong; we want to be a part of society, and through shopping we reaffirm our sense of belonging. Hence, the act of shopping itself becomes a habit, an end in itself as a substitute to satisfying basic psychological needs. According to Erich Fromm, these include wanting others to care about and respect us, and to develop loving relationships, to have a feeling of belonging to a social group, to know how we fit into the world, to have goals, to have a sense of accomplishment.53 However, if consumption is ultimately a poor substitute for gaining the respect of others, then consumerism will lead to an anxious life. The crucial point is that the corporate world has reconstructed culture in such a way that we seek to obtain these psychological rewards through consumption from which corporations can profit rather than from other types of activities that are not monetized— enjoying nature or music, reading, family and friends. Whybrow voices a similar sentiment when he observes that “despite our material riches what eludes many Americans, beyond a good night’s sleep, is a genuine sense of fulfillment—a sense of being in harmony with others and oneself.”54 According to Fromm: We consume everything with voracity. Behind this consumptive frenzy, lies an inner vacuity, an incapacity of people to be autonomous, to be truly productive citizens and unique selves. The perennial challenge is to imagine an alternative existence for ourselves—one that is ever more intelligent, humane and compassionate . . . There is, in fact, a sense of depression, a sense of loneliness. We find the clinical evidence for this connection in the fact that, very often, overeating and overbuying are the results of states of depression or intense anxiety55 . . . What we feel as freedom is, to a large extent, the freedom to buy or to consume; that is to say, to choose between many, many different things and to say: “I want this cigarette. I want this car. I want this thing rather than another.” Precisely because many of the competing brands are not in reality very different, the individual feels the great power of being free to choose.56 In reality, however, our choices are limited and manipulated by corporations, while “our emotional life has become impoverished.”57 Fromm urged us to regain “the right to be one self . . . We live in . . . [a] Western industrialized society . . . which creates a . . . type of Man whom one could call homo consumens, the consumer Man . . . He devotes his life to producing

The Nature of Demand  53 things and consuming things,” and in the process he is losing his human nature and becoming an object to be manipulated—“not much more than a mechanism.”59 Similarly, Aldous Huxley saw presciently that the threats to our individualism and freedom can come from many sources, not just from governments. He noted astutely that Madison Avenue discovered long ago that the shortest way to the parents’ bank account is through their offspring: 58

Today’s children walk around singing beer commercials and toothpaste commercials  . . . this whole question of children, I think, is a terribly important one because children are quite clearly much more suggestible than the average grownup; and . . . all the propaganda [is] an extraordinarily powerful force playing on these children, who after all are going to grow up and be adults quite soon . . . The children of Europe used to be called “cannon fodder” and here in the United States they are “television and radio fodder” . . . after all, you can read in the trade journals the most lyrical accounts of how necessary it is, to get hold of the children because then they will be loyal brand buyers later on.60 Huxley’s insights were prescient. We were so preoccupied with the threat of big government controlling our lives that we were blindsided by the threat of other institutions amassing power, namely Madison Avenue, Wall Street, Hollywood, Silicon Valley, and the mega-­corporations that slowly but incrementally did exactly that which we feared: limit our freedoms and manipulate our individuality. Enter the IT revolution and suddenly we are unexpectedly much closer to Huxley’s and Orwell’s dystopian vision. “Big Brother is Watching You” not only through surveillance by the state but also by the giant megacorporations of Facebook, Amazon, eBay, and Google. They are collecting and storing data on every move we make on the Internet and influence and take advantage of our psychological weaknesses and incentivize our tendencies toward consumerism. Facebook also classifies our political views into a spectrum from liberal to conservative. This is true unfreedom: welcome to 1984. Having lost control of ourselves, we become depressed in ever greater numbers. We can maintain overconsumption and social stability only with the use of antidepressants Prozac and Valium.61 The use of such drugs has increased phenomenally, in step with our consumption without gratification.62 A remarkable 213 million prescriptions for such drugs were dispensed in 2010 in the U.S.63 Anti-depressant use has jumped by 65% in 15 years.64

Notes 1 Baruch Spinoza, Ethics, Part IV, “Of Human Bondage, or the Strength of the Emotions” (1677). This is from where Somerset Maugham took the title of his book, Of Human Bondage (New York: George H. Doran Co., 1915). 2 Wikipedia contributors, “Theodore W. Adorno,” Wikipedia: The Free Encyclopedia. 3 Peter Gray, Psychology, 4th ed. (New York: Worth, 2002), p. 17. 4 Louis M. Augusto, “Unconscious Knowledge: A Survey,” Advances in Cognitive Psychology 6 (2010): 116–141.

54  The Nature of Demand 5 Juliet Schor, Born to Buy: The Commercialized Child and the New Consumer Culture (New York: Scribner, 2005). 6 Philip Kotler and Gary Armstrong, Principles of Marketing, 17th ed. (New York: Prentice Hall, 2017). 7 Andrea Dworkin and Catharine A. MacKinnon, Pornography and Civil Rights: A New Day for Women’s Equality (Minneapolis, MN: Organizing Against Pornography, 1988); Matthew Hutson, “Lust Now, Pay Later: Keeping Up with Your Joneses,” Psychology Today, May 1, 2008. 8 Lara O’Reilly, “McDonald’s Slapped Down for Focusing Its Happy Meal Advertising on the Toy and Not the Food,” Business Insider, May 15, 2015. 9 Mike McIntire, “Selling a New Generation on Guns,” The New York Times, January 26, 2013. 10 Hannah Rounds, “Average Household Credit Card Debt in America: 2017 Statistics.” www.magnifymoney. com/blog/news/u-s-credit-card-debt-by-the-numbers628618371. 11 Seeing this need to learn about being able to live a happier life, Yale University is now offering a course on the subject. David Shimer, “Yale’s Most Popular Class Ever: Happiness,” The New York Times, January 26, 2018. 12 “[m]ost men and women will grow up to love their servitude.” Aldous Huxley, Brave New World (London: Chatto and Windus, 1931). 13 Judith Warner, “Dysregulation Nation,” The New York Times, June 14, 2010. 14 “Mike Wallace Interviews Aldous Huxley,” May 18, 1958, YouTube video, www.youtube.com/ watch?v=HSx91KiNyFU; the transcript is at: www.cuttingthroughthematrix.com/articles/Mike_ Wallace_interviews_Aldous_Huxley_May_18_1958.html. 15 Ernst F. Schumacher, Small Is Beautiful: Economics as if People Mattered (New York: Harper Torchbook, 1973). By “accomplishing so little,” he means that it provides so little satisfaction. 16 Peter Whybrow interview on Charlie Rose, March 18, 2005 and October 12, 2015. https://charlierose. com/videos/10351. 17 Whybrow, American Mania, book cover. 18 U.S. Department of Labor, Bureau of Labor Statistics, 100 Years of U.S. Consumer Spending: Data for the Nation, New York City, and Boston, August 3, 2006. www.bls.gov/opub/uscs/report991.pdf. 19 Lotfi A. Zadeh, “Fuzzy Logic and Approximate Reasoning,” Synthese 30 (1975): 407–428. 2 0 Amartya Sen, Commodities and Capabilities (Amsterdam: North-Holland, 1985). 21 U.S. Census, “Poverty Thresholds, 2016.” www.census.gov/data/tables/time-series/demo/incomepoverty/historical-poverty-thresholds.html. 2 2 George Akerlof and Robert Shiller, Phishing for Phools: The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press, 2015). 23 According to Erich Fromm, it is the “right of each man to unfold as an individual and as a human being.” Erich Fromm, “The Automaton Citizen and Human Rights,” a lecture in 1966. www. fromm-gesellschaft.eu/images/pdf-Dateien/2008a-1966-e.pdf. Erich Fromm, The Sane Society (London: Routledge & Kegan Paul, 1956); Erich Fromm, The Art of Loving (New York: Harper & Row, 1956). 2 4 B. Toll and P. Ling, “The Virginia Slims Identity Crisis: And Inside Look at Tobacco Industry Marketing to Women,” Tobacco Control 14 (2005) 3:172–180. 25 “Honey, I Blew Up the Marlboro Man,” Tobacco Control 1 (1992) 4: 300–303. 2 6 The character seemed invincible. However, “the three actors who played the Marlboro Man died of lung cancer.” Katie Connolly, “Six ads that changed the way you think,” BBC News, January 3, 2011 27 A. Hyland, et al., “Happy Birthday Marlboro: The Cigarette Whose Taste Outlasts Its Customers,” Tobacco Control 15 (2006) 2: 75–77. 28 Douglas Galbi, “U.S. Advertising Expenditure Data,” Purple Motes, September 14, 2008. 29 In contrast, the value of motor vehicle output was $540 billion. U.S. Department of Commerce, Bureau of Economic Analysis, Income and Product Accounts Tables: Table 1.2.5. Gross Domestic Product by Major Type of Product. https://bea.gov/iTable/iTable.cfm?ReqID=9#reqid=9&step=3&isur i=1&903=19. 30 Exceptions are anti-consumerist organizations such as Adbusters, founded by Kalle Lasn, and people like Naomi Klein, who advocate against addictive consumerism. 31 Abraham Maslow, “A Theory of Human Motivation,” Psychological Review 50 (1943): 370–396. 32 Thorstein Veblen, The Theory of the Leisure Class: An Economic Study of Institutions (London: Macmillan, 1899), p. 110.

The Nature of Demand  55 33 Stephen A. Marglin, The Dismal Science: How Thinking Like an Economist Undermines Community (Cambridge, MA: Harvard University Press, 2010). Mihaly Csikszentmihalyi, Flow: The Psychology of Optimal Experience (New York: Harper, 2008). Martin Seligman, Flourish: A Visionary New Understanding of Happiness and Well-Being (New York: The Free Press, 2012). 34 United Nations, “Universal Declaration of Human Rights,” Article 25. www.un.org/en/universal-­ declaration-human-rights/. 35 Former CEO of Tyco International Dennis Kozlowski spent $2 million on his wife’s birthday party but ended up serving 6.5 years in jail for fraud. Kia Makarechi, “What Happens After You Serve Your White-Collar Prison Sentence?” Vanity Fair, March 2, 2015. 36 “Childhood is a precious and finite thing,” said one of the builders of these houses. “And a special playhouse is not the sort of thing you can put off until the economy gets better.” Kate Murphy, “Child’s Play, Grown-Up Cash,” The New York Times, July 20, 2011. 37 Robert Frank, “Baccarat Meets Bomb-Proof Glass on the High Seas,” The Wall Street Journal, April 23, 2010. 38 The number of breast augmentation procedures has tripled since 1997. The American Society for Aesthetic Plastic Surgery, “Cosmetic Surgery National Data Bank Statistics, 2016,” pp. 10, 11, 23. www. surgery.org/sites/default/files/ASAPS-Stats2016.pdf. 39 Bruce C. Greenwald and Joseph Stiglitz, “Externalities in Economies with Imperfect Information and Incomplete Markets,” Quarterly Journal of Economics 101 (1986): 229–264. 40 The Roosevelt Institute, “Stiglitz: The Invisible Hand is Invisible Because it Isn’t There,” http://­ rooseveltinstitute.org/stiglitz-invisible-hand-invisible-because-it-isnt-there-2/; Joseph Stiglitz, “There Is No Invisible Hand,” The Guardian, December 20, 2002. 41 Joseph Stiglitz, The Price of Inequality (New York: W.W. Norton, 2012). 42 It is about as appropriate for today’s economy as Newton’s principles of motion are to subatomic particles. 43 He still maintains his mansion in Greenwich, CT. Celebrity Net Worth, “Richard Fuld Net Worth.” www. celebritynetworth.com/richest-businessmen/wall-street/richard-fuld-net-worth/. 44 Peter Whybrow, “Dangerously Addictive. Why We Are Biologically Ill-Suited to the Riches of Modern America,” The Chronicle of Higher Education, March 13, 2009; Peter Whybrow, The Well-Tuned Brain: The Remedy for a Manic Society (New York: W.W. Norton & Company, 2016). 45 Stephen LeRoy, “Is the ‘Invisible Hand’ Still Relevant?” FRBSF Economic Letter no. 14, May 3, 2010. 46 See his Nobel Prize lecture, “Information and the Change in the Paradigm in Economics,” Stockholm University, Aula Magna, December 8, 2001. www.nobelprize.org/mediaplayer/index.php?id=507. 47 Simon P. Anderson, “Product Differentiation,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 48 Ibid. 4 9 Elisabeth Leamy, “Generic vs. Brand-Name Gas: Are They Different?” ABC News Good Morning America, March 24, 2007. 50 Tibor Scitovsky, The Joyless Economy: An Inquiry into Human Satisfaction and Consumer Dissatisfaction (Oxford, UK: Oxford University Press, 1976); Shirley Lee and Avis Mysyk, “The Medicalization of Compulsive Buying,” Social Science and Medicine 58 (2004) 9: 1709–1718. 51 Peter Whybrow, American Mania: When More Is Not Enough (New York: W.W. Norton, 2005); Peter Whybrow, “Dangerously Addictive. Why We Are Biologically Ill-Suited to the Riches of Modern America,” The Chronicle of Higher Education, March 13, 2009. 52 Judith Warner, “Dysregulation Nation.” The New York Times, June 18, 2010. 5 3 Wikipedia contributors, “Erich Fromm,” Wikipedia: The Free Encyclopedia. 54 Peter Whybrow, Get Satisfied: How Twenty People Like You Found the Satisfaction of Enough (New York: Easton Studio Press, 2007). 5 5 “Homo Consumens,” YouTube video, posted by “Q&A projects,” www.youtube.com/watch?v= VeaWHrFrXF0. 56 Mike Wallace interview: Erich Fromm, May 25, 1958. 5 7 Ibid. 58 Ibid. 59 Ibid. 60 Aldous Huxley, interview with Mike Wallace.

56  The Nature of Demand 61 Robin Marantz Henig, “Valium’s Contribution to Our New Normal,” The New York Times, September 29, 2012. 62 Antidepressant use increased from 5.8% of the population in 1996 to 10.1% in 2005. The increase in nine years was from 13.3 to 27.0 million persons. Mark Olfson and Steven Marcus, “National Patterns in Antidepressant Medication Treatment,” Archives of General Psychiatry 66 (2009) 8: 848–856. 63 Wikipedia contributors, “Antidepressant,” Wikipedia: The Free Encyclopedia. The use of antidepressant drugs increased by a factor of four between 1990 and 2003. Ramin Mojtabai, “Increase in Antidepressant Medication in the U.S. Adult Population Between 1990 and 2003,” Psychotherapy and Psychosomatics 77 (2008) 2: 83–92. 64 E.J. Mundell, “US Antidepressant Use Jumps 65 Percent in 15 years,” Medical Reporter, August 15, 2017.

4 Homo Oeconomicus Is Extinct The Foundations of Behavioral Economics

I see the Right, and I Approve it too, Condemn the Wrong—and yet the Wrong Pursue. Ovid1

Economic theory’s gravest mistake is its clinging obstinately to the fiction that the world is inhabited by a species of homo oeconomicus, although psychologists agree that this is dead wrong, that this is merely a one-dimensional caricature of real flesh and blood people. Psychologists should know, since they study the mind on an experimental basis. In this chapter we stress the importance of abandoning the rational-agent utility-maximizing model by demonstrating the weaknesses and biases of the human mind.2 We also explore the importance of intuition, emotion, and status seeking in economic behavior.

Utility Maximization The conventional assumption in economics is that people are rational and know what they want. They do not need protection from powerful corporations whose employees are much smarter than they are in order to coax them into buying things they do not really want to buy. The mainstream assumption is that consumers maximize their welfare or utility. Rationality is the use of reasoning to achieve optimal ends in an objective manner logically, without emotion, reflex, intuition, or instinct.3 One consumes so as to obtain the most satisfaction out of the money spent. In order to be able to accomplish this: (a) consumers need to have perfect knowledge of all goods (they should not be confused about the quality of the product they are buying and should read and understand the legal implications of the fine print); (b) they need to know their own preferences (utility function) so that they can arrange the goods in order of their preferences; (c) they should not choose randomly or capriciously: their preferences should be stable; and (d) transitivity has to hold in their preferences, that is to say, if they like hamburgers better than hot dogs and hot dogs better than grilled cheese, then, if they are rational, they must like hamburgers better than grilled cheese sandwiches. The reasons behind these conditions are understandable: if consumers do not know all the attributes, including their qualities and prices of all the goods available to them, then they would not be able to make a reasoned choice. If they do not know themselves sufficiently what they like or dislike, how could they possibly satisfy their own desires? And if

58  Homo Oeconomicus Is Extinct transitivity did not hold, they would not be able to order the goods according to their preferences. They would be incoherent. The above set of assumptions has been used extensively, because they are eloquent and simple and because a lot of interesting models and theorems can be derived from them. When consumers maximize their utility and firms produce under perfectly competitive conditions, the economy will be efficient, provided there are no externalities such as pollution. And that is a desirable result. So economists are quite fond of this set of assumptions, which implies that people choose consistently, with reason, thinking through their needs and wants, with full knowledge of prices and the quantities they want. Their actions are governed by logic rather than habit, intuition, emotion, their unconscious mind, or conditioning. They are not manipulated, and they are not simply copying what other people are buying. And who are we to intervene in that decision? Why should the government care how consumers spend their money? However, textbook examples are always straightforward and never include a decision that includes uncertainty or possible deception or imperfect information: they provide examples in which the choice is between a simple set of alternatives. It is a single decision among well-known generic goods and no time dimension is involved. Surely one knows whether one likes hot dogs better than grilled cheese sandwiches at this moment, and under such circumstances a self-interested consumer should be able to choose satisfactorily without being confused. This simple choice is essentially a “no brainer” requiring no judgment at all. However, such examples are fundamentally misleading, because they make it appear as though the procedure for such a simple decision can be generalized and applied to all economic choices, including much more complex ones, or ones that require a sequence of decisions and for which quality is difficult to ascertain and which include crucial fine print and knowledge of details. That was precisely Alan Greenspan’s mistake. He thought that selling mortgage-backed securities was like selling cereal and therefore did not need government oversight. Of course, he was wrong, because all real markets (as opposed to imaginary ones) need government oversight to various degrees. So the cereal market is governed by regulations of the Food and Drug Administration.4 Thus, decisions pertaining to complex products such as mortgages, insurance, cell phone contracts, apartment leases, and investments are qualitatively different from buying cereal.5 Generalizing from simple examples to the complex economy is a major shortcoming of conventional economics with unfortunate consequences for consumers’ welfare. The perfectly rational homo oeconomicus is an odious assumption, because it implies that consumer protection is superfluous, thereby making it difficult for many consumers to navigate smoothly through our very complex economic system. Without consumer protection too many consumers fall prey to unscrupulous marketing techniques as we witnessed in the predatory lending practices in the run up to the Meltdown of 2008.6

Optimization Is Impossible for Finite Minds Every psychologist knows that human beings are incapable of being rational and of maximizing utility in a coherent manner.7 Understandably, we do not like to admit it, insofar as much of what we do appears obviously right to us on the surface. Nonetheless, our brain is

Homo Oeconomicus Is Extinct  59 far from perfect. “The purely economic man is indeed close to being a social moron.”8 With this memorable assertion, Noble Prize winning Harvard economist, Amartya Sen, refuted the concept of Homo oeconomicus for a litany of reasons. We are often unaware of why we desire something, as the reasons are hidden from our conscious thought processes or are embedded in evolutionary physiology, as is our craving for sweets. Our attention span is limited: we experience information overload, we do not have the time to pay attention to the contract we are signing, we lose our patience, we act impulsively, and we have great difficulty assessing probabilities. Moreover, often there is not enough time to think about decisions carefully, and insufficient time to sort out the relevant information from background noise; we also have difficulty assessing the quality of information. All these issues play a role in our inability to reach an optimum decision, and explain why we frequently make mistakes and come to regret the decisions we made and become frustrated. Most decisions call for human judgment under conditions of uncertainty about outcomes whose probability is known only vaguely. Hence, very few of our decisions, from the most trivial to the most momentous, can be considered rational. They are guided, in the main, by our unconscious mind, by wishful thinking, faith, intuition, emotion, and are based on partial knowledge or are merely random. We also make vague guesses about probabilities. We discuss later the evidence supporting this perspective.9

Our Brain Is Imperfect We are unable to pursue our self-interest to maximize our utility because our brain is imperfect. In fact, none of our body components is perfect. Do we see as perfectly as an eagle, or smell as well as a dog? Why would the brain be perfect? It is a product of evolution, as are all our other organs, and evolution does not aim for perfection. Good enough to reproduce is good enough for evolution. This implies that we do not have the brain of a Superman or Wonderwoman; we do not all have an IQ score of 130, as academic economists seem to imply. To be sure, it was good enough to survive and to reproduce. Our brain is much more complex than economists assume. It is made up of many specialized modules, which sometimes work together well but at other times hold contradictory beliefs, vacillate between polar opposites, and violate strongly held moral beliefs.10 According to Peter Whybrow, professor of psychiatry at UCLA and award-winning author, “The human brain is a hybrid: an evolved hierarchy of three-brains-in-one.” We have a reptilian “lizard” brain, which controls our bodily functions such as our breathing and heart muscles. Around this primitive core developed, during the course of millennia, “the limbic cortex . . . the early mammalian brain, which is the root of kinship behavior and nurturance.”11 The expansion of this part of the brain culminated in the development of our species’ unique prefrontal lobes, where reasoning takes place. While this enables us to reason, that does not imply that our choices are made rationally all or even most of the time. If the process of making choices in our self-interest were a snap, our society would not be in the disarray outlined in Chapter 2. There would not be so many of us discontented with our lives, struggling, unhappy, depressed, dependent on antidepressants, wantonly killing people, or behind bars. If this is the best we can do maximizing utility, our brains must not be such reliable guides to action.

60  Homo Oeconomicus Is Extinct Our brain, our hormones, our genetic make-up, our nervous system all stand in the way of making rational decisions according to Whybrow: “we remain driven by our ancient desires. Desire is as vital as breathing … [but] when the brain’s reward circuits are overloaded or unconstrained, then desire can turn to craving and to an addictive greed that co-opts executive analysis and common sense.”12 In other words, the rational part of our brain is not always in control. Our craving for sweets, for instance, provided some evolutionary advantage millennia ago when nourishment was scarce. But evolution did not give us hormones to switch off this desire, nor the will power to resist it, because that was unnecessary in the past characterized by endemic food shortages. Thus, when combined with corporations’ profiting from selling sweet drinks, our uncontrollable cravings make us sick by inducing a diabetic epidemic. Thus, two-thirds of the U.S. population became overweight or obese. In sum, our hormonal system and our cravings, which came into being through evolution, help explain why the rational utility-maximizing model is unrealistic. As the incidence of obesity or the debt trap indicates, the assumption of rationality is not at all benign. It is insidious, because it leaves the consumers unprotected against the powerful and leads to a general level of discontent permeating the society. Rationality was not the only human attribute favored by natural selection. It would not have been optimal to rely exclusively on reasoning in making decisions as hunters and gatherers, because many significant problems could not be solved logically or fast enough to be useful, given the uncertainties and incomplete information associated with them. In such complex circumstances, rational thinking would have led humans to become catatonic. Instead, we were selected also for being able to make quick decisions on little information. And for that we needed guidance from intuition, emotion, instinct, judgment, and reflex. After millions of years of evolution we continue to make decisions in such a manner, often using contradictory and inconclusive information. In other words, human beings have not become optimal decision makers through evolution. Evolution did not make us into Superman and Wonderwoman. Nonetheless, our brain is a wonderful instrument, as are our eyes, but note that evolution did not eliminate either the “blind spot” or color blindness. It is not useful to consider rationality as a binary characteristic. Human behavior … requires a fluid interaction between controlled and automatic processes … However, many behaviors that emerge from this interplay are routinely and falsely interpreted as being the product of cognitive deliberation alone … We naturally tend to exaggerate the importance of control.13

Neuroeconomics The brain is made up of 100 billion neurons which communicate with each other using chemical signals. Economists recently began to explore how these neural networks affect economic behavior and the field of neuroeconomics was born. Experiments are conducted using functional magnetic resonance imaging, which registers blood flow in the capillaries of the brain and thereby identifies neurons firing electrochemical signals. These experiments revealed weaknesses in the standard theory of utility maximization. Brain activity showed

Homo Oeconomicus Is Extinct  61 that the hardwired circuits postulated by standard decision theory are not always activated. The brain can use other processes as well. For instance, if the choice is between an alternative involving certainty and one involving risk, the processing takes place in a different part of the brain than when both alternatives are risky.14 Amazingly, parallel processors are used for different tasks, and the hardwired circuits of reason are not always in control. This can also explain why emotions can override rational considerations. “Brain mechanisms combine controlled and automatic processes, operating using cognition and affect [emotion] … Reason has its hands full with headstrong passions and appetites.”15 Neuroeconomics is a promising new field of research and will undoubtedly reveal many secrets of the brain in the near future.

Bounded Rationality More than half a century ago, Herbert Simon argued convincingly that rationality has its limits: people are unable to maximize a utility function in the real world insofar as it is beyond the mind’s capacity to do so. Simon received a Nobel Prize in economics for his research, yet textbooks continue to ignore his insights even though it is widely recognized that “psychology and economics provide wide-ranging evidence that bounded rationality is important.”16 Actually, it is so significant that it should be the default model in economics instead of the more mathematically tractable optimizing-rational-agent model. The utility function is an abstraction; it does not exist in reality as our ability to feel temperature or see light does. Not being able to optimize an imaginary utility function does not mean that we are silly, but we need to recognize that computer-like optimization is beyond our capacity. It would be too burdensome even if we had the cognitive ability to do so. Off the blackboard we have too many serious limitations that constrain us from attaining an optimum consumption bundle. These limitations are such as lack of information of price or on the quality of the product, limitations of our own intelligence to ascertain the conditions specified in a contract, inability to assign probabilities to future events, inability to pay attention to a salesperson’s presentation, forgetting to ask all relevant questions, misunderstanding the terms of a contract, being gullible, or being outright misled by someone more knowledgeable or smarter than we are. The limitation might also be information overload, too much information for the brain’s working memory capacity, which can lead to confusion, misinterpretation, or misjudgement. Time pressure can also hinder us from making good decisions—not having enough time to think about a problem can lead us to jump to conclusions or use a rule of thumb.17 If we are harried or under stress, we may not be able to concentrate on understanding all the properties of the product we are buying. The causes of bounded rationality are innumerable. An additional issue is that when making most important decisions, consumers seldom have complete information about available alternatives. Generating information about these alternatives and then understanding them is a lengthy process requiring money, patience, and perseverance so that it becomes a major hindrance to arriving at a decent solution. It is more like solving an intricate puzzle than the no-brainer choices presented in textbooks. This is especially true for complex decisions and especially for poor people who lack the funds for extensive search costs and the social network that aids the search process.

62  Homo Oeconomicus Is Extinct Of course, we can easily solve the kind of transparent problems in textbooks. However, in the real world the choice often becomes intractable when deciding among multifaceted products such as health insurance, mortgages, labor contracts, particularly if the counterparty is able to hide crucial conditions in small print and obfuscate crucial aspects relevant to the choice. It takes time, effort, and money—transactions costs—to find out what kinds of health insurance are being offered. Only a Superman or Wonderwoman could separate fact from fiction and find the optimum under such difficult circumstances, but with our limited cognitive capacity, the ordinary human mind has no chance at all to ascertain the optimum in finite time. Complex choices involve a problem-solving process requiring a great deal of intelligence, patience, experience, self-control, and ultimately human judgment more often than not associated with probabilities. Searching for alternatives and judging their consequences in real time prior to making the choice is a challenging process. Companies are pursuing a strategy to avoid transparency as much as possible by offering plans that are very complicated and structured differently from other plans so that comparison with their offers becomes impractical. Their strategy works because its opaqueness softens competition. In such cases, there is little chance of making an informed rational decision. In making such decisions, I generally use a rule of thumb to make a choice and keeping my fingers crossed, which is far from making a rational decision. Note that firms can devote considerable energy to outsmarting consumers. A consumer might have a couple of hours to devote to solving such a complex problem, whereas the insurance companies can hire an army of math wizards and psychology experts to devote themselves full time for months to contemplate the most effective way to exploit people’s ignorance. Guess who will win that contest of wits? In short, corporations have their tricks to outmanoeuvre the consumer most of the time as they have many more resources to tilt the playing field to their advantage. That is simply power to manipulate consumers. When I did receive the booklet describing the terms of a health insurance contract, it was some 80 pages long. Needless to say, I never did get around to reading it. Consider the drug plans offered for Medicare Part D (Figure 4.1). I do not think there is a mortal on earth who could ascertain what the best plan for her is in a reasonable time. Under such circumstances one resorts to simplification by using a rule of thumb.18 Insurance companies obviously make the offer in this opaque way in order to make it difficult to understand the details of the policy so that competition would not eliminate their profit. To be sure, there are organizations that sometimes help consumers make reasoned decisions, such as AARP, but these affect only a tiny fraction of our consumption decisions.

Satisficing Instead of Optimizing Given bounded rationality, consumers have to resort to simpler ways to satisfy their desires using a rule of thumb. They will search until they find a satisfactory solution, given their level of aspiration. This way of deciding is called satisficing. In the mid-1950s, Herbert Simon demonstrated that people seek to find a satisfactory solution to the problem at hand instead of seeking the best possible solution—because that would be much too difficult and essentially unattainable.19 Given the limitations of our brain to process information, the constraints of time and of finances, the harried lives we live, the incredible amount of information we need

Homo Oeconomicus Is Extinct  63 AARP MedicareRx Preferred (PDP) (S5820-007-0)



Monthly Estimated Annual Drug Premium: [?] Costs: [?]

Deductibles: [?] and Drug Copay/ Coinsurance: [?]

Drug Restrictions: [?]

Drug Coverage: [?]

Estimated Overall Plan Annual Health Rating: [?] and Drug Costs: [?]

$1,670

Annual Drug Deductible: $0.00 Health Plan Deductible: N/A Drug Copay/ Coinsurance: $7 $81, 33%

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$4,800 Includes $3,138 for Original Medicare

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Monthly Estimated Annual Drug Premium: [?] Costs: [?]

Deductibles: [?] and Drug Copay/ Coinsurance: [?]

Drug Restrictions: [?]

Drug Coverage: [?]

Estimated Overall Plan Annual Health Rating: [?] and Drug Costs: [?]

$1,752

Annual Drug Deductible: $150.00 Health Plan Deductible: N/A Drug Copay/ Coinsurance: $10, 15% - 32%

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Monthly Estimated Annual Drug Premium: [?] Costs: [?]

Deductibles: [?] and Drug Copay/ Coinsurance: [?]

Drug Restrictions: [?]

Drug Coverage: [?]

Estimated Overall Plan Annual Health Rating: [?] and Drug Costs: [?]

$46.00 Drug: $46.00 Health: N/A

Annual Drug Deductible: $0.00 Health Plan Deductible: N/A Drug Copay/ Coinsurance: $7 $74, 33%

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Figure 4.1  Medicare Part D Options Confuse to process, and the complexity of the problems to be solved, we are content with finding a good-enough outcome. Trying to maximize would be much too difficult; it would get us bogged down in everyday life, would be frustrating, and ultimately would lead to paralysis. Satisficing is much more realistic than the maximization approach. One of the critical consequences of the satisficing model is that the sequence in which choices are presented makes a difference to the ultimate outcome, whereas in the maximizing model with perfect information it does not. In the maximizing model it makes no difference in which order food choices are presented: consumers still know that they prefer hamburgers over hot dogs or over a grilled cheese sandwich. In that case, time and space do not play a role. Now, let’s try out the two models in an imaginary supermarket. The choice at a supermarket is not between two items, as in the textbooks, but among 25,000 items, and our cognitive capacity is unable to handle that amount of information. Hence, as one enters the

64  Homo Oeconomicus Is Extinct store we know neither all the goods being offered for sale nor their prices, thereby violating a basic precondition of optimization. Under such circumstances, maximization is out of the question, and we resort to shortcuts to accomplish our goals: we satisfice, meaning, we seek an acceptable solution to alleviating hunger. We choose an aisle and the products come into view sequentially. Note that early choices influence our subsequent decisions. We might see some chicken fingers in the deli department and they look good enough for dinner. So we buy some. Yet, if we see another option later on, such as frozen pizza on sale in another aisle, we will not buy it, because it would take too much effort to return the chicken fingers to the deli section. Social norms prevent us from merely leaving the chicken fingers in the pizza section and taking the pizza instead. However, if we had gone down the frozen food section first and had noticed the pizza on sale, we would have bought it instead of the chicken fingers. In other words, we were not confronted with a fixed set of alternatives as we entered the store. We had to search in real time and space in a purposeful manner: the goal was to buy something for dinner. This goal was satisfied but the choice was influenced by the happenstance of our walking down one aisle of the supermarket first instead of another, and it was not easy to reverse once the initial choice had been made.20 Moreover, it would have been too time consuming to first find all the available alternatives and their prices in the store. In sum, with the limited time and information at our disposal, we found an acceptable solution to our dinner problem by satisficing. In the presence of transaction costs associated with searching in real space and time, we are unable to choose the best possible dinner for ourselves, but we are satisfied with a good-enough dinner.21 And our choices may not be consistent. If I had to do it over again, I might choose to go down a different aisle first and then would end up with a different dinner. In other words, an optimum decision can be reached easily on college blackboards but not by real human beings in real-world situations. The key difference between this example and the no-brainers presented in textbooks is that this problem entailed a sequence of decisions under uncertainty with limited information and included transaction costs associated with searching in space, with a time constraint. Even though this is a common problem occurring every day, such choices are not found in textbooks, because even such simple models are anathema to mainstream economics as they contradict most—if not all—of the eloquent theorems of neoclassical economics. Satisficing does not conform to models of optimization by rational fully informed economic agents with perfect foresight.

Biases and Wonders of Intuition Behavioral economists, inspired by Daniel Kahneman, Amos Tversky, and Richard Thaler have gone beyond bounded rationality by demonstrating decades ago that intuition plays a major role in our thinking, and that the rational part of our brain is not completely in charge of our actions, neither does it generally supervise the decisions we make intuitively.22 They refer to these two ways of thinking as System 1 (intuition) and System 2 (reasoning).23 Intuitive thoughts come to mind spontaneously. The operations of System 1 are fast, automatic, effortless, associative, impulsive, and difficult to control or modify. They are not voluntary, whereas those of System 2 are slower, deliberate, and take effort.

Homo Oeconomicus Is Extinct  65 As a survival strategy in a complex and uncertain environment, human brains developed ways to make decisions spontaneously and intuitively using rules of thumb. Faced with many unknowns through the millions of years of evolution, we developed skills to make crucial decisions in the blink of an eye, often with little information, which is to say, automatically and mostly without deliberate thinking.24 We often have to make judgments quickly in order to reduce the heavy load of trying to solve a problem with incomplete information and uncertain outcomes without becoming catatonic. However, the other side of the coin is that the intuition and rule of thumb we use have many biases, and consequently we make systematic mistakes; many of our decisions are outright irrational.25 We make biased assessments of uncertainty and easily become confused, have limited self-control, and have a tendency to focus on the present without giving the future much thought. Which 20-yearold thinks seriously about her retirement income? Our genetic disposition, including our instinct for survival as well as our potent sex drive, also often overrides our rational self. In sum, psychological experiments suggest that human beings are incapable of being coherent, rational, and exercising perfect self-control. Moreover, analyzing complex problems is challenging, particularly under time pressure. (Real-life problems differ greatly from typical exam questions, because for the latter it is clear that a solution does exist whereas that is not necessarily the case for real-life problems we confront.) People are not used to thinking hard in day-to-day life, and in such cases, System 2 gets stuck and System 1 at least provides a tolerable solution, even if it is often erroneous. Thus, choice is not always an outcome of reasoning; rather, intuition almost always plays an essential role, unless the choice is of trivial complexity. We tend to trust a plausible judgment that System 1 provides quickly, but it is prone to all sorts of systematic biases, and System 2 is incapable of monitoring it properly or overriding its judgments. System 2 supervises System 1 only lightly. Ignoring behavioral economics makes mainstream economics textbooks misleading: real human beings are not robots; they are prone to a large number of systematic biases, such as severe errors in judgment especially in confronting choice under uncertainty and in assessing probabilities.26

Heuristics We tend to use heuristics, or attribute substitution in complex decisions. A daunting challenge in many cases is to make a decision when the problem is computationally so complex and the available information is so scanty that we are unable to make a reasoned decision. Should I quit my current job and look for a better one? Should I accept this job offer or wait for another? Kahneman and Tversky have shown that in circumstances in which a problem is too difficult to solve in a given time, we rely on heuristics—rules of thumb—to make a decision. That ability to act at times of ambiguity did provide an evolutionary advantage because becoming catatonic could have become fatal. So we learned to substitute a related, but easier, problem for the inaccessible one we are facing. In a sense, the mind makes an information-­processing shortcut—an intuitive judgment: “People are not accustomed to thinking hard, and are often content to trust a plausible judgment that comes to mind.”27 The problem we use as a substitute is easily accessible to us, perhaps because of our prior experiences or those of others. (I personally used my father’s experience in forming some of

66  Homo Oeconomicus Is Extinct my own decision about a similar problem whose solution was otherwise inaccessible to me.) One solves a problem one can. It is better than being stuck. Evolution did not favour those who got stuck on a problem. The substitution is done intuitively, so we are unaware of it and it is not under the control of System 2. The use of heuristics is one of the many sources of our cognitive biases. In other words, rationality is beyond the ability of mortal souls.28

Framing, Accessibility, and Anchoring We do not always react identically to the same information. Our choices depend critically on how these facts are presented or “framed.” Such framing effects are important in how our unconscious reacts to a problem. Emotionally, it makes a difference if we say that out of 100 people 90 will survive an operation, or if we say that 10 out of 100 will die. The information is identical but our emotional response differs, because it makes a difference whether we focus our attention on surviving or dying. This is not rational but emotional. Hence, framing effects can also lead to preference reversals. For instance, you might choose chemotherapy when one of the doctors presents the decision in terms of survival but decide to change your mind if another doctor presents the same evidence in terms of dying. In other words, it is not the facts that matter but our perception, and this is important in consumer behavior because it implies that our decisions depend on how choices are framed. The implication is that we are incapable of being rational or coherent insofar as preference reversals contradict the consistency requirement of rational decision making. Of course, marketers know this and frame their advertisements in such a way as to bypass System 2 to the extent possible. It also implies that we are open to manipulation. Given that people watch on average three hours of TV per day, Madison Avenue has plenty of opportunity to interfere with our ability to use System 2 to make decisions, as advertisements affect our subconscious substantially. Neuromarketers are studying ways to influence us most effectively.29 Behavioral economists documented through years of experimenting that the reasons we are prone to many logical fallacies is that intuition overrides the rules of logic and of probability. For instance, people are willing to pay more for a life insurance policy that pays in case of terrorist attack while traveling than for one that pays in case of death from any cause, although it is clear upon reflection that the probability of the second scenario is greater than that of the first: it pays in case of death from terrorist attack as well as from other causes. However, framing the offer in terms of terrorism triggers basic emotions that lead to ignoring basic principles of probability.30 Thus, some very low-probability events, such as being subject to a terrorist attack, are magnified whereas some high-probability events are attenuated. In addition, some attributes of objects are more accessible to us than others. The average length of the lines in Figure 4.2 is instantaneously determined by our perceptual system, because the average is a “natural assessment.” However, the sum of those lines is not available to us immediately. We need to compute it with effort using System 2. It is not a natural assessment. Furthermore, context affects accessibility. What do you see in Figure 4.3a? The middle object looks like the letter B. Now look at Figure 4.3b. What do you see? Most people see the number 13. Because the context differs, our perceptual system interprets the same ambiguous

Homo Oeconomicus Is Extinct  67

Figure 4.2  What Is the Average Length of These Lines? middle object differently. The surroundings help the mind fill in the ambiguities. This psychological principle is important in ascertaining the quality of products and is generally exploited by the advertising industry. It makes us vulnerable to manipulation. For instance, when we look at a car we can immediately see its outside condition—if it has scratches, dents, or if the paint has faded. But the attributes of its engine and performance are not as easily ascertainable. It takes deliberate thinking to try to assess them. Knowing that appearances and context matter, car advertisements often influence our mood and emotions using power, sex, or celebrities to focus our attention on attributes that are easily accessible. These are registered automatically in our perceptual system without our consciously thinking about it, that is, without intent or effort. Preferences are affected by irrelevant features of the advertisement, such as an attractive model standing next to it wearing a revealing dress. Such strategies are frequently used, because the enticing image is easily accessible and will be unconsciously associated with the car without our even being

Figures 4.3a and b  Context Matters a Lot in Case of Ambiguity

68  Homo Oeconomicus Is Extinct aware of it. In other words, Madison Avenue tries to turn the decision from a rational one to an emotional one. This also contradicts the rational-agent model, because rational people would not be affected by irrelevant features such as a celebrity standing next to the car. Anchoring occurs when we focus and rely on some information more than we should in making decisions and consequently overlook other important aspects. That is how “teaser rates” manipulated people to sign mortgages they did not fully understand. By stressing low initial mortgage rates, customers’ attention was turned away from its variable nature. Mortgage brokers used anchoring extensively in the predatory lending schemes that gave rise to the subprime mortgage crisis.

Prospect Theory Are changes or levels more accessible to our brain? According to conventional theory, it is the amount (level) of consumption that yields utility. A given amount of cereal will induce a given amount of satisfaction, regardless of our accustomed level of cereal consumption. Kahneman and Tversky, however, showed a generation ago that this assumption is incorrect; it is not the way human psychology works. According to their experiments, our valuation of something (other than a basic need) is not a constant but depends on a reference value. They thereby overturned the utility principle advocated by mainstream economists. They emphasize that the value of the absolute magnitude of wealth, health, prestige, welfare, or consumption is much more difficult for us to ascertain than changes in these variables. Our brain can evaluate changes more easily than it can gauge the levels themselves, because we become accustomed (adapted) to the current levels. In short, perception is reference dependent. Thus, we use a reference level of consumption to be the measuring scale: what others are having or what we had the day before or what we anticipated. The expected utility function of a risk-averse individual is concave (Figure 4.4). Suppose there are two possible outcomes, A and B, each with equal probability. Suppose A=$0, B=$100. Then the expected income is C=½(B+A)=$50 and the expected level of utility is ½(U(B)+U(A)) as shown on the y-axis. Suppose the income is C=$50 with certainty. Notice that U(C) (the utility of $50) with certainty exceeds the expected utility of C=$50 if it is uncertain: U(C)>0.5(U(B)+U(A)) even though on average C=$50=½(B+A) in both scenarios. That means that the stress associated with not knowing if income will be $0 or $100 detracts from utility even if the expected value of the gamble is $50. This is the logic behind insurance markets. People are willing to pay a premium in order to avoid uncertain outcomes. The point of the diagram is that $50 with certainty has greater utility than a gamble of $0 or $100 even though the expected value of the gamble is the same $50. In contrast, the utility function of a risk-seeking person is convex (Figure 4.5). The gamble in this case is the same as above, except in this case the person enjoys the excitement associated with risk. Consequently, the utility of the gamble exceeds that of C with certainty: U(C)U(−1M). The value of a gain obviously exceeds that of a loss. So Kahneman and Tversky’s model yields the commonsensical result. In a sense, Kahneman and Tversky did for economics what Einstein’s theory of relativity did for physics. Before Einstein, people thought that time was constant and immutable. Einstein showed that it was relative. Similarly, Kahneman and Tversky

72  Homo Oeconomicus Is Extinct Value

U(+0.1M)

−1M Losses

+0.1M

Gains

U(−1M)

Starting level of wealth

Figure 4.8  Comparison of Cathy’s and Susan’s Utility According to Prospect Theory

showed that utility is not a constant function of wealth or income. States (levels) of income or wealth are not the conveyors of utility; rather, changes in those levels are.34 As a consequence, when we first purchase an iPhone our level of utility spikes, but after we have owned it for a while we get used to it and it no longer provides as much satisfaction. We have adapted to its use. In short, our reference point plays a major role in determining the amount of utility (satisfaction) we receive from an object. Put another way, utility cannot be divorced from emotion, and emotion is triggered by changes. Conventional consumer theory is unrealistic because it ignores the pain of losses and the regret of mistakes. Kahneman and Tversky catapulted economics from eighteenthcentury certitude to twentieth-century relativity. A choice between two options provides another example of prospect theory: option 1 is a loss of $75 with certainty, while option 2 is a gamble with 50% chance of losing $200 or 50% chance of gaining $50. The expected value of the second option is the same as that of option 1: a loss of $75 since ½(−$200)+½($50) = −$100+$25 = −$75. Which choice would a typical investor prefer? Given that most people are risk averse, they are usually willing to pay to avoid risk (Figure 4.4). Hence, standard utility theory would suggest that most people, being risk averse, would choose option 1, the certain option (Figure 4.9). The utility of the gamble is the utility of the expected value of −$75, with the gamble being half way between U(+50) and U(−200). The diagonal dotted line is drawn only to indicate where the half way point is on the y-axis between U(+50) and U(−200).35 As is evident from Figure 4.9, the utility of −$75 with certainty [U(−75)]—option 1—exceeds the utility of

Homo Oeconomicus Is Extinct  73 Utility

U(+50) U(−75)

Utility of Gamble

U(−200) −$200

−$75

+$50

Wealth

Now

Figure 4.9  Conventional Comparison of Two Options the gamble, which is the utility of the expected value of −$75—option 2—i.e., when the outcome is uncertain. So, one would expect risk-averse people to choose option 1. However, experiments contradict this conventional model. Most people actually choose option 2, the gamble, which is inconsistent with risk aversion and implies that in this case most people are risk seeking in losses since in option 2 they might lose much more than the $75 loss of option 1.36 A possible reason for the anomaly is that people’s perception is focused on the possible gain of $50; put another way, the small gain is magnified out of proportion, while the large loss is reduced disproportionally. In other words, people focus excessively on the gain and discount the probability of a much greater loss. However, the choice of option 2 is obvious in prospect theory (Figure 4.10). Note that the gain is depicted in quadrant 1 and yields considerable value in the positive range of the y-axis even if in the ultimate calculation of expected utility only half of this utility gain counts insofar as the probability of its occurring is 50%. The losses are depicted in quadrant 3. While U(−200)U(−75). No wonder that most people choose option 2: prospect theory conforms to experimental evidence and predicts that people will accept the gamble rather than the $75 loss with certainty. Thus, a basic prediction of prospect theory is that while people are risk averse in gains, they

74  Homo Oeconomicus Is Extinct Value

U(+50)

0.5*U(+50) −200 Losses

−75

+ 50 Gains

0

0.5(U(+50)+U(−200))>U(−75) 0.5*U(−200) U(−75) U(−200)

Figure 4.10  Experimental Results Conform to Prospect Theory: The Case of Two Options

are risk seeking in losses even if this might seem counterintuitive. Such a disposition was surely part of the reason for the excessive risk taking during the financial crisis of 2008. Risk seeking in losses explains the $9 billion loss in 2012 of a trader for JPMorgan, dubbed “The London Whale.”37 The chances investors are willing to take are disproportional to the possible gains. Understanding prospect theory is an important reason for the regulation of the financial sector. Kahneman and Tversky’s experiments led to the new field of behavioral economics, which replaces rational agent models with a more psychologically informed view of human decision making.

Behavioral Economics The field of behavioral economics overcomes the limitations of naïve psychological assumptions about human abilities. The field encompasses the role of heuristics, psychological biases, framing effects, anchoring, and emotion in order to understand not fully rational decision making. The mispricing of risk, of housing, and of stocks in the run-up to the 2008 financial crisis is just one example of its concern. Even the stock market overreacts to news and is subject to bubbles and crashes. In behavioral finance, such inefficiencies are due to overconfidence, inattention to price movements, speculation, inappropriate expectations, and herding behavior. These can create positive feedback loops. Asset bubbles cannot be understood in the conventional supply and demand framework. The reason is that if stock prices or house prices begin to rise by chance for any reason, then investors will demand fewer of those stocks or houses, so the quantity demanded will

Homo Oeconomicus Is Extinct  75 Price Demand

Supply

New Price

Equilibrium Price

Equilibrium Quantity

Quantity

Figure 4.11  Conventional Demand and Supply Analysis with Negative Feedback

decline while more people will want to sell them (Figure 4.11). The excess supply means that there will be pressure in the market to lower prices back toward the initial equilibrium level. This is the conventional negative feedback loop: market forces re-establish the prior equilibrium. This is the model that Greenspan and Bernanke used to remain complacent about the doubling of house prices prior to the crash of 2008. No worries: the market knows what it is doing. While the conventional model is appropriate to think about many goods, it is not a very good model for asset markets whose dynamics depend so much on expectations and speculation. The reason is that if prices increase from their initial equilibrium value P0 by chance, then investors might form exaggerated expectations that they will continue to increase (Figure 4.12). An expectation of price increase means that investors would realize capital gains making that asset more lucrative. The change in expectation shifts the demand curve to the right to D1 establishing a new equilibrium at P1 and Q1. As more investors realize the lucrative nature of these capital gains, the demand curve continues to shift to D2, D3, etc., thereby creating a positive feedback loop that contributes to further price increases P2, P3, etc. This can continue until the market runs out of speculators or gullible people followed by a collapse of prices. Such errors create large inefficiencies as well as negative externalities followed by a depression as in the 1930s or a recession as in 2008.

76  Homo Oeconomicus Is Extinct Price Demand T = 0

D=1 Time = 1

P3 P2

D2

Supply

D3

T=2

T=3

Time = 3 Time = 2

P1 Time = 1 P0

Time = 1 T = 2 T = 3

Q0

Q1

Q2

Q3

Quantity

Figure 4.12  Positive Feedback Loop Causes Asset Price Bubbles

Cognitive Endowment Human cognitive endowment is quite heterogeneous. This poses an independent challenge for orthodox economics as textbooks quietly assume that people who participate in the marketplace are homogeneous and have the same IQ, so they are all equally capable of solving the complex economic problems in today’s global system. However, this is obviously untrue: both cognitive ability and economic literacy vary enormously in the population.38 The mean IQ in a population is about 100 and is normally distributed. That implies that about 16% of the population has an IQ below 85 and about the same proportion has an IQ above 115. That means that the latter group can think faster, has a larger working memory, and can solve problems more accurately than the former group. This advantage provides tremendous opportunities for deception and manipulation when the former interacts with the latter. Although this issue is neglected in orthodox economics, it is important especially because businesses can afford to hire the very smartest to entrap those with lower cognitive ability. Thus, sellers can take advantage of the inability of the buyer to understand detailed aspects of a transaction. That is one important reason why extensive consumer protection would be important. Caveat emptor—let the buyer beware—is neither fair nor a reliable principle when the buyer is at a disadvantage relative to the seller. This is one of the reasons for the poverty trap. The smart entrapped and exploited the weaknesses of their clients frequently during the subprime-mortgage debacle as well as with the chronic runaway credit-card debt for which

Homo Oeconomicus Is Extinct  77 the various complex stipulations were hidden and impossible to understand by many people. The counterparties were not equally informed about the transaction and were not equally capable of understanding the terms and risks involved. And most of the important things we purchase in a modern economy involve agreements that are extremely complicated and difficult to understand. That is why the U.S. Congress created the Consumer Financial Protection Bureau.39 As Elizabeth Warren, who was in charge initially, warned, “The time for hiding tricks and traps in fine print is over.”40 She was a bit too optimistic. Under the Trump administration the agency is administered by someone who does not believe in its mission.

Genetic Endowment Genetic endowment influences a large number of personal traits that in turn influence an individual’s economic activity. Such attributes include cognitive ability, even if the social environment also plays a crucial role. Twin studies indicate that education and earnings are influenced by our genes as well as by our social environment.41 The emergent field of “genoeconomics” hypothesizes that economic outcomes such as income and wealth may be “about as heritable as many medical conditions.”42 Our genetic codes are an essential aspect of human nature and are therefore an important determinant of economic outcomes.43 A burgeoning literature argues persuasively that many of our choices are actually not the outcome of conscious cognitive processes alone but are influenced in important ways by our genetic endowment and its interaction with the environment.44 “Variation in a surprisingly wide range of behaviors is substantially influenced by genetic differences.”45 For instance, the heritability of the degree of risk aversion is estimated to be about 45%.46 The role played by genetics in such attributes as IQ, educational attainment, earnings, empathy, and aspects of our personality such as our impatience, will power, attention span, or risk taking may be as great as the role played by cultural norms and expectations.47 Future research may well discover the genetic (or hormonal) basis of other personality traits that are important in economics, such as ambition, myopia, the rate of time preference, trust, selfishness, and other latent variables used in economic theory to explain such outcomes as credit card debt, perseverance, entrepreneurship, schooling attainment, diligence even if these are also influenced also by cultural and social factors. Hence, rational choice is not an adequate assumption if the effect of our genetic endowment is so influential: “in much of what we think, feel and do we march to ancient drummers.”48 Thus, our genetic endowment also influences our lifetime income. In sum, in many respects, our prefrontal cortex is not in control. Rather, our actions are guided to a considerable extent also by our genetic code, its interaction with the environment, and the environment’s effects on our brain circuits. In short, biology influences human behavior significantly. According to Edward O. Wilson, “in order to understand the human condition, it is necessary to accept that we do have instincts.”49

Notes 1 Metamorphoses (ad 8), p. 203. 2 Richard Thaler, Misbehaving: The Making of Behavioral Economics (New York: W.W. Norton & Co., 2016).

78  Homo Oeconomicus Is Extinct 3 This definition comes from psychology. Many Econ 101 textbooks do not define rationality but assume it as an axiom. 4 I searched for “cereal” on their website and received 1160 of links referring to regulations, www.fda.gov/. 5 Much to my surprise, my monthly internet bill has been raised repeatedly without my knowledge. Perhaps it was part of the fine print in the contract I signed without knowing it. My rule of thumb is that whenever I sign a contract the chances are that I will be surprised by extra charges in some way. 6 Jessica Sberlati, “Countrywide Commercial 3,” YouTube, October 26, 2007. 7 The assumption of rationality is a “nonstarter,” according to Kahneman. Links to his extremely informative lectures are available on his home page. www.princeton.edu/~kahneman/. 8 Amartya Sen, “Rational Fools: A Critique of the Behavioural Foundations of Economic Theory,” Philosophy and Public Affairs 6 (1977): 336. 9 The famous Cambridge economist, Joan Robinson, noted that “utility maximization is a metaphysical concept of impregnable circularity.” Christopher D. Carroll, “Punter of Last Resort,” March 13, 2009. http://voxeu.org/debates/commentaries/punter-last-resort. 10 Robert Kurzban, Why Everyone (Else) Is a Hypocrite: Evolution and the Modular Mind (Princeton, NJ: Princeton University Press, 2011). 11 Peter C. Whybrow, “Dangerously Addictive: Why We Are Biologically Ill-Suited to the Riches of Modern America,” The Chronicle of Higher Education, March 13, 2009. 12 Peter C. Whybrow, American Mania: When More Is Not Enough (New York: W.W. Norton, 2005). 13 Colin Camerer, George Loewenstein, and Drazen Prelec, “Neuroeconomics: How Neuroscience Can Inform Economics,” Journal of Economic Literature 43 (2005): 9–64. 14 John Dickhaut, Kevin McCabe, Jennifer C. Nagode, Aldo Rustichini, Kip Smith, and Jose Pardo, “The Impact of the Certainty Context on the Process of Choice,” Proceedings of the National Academy of Sciences of the United States of America 100 (2003): 3536–3541. 15 Camerer, Loewenstein, and Prelec, “Neuroeconomics.” 16 John Conlisk, “Why Bounded Rationality?” Journal of Economic Literature 34 (1996) 2: 669–700. 17 Herbert A. Simon, Models of Bounded Rationality (Cambridge, MA: MIT Press, 1982). 18 A rule of thumb is a procedure derived from experience or custom that enables one to find a satisfactory approach to a particular problem (perhaps using analogy) when (1) too little information is available to do so in any other way; (2) when there is insufficient time to consider all important aspects of the problem that could influence the decision; or (3) when it is impractical, impossible, or too costly to find a better solution. The procedure is similar to an educated guess or using commonsense, but can often be deceiving, far from optimal, and can also lead to stereotyping and prejudice. 19 Herbert A. Simon, “A Behavioral Model of Rational Choice,” Quarterly Journal of Economics 69 (1955): 99–118. 2 0 With the Internet, some planning and comparison shopping might well improve, but at the same time firms collect a lot of information on consumers that opens them up to manipulation. The impact of the latter effect is likely to outweigh the former. 21 Richard Thaler, Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press, 2008). 2 2 Richard Thaler, “Behavioral Economics: Past, Present, and Future,” American Economic Review 106 (2016) 7: 1577–1600. 23 Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus and Giroux, 2011). 2 4 Malcolm Gladwell, Blink: The Power of Thinking Without Thinking (New York: Little, Brown, 2005). 25 Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions (New York: HarperCollins, 2008); Dan Ariely, The Upside of Irrationality (New York: HarperCollins, 2010). See his lecture on YouTube, “Dan Ariely: The Upside of Irrationality,” www.youtube.com/watch?v=vsBqFayrDY. 26 Wikipedia lists more than 100 cognitive biases. Wikipedia contributors, “List of Cognitive Biases,” Wikipedia: The Free Encyclopedia. 27 Daniel Kahneman, “Maps of Bounded Rationality: Psychology for Behavioral Economics,” American Economic Review 93 (2003) 5: 1449–1475, here p. 1450. 28 Nobel Prize, “Prize Lecture by Daniel Kahneman,” www.nobelprize.org/mediaplayer/?id=531. 29 “If pitches are to succeed, they need to reach the subconscious level of the brain, the place where consumers develop initial interest in products, inclinations to buy them and brand loyalty,” says A.K. Pradeep, the founder and chief executive of a neuromarketing firm NeuroFocus. Natasha Singer, “Making Ads That Whisper to the Brain,” The New York Times, November 13, 2010.

Homo Oeconomicus Is Extinct  79 30 The “conjunction rule” in probability theory states that the probability that a person belongs to both categories A and B cannot be greater than the probability that she belongs to category B alone. Kahneman and Tversky showed that this axiom is violated using the following description of a person: “Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.” Almost everyone rated the probability that “Linda is a bank teller and is active in the feminist movement” higher than the probability that “Linda is a bank teller.” This fallacy occurs because we tend to anchor our thoughts on the description of Linda’s feminist nature and intuitively assume that she is representative of feminism. The focus on this representative attribute draws our attention away from the obvious fact that if she is a feminist bank teller, she must be a bank teller as well. 31 One might argue that it is not advisable to compare the utility of two different persons. But then one can also think of this example as Cathy in two different moments in time. Besides, why do we have so many representative agent models in economics if one should not assume that people are comparable? The whole literature on microfoundations of macroeconomics is based on the idea that there is a typical person. If there is a typical person, there can be two typical persons. Moreover, we also aggregate incomes of different people in order to assess the national income of a country at a moment in time or across time. Macromodels use representative firms. It appears that when it is convenient to do so, economists assume that there is a typical person who can represent the whole society and therefore they do compare utility functions across individuals, but when it would be inconvenient to do so they refuse to do so. 32 These two quadrants are disregarded because in quadrant 2 the value function would imply that a loss in wealth would increase utility and quadrant 4 would imply that gains in wealth would decrease utility. So these two quadrants are nonsensical. 33 Loss aversion explains the endowment effect. 34 “NBR Interview with Daniel Kahneman: Your Mind and Your Money,” www.youtube.com/watch?v= rZUylXXJbhE. 35 This is the case since −$75 on the x-axis is half way between −$200 and +$50. 36 The experiment has been repeated with a large number of different combinations of numbers. As long as negative prospects are involved, people are risk seeking: “the majority of subjects were willing to accept a risk of 0.8 to lose 4,000, in preference to a sure loss of 3,000, although the gamble has a lower expected value.” Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decisions Under Risk,” Econometrica 47 (1979): 263–291, here p. 268. 37 This was the largest single trading loss in recorded history. However, there are 20 other trades with losses greater than $1 billion. Wikepedia Contributors, “List of Trading Losses.” 38 William T. Dickens, “Cognitive Ability,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 39 A fine of $210 million was levied on Capitol One for deceptive banking practices. See Ben Protess and Jessica Silver-Greenberg, “Consumer Watchdog Fines Capital One for Deceptive Credit Card Practices,” The New York Times, July 18, 2012. 40 Elizabeth Warren, “Fighting to Protect Consumers,” The White House Blog, September 17, 2010. 41 Paul Taubman, “The Determinants of Earnings: Genetics, Family, and Other Environments: A Study of White Male Twins,” American Economic Review 66 (1976) 5: 858–870. 42 Daniel J. Benjamin, David Cesarini, Christopher F. Chabris, Edward L. Glaeser, David I. Laibson, Vilmundur Guðnason, Tamara B. Harris, Leonore J. Launer, Shaun Purcell, Albert Vernon Smith, Magnus Johannesson, Patrik K.E. Magnusson, Jonathan P. Beauchamp, Nicholas A. Christakis, Craig S. Atwood, Benjamin Hebert, Jeremy Freese, Robert M. Hauser, Taissa S. Hauser, Alexander Grankvist, Christina M. Hultman, and Paul Lichtenstein, “The Promises and Pitfalls of Genoeconomics,” Annual Review of Economics 4 (July 2012): 627–662. 43 Michael J. Zyphur, Jayanth Narayanan, Richard D. Arvey, and Gordon J. Alexander, “The Genetics of Economic Risk Preferences,” Journal of Behavioral Decision Making 22 (2009): 367–377. Sociological attributes are also associated with genetic propensities. See Guang Guo, Michael E. Roettger, and Tianji Cai, “The Integration of Genetic Propensities into Social-Control Models of Delinquency and Violence Among Male Youths,” American Sociological Review 73 (2008): 543–568; Arthur J. Robson, “The Biological Basis of Economic Behavior,” Journal of Economic Literature 29 (2001): 11–33; Arthur J. Robson and Larry Samuelson, “The Evolutionary Foundations of Preferences,” in Handbook of Social Economics, ed. Jess Benhabib, Alberto Bisin, and Matthew O. Jackson (Amsterdam: North Holland Press, 2010), pp. 221–310.

80  Homo Oeconomicus Is Extinct 44 Deirdre Barrett, Supernormal Stimuli: How Primal Urges Overran Their Evolutionary Purpose (New York: W.W. Norton, 2010); A. Knafo, S. Israel, A. Darvasi, R. Bachner-Melman, F. Uzefovsky, L. Cohen, E. Feldman, E. Lerer, E. Laiba, Y. Raz, L. Nemanov, I. Gritsenko, C. Dina, G. Agam, B. Dean, G. Bornstein, and R.P. Ebstein, “Individual Differences in Allocation of Funds in the Dictator Game Associated with Length of the Arginine Vasopressin 1a Receptor RS3 Promoter Region and Correlation Between RS3 Length and Hippocampal mRNA,” Genes, Brain and Behavior 7 (2008) 3: 266–275. Hormone levels also have a role in our economic behavior. Terence C. Burnham, “High-Testosterone Men Reject Low Ultimatum Game Offers,” Proceedings of the Royal Society B 274 (2007) 1623: 2327–2330. 45 William T. Dickens, “Behavioural Genetics,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). This is also the case for social outcomes. Guang Guo, Michael Roettger, and Tianji Cai, “The Integration of Genetic Propensities into Social-Control Models of Delinquency and Violence Among Male Youths,” American Sociological Review, 73 (2008) 4: 543–568. 46 Jonathan P. Beauchamp, David Cesarini, Magnus Johannesson, Matthijs J.H.M. der Loos, Philipp D. Koellinger, Patrick J.F. Groenen, James H. Fowler, Niels Rosenquist, Roy Thurik, and Nicholas A. Christakis, “Molecular Genetics and Economics,” Journal of Economic Perspectives 25 (2011) 4: 1–27. 47 Jere Richard Behrman and Paul Taubman, “Is Schooling ‘Mostly in the Genes’? Nature-Nurture Decomposition Using Data on Relatives,” Journal of Political Economy 97 (1989) 6: 1425–1446; David Cesarini, Christopher Dawes, Magnus Johannesson, Paul Lichtenstein, and Björn Wallace, “Genetic Variation in Preferences for Giving and Risk Taking,” The Quarterly Journal of Economics 124 (2009) 2: 809–842. 48 Whybrow, American Mania, op cit., p. 57. 49 Edward O. Wilson, “Evolution and Our Inner Conflict,” The New York Times, June 24, 2012; Edward O. Wilson, The Social Conquest of Earth (New York: W.W. Norton, 2012).

5 Taste Makers and Consumption

We have argued up to now that the standard microeconomic canon of consumption is not objective. It begins with arbitrary assumptions that contradict experimental evidence and disregard important aspects of the real existing economy such as the distribution of political and economic power. The standard narrative supports a free-market ideology by disregarding facts and theories contradicting the canon such as the concept of satisficing that fits the facts better than the optimizing model favored by the mainstream. Standard textbooks treat major shortcomings of neoclassical theories such as imperfect information as epiphenomenon and are replete with hidden value judgments by disregarding sustainability and the welfare of future generations. In short, they are biased in favor of the market even if it has come up short. We continue to point to the flaws in the standard treatment of the subject by arguing that they have not been effective in providing a stress-free life, an equitable distribution of income, and a high-quality life in which most people feel good about themselves and their social relationships. The focus on efficiency instead of on equity or on sustainability is itself a cultural norm based on a value judgment and is therefore not free of ideology.

The Influence of Corporate Power Power is the ability to control either the action or thought of others. Thus, wealth translates directly into power. Adam Smith knew it, as did the founding fathers. Wealth can provide irresistible incentives for politicians to act on behalf of people with money. There are different kinds of power: power to influence institutions and legislation in order to further economic gain; power to influence cultural norms; and power to influence our buying habits. They all enhance profits and diminish our human agency. However, power does not exist in perfectly competitive markets insofar as in such markets there are countless sellers and countless buyers, and power is diffused until it becomes negligible; in that case it does not pay even to advertise. Because mainstream principles courses focus on perfectly competitive markets, they can skirt the issue of power. It does not exist in such a market. While this is the default model used in most introductory analysis, it is obviously misleading, because one of the basic principles of free-market economics is the tendency of power to concentrate in the hands of oligopolies or monopolies. Businesses want to avoid perfectly competitive markets like the plague and usually think of ways of doing so. This was the case with the “Robber Barons,” of the late nineteenth century: with the expansion of railroads, finance, petroleum, and steel, a new wealthy class gained prominence using

82  Taste Makers and Consumption questionable business practices to make their fortunes. It is not different at all with the new power brokers of the digital age in the twenty-first century. An early warning came from President Dwight Eisenhower, whose farewell address in 1961 unabashedly warned the nation of the “unwarranted influence” of the “military-industrial complex,” and the “potential for the disastrous rise of misplaced power.”1 In the half-­century since this warning, corporations have extended their control over society beyond the military-­industrial complex to encompass the financial sector and capture government to a greater extent than ever before. With the Trump administration in the hands of generals and billionaires, Eisenhower’s warning has materialized fully.2 Both political and economic power was transferred from Main Street to mega-corporations and to millionaires. And the military is one institution which is universally supported by U.S. politicians and the U.S. population. The problem starts with the fact that corporations are considered legal persons. This makes sense for conducting business. However, it makes absolutely no sense to consider a business as a person allowed to influence political activity. The harmful element in this legal fiction is that political rights of individuals are extended to a fictitious entity with extensive financial resources. The First (1791) and the Fourteenth (1868) amendments of the U.S. Constitution were intended to guarantee the basic rights of free speech to flesh-and-blood human beings and to protect the rights of freed slaves. Originally, they had nothing to do with businesses. The extension of these rights to inanimate entities demeans our humanity. The rights of corporations ought to be confined strictly to economic activity and ought not be allowed to extend into the political sphere. Insofar as inanimate entities cannot speak, they ought not be protected by the First Amendment. That would enable us to limit their activity outside of the business sphere and thus regain our control over our political processes. When corporations have employees speak for them, the implication is that flesh-and-blood individuals have multiple voices in society: both as their real selves and as spokespeople for an inanimate entity we call a firm. This violates the principle of one person one vote and is contrary to democratic principles as it brings about a skewed distribution of power. This is exacerbated, of course, by the imbalance in the distribution of financial resources which enables corporations to exert crucial influence on politicians. In this way, profits are translated into political and social power with tremendous feedback effects on the economic structure and its institutions. Anyhow, equating monetary contributions with free speech borders on the bizarre. Thus, oligopolies such as Goldman Sachs and JPMorgan Chase do have lots of clout to set prices and to manipulate the market to their benefit. Barclays and UBS were caught manipulating interest rates and fined $0.45 billion and $1.5 billion respectively.3 Power enables vested interests to develop and further skew economic advantages in their favor by rewriting the rules governing market activity in such a way that their initial advantages lead to further political power imbalances which, in turn, increases their privileges and advantages.4 This becomes a vicious circle of power, privilege, and profits leading to the diminution in political influence of Everyman on Main Street. This is precisely what has happened to Congress with substantial feedback effects to the economy.5 The financial sector spent $2.7 billion on lobbying from 1999 to 2008, while individuals and committees affiliated with the industry made more than $1 billion in campaign contributions to gain further economic advantage.6 The pharma industry spent $150 million

Taste Makers and Consumption  83 lobbying Congress just in 2016. It is unjust and dangerous that corporations may spend unlimited funds to influence political campaigns; they do not have to disclose their contributions even to their shareholders, the actual owners of the firms. Thus, CEOs can spend the owner’s money and lobby even against the interests of their shareholders without them knowing it.8 That is a convoluted situation.9 In order to accomplish this, corporations spend a dizzying amount—$2.6 billion per annum— more than the money needed to fund the House and Senate combined.10 Some corporations have as many as 100 lobbyists working for them. They can thus be at every committee meeting at any time. In the meanwhile, the underemployed have no lobbyists and can make no campaign contributions whatsoever. Under such unbalanced circumstances, the market’s playing field cannot possibly remain level.11 No wonder corporate welfarism has run amok: “Nationwide state and local subsidies for corporations totaled more than $70 billion in 2010.”12 Corporate greed is widespread: pharmaceuticals lobbied to prevent the government lowering the price of prescription drugs that brought into being the Medicare Part D law, thereby gaining a $200 billion profit surge over the course of a decade.13 And let us not forget the trillions of dollars that have been put at the disposal of the financial sector by the Federal Reserve on very favorable terms in the wake of the Meltdown of 2008. It was all justified as bringing the economy back from the brink, but justification to help the men and women of Main Street usually eludes the elite in power (Chapter 14). Yet, the dispersion of power is the very essence of a democratic political system inasmuch as a democracy turns into a plutocracy if economic power is concentrated among an elite oligarchy. Thus, the concentration of wealth is anathema to democratic institutions,14 and therefore we desperately need to foster countervailing sources of power to check the innate desire of CEOs to further tilt the laws and institutions of government to their benefit.15 Power and the quest for more power frequently lead to abuses. Sixty people were guilty recently by mid-2012 of insider trading crimes, including a former Goldman Sachs board member.16 Few weeks go by without news of another scandal.17 In addition, designing the market system to their benefit, the amassed power of oligopolies enables them to squelch competition and thereby reap near-monopoly profits. The invisible hand is shackled in the process.18 Markets can be efficient only to the extent that power is decentralized. Concentration of power prevents efficient outcomes by tilting the rules of the game in favour of the powerful so that we have to compete on the oligarchs’ terms rather than on ours. Franklin D. Roosevelt understood well the importance of the dispersion of power. He warned us about “industrial dictatorship” imposing wages on working people and about “economic royalty” expropriating other people’s money.19 Joseph Stiglitz has described this power imbalance as socialism for the rich and capitalism for the rest of us.20 7

Interdependent Utility Functions Conventional economic theory assumes that individual consumer preferences are independent of each other. Under this unrealistic assumption, people’s demand for goods varies only if their own income changes or the prices of goods change, but not if their neighbor’s consumption changes. Thus, in neoclassical theory there is no place either for interaction effects among consumers or manipulation of desires. This is another reason why the official

84  Taste Makers and Consumption axiom of utility maximization of an isolated consumer is wrong.21 In fact, there are many strong interdependent effects in consumption. More than a century ago, Thorstein Veblen argued forcefully that consumption was governed mainly by social norms, habit, custom, and such irrational motives as status seeking, snobbism, keeping up with the Joneses, by the bandwagon effect, or herding behavior.22 Consumption has a significant social component; in fact, one seldom consumes in isolation. As society became more affluent, Veblen’s interdependent utility functions have become more prominent in consumption.23 There are many more consumption externalities now than there were a century ago, and a long list of distinguished economists has argued that relative consumption and relative incomes do matter substantially.24 Economics should acknowledge the interrelatedness of consumption: people copy the buying habits of their peers and of opinion leaders and care a lot about what others think of their consumption. This externality is particularly relevant for luxury or positional goods—ostentatious display of wealth meant to impress others and to seek social status—they produce negative externalities as they affect others adversely.25 These externalities are not considered in economics or in the gross national product (GNP) accounts. James Duesenberry emphasized the interdependence utility functions.26 He suggested that utility depends on past consumption as well as that of our peers. Robert Frank pointed out that this is similar to an arms race: positional goods are goods that produce negative externalities; they signal social position and thereby affect the way others feel and what they purchase. Status seeking means that consumers will spend more on positional goods than on those goods that are not visible to others. This is a distortion and decreases social welfare. The quest for status is futile from the point of view of society as a whole, insofar as it is a zero-sum game. If one climbs in the hierarchy, others descend in relative terms. The decline in the savings rate (see Figure 12.2 in Chapter 12) in spite of increases in income can be understood in terms of increased competition for positional goods inasmuch as savings are non-positional—after all, the amount of money in one’s savings account is not common knowledge in the way a new outfit, car, or house are. In standard theory, one would expect savings, as a normal good,27 to increase with income and not to decline to 3.0% as it did for the three years between 2005 and 2007 and again in early 2018. In contrast, for the 23 years between 1959 and 1982 the average personal saving rate was 11.4%, at a lower level of income.28 It began to decline in 1983 in line with the increase in inequality in spite of the rise in income. That is quite an anomaly in conventional economics but can be understood easily in terms of the relative income hypothesis as the middle class was trying desperately to keep up with the consumption habits of the elite, whose income was increasing rapidly while those of the rest of the society was lagging behind. The fashion industry is just one example of the way our taste for clothing is manipulated for profit. With the help of Madison Avenue, the fashion industry creates a bandwagon effect that makes consumers feel uncomfortable if they do not conform to the current dress code.29 They feel left out and are anxious about being ostracized.30 Status seeking most probably has an evolutionary basis as people with high status had a higher probability of surviving and reproducing.31 The increased competition for status is probably the reason why people are working as many hours in 2017 as they did in 1982 (34.0 hours per week).32 In order to keep up with the consumption of the elite, the rest of the population works longer hours and the average

Taste Makers and Consumption  85 household has two workers in the labor force whereas a generation ago one worker sufficed to maintain a family of four. Insofar as leisure is a normal good, one would have expected people to enjoy more of it as incomes were increasing, as until 1998 median household income was rising. Instead, leisure was not increasing and working hours per family increased, because most incomes failed to keep pace with the rise of income of the top 1%. They had to work longer hours in order to keep up with the Joneses. Hence, progressive taxation, which counters the exaggerated competition for status and hence the purchase of positional goods, would increase social welfare, contrary to conventional theory. Government regulations that foster safety, savings, health, leisure activity such as holidays, and consumption taxes on luxury goods would be welfare enhancing. Keeping up with the Joneses—in search of the fantasy of the American Dream—leads to an epidemic of stress, overwork, and accumulation of debt without fulfillment.

Society Society is another concept absent from standard economics: super-individualistic economic theory assumes that we do not influence one another through our economic activity. Yet, we are not Robinson Crusoes: behavior in society is highly structured by cultural expectations, institutions, and social norms. These influence our value system, which calibrates our aspirations, constrains our choices, and channels our actions. These norms contribute greatly to defining our aesthetic sense and the terms under which we can become fullfledged esteemed members of the society. We do not act in a vacuum: very few of our decisions are autonomous. Most people do not want to become outcasts and therefore tend to conform to the basic established attitudes, mores, and accepted behavior of our respective societies.33 That means that we learn from other people’s actions how we should act, what we should consider important in our lives, how to gain power and respect within the social order.34 We follow fashion trends in order to belong. The rules are complex: the color coordination must be right and an inch can make a big difference on the size of a lapel or necktie or a hemline. It just might be a deal breaker when applying for a job. We need to know the terms under which we are going to be accepted by our peers. If we see people around us idolizing money, we are more likely to devote our lives to its acquisition as a means to achieve acceptance and position than in a society that holds spirituality in higher esteem and considers money inferior. Therefore, the values of the culture in which we live have an overarching influence on our attitudes even if we have internalized them to such a degree that we might not recognize them. The value structure is ingrained in the subconscious crevices of our mind, or might instead be the explicit outcome of overt peer pressure. We want to belong because that gives us a sense of security. We copy. If people shop a lot in our society, then we too have a good chance of becoming compulsive shoppers.35 If people selling drugs are the ones with money in the neighbourhood, one just might want to give it a try oneself. It takes energy and determination to defy norms and to overcome social pressure.36 It does not come easily or automatically. In other words, group interaction is a crucial element in economic activity.37 We order differently in a restaurant when we are alone than when we are with others. Someone may convince you to have an extra drink just as you are about to leave a party. In fact, we do

86  Taste Makers and Consumption very little consumption by ourselves in isolation. That is how the culture of consumption is propagated from one generation to the next. The discipline of social psychology—disregarded by economists—focuses on analyzing the ways in which the social environment shapes our character, our mindset, our habits, our tastes, and our actions. Researchers have found that small-scale societies differ considerably from industrialized populations, and Western societies differ from non-Western societies in several dimensions of cognition, social decision-making, altruism, or norms of civic cooperation.38 In his Ethics, Aristotle recognized, three centuries before the Common Era, that institutions, social structures, and culture determine our attitudes in a vast number of domains including moral judgments. To be sure, there are feedback effects so that our character ultimately also influences institutions and culture. Hence, human character is malleable and the way we interpret the world is endogenous to the socioeconomic system. These findings deviate markedly from the rugged individualistic ideal of mainstream economics. Stampedes at Walmart stores are examples of herding behavior. One person starts running and it becomes contagious often resulting in injury, and people have been trampled to death even.39 People lose their individuality in a crowd: normal inhibitions melt away and one acts as a “faceless” member of a group rather than as an individual. Gender roles are also socially constructed. Until the 1960s, married women were expec­ ted to be homemakers. With the equal rights movement women’s labor force participation increased markedly. In 1950 just 20% of married women with children worked, whereas by the turn of the twenty-first century nearly 70% did.40 Such major changes do not come about through utility maximization but require substantial shifts in social norms, expectations, values, and peer pressure. It was brought about by a feminist social movement with economic consequences. Feminist economists argue that the traditional economic theory is culturally overwhelmingly masculine with concepts such as competition, selfishness, and rationality, and disregards traditional feminine values that emphasize cooperation, altruism, and emotional intelligence. Moreover, women are more likely to want to include household work in GNP accounts. Hence, arguably, mainstream economics propagates a masculine bias.

Culture Culture is the software of our mind for interpreting the world; it is a system of symbolic codes, the sum total of our mental constructs about our values and social interactions. Culture is the lens through which we see the world, a distinct set of attitudes, mores, symbols, beliefs, and mental reflexes that gives meaning to our life and defines us as a member of a group. A shared value system is part of culture, such as the way we define private property and the degree to which we hold it sacred. What is acceptable behavior, standards for beauty, and what is desirable all fall within this realm. Norms of behavior in society are rules to which one is expected to adhere in order to remain a respected member of the group. Thus, the extent to which we feel obligated to keep our word, or are willing to subvert the intentions of incomplete contracts, is also an integral part of the culture. The extent to which we adhere to religious or moral precepts is part of our culture. The Ninth Commandment, for instance, lowered transaction costs by advocating honesty and thereby fostered economic growth.

Taste Makers and Consumption  87 This has important economic implications insofar as the extent to which and under what circumstances we are willing to trust our counterparty is a major determinant of efficiency. The extent to which society tolerates deviations from truth will determine such important factors as the kinds of advertising and packaging that are allowed in the marketplace. How much inequality or poverty will be tolerated? How are gender roles defined? How much redistribution is the society willing to accept? How much effort are workers willing to expend? Our work ethic, as Max Weber pointed out, is an important part of our culture.41 Our degree of impatience and our respect for laws are all part of culture. It is basically all the reflexive actions we take without deeply thinking about them. In other words, almost every economic decision has cultural components, including our preferences and our expectation formations, and our perception of risk. Hence, it influences most economic concepts. The economy and culture are inseparable.42 They are inextricably intertwined. According to sociologist Daniel Bell markets are unable to create social norms such that they perpetuate themselves. He argued that the culture created by capitalism generates a need for instant gratification which slowly undermines the Protestant work ethic that was fundamental to capitalism’s success. He asserted that there is a problem: [o]f managing a complex polity when the values of the society stress unrestrained appetite. The contradictions I see in contemporary capitalism derive from the unraveling of the threads which had once held the culture and the economy together, from the influence of the hedonism which has become the prevailing value in our society.43 A “porno-pop culture,” gaudily dressed and foul-mouthed, has a hard time sustaining capitalism as the ethic of hard work erodes.44 The constant search for pleasure crowds out effortful work, savings, investments, and character with the public interest to heart. This market-driven culture denigrates frugality and instead propagates the fantasy that consumption will lead to a good life. Consequently, Bell suggests, capitalism contains the seeds of its own destruction: the market cannot perpetuate itself in a stable manner cut off from its moral anchors. Christopher Lasch was another critic of the super-charged market-driven culture industry of post-industrial capitalism that created a pathologically narcissistic personality type.45 He observed that people’s sense of identity and self-worth had diminished. Corporations would not profit from people with a strong sense of identity, firm self-respect, and strong will power. That person would not be a compulsive and impulsive shopper who can be swayed and tempted. However, corporations can profit from those who are developmentally stymied and whose selfcontrol is limited so that they are open to influence by trendsetters, buy the latest gadgets, succumb to new fashion fads, spend money recklessly, and think nothing about future generations. Businesses benefit from spendthrifts because they can extract the last cent of their pay checks and the last dollar of their credit cards.46 There is no need to worry about the welfare of unborn generations. The yuppies were good for the balance sheet of the corporate world. These messages of the culture industry are propagated through advertisements, TV, social media, and Hollywood celebrities. To live for the moment is the prevailing passion—to live for yourself, not for your predecessors or posterity. We are fast losing the sense of historical continuity, the sense of belonging to a succession of generations originating in the past and stretching into the future.47

88  Taste Makers and Consumption Lasch wrote those words more than a generation ago. They are even more relevant today. Our elites have lost the meaning of prudence, of setting reasonable limits, of guiding our appetite, of defending cultural values such as delayed gratification and responsible leadership.48 Instead of providing guidance, our elites have failed to defend our cultural heritage and surrendered leadership to those vested interests who would profit from our carelessness: the mega-corporations. Culture has been set free of its moorings and allowed to drift in the direction of money making with people needing constant external validation through the sense of control gained through shopping.49 The corporate world trivializes unprofitable aspects of life including morality and virtue.

Fairness Humans have a sense of fairness, a belief that some actions are reasonable and just. Fairness implies the adherence to social norms such as reciprocity, or an equitable distribution of resources, goods, or income.50 It conforms to the ethical rules of society. This disposition is due partly to innate human nature and it is partly socially constructed and learned.51 In either case, most people agree that it is not fair, for instance, to raise the price of gasoline already in storage if Organization of the Petroleum Exporting Countries (OPEC) raises the price of oil or when airlines engage in price gouging at a time of mass evacuation fleeing hurricane Irma.52 When Martin Shkreli raised the price of a drug for treating parasitic infection from $13.50 to $750 the outcry was universal.53 Senator Blumenthal called EpiPen price gouging “morally bankrupt.”54 In other words, market outcomes are often morally unpalatable. In experiments, people reveal their sense of fairness in dividing a windfall between two persons. The person originally in possession of the windfall usually retains about 60% of it. This implies that we are not completely selfish but care about our gain in proportion to that of others. Moreover, people tend to be vengeful toward those who betray their culturally dependent sense of propriety. People have social preferences and do not only care for their own wellbeing. They are also averse to inequality in allocation of resources and are concerned with what others think of their consumption.55 Such experimental evidence can explain charitable contributions, wage dispersion within firms, strikes, and many other economic phenomena. It should be the goal of the economics discipline to incorporate the concept of fairness into its theories and policies.

Efficiency vs. Equity Efficiency is a cornerstone of mainstream thinking, an integral part of its value system. The market economy is supposedly efficient. Production is efficient; meaning that firms produce optimally the right amount of goods; thus, more could not be produced with the given amount of inputs. Consumption is also efficient: people know what they want and how to get it, and no more satisfaction could possibly be squeezed out of the goods they consume, given their income. Nobody could gain without someone being hurt. However, this is not a very good definition: on these terms, slavery was also efficient because the slaves’ wellbeing could not be improved without making their captors worse off. So an efficient system may well be unjust.

Taste Makers and Consumption  89 This conceptualization of efficiency is not value neutral. Why not emphasize sustainability or morality or fairness or equality or meeting basic needs for all, instead? Textbooks assume incorrectly that everyone values efficiency above all else. I think most people would prefer to live in a just society more than in an efficient one. Furthermore, the definition implicitly accepts the current endowment of wealth and income as an integral part of the efficient outcomes. This is also an implicit value judgment and is not based on any moral justification, as the current distribution of income and wealth is not at all just, according to political philosopher John Rawls. Rawls argued that the just society is one that one would choose without knowing what your position in it would be if you were dropped into it at random.56 One would most likely accept the social contract in a just society designed behind a “veil of ignorance” insofar as one is risk averse and would not want to end up at the bottom of the social pyramid. He suggested that the decisions we make now are biased insofar as we know our current standing in the social order. We already have information on our endowments: how smart we are, the color of our skin, our gender, our wealth, or our socioeconomic status. This knowledge obviously sways our judgment. If we are smart, talented, and have access to education as Bill Gates did—he had use of a mainframe computer in his high school, a privilege in those days—we would likely support a meritocracy based on education. The descendants of Sam Walton, Fred Koch, or Frank Mars likely have no problem with inherited wealth. If we were Kobe Bryant or LeBron James, we would no doubt think that we deserved an annual salary of $20–30 million. We are not likely to attribute our talents to luck, our father’s coaching, or our genes and concede that we really don’t deserve that much money. However, our opinions would be different if we designed a society from scratch without knowing in advance where we would end up in that society’s distribution of intelligence, talent, looks, inherited wealth, or family background. Without that a priori knowledge, we would no doubt be much more careful in constructing a society that distributed income on the basis of luck of birth. We would likely create a safety net that ensured that even those with not much luck and with limited talents would be able to satisfy at least their basic needs. If we had to enter the society at random, most risk-averse people would not create a society in which the distribution of income was as extremely skewed as it is in the U.S. now. After all, we might find ourselves at the very bottom of the distribution in the South Bronx with a dysfunctional family. Choosing behind a veil of ignorance, we would maximize the welfare of the least advantaged in order to ensure that we would not end up marginalized and in utter destitution. There must be something wrong with a definition according to which it is deemed efficient for Victoria’s Secret to produce million-dollar bras costing some $133 million over the prior two decades,57 and for children to play in quarter-million-dollar playhouses while at the same time other children in slums lack access to decent education and adequate health care. It defies common sense. Moreover, the distribution of resources also affects the quantity of output inasmuch as resources may not be in the most productive hands. Some productive persons may well have insufficient capital but no collateral to gain access to the capital market. According to the common wisdom, banks with excess capital would lend to the person who is more productive, but that does not happen if collateral plays a decisive role in the credit market.

90  Taste Makers and Consumption Consider how much the educational achievement and productivity of the next generation could be increased by equalizing the educational resources available to all youth in the U.S. An immense amount of human capital is wasted by depriving children and youth of efficient educational systems. A transfer of funds from the million-dollar bras and 300-million-dollar yachts of the wealthy to underprivileged school systems would raise their educational standards, thereby increasing immensely the educational opportunities of the poor without the wealthy feeling a great strain in their lifestyle.58 This would lead to a marked increase in productivity, and hence efficiency, of the population over time. Thus, redistribution is not only fair, it can also increase efficiency if one defines efficiency as maximizing output over time. Admittedly, conventional welfare analysis avoids making interpersonal comparisons when it pertains to redistribution of wealth, but it does not avoid aggregating welfare when it is ideologically convenient. For instance, when we calculate national income per capita as a welfare measure, we implicitly assume that the utility of a dollar’s worth of income is the same for all individuals, which is a violation of the prohibition on interpersonal comparison of utility.59 The conventional definition of efficiency is also not very useful in policy considerations. It is a prescription in defence of the status quo because some people are invariably made worse off by every economic policy. As a consequence, a rule requiring that an alternative allocation leave no participant worse off overwhelmingly favors the status quo. There are many other aspects of the status quo that are inefficient. For example, businesses find it beneficial to confuse consumers. There are many hidden charges associated with credit card debt. That is why the government enacted legislation in 2009 in order to rein in the power of credit card companies to charge hidden, gimmicky penalties.60 Even after the legislation, some companies are charging usurious interest rates but in such a way that it is not obvious to consumers.61 Deceptive practices are not efficient, because they enrich some at the expense of others without their consent. Markets with asymmetric information are also not efficient, and that means most of the time.

Self-Interest and Altruism Altruism is the attribute of being concerned about the welfare of others and considering “the interests of other persons, without the need of ulterior motives.”62 Hundreds of experiments have verified that we are not totally selfish; being self-interested is not a binary attribute.63 We are capable of self-sacrifice for the benefit of others or for an intangible cause or idea.64 Rather, there is a culturally dependent continuum between the two polar extremes of being a Mother Teresa or a Dick Fuld (the CEO of Lehman Brothers who famously declared that he wanted to rip out the hearts of short sellers and eat them). In my judgment, human nature is nearly two-thirds selfish. Neuroscientists have shown that humans are hardwired for empathy and act altruistically even if they do not derive benefit from it.65 We could not live in families, groups, or societies if we were completely egoistic. Evolution has selected characteristics which predispose us to be concerned about the welfare of others.66 We cooperate with genetic strangers. Individuals who entirely disregarded group interests would have been ostracized and would have had difficulty surviving in the wild. It made sense to care for the other members of the family or tribe, as a means hunt and to defend against outsiders. Hunting in groups required cooperation, and hunting big game implied sharing as the best strategy, because the meat obtained was too much to consume by a hunter alone.

Taste Makers and Consumption  91 In other words, humans survived as members of a group and not as individuals. Thus, those without any empathy for the welfare of others would have been ostracized and expelled from the tribe. Except for a handful of psychopaths altruism is hardwired into our genes so that self-centered utility maximization is not in our nature and is therefore an unrealistic assumption. There is research on neural activity that suggests as much.67 So those who cared for the welfare of the group had a higher probability of passing on their genes to the next generation. As Adam Smith noted, we are by nature altruistic to some degree without regard to our own advantage.68 He recognized that we are interested in the fortunes of others and feel pity and compassion, even for strangers.69 We do not like to see the misery of others and “derive sorrow from the sorrow of others” even on the big screen.70 However, social norms play an important role on how altruistic we become as adults.71 Brain research identified “mirror neurons” that fire when we see others in distress, as though it were our own experience. Thus, “Smith (and Hume before him) had identified sympathy as a pervasive feature of human nature by the power of introspection . . . There is now ample evidence that there is a deep reason for Smith’s intuition . . . Sympathy has a basis in the way the brain works.”72 By neglecting altruism, Econ 101 textbooks lead us astray: it is wrong to suggest that we maximize a utility function that includes only our own consumption. Altruism toward relatives has been discussed in terms of our propensity to propagate our genes. However, this has been extended by the concept of multilevel selection. Edward Wilson explains: “hereditary social behavior improves the competitive ability not of just individuals within groups but among groups as a whole.” Thus, people have an “intense, obsessive interest . . . in other people.” In addition, human nature includes: [t]he overpowering instinctual urge to belong to groups . . . Competition among groups . . .  promoted altruism and cooperation among all the group members. It led to group-wide morality and a sense of conscience and honor . . . To yield completely to the instinctual urgings born from individual selection would dissolve society.73 Our universal sense of fairness must have its roots in such evolutionary selection processes based on altruistic commitment to the group. Overlooking the role of fairness in economic life is a major setback for conventional economics.

Positive and Normative Economics Economists distinguish between positive economics, which is supposedly objective analyzing the economy using “scientific” methods, and normative economics, which pertains to what ought to be. The former is allegedly value free while the latter involves value judgments. However, the distinction is artificial, because it is impossible to undertake economic analysis without making assumptions that involve value judgments even if they might appear intuitively plausible. (See discussion above of efficiency.) What issues one considers positive economics depends on cultural norms and requires the use of a value system. For instance, economists assume that people are rational, although psychologists have proven beyond a reasonable doubt that people are not capable of being rational or coherent. Thus, the deliberate disregard of the results of scientific research in sister disciplines is itself a value judgment. Moreover, accepting the current distribution of wealth in theorizing about efficiency implies

92  Taste Makers and Consumption a value judgment. It does not originate in a scientific canon. Defining the current distribution as acceptable and efficient is not value free. It requires a value judgment. Emphasizing efficiency over sustainability is another example of a value judgment common in mainstream economics; it is not anchored in objectivity. Not distinguishing between basic needs and wants is a subjective value judgment. In other words, it is impossible to have a valueneutral economic theory: the mainstream considers the assumption that wants are unlimited to be positive economics, whereas others consider this to be part of a culturally determined value system. There is no empirical evidence that insatiability is the norm of human nature. Rather, such attributes are learned in the process of acculturation. The hostility of textbooks toward the government is another distinctly U.S. cultural attribute. That worldview does not consider the need for consumer protection from powerful business interests, even though government protection of consumers has yielded such successes as halving the number of cigarette smokers; that would have been impossible without government policy. Some argue that theories ought not be judged by the verity of their assumptions but by their ability to make valid predictions. However, that is in itself a value judgment open to question. Yet, economics is not known for its accurate forecasting. It failed miserably at predicting the Great Recession even though there were enough warnings that people in authority chose to disregard.74 In short, economic models come up short in predicting and forecasting in real-world situations.

Expected vs. Realized Utility There is another problem with conventional utility maximization theory. It rarely distinguishes between expected and realized utility. It assumes that when consumers purchase chicken fingers for $4.30 they actually received at least $4.30 worth of utility from them. The reasoning is that because they paid for them they must have gotten that much value. However, this inference is short-sighted: consumers paid for them before they consumed them. Hence, at the time of the transaction they expected to receive at least $4.30 worth of satisfaction, but upon consumption the satisfaction could turn out to be different than the one anticipated. As a consequence, we need to distinguish between expected and realized utility. The amount consumers spend need not be equal to the amount of utility they actually receive from what they purchased, and this is yet another reason why consumption and income ought not be equated with welfare. Actually, we make systematic mistakes in forecasting utility. Many people fail to distinguish between the initial level of utility obtained from a good and future levels of utility. Consumers generally do not account in their decisions for adaptation and do not anticipate accurately the rate at which utility depreciates over time. People tend to exaggerate the effect of purchases on their long-run level of satisfaction. There are also biases in how much we remember experiences. Economists emphasize the experiencing of consumption, but anticipation and remembering generate utility as well which they disregard. People usually undervalue these aspects of consumption in their decisions. The ice cream cone consumed a year ago most likely no longer provides any satisfaction. However, expenditure on vacations is remembered longer and the rate of decay in remembering is not given sufficient weight at the time the decision is made. In other words, people make errors in their consumption decisions, including forecasting the rate of decay of utility obtained from consumption.

Taste Makers and Consumption  93 Furthermore, we often regret our purchases, because advertisers take advantage of our psychological weaknesses and entice us into buying products that we subsequently regret.75 We are also often misled into accepting contracts without fully understanding them. Often the problem is that we do not even know what questions to ask in order to make an informed decision. The use of the Internet frequently leads to frustrated customers who are dissatisfied with the products purchased.76 I know that I myself am often duped with a complex purchase—contracts for credit cards, cell phones, satellite TV reception—for the first time or under time pressure, and I generally do so with imperfect information.77

Imperfect Information Textbooks imply that the price of a product is all the information one needs to make a rational choice about its purchase. This is true only with trivial choices. In most real-world cases, obtaining accurate and reliable information about a good or service is costly, difficult, takes effort, and is often simply out of our reach. Inasmuch as imperfect information is pervasive the textbook no-brainers should not be the default model. Thus, acquiring pertinent information is a huge problem trivialized in textbooks. This poses an enormous obstacle to efficient consumption and production, because information uncertainty, incomplete information, and asymmetric information are pervasive.78 According to Joseph Stiglitz, who received a Nobel Prize for his research on information economics, “even a small amount of information imperfection could have a profound effect on the nature of the equilibrium.”79 This means that efficient outcomes are rarely attainable in practice especially since producers obscure and manipulate information so as to make certain attributes more accessible than others while hiding some information altogether.80 Given that information is costly to acquire and is asymmetrically distributed, and given the unequal distribution of wealth, education, and cognitive abilities, the free market provides ample opportunities for opportunistic behavior on the part of sellers. Hence, they can exploit their information advantages. This is inefficient and impinges on the quality of life in general. Consequently, we almost always have to decide with incomplete information, which is a challenge to our ability to make satisfactory decisions, let alone optimal ones. This provides an opportunity for those in the know to take advantage of our inexperience, illiteracy, naiveté, or ignorance. An exchange in which one party knows more about the good, service, or contract than the other, is referred to as an asymmetric information problem.81 For instance, the bankers knew much more about the riskiness of adjustable rate mortgages than did the borrowers who signed on to them during the run-up to the Meltdown of 2008. Moreover, those who packaged exotic securities that subsequently became toxic, knew much more about the product than the investors who bought them (Chapter 14). As a consequence, opportunistic behavior (a.k.a. deception) played a substantial role in the years preceding the crisis. Some of the firms were subsequently caught: Goldman Sachs had to pay a $650 million fine for just one such transaction. But that was not much of a consolation to those who were defrauded and of course, that was a drop in the bucket for the firm: just a cost of doing business. Insider (private) information is another issue. The originator mortgage broker knew the creditworthiness of the borrower, but the investors to whom the mortgage securities were sold knew much less. Asymmetric information was at the root of the subprime mortgage crisis: insiders acted strategically and took advantage of those who did not have as much

94  Taste Makers and Consumption knowledge of finance as they did. Millions of substandard contracts were signed by parties with asymmetric information. Stiglitz suggests that: [t]he economics of information has constituted a revolution in economics . . . upsetting longstanding presumptions, including that of market efficiency, with profound implications for economic policy. Information failures are associated with numerous other market failures, including incomplete risk markets, imperfect capital markets, and imperfections in competition, enhancing opportunities for rent seeking and exploitation.82 In other words, the neglect of asymmetric information is not a trivial oversight in Econ 101! Students should not study economics without being made aware of the ubiquitous information problem in markets, as it is a major impediment to efficient outcomes. The uneven distribution of information is one of the Achilles heels of markets. Laissez faire and the invisible hand do not lead to efficient outcomes in the presence of imperfect information.83 As a consequence, consumer protection is warranted. Producers have much more information about their product than consumers, and it is unfair to put all the burden of acquiring adequate information on the buyer so that he can decide appropriately. Letting the buyer beware (caveat emptor) is an unfair rule of thumb. Instead, regulation can constrain sellers to be on good behavior. Not to deceive each other should be a mutual obligation. All of the burden should not be on the buyer. In the presence of asymmetric information, government-­ mandated dissemination of information can lower transaction costs and improve the buyer’s ability to make an informed, satisfactory decision. Truthful packaging and truthful advertising could raise consumer satisfaction considerably. I believe that taking advantage of asymmetric information in the course of an economic exchange is taking self-interest too far. If one party exploits the counterparty’s lack of information in order to gain at the other’s expense, then he is unfair. This is quite similar to the idea of “infliction of pain on others for private advantage.”84

Signaling Signals are tangible signs and therefore generate information. In a market with imperfect information, signals are important because they are substitutes for unobservable information. For instance, a diploma is a signal of having achieved some level of academic proficiency. Students attend college not only to learn but also to demonstrate (generate a signal) to future employers that they have the attributes to perform well under challenging circumstances. The acquisition of the diploma is a signal that one has the requisite stamina, will power, and intelligence to successfully complete a complicated educational program. For employers the diploma represents unobservable attributes: reliability, ability to work under stress, flexibility in new situations, and willingness to cooperate. In a market with imperfect information, the diploma has a large value beyond the value of the knowledge learned in college. It signals the possession of intangible attributes. That is why people who possess a high school or college diploma earn disproportionately more than those who left school shortly before graduating, although the additional knowledge gained during the missing time is probably not crucial for the job. In that sense, the additional effort of obtaining the credential is inefficient because students could have

Taste Makers and Consumption  95

Illustration 5.1  What Is One Without a Mansion and a Yacht? The Lifestyle of the Superrich and Super-Famous Includes Conspicuous Consumption. It Is Rampant at a Time When Tens of Millions Are Deprived of the Basic Human Right of Decent Education and Health Care. Credit: iStock.com/mariakraynova.

performed as well on the job without the diploma. However, with imperfect information they are incapable of demonstrating that aspect of their character; the diploma thus signals a bundle of desirable attitudes and abilities.85 The signal adds value to the student because of imperfect information. Thus, there is a divergence between private and social returns to education. For the student it is worth investing in the diploma, but from the point of view of the society, the additional resources spent on generating the signal is wasted and inefficient since the investment did not lead to an increase in productivity. Nonetheless, it is a necessary investment because information on true productivity is difficult to ascertain otherwise. Firms find it profitable to sometimes sell a product below cost in order to generate a signal that they have the lowest prices. Such loss-leader strategies entice consumers to frequent that establishment and can lead to inefficient outcomes because the consumers’ decision is not based on complete knowledge of all the prices they will encounter. Prices on other products offered by the firm might be higher; hence, their total purchases may cost more than at other firms. Signaling social status is another type of inefficient consumption. Veblen suggested that through conspicuous consumption the rich signal their social position and thereby create a negative externality since it creates a feeling of envy in others. It is an expensive way to let the world know one’s place in society and induces others to emulate the consumption habits of the rich even at the cost of becoming indebted.

Notes 1 “Eisenhower Warns Us of the Military Industrial Complex,” YouTube video. www.youtube.com/watch?v= 8y06NSBBRtY; James Ledbetter, “What Ike Got Right,” The New York Times, December 13, 2010. 2 “The Military-Industrial Complex Rides Ever Higher,” Tom Engelhardt, “Junta Lite: How Generals and Billionaires Took over Trump’s Militarized America,” The Guardian, March 1, 2017.

96  Taste Makers and Consumption 3 Alexandra Alper and Kirstin Ridley, “Barclays Paying $435 Million to Settle Libor Probe,” Reuters, June 27, 2012. 4 Economists can be also captured by wealth, as is so vividly portrayed in the award-winning film Inside Job. 5 Bill Moyers Journal, “Simon Johnson and Marcy Kaptur, interview,” October 9, 2009. 6 Sewell Chan, “Financial Crisis Was Avoidable, Inquiry Finds,” The New York Times, January 25, 2011. 7 Rick Claypool, “Pharmaceutical Industry Profits Exceed Industry’s Self-Reported R&D Costs,” Public Citizen, March 31, 2017. 8 Mike McIntire and Nicholas Confessore, “Groups Shield Political Gifts of Businesses,” The New York Times, July 8, 2012. 9 “They [lobbyists working for major corporations] killed a major labor law reform, rolled back regulation, lowered their taxes, and helped to move public opinion in favor of less government intervention in the economy.” Lee Drutman, “How Corporate Lobbyists Conquered American Democracy,” The Atlantic, April 20, 2015. 10 Ibid. 11 In a revealing Freudian slip, Representative Spencer Bachus of Alabama, the chairman of the House Financial Services Committee at the time, told The Birmingham News that “Washington and the regulators are there to serve the banks.” He could not have made it clearer the extent to which high finance has captured Washington for all intents and purposes. Editorial, “How to Derail Financial Reform,” The New York Times, December 26, 2010. 12 David Cay Johnston, “How Corporate Socialism Destroys,” Reuters, June 1, 2012. 13 Lee Drutman, “How Corporate Lobbyists Conquered American Democracy,” The Atlantic, April 20, 2015. 14 Charles Wright Mills, The Power Elite (Oxford, UK: Oxford University Press, 1956); G. William Domhoff, Who Rules America? (Englewood Cliffs, NJ: Prentice-Hall, 1967). 15 Lee Drutman, The Business of America is Lobbying: How Corporations Became Politicized and Politics Became More Corporate (New York: Oxford University Press, 2015). 16 Peter Lattman and Azam Ahmed, “Rajat Gupta Convicted of Insider Trading,” The New York Times, June 15, 2012. 17 Stephanie Clifford and Colin Moynihan, “Martin Shkreli Is Found Guilty of Fraud,” The New York Times, August 4, 2017. 18 Joseph Stiglitz, “There Is No Invisible Hand,” The Guardian, December 20, 2002. 19 Franklin D. Roosevelt, “Speech Before the 1936 Democratic National Convention” (Philadelphia, PA, June 27, 1936). www.austincc.edu/lpatrick/his2341/fdr36acceptancespeech.htm. 2 0 Joseph Stiglitz, “America’s Socialism for the Rich,” The Economists’ Voice 6 (2009) 6: 1–3. 21 Samuel Bowles, “Endogenous Preferences: The Cultural Consequences of Markets and Other Economic Institutions,” Journal of Economic Literature 36 (1998) 1: 75–111. 2 2 Geoffrey M. Hodgson, “Veblen, Thorstein Bunde (1857–1929),” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 23 “How many people ruin themselves by laying out money on trinkets of frivolous utility?” Adam Smith, The Theory of Moral Sentiments (London: A. Millar, 1759), IV.I.6. www.econlib.org/library/ Smith/smMS.html. 2 4 Robert Frank, Choosing the Right Pond: Human Behavior and the Quest for Status (New York: Oxford University Press, 1985); Robert Frank, “The Demand for Unobservable and Other Nonpositional Goods,” American Economic Review 75 (1985) 1: 101–116; Richard Easterlin, “The Economics of Happiness,” Daedalus 133 (2004) 2: 26–33. 25 Veblen, Theory of the Leisure Class, p. 110. 26 James Duesenberry, Income, Saving, and the Theory of Consumer Behavior (Cambridge, MA: Harvard University Press, 1949). 27 A normal good is one whose consumption increases with rising income, as long as its relative price remains unchanged. 28 Federal Reserve Bank of St. Louis. Personal Saving Rate. https://fred.stlouisfed.org/series/PSAVERT. 29 Solomon Asch, “Opinions and Social Pressure,” Scientific American 193 (1955): 31–35; Harvey Leibenstein, “Bandwagon, Snob, and Veblen Effects in the Theory of Consumers’ Demand,” Quarterly Journal of Economics 64 (1950) 2: 183–207. 30 Robert H. Frank, “Consumption Externalities,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008).

Taste Makers and Consumption  97 31 Arthur J. Robson, “The Biological Basis of Economic Behavior,” Journal of Economic Literature 29 (2001): 11–33. 32 Federal Reserve Bank of St. Louis, “Average Annual Hours Worked.” https://fred.stlouisfed.org/ series/AVHWPEUSA065NRUG. 33 “Anybody who is not like everybody, who does not think like everybody, runs the risk of being eliminated,” wrote Spanish philosopher José Ortega y Gasset in 1929 in The Revolt of the Masses (New York: W.W. Norton, 1994). 34 Nellie Bowles, “To Fit into Silicon Valley, Wear These Wool Shoes,” The New York Times, August 11, 2017. 35 The Shulman Center for Compulsive Theft, Spending & Hoarding, “Shopaholics Anonymous.” www. shopaholicsanonymous.org/; Wikipedia contributors, “Shopaholic.” 36 Solomon E. Asch, “Opinions and Social Pressure,” Scientific American 193 (1955): 31–35. 37 Robert H. Frank, “Positional Externalities Cause Large and Preventable Welfare Losses,” American Economic Review 95 (2005) 2: 137–141. 38 Joseph Henrich, Steven Heine, Ara Norenzayan, “The Weirdest People in the World?” Behavioral and Brain Sciences 33 (2010): 61–135; Ernst Fehr and Simon Gächter, “Altruistic Punishment in Humans,” Nature 415 (2002) 6868: 137–140. 39 “Wal-Mart Worker Killed in Black Friday Stampede,” www.youtube.com/watch?v=f5EU4GRudvc. 40 Sharon R. Cohany and Emy Sok, “Married Mothers in the Labor Force,” Monthly Labor Review 130 (2007) 2: 9–16. 41 Max Weber, The Protestant Ethic and the Spirit of Capitalism (London & Boston, MA: Unwin Hyman, 1930. Originally published in 1905). 42 Luigi Guiso, Paola Sapienza, and Luigi Zingales, “Does Culture Affect Economic Outcomes?” Journal of Economic Perspectives 20 (2006) 2: 23–48. 43 Daniel Bell, The Cultural Contradictions of Capitalism (New York: Basic Books, 1976), pp. 21–22. 44 Ibid., p. 51. 45 Christopher Lasch, The Culture of Narcissism: American Life in an Age of Diminishing Expectations (New York: W.W. Norton, 1979). 46 Robert H. Frank, Luxury Fever (Princeton, NJ: Princeton University Press, 1999). 47 Christopher Lasch, “The Narcissist Society,” The New York Review of Books, September 30, 1976. 48 Christophe Hayes, Twilight of the Elites (New York: Crown, 2012). 4 9 James Galbraith calls this the “corporate republic” in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too (New York: The Free Press, 2008). 50 Golnaz Tabibnia and Matthew D. Lieberman, “Fairness and Cooperation Are Rewarding: Evidence from Social Cognitive Neuroscience,” Annals of the New York Academy of Sciences 1118 (2007): 90–101. 51 Peter Corning, The Fair Society: The Science of Human Nature and the Pursuit of Social Justice (Chicago, IL: University of Chicago Press, 2011). 52 Price of one ticket was increased from $547 to $3200. Justin Sablich, “Airlines Face Criticism Amid Irma Price-Gouging Complaints,” The New York Times, September 9, 2017. 5 3 Andrew Pollack, “Drug Goes from $13.50 a Tablet to $750, Overnight,” The New York Times, September 20, 2015. 54 The price of EpiPen, an anti-allergy injection, soared from $103 to $608. Ben Popken, “Mylan Execs Gave Themselves Raises as They Hiked EpiPen Prices,” CNBC News, August 23, 2016. 5 5 Colin F. Camerer, “Behavioural Game Theory,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 56 John Rawls, A Theory of Justice (Cambridge, MA: Harvard University Press, 1971). 5 7 Sally Holmes, “$133 Million in Bras: The Complete Evolution of the Victoria’s Secret Fantasy Bra,” Elle, November 28, 2016. 58 There are 140,000 people worldwide with assets of $50 million or more, half of them in the U.S. Scott Shane, Spencer Woodman, and Michael Forsythe, “How Business Titans, Pop Stars and Royals Hide Their Wealth,” The New York Times, November 7, 2017. 59 Similarly, when it adopts the Kaldor-Hicks criterion to undertake economic policy, it assumes implicitly that utility levels can be compared across individuals. 60 “To amend the Truth in Lending Act to establish fair and transparent practices relating to the extension of credit under an open end consumer credit plan,” U.S. Congress, House, Credit Card Act of 2009, HR 627, 111th Congress, 1st session, January 6, 2009. The act protects consumers in a myriad of ways from the chicanery of credit card companies. One example of the many: “Requires a card

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61 62 63 64

65 66 67

68 69 7 0

71 72 73 74 7 5 76 77 7 8 7 9 80

81

8 2 8 3 8 4 85

issuer, upon receipt of payment, to apply amounts in excess of the minimum payment amount first to the balance bearing the highest rate of interest, and then to each successive balance bearing the next highest rate of interest, until the payment is exhausted.” James Kwak, “When a 79.9% APR Is Good?” The Baseline Scenario, January 8, 2010. Thomas Nagel, The Possibility of Altruism (Oxford, UK: Clarendon Press, 1970), p. 79. In evolutionary biology, altruism is defined in terms of one organism raising another organism’s reproductive success at the expense of its own. James Andreoni, William T. Harbaugh, and Lise Vesterlund, “Altruism in Experiments,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). Ernst Fehr and Bettina Rockenbach, “Human Altruism: Economic, Neural, and Evolutionary Perspectives,” Current Opinions in Neurobiology 14 (2004) 6: 784–790. Ernst Fehr, Helen Bernhard, and Bettina Rockenbach, “Egalitarianism in Young Children,” Nature 454 (2008): 1079–1083. Dharol Tankersley, C. Jill Stowe, and Scott A. Huettel, “Altruism Is Associated with an Increased Neural Response to Agency,” Nature Neuroscience 10 (2007): 150–151; Golnaz Tabibnia and Matthew Lieberman, “Fairness and Cooperation are Rewarding: Evidence from Social Cognitive Neuroscience,” Annals of the New York Academy of Sciences 1118 (2007) 1: 90–101. Smith, The Theory of Moral Sentiments (1759). To be sure, there was self-interested reciprocity as well, and we can also derive pleasure from believing that we are altruistic. Smith, The Theory of Moral Sentiments I.I.1; Alexander J. Field, Altruistically Inclined? The Behavioral Sciences, Evolutionary Theory, and the Origins of Reciprocity (Ann Arbor, MI: University of Michigan Press, 2002). Experiments reveal that women are more altruistic than men. Rachel Croson and Uri Gneezy, “Gender Differences in Preferences,” Journal of Economic Literature 47 (2009) 2: 1–27. Aldo Rustichini, “Introduction. Neuroeconomics: Present and Future,” Games and Economic Behavior 52 (2005): 201–212. Edward O. Wilson, “Evolution and Our Inner Conflict,” The New York Times, June 24, 2012. “The collapse of the housing bubble will lead to a loss of between $1.3 trillion and $2.6 trillion of housing wealth,” Dean Baker, “The Run-up in Home Prices: A Bubble,” Challenge 45 (2002) 6: 93–119. This is known as buyer’s remorse. “Ripoff Report,” has thousands of stories about scams: www.ripoffreport.com/reports/specific_ search/internet. James Kwak’s description of his experience moving his DSL service with Verizon as “More Telecom Hell,” Baseline Scenario, August 18, 2010. Joseph Stiglitz, Information and Economic Analysis, vol. 1, Selected Works of Joseph E. Stiglitz (Oxford, UK: Oxford University Press, 2009). Joseph Stiglitz, “Information and the Change in the Paradigm in Economics,” American Economic Review 92 (2002) 3: 460–501, at p. 461. “Artificial intelligence is going to be able keep track of our moods in the near future using social network and take advantage of this information to be able to manipulate us even more effectively,” Fabon Dzogang, Stafford Lightman, and Nello Cristianini, “Circadian Mood Variations in Twitter Content,” Brain and Neuroscience Advances, 2017. George Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84 (1970): 488–450; George Akerlof, “Behavioral Macroeconomics and Macroeconomic Behavior,” American Economic Review 92 (2002) 3: 411–433. Joseph Stiglitz, “The Revolution of Information Economics: The Past and the Future,” National Bureau of Economic Research Working Paper No. 23780, September 2017. Joseph Stiglitz, “The Invisible Hand and Modern Welfare Economics,” National Bureau of Economic Research Working Paper No. 3641, March 1991. Avner Offer, “A Warrant for Pain: Caveat Emptor vs. the Duty of Care in American Medicine, c. 1970–2010,” Real-World Economics Review 61 (2012): 85–99. Michael Spence, “Job Market Signaling,” Quarterly Journal of Economics 87 (1973) 3: 355–374.

6 Firms and Imperfect Competition

Wealth, as Mr. Hobbes says, is power. Adam Smith1

We next examine aspects of the microeconomic theory of the firm that are usually glossed over in Econ 101. Standard economic theory focuses on the perfectly competitive model. This assumes that there are innumerable firms which produce a homogenous product. There are no brands since everyone produces the same generic product. So, there is no product differentiation, no differences in quality, and hence no advertisements. There is not much sense in advertising for generic cereal because one firm’s cereal is the same as all the others. These are important features of perfectly competitive markets. However, there are obviously not too many products like that. The price of a product in such a market is determined by aggregate supply and demand; consequently, no single firm has the power to influence the price. In such a case every firm is a price taker. Hence, the demand for the product of each firm is given by the market price. Firms will produce as long as they can at least break even at the given price. Consequently, firms are producing efficiently at the minimum unit cost and have just enough revenue to stay in business. In such an equilibrium, price equals both marginal and average cost and the consumer is “king”: firms produce what consumers want (see Figure 3.1 in Chapter 3). This is fundamentally poor pedagogy, because it emphasizes a market structure that is essentially irrelevant in today’s economy except for homogeneous raw materials in wholesale markets. In our time, practically no consumer good is produced under the above conditions. Rather, the dominant market structure is called imperfect competition. The concentration of production implies that firms are not price takers but retain the power to determine prices, wages, and to manipulate consumer wants (Figure 3.2). Moreover, they also influence the political process so that firms can amass further market power. Competition among oligopolies and monopolies has entirely different consequences for market outcomes than competition among price takers. Hence, we focus in this chapter on the salient aspects of imperfect competition and delineate how that affects market outcomes for consumers.

Firms Conventional textbooks describe a firm as an individual decision maker, analogous to the consumer, who is also assumed to be a sole decision maker. There is a shoemaker and

100  Firms and Imperfect Competition a seamstress near me who own their businesses and work alone. Theirs would be such a textbook firm, but one has to think hard to come up with other such entities. Such firms are a negligible part of the economy. Most are hierarchical, authoritarian organizations within which the visible hand of management replaces the invisible hand of the market.2 Thus, they resemble other bureaucratic institutions such as government agencies. A corporation, then, is not a person and does not make decisions as an individual. Rather, it is an organization with managers employing a labor force of hundreds of thousands: Bank of America employs 208,000; IBM employs 380,000; and Walmart 2.3 million.3 The efficient coordination and monitoring of employees within such a mega-corporation are nearly impossible efficiently because the actual owners of the firms, the shareholders, are far away and cannot provide adequate oversight. To be sure, the wasting of resources in large firms is compensated by the gains obtained through economies of scale, lowering of transaction costs, and oligopoly profits. Such giant enterprises employ too many people with conflicting goals to be able to optimize. Some shirk; others seek their own advantages. It is not feasible to align the incentive of each employee with that of the firm, especially since they presumably want to do the best for themselves and not for the firm. Managers provide oversight, to be sure, but monitoring is unwieldy. Money managers before the financial storm of 2008 took excessive risks in order to increase their immediate bonuses without regard to their long-run effects on the firm. The crisis did not change the attitude toward risky behavior. Bruno Iksil, a.k.a “The London Whale,” lost some $9 billion for JPMorgan Chase in 2012 in trades that Jamie Dimon himself, CEO of the bank, called “flawed, complex, poorly reviewed, poorly executed, and poorly monitored.”4 The bank paid $920 million in penalties to regulators.5 His immediate supervisor, Javier Martin-Artajo, who tried to hide the losses, earned $11 million the previous year. The work of their boss, Ina Drew, was deemed worth $14 million the previous year but did not understand the trades and failed to oversee the gamble.6 This is obviously an extraordinary case, but such issues on a smaller scale are ubiquitous and characteristic of large organizations including even non-profits.7 Providing effective oversight to employees is difficult, takes effort, and is costly, sometimes prohibitively so. Additional obstacles to optimization include the uncertainty about future demand and disruptive technologies affecting the firm. Furthermore, persons in charge have only vague knowledge of how much demand would change in response to variations in the price it charges for its product. Hence, it cannot determine the profit-maximizing price-output combination. The best managers can do is to satisfice with bounded rationality; in this regard, their strategy is similar to that of consumers. As consumers, firms adapt rules-of-thumb to solving their problem, such as the mark-up rule which multiplies the cost of a product by a constant factor in order to obtain the selling price. The firm is not organized internally as a market. This is a seeming contradiction in the theory of those who advocate the beneficial effects of both the free market and corporations. The two are established on very different principles. The former is supposed to be democratic, with power diffused. The latter, in contrast, is authoritarian, with concentration of power. Such authoritarian organizations can be subject to groupthink by which employees do not evaluate critically the orders of their superiors.8 Groupthink can lead to dysfunctional dynamics as alternative perspectives are suppressed as happened prior to the Meltdown of 2008. Both Federal Reserve Chairman Alan Greenspan and his successor Ben Bernanke did

Firms and Imperfect Competition  101 not think that systemic effects were potentially destabilizing, and consequently the 1000 or so PhD economist employees of the Federal Reserve system went along with that mistake without questioning it.9

The Illusion of Perfect Competition Most students take away from Econ 101 that competition is the mechanism that guarantees efficient markets. That is also the formulation that reverberates frequently in the media and has entered public consciousness. Hence, it is important to understand that competition is not sufficient to bring about efficiency. Many conditions must exist for efficiency: there have to be countless sellers and buyers of an undifferentiated product, and both counterparties have to be rational, know the quality of the product, and transaction costs and negative externalities have to be absent. Such perfectly competitive markets no longer exist that pertain to consumers on Main Street. Instead, they are confined to raw material markets sold wholesale such as wheat and oil. Unfortunately, Greenspan and Bernanke applied this model to the financial sector where none of the above preconditions obtained. It was not perfectly competitive and had plenty of asymmetric information. Obviously, they were taught Econ 101 incorrectly. Today’s markets are dominated by oligopolies and monopolies, and competition among a few firms in a market segment differs from the Econ 101 examples. Perfectly competitive outcomes including zero profits are anathema to CEOs so they avoid them at all cost and obtain advantages through market power. The strategies firms employ to accomplish this include product differentiation as a form of nonprice competition. As long as firms such as Louis Vuitton have monopoly rights to manufacture products with that name, and its designs are protected by law, they will be able to earn profits even though its handbags are close substitutes to those of its competitors Gucci, Dior, Prada, and Chanel. EpiPen used to treat emergency allergy reactions is an example of oligopoly pricing. Heather Bresch, as CEO of Mylan, a generic drug maker which has an 85% market share, increased the price of EpiPen from $100 to $600 (500%) between 2007 and 2016. Her annual salary increased correspondingly from $2.4 million to $19 million (671%).10 The invisible hand did not improve social welfare. Thus, competitive markets are not automatically efficient. Imperfect markets with imperfect information dominate in the real economy. So the default model should be that markets are not efficient. Yet, many textbooks argue as though such concepts apply to all markets: “We have seen that markets have remarkable efficiency properties,” write Samuelson and Nordhaus,11 forgetting the qualifier “perfectly competitive” and also neglecting the complication of imperfect information. That is the reason why the notion that markets are efficient has become the dominant ideology. The missing concepts make the above formulation—and many others like it—misleading since students take away the idea that all markets are efficient without exception, as long as there is competition. Witness the consensus that emerged to deregulate the financial sector.

Imperfect Competition: Oligopolies and Monopolies Firms in a market dominated by a few large sellers are oligopolies. If there is just one seller then it is a monopoly. Such firms have sufficient market power to affect prices because of concentration of market share. Competition among such firms does not assure an efficient

102  Firms and Imperfect Competition outcome. Instead, prices then exceed average unit cost and profits are generated. In addition, oligopolies and monopolies do not produce at the minimum of average cost. Therefore, they produce inefficiently in spite of competition. Imperfect competition prevails because of strategic behavior or collusion, tacit or explicit. The mainstream argues that in the long run, firms will enter the market until the profits of oligopolies are competed away. However, that is inaccurate, because it does not specify how long that will take and therefore may not be pertinent in the relevant time frame. Existing firms try to keep competing firms from entering the market using advertising as a barrier to guarantee that potential competitors have to make a large lump-sum investment before they can become viable competitors and gain a sufficiently large market share to make it worthwhile for them to enter the industry. Alternatively, existing firms tweak their products sufficiently so as to avoid the long-run outcome. Besides, even if they were not earning a profit, oligopolies and monopolies are still inefficient, because the prices they charge for their product exceed marginal cost and because they still produce with excess capacity. The Walgreens around the corner is empty much of the time. Another form of imperfect competition is spatial monopoly, such as Walgreens or gas stations, since they have a monopoly on selling at a certain location. Yet, there is hefty competition, so most of them earn small profits. Nonetheless, it is an inefficient form of market organization insofar as there are too many gas stations and none of them is used at full capacity, leading to a misallocation of resources that could be put to other uses. That form of industrial organization dominates much of the retail sector: drugstores, restaurants, supermarkets, department stores, and similar brick-and-mortar firms are very competitive, are usually not great profit makers, and are inefficient. The real monopoly profits are made by the pharmaceutical companies who deliver to the drugstores, the oil companies who deliver to the gas stations, and of course the financial sector. Banks earned $100 billion on credit cards alone in 2015.12 Big Pharma claims that the exorbitant prices are used for research and development. But that is only half true because monopoly prices also generate profits that accrue to shareholders and CEOs. From 2006 through 2015, the 18 drug companies listed in the Standard & Poor’s 500 index spent a combined $516 billion on buybacks and dividends but only $465 billion on research and development.13 And this does not even include the billions spent on CEO and other top management’s bloated salaries and bonuses. In 2014, Lamberto Andreotti of Bristol-Myers Squibb got $27 million and Kenneth Frazier of Merck & Co. got a hefty $25 million. I am sure that decent managers could be found for a small fraction of these salaries.14 Creating and promoting brands is a way to differentiate the firm’s product from the rest of the market to avoid perfect competition. For example, although Apple does compete with many technology companies, it still reaps big profits because it has products with a unique design and features that are protected by copyright law and may not be duplicated. No one else is allowed to produce iPods, iPhones, iPads, or Macs, granting Apple a monopoly, and it can set the price of these products. In order to stay ahead of the competition, it brings out a new generation of its products yearly. The price of an iPod has been in the $300–$400 range since its introduction in 2001.15 So competition does not have the effect even in the long run as it does in theory, because the real world is dynamic, whereas the theoretic world is static. The firm does not stand still in response to competition but devises ways to elude the consequences. Unlike perfectly competitive firms, nearly all oligopolies and monopolies

Firms and Imperfect Competition  103 can avoid the long-run solution of no profits and do earn hefty profits in spite of competition because they are producing unique products. These profits are far from temporary. Government subsidies are another way to enhance profits; the oil industry, for instance, receives large subsidies from the government while banks received loans from the Fed at a near-zero interest rate for seven years (2009–2015).16 It is difficult not to make profits that way. For example, the mortgage giant Fannie Mae, in government conservatorship, earned profits of $86 billion in 2013.17 Thus, the default model of industrial organization should be oligopolies and monopolies in which all profits are not competed away, rather than the tiny firms of the perfectly competitive model. To be sure, the mainstream argues that such residual profits are factor payments to entrepreneurship or returns to risk taking and not really “true” profits. However, that is just creative accounting or finagling to call profits by another name. Competition is supposedly the mechanism by which the more productive firms producing a better product survive, but better in what sense? When competition intensifies it may well be that the unscrupulous are the ones that thrive. Wachovia Bank, for instance, was fined $160 million for laundering Mexican drug money in 2010. The bank’s CEO, G. Kennedy Thompson, received $15 million before the bank became bankrupt.18 Tom Hayes, the culprit in the LIBOR interest-rate fixing scandal, received an 11-year jail sentence.19 Competition can become brutal, including unethical behavior, and there is no presumption that the outcome will be socially desirable because other firms will follow suit and match the deception in order to survive as long as the tricks are not easily discernible.20 To be sure, many inefficient firms that took on too much risk, such as IndyMac, Countrywide, Washington Mutual, and Lehman Brothers, failed during the 2008 Meltdown, but many similarly structured firms survived, thanks to the government bailouts. Furthermore, their CEOs endured the crisis with their hundreds of millions intact. The meltdown is an example of how individual and group interests diverge despite competition. The interest of Angelo Mozilo, CEO of Countrywide Financial, a pioneer and major originator of subprime mortgages, was to extract as much money as possible from his firm without consideration of the millions of people who would be thrown out of work as a consequence of his actions. After the crisis his net worth is still about $600 million.21 The net worth of other culprits whose firms disappeared in the Meltdown include (in millions) Roland Arnall, Ameriquest ($1,500); Jon Corzine, MF Global ($350); Dick Fuld, Lehman Brothers ($250); John Thain, Merrill Lynch ($100); James Cayne, Bear Stearns ($100). However, thousands of their customers and investors lost everything they had and millions of others were hurt severely through lower salaries or loss of pensions by their reckless behavior.22 Even Alan Greenspan, former Chairman of the Federal Reserve, who let the crisis accumulate, has a net worth of $10 million. In other words, they were immune to the calamity while much of the population paid dearly. The “invisible hand” was nowhere to be seen. Oligopolies and monopolies do not have supply curves, since they have market power and choose that combination of price and quantity that yields satisfactory profits. They are large relative to the market and have a unique product to sell and therefore are not price takers (Figure 6.1).23 Consequently, iPods do not have a supply curve. Apple supplies as many iPods as demanded at the price it sets. Over the years, the company has not varied the price of iPods or iPhones by much. Instead of competing with price, it competes with features and by creating a hype about its product through advertisement.24 Similarly, the

104  Firms and Imperfect Competition

Figure 6.1  Profit of a Monopolist (Without Fixed Costs) Windows operating system is a monopoly in an oligopolistic market structure competing mainly with Apple computers. Thus, Microsoft has market power and is not willing to supply its products at the socially optimal price. It offers its software at a price that obtains a substantial profit for the firm: $17 billion in 2016.25 Another obstacle to attaining efficient outcomes is posed by first-mover advantages. Learning-by-doing might lower the production costs of those firms who produced a product first to such an extent that a latecomer can never catch up. In this case, a firm might be a low-cost producer for no other reason than having the luck of being the first to have produced a good.

Prices As mentioned earlier, oligopolies and monopolies do not have supply curves. Most firms have only a vague notion of the price elasticity of demand for their products, so they are satisficing with respect to the price they charge. Furthermore, firms devote much effort to scrambling the price-quantity-quality relationship so as to focus consumers’ attention on the attractive aspects of their offer and keeping quiet about the less attractive ones. Firms use multiple strategies to distort perceptions in order to tilt the playing field in their favor, for instance, by increasing the transaction costs of acquiring information on the attributes of the product or making it difficult to do comparison shopping. This is a selection device to separate those seriously interested in the product from those who are less so, and once the serious consumers invest in finding out the price, they are less likely to go to a competitor, where they would have to invest time and effort again with an uncertain payoff. In addition, such a strategy keeps the information out of the easy reach of competitors, thereby avoiding the ill effects of price competition.

Firms and Imperfect Competition  105 Thus, garbling prices is in the firm’s interest as is enticing the customer without revealing the price early on in the encounter. Their marketing includes the use of anchoring and framing strategies to focus on how much will be saved by purchasing a product rather than accentuating its actual price; they give the monthly instalment price rather than the total cost of an automobile. Firms set deadlines on discounts so that the consumers feel they have limited time to think about the purchase; they offer two for the price of one while inventory lasts; final day of sale offers; they offer teaser rates such as 0% financing for the first three months; they conceal the length of the contract, that is, by automatic renewals until canceled. Another finagling strategy is to put unsavory information into the small-print section of the contract while offering low “teaser” interest rates in large print. The list of gimmicks, traps, and deceptions is practically unlimited. But the main insight is that firms hire the smartest to do their utmost to confuse the consumer and make comparison shopping demanding. That is why, for example, the weight of cereal boxes is not uniform and why the easily accessible attribute of the size of cereal boxes is inflated so that a good portion of the box is usually empty. Producers are making it difficult to compare brands. So applying the perfectly competitive model to the real world is archaic. For instance, gasoline prices are influenced significantly by OPEC—a cartel. While there is still competition, the price is determined administratively. They consider how much they want to charge given other suppliers in the market and then calibrate their supply to that price. In other words, the causation is not from supply to price, but from price to supply. Or consider that most big banks charge $33–$37 for each overdraft, which is far above cost.26 This is pure profit. The reality is that competition does not lower this prevailing price because the CEOs know that if they were to lower the penalty, the rival banks would counter by following suit and the new equilibrium would be lower fees without gaining new customers implying that profits would decrease as well. The CEOs have learned that price wars are futile.27 This is a form of tacit collusion. Quantity demanded is determined not only by current prices but also by the history of prices because that influences price expectations. Higher prices today do not always lead to a decline in the quantity demanded. Suppose the price of a good has been rising for a while. One might interpret the current increase in price as a signal that prices will continue to rise and therefore buy even more of the good now in order to avoid higher prices in the future (see Figure 4.12 in Chapter 4). Or suppose that the price of a good falls: one might interpret that as an indication that quality has declined and buy less of the good. So the relationship between price of a good and the quantity demanded depends also on expectations; prices can also be used as a signal of quality. Multiple equilibria are possible. There was no indication in, say 1900, that medical costs in Europe and the U.S. would diverge substantially. Medical costs in the U.S. would not have become twice that in Europe if the American Medical Association and the insurance companies would not have gained such a powerful position in determining the structure of the system. That is the concept of multiple equilibrium. Current prices of medical services in the U.S. could have been the same as in Europe if institutions, vested interests, and lobbies had developed differently. Allowing prices to ration goods has a moral aspect to it as well when the goods pertain to basic needs such as health care. It is inhumane to see famine amidst plenty. In August 2017, 20 million people were at risk of famine in Somalia, South Sudan, Nigeria, and Yemen;28 this is quite a contrast, for example, with supermodel Linda Evangelista’s asking the French

106  Firms and Imperfect Competition billionaire Francois Henri-Pinault for $46,000 a month in child support for their four-yearold son.29 While Louis Vuitton’s website featured shoes selling for $1,690 a pair, and some handbags carried a price tag in the $4,000 range,30 a mother killed her children because of financial desperation.31 Every day one learns about such colossal discrepancies. The only logical inference is that the winner-take-all society has very great difficulty preventing excesses, such as setting commonsense limits so as to prevent great disparities in income and opportunity. Rationing basic necessities by price is often callous and cruel toward the poor, homeless, desperate, or otherwise disadvantaged.

Equilibrium and Disequilibrium The conventional view presented in textbooks is that the immutable law of supply and demand implies that equilibrium—where supply equals demand—exists in all markets at all times. Yet, it is unclear what mechanism would enable markets to reach such an equilibrium, and it is never ever specified how long it would take to reach it. Price depends on two crucial variables often absent from conventional supply and demand models: location and time. We do not always have the patience to wait for the market to find equilibrium. As Keynes famously said, “in the long run we are all dead”—that is, hungry people do not have time to wait for the price of bread to decline until they can afford it. With information and transaction costs it is not easy to match buyers and sellers, and decentralized markets do not have a straightforward mechanism to accomplish this. Therefore, some models imagine a hypothetical auctioneer who calls out prices and quantities by trial and error until total quantity supplied matches total quantity demanded and thus the market-clearing price (or equilibrium) is reached. Otherwise, if people would start buying before equilibrium is reached, prices would fluctuate. There would not be a unique price for the product in that market. However, such a fictitious character as an auctioneer is not realistic since she would either be an authority figure, a dictator, or would have to be compensated, driving an inefficient wedge between prices paid and prices received, or a benevolent dictator, which would not be consistent with the mainstream view that the economy is made up of selfish individuals. An altruistic auctioneer would somehow have to come from outside of the system. This is a conundrum in mainstream theory, especially since the auctioneer must unilaterally prohibit trade from occurring before the equilibrium solution is found. So she would have to have plenary powers to maintain order and not allow any sales prior to reaching the equilibrium price. In short, price discovery is a more complex process than students are led to believe. Such a theoretical auctioneer implies that the coordinating power of the price mechanism is of limited value without an authority figure.32 Competition alone is insufficient. Admittedly, the Internet might well improve price discovery, but note that firms are already learning how to extract additional profits using price discrimination even on the Web. For instance, Staples Inc. has offered different prices on Web sales depending on the buyer’s physical location.33 I myself had a similar experience purchasing a ticket from U.S. Airways. To my amazement, the price depended on the portal from which I accessed the company’s website! That is called price discrimination. The process of matching buyers to sellers can even lead to chaos or have fatal consequences: at a “Black Friday” “doorbuster” sale at Walmart in 2008 in which many products were priced as “loss leaders”—items sold below cost—a person was trampled to death.34

Firms and Imperfect Competition  107 Would General Motors and Chrysler have filed for (Chapter 11) bankrupcy if matching supply and demand were so easy? Such matching is not trivial because producers and consumers are not in the same place at the same time, and because middlemen are involved; furthermore, there is a considerable time lag between the onset of production and the sale of the product. Thus, producers have a formidable information problem and have to forecast demand and anticipate market developments well in advance, with plenty of uncertainty. This is not a trivial task. Consequently, there is constant volatility of demand and inventory cycles, leading to turmoil in the labor market, generally detracting from the quality of life.

Adverse Selection If the quality of a product is not easily distinguishable by buyers, some may choose the lowerquality one. Others, however, may take the price as a signal of quality. Such issues arise in markets with asymmetric information about quality, including most complex exchanges including credit markets, used car markets, and insurance markets.35 The insurance company does not know about the applicants’ health or driving ability as much as the applicants themselves do. Markets with adverse selection are generally inefficient. If insurers set a price for health insurance with a given level of coverage based on the average health of the population, then the less healthy people will find the insurance more attractive and will be more likely to buy it than healthy ones. Consequently, the average health of those insured will be lower than that of the population, implying that the company will incur higher costs than expected, inducing it to raise the price of insurance. This, in turn, will induce more of the healthier people not to buy insurance. In markets with such a negative feedback loop, the insurance company will have a “bad selection” of customers, that is, there will be an adverse selection from the company’s point of view, and this could well lead to a spiral of price increases, prompting a collapse of the insurance market as an increasing number of customers find it unattractive to buy the product. In such cases, government-mandated insurance may be the only way to improve the efficiency of the market.

Notes 1 “Of the Real and Nominal Price of Commodities, or Their Price in Labour, and Their Price in Money,” Book I, chapter V, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. Edwin Cannan (London: Methuen, 1904). 2 Alfred Chandler, The Visible Hand: The Managerial Revolution in American Business (Cambridge, MA: Belknap Press, 1977). 3 The United States Department of Defense has circa 2 million employees. 4 Wikipedia contributors, “2012 JPMorgan Chase Trading Loss.” 5 Dominic Rushe, “London Whale Scandal to Cost JPMorgan $920m in Penalties,” The Guardian, U.S. edition, September 19, 2013. 6 Wikipedia contributors, “Ina Drew.” 7 For instance, the University of North Carolina at Chapel Hill offered bogus courses in order to lighten the academic load of athletes. David Ridpath, “North Carolina’s Latest Attempt at Deflecting Academic Fraud Allegations As Expected,” Forbes, May 25, 2017. 8 William H. Whyte, Jr., “Groupthink,” Fortune, March 1952, 114–117. Whyte emphasized that in the corporate ethic our individuality becomes subservient to a group ideology. Groupthink becomes a rationalized conformity in order to maintain and enhance our position and income in the organization. 9 “[Bernanke] rarely challenged Greenspan. He wouldn’t have gotten into that club if he didn’t go along . . . Mr. Greenspan ran a tight ship, and he didn’t fancy people spouting off with their own views,” John Cassidy, “Anatomy of a Meltdown,” The New Yorker, December 1, 2008.

108  Firms and Imperfect Competition 10 The University of West Virginia granted a bogus executive MBA to her, the daughter of the Governor, in 2007. It was later withdrawn. Wikipedia Contributors, “Heather Bresch.” 11 Paul Samuelson and William Nordhaus, Economics, 19th ed. (New York: McGraw-Hill/Irwin, 2009), p. 164. To be sure, on page 169 they do admit that such firms are “hard to find,” and on page 187 they say that they are rare. The question lingers if it is advisable to include such inconsistencies in a textbook for beginners. 12 Outstanding credit card debt reached a record $1 trillion by the summer of 2017. Jessica SilverGreenberg and Stacy Cowley, “A Boom in Credit Cards: Great News for Banks, Less So Consumers,” The New York Times, October 19, 2017. 13 William Lazonick, Matt Hopkins, Ken Jacobson, Mustafa Erdem Sakinç and Öner Tulum, “US Pharma’s Financialized Business Model,” Institute for New Economic Thinking, Working Paper No. 60, July 13, 2017. 14 Tracy Staton, “The Top 20 Highest-Paid Biopharma CEOs,” FiercePharma. www.fiercepharma.com/ special-report/top-20-highest-paid-biopharma-ceos. Matt Krantz, “Drug prices Are High. So Are the CEOs’ Pay,” USA Today, August 26, 2016. 15 The iPod Touch, introduced in 2007 as a successor to the original product, was selling on eBay in August 2017 in the $325–$550 range. In other words, prices have not changed significantly in the intervening 16 years. 16 David Kocieniewski, “As Oil Industry Fights a Tax, It Reaps Subsidies,” The New York Times, July 3, 2010. 17 Wikipedia Contributors, “List of Largest Corporate Profits and Losses.” 18 Wikipedia Contributors, “G. Kennedy Thompson”; Ed Vulliamy, “How a Big US Bank Laundered Billions from Mexico’s Murderous Drug Gangs,” The Observer, April 2, 2011. 19 Jill Treanor, “Libor Interest Rate to Be Phased Out After String of Scandals,” The Guardian, July 28, 2017. 2 0 David Brooks, “Why Our Elites Stink,” The New York Times, July 12, 2012. 21 Celebrity Net Worth, “Angelo Mozilo,” “Richard Fuld,” “John Thain,” and “James Cayne.” Dennis Hevesi, “Roland Arnall, Mortgage Innovator, Dies at 68,” The New York Times, March 18, 2008. 2 2 140 banks failed in 2009 and another 157 in 2010. Wikipedia contributors, “List of Bank Failures in the United States (2008–Present).” 23 Edward Chamberlin, The Theory of Monopolistic Competition: A Re-Orientation of the Theory of Value (Cambridge, MA: Harvard University Press, 1933). Joan Robinson, The Economics of Imperfect Competition (London: Macmillan, 1933). 2 4 Wikipedia Contributors, “iPod Classic,” “List of iPod Models.” 25 Fortune “Global 500.” http://fortune.com/global500/microsoft/. 26 Spencer Tierney, “Overdraft Fees: What Banks Charge,” nerdwallet. 27 Smriti Chand, “Pricing Determination under Oligopoly Market.” www.yourarticlelibrary.com/economics/ pricing-determination-under-oligopoly-market-economics/28916/. 28 Nadifa Mohamed, “A Fierce Famine Stalks Africa,” The New York Times, June 12, 2017. 29 Evangelista has a net worth of $18 million. www.therichest.com/celebnetworth/celeb/model/lindaevangelista-net-worth/. Robert Frank, “How Does a Four-Year-Old Spend $46,000 a Month?” The Wall Street Journal, August 3, 2011. Kathleen Elkins, “21 Outrageous Ways the Super Rich Spend their Money,” Business Insider, July 27, 2015. 30 http://us.louisvuitton.com/eng-us/women/shoes/_/N-12x7xd9?campaign=sem_GG-US-ENG-ECBRAN-SHOE&gclid=CjwKCAjwos7NBRAWEiwAypNCe1_mFx_3AGhCJ-5xRgDlgyVBtXT8Cj0dWI2GX L98BlQeIJ6BsQ7dShoCbQEQAvD_BwE. Stephanie Clifford, “Even Marked Up, Luxury Goods Fly Off Shelves,” The New York Times, August 3, 2011. 31 Being unable to take care of her two children a financially desperate unemployed woman killed them for which she received a 35-year sentence. Robbie Brown, “Mother in South Carolina Killed 2 Children, Police Say,” The New York Times, August 17, 2010. 32 F.H. Hahn, “Auctioneer,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 33 Based on the IP address of the computer, the difference was about 10%. “A Tale of Two Prices,” The Wall Street Journal, December 24, 2012. 34 CBS, “Store Worker Trampled, Dies,” November 28, 2008, www.youtube.com/watch?v=7aUwmsi6Wc0. Walmart was fined the ridiculously low sum of $7,000 by OSHA. Dave Jamleson, “Walmart Has Finally Stopped Fighting The $7,000 Fine for a Worker’s Death on Black Friday in 2008,” Huffington Post, March 19, 2015. Searching for “Black Friday Chaos,” brings up many scenes of violence, a horrific statement on Western Civilization. 35 George Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84 (1970): 488–500.

7 Returns to the Factors of Production

Monetary returns to the factors of production include the compensation for labor, the payment to the owners of capital and natural resources, and the rent on land. Compensation might include wages, salary, bonuses, and Medicare and social security contributions of employers. In perfectly competitive markets labor, capital, managers, and CEOs receive their just rewards: their opportunity cost or the value of their contribution to the firm. There is hardly any role for government in this fantasy economy as everything is working smoothly. Since there are no profits to wrangle over, all problems are solved conveniently by the market. The takeaway impression that millions of students retain years after their introductory course ended is that competition solves all the important problems in the economy and hence markets are efficient. Government guidance is superfluous and merely leads to inefficiencies. This is not a reasonable description of the real existing economy made up of powerful oligopolies rather than perfectly competitive firms. Corporations combine factors of production in order to produce goods and services. Infrastructure, entrepreneurship, social capital, institutions, knowledge, human capital, culture, the legal system, and natural resources are additional important factors of production often disregarded. In today’s knowledge economy, we should accentuate the role of intangible factors such as human capital and information (including big data) in the economy. In addition, firms are embedded in a framework provided by the community including public goods, legal system, and custom without which businesses could not thrive.

Marginal Theory Marginal utility, marginal cost, marginal product, and marginal revenue—let’s just call these abstractions marginal everything (ME)—play a fundamental role in mainstream economic thought. If people were rational and if ME were measurable, then it would make sense that they would hold the key to determining output and consumption. Output would be constrained by marginal cost, wages would equal the value of the marginal product of labor, marginal revenue would be equal to marginal cost, and the other optimal conditions derived on blackboards millions of times would hold. Yet, there are myriad problems with this theory applied in the real world. It assumes that everything is continuously divisible so all the functions are differentiable. The calculation of marginal product of labor would require a tiny variation in the quantity of labor hired so that its contribution to output could be calculated. But that is hopelessly

110  Returns to the Factors of Production difficult, if not outright impossible, in real-world situations. Firms cannot hire managers by the hour or the day in order to ascertain what their contribution to total product is, for instance. Capital is similarly lumpy, not divisible either. Furthermore, there are many professions whose marginal products are unknowable even in theory. Teaching, policing, firefighting, and civil service fall into this category; their contribution to social well-being or productivity is a matter of judgment. One-fifth of the labor force works for the government in the U.S.—plus 1.1 million people are in the military—with no measurable marginal product. With so many people working in occupations whose marginal product’s value is in principle undefined, the rest of the labor market is distorted anyhow so that even if we could measure marginal product there, it would be inaccurate. What about marginal utility? What is the marginal utility of my consuming a piece of cake? I do not have a clear sense of that. It is a surge of fleeting pleasure that is soon forgotten and turns into regret. Daniel Kahneman and Amos Tversky have shown how many cognitive errors people make about their own utility (Chapter 4); it would be far-fetched to think that they can determine their marginal utility accurately or even approximately. Given the impossibility of calculating ME, we generally substitute a rule of thumb, a heuristic, a convention, or follow past practice to reach a good-enough solution. That is to say, both consumers and producers are satisficing without the use of information on ME. Otherwise we would become catatonic. There is an additional problem of aggregation of the factors of production. How do we add up the capital stock? How do we add computers and automobiles and buildings? And how should we aggregate the clean-up crew with the shop foreman or the members of the information technology (IT) department to get the total labor force? If we are unable to compute the aggregates, we are unable to find the output of the marginal worker or that of the marginal capital stock. And what is the contribution to output of public goods such as the Internet? Another contentious issue is that often there are fixed proportions in consumption as well as in production. I type on one keyboard. The addition of a second keyboard would not contribute to my output. Take it away, though, and I won’t be able to use the computer at all. So how would we ascertain our joint product between the keyboard and me? The marginal principle does not help in such cases. A firm’s output is limited by the quantity demanded of its product. Most firms are best represented by constant returns to scale technology; that is, marginal cost is generally not increasing for most firms, because large-scale unemployment and underutilization of capital stock mean that they could expand production without incurring rising costs of their inputs. Hence, constant marginal and average costs should be the default model. Demand constrains output of firms in most cases and not increasing marginal costs. In any case, price is generally greater than marginal cost, so most firms earn profit.

Wages In traditional theory, firms pay wages equal to the value of marginal product of their workers. This theorem implies that real wages should keep pace with labor productivity. Yet, it is contradicted by the evidence: the growth in compensation (which includes wages, bonuses,

Returns to the Factors of Production  111 Table 7.1  Growth in Productivity and Real Wages, U.S., 1947–2011

Number of Years 1) 1947–1970 2) 1970–1982 3) 1982–2016 3a) 1982–1999 3b) 1999–2016

23 12 34 17 17

Productivity Growth %

Wages Growth %

Ratio

Difference

Total

Annual

Total

Annual

Annual

Annual (%)

85 19 94 41 37

2.7 1.4 2.0 2.0 1.9

83 14 40 20 16

2.7 1.1 1.0 1.1 0.9

0.98 0.74 0.43 0.49 0.44

0.0 −0.3 −1.0 −0.9 −1.0

Note: Total refers to the total percent increase during the period. Annual is the annual compounded growth rate. Ratio is the ratio of annual growth rates. 2017 refers to the first half of the year. Wages refers to total compensation. Source: Susan Fleck, John Glaser, and Shawn Sprague, “The Compensation-Productivity Gap: A Visual Essay,” Monthly Labor Review, January 2011: 57–69. Data for 2012–2016 was kindly provided by Shawn Sprague of the BLS.

and benefits) has fallen far behind productivity growth since circa 1973 (Figure 7.1). Between 1947 and 1973 the two growth rates were exactly equal, just as theory predicted; both almost doubled in a quarter-century, growing at an impressive rate of 2.7% (Table 7.1). However, this post-World War II golden age ended in the 1970s during two major oil shocks and double-digit inflation. So, growth in productivity was cut in half to 1.4% and growth of real compensation fell to 1.1%, but they still remained linked to one another (Table 7.1). The difference was merely 0.3% per annum. The real structural break in this

450

Labor Productivity

400 350 300 250 200

Real Hourly Compensation

150 100

1950

1960

1970

1980

1990

Figure 7.1  Index of the Productivity-Wage Gap in the U.S. Note: 1947 = 100. Source: see Table 7.1.

2000

2010

112  Returns to the Factors of Production relationship appeared in 1982, as a wide gap opened up thereafter: productivity increased to 2.0% per annum, twice as fast as the rate of compensation, which decelerated to 1.0% per annum (Table 7.1). Consequently, between 1982 and 2016 productivity increased by 94% while compensation increased by just 40%. This divergence contradicts obviously the theory that real wages equal the value of marginal product of labor.1 Competition for labor did not suffice to bring about the theoretical outcome.2 Firms took advantage of their power and payed workers far less than what they were worth. So the productivity-compensation gap is an indication of the unfair treatment of labor. Power enables corporations to game the system.3 For instance, they prohibit franchises from hiring workers away from other firms within the same system. So, one Burger King may not hire workers from another Burger King. Since switching jobs is an important way to increase one’s salary, this restriction—hidden in some obscure small print of contracts—puts a damper on mobility and wage growth. This trick must affect thousands of workers since the fast food industry employs some 4.3 million.4 What brought about this abrupt divergence in the relationship between wages and productivity in the 1980s? Globalization was not yet in full swing. The North American Free Trade Agreement (NAFTA) became effective in 1994. China was just waking up from its lengthy slumber and did not join the World Trade Organization until 2001. So the trade deficits associated with globalization were not yet exerting great pressure on the U.S. workforce by exporting jobs by the millions causing great dislocation.5 Technological unemployment associated with the IT revolution was also not yet evident. For instance, Apple Inc., founded in 1976, was still in its infancy, and IBM did not begin production of personal computers until 1981 when Microsoft had 32 employees.6 The Internet began to have a major impact in the 1990s. So these economic forces were not yet felt in the labor market in the early 1980s. Instead, the watershed came in the wake of the 1981 strike of the Professional Air Traffic Controllers Organization that was put down by the Reagan Administration. The union ceased to exist, and 11,000 employees were fired, signaling the end of the influence of big labor.7 Intimidated, the number of strikes involving at least 1,000 workers declined thereafter from 235 in 1979 to just 17 by 1999,8 and the share of the labor force in unions, still 26% under the Carter presidency was fully one-third less, down to 17% by the end of Reagan’s second term.9 So union power was diminishing quickly.10 The reversal in government attitude is signified by the fact that until President Carter all Secretaries of Labor were union leaders.11 Reagan appointed the first businessman as Secretary of Labor who proceeded to introduce a number of anti-labor and pro-business practices.12 A series of such nuanced and overt policy changes completely changed the balance of power in the labor market in favor of corporations. Why were the unions important for the middle class? Because collectively workers had countervailing power and without that employees were left to fend for themselves.13 United, workers had some bargaining power, divided they had none. Information also played a role: unions hired economists who knew by how much labor productivity had grown, they knew how much the profit of the firm was and could argue with management at the bargaining table. They could strike or threaten to strike, their ultimate weapon. Individual workers had no such knowledge and had no such leverage to influence management. Thus, they lost out

Returns to the Factors of Production  113

Illustration 7.1  United, Labor Would Have Countervailing Power and Obtain a Bigger Share of the Pie. Divided It Has Little or None.

and productivity grew 2.3 times as fast as wages. The difference accrued to profits, as well as the salaries of management which grew exponentially. That is not all. The official numbers from the Bureau of Labor Statistics in Table 7.1 and Figure 7.1 conflate the salary and bonuses of CEOs with the wages of ordinary workers.14 The CEO salaries are not all labor income. They differ from that of the ordinary employee in that the former maintained their power and even expanded upon it as profits rose. They did not need unions to bargain with the board of directors who were often their friends or own appointees. They knew what the profits were; they were closer to the check books and were writing their own checks to themselves, as though they were the owners of the firms.15 They were well positioned to bargain and extract a larger share of the growing profits. There is no real market for CEOs. The positions are not advertised and there is no transparency on how CEOs are chosen. Firms are not finding the lowest bidder for the job. Board members have no incentive to strike a hard bargain since they are committing the shareholders’ money and not their own. It would not retain any of the potential savings for itself. Thus, the principalagent problem is important. The average compensation of CEOs of the U.S.’s 350 largest corporations was $15.6 million in 2016. These millions increased substantially labor compensation shown in Figure 7.1 and Table 7.1. Hence, the productivity-compensation gap is even larger for typical employees

114  Returns to the Factors of Production than Figure 7.1 implies. The ratio of CEO pay to that of the ordinary worker increased enormously just as the compensation-wage gap widened. In 1965 the ratio was “merely” 20:1.16 In 1978 it was still 30:1 but by 1989 it was 59 and accelerated thereafter, reaching 260 times the annual pay of the typical worker by 2016. That would have been impossible without the compensation-wage gap. The CEOs captured a part of the gains in productivity of their employees.17 So, most of the compensation of CEOs is rent rather than compensation for productivity.18 The inconvenient truth is that the annual earnings of men working full time have not increased since 1972, adjusted for inflation (Figure 7.2).19 They have actually decreased by $600!20 This has not happened since the founding of the republic. The implication is that the increase in wages apparent in Table 7.1 and Figure 7.1 has been limited mainly to women and to top earners.21 Moreover, non-employment has risen among men as the labor force participation rate of women rose. In 1972 95% of men between the ages of 25 and 54 were in the labor force. By 2016 that share was down to 88%, as many have dropped out completely.22 In contrast, the salaries of women increased substantially (Figure 7.2), from $21,000 to $43,000 per annum, although their incomes were still $10,000 below those of men. Moreover, the rate of increase of women’s income has been at a snail’s pace in the twentyfirst century: the increase was just $162 per annum. It is not at all plausible to suppose that the productivity of men would have stagnated in this period and that only the productivity of women would have risen. Hence, the productivity hypothesis of wage determination is hardly convincing.

55000 50000 45000 40000 35000 30000 25000 20000 1955

1965

1975

1985

Men

1995

2005

2015

Women

Figure 7.2  Median Income by Gender in 2016 Dollars, 1955–2016 Note: Full-Time, Year-Round Workers Source: U.S. Census, Historical Income Table P36. Full-Time, Year-Round Workers by Median Income and Sex.

Returns to the Factors of Production  115 The increasing labor-force participation of women between 1960 and 1980 meant that their share of the labor force increased from a third to 43% and their numbers swelled by 22.3 million, whereas the number of men increased by just 15.0 million.23 Given that women were willing to accept lower wages, firms took advantage and gave women priority especially in mid-skilled occupations.24 So, the wages of men with high school education was depressed. According to one estimate, a 10% increase in the number of women in the labor force might lower wages of high school graduates by 3%. Given that the number of women in the labor force increased by 100% between 1960 and 1980, it is possible that the wages of low- and mid-skilled men was depressed by as much as 30%.25 While this is speculative, the wages of men with only a high school diploma did decline by 18% from $22 to $18 (1973–1996) and then drifted sideways. In 2015 it was still $18.60. Similarly, men without a high school diploma declined by 28% by 1996 and then remained unchanged.26 As a consequence of wage stagnation or decline and the inferior bargaining position of labor, their share of GDP has declined by 4.1% since the 1970s (Figure 7.3).27 Perhaps this decline does not seem large, but in dollar terms it was substantial. In a $18.4 trillion economy (2016) the decline in labor’s share is worth $760 billion or some $5,000 for every member of the labor force. That is what workers lost as a consequence of their weaker bargaining position. To be sure, globalization and the IT revolution also put pressure on labor’s share, but had the countervailing power of labor been retained, unions would have mitigated the destructive forces of these impersonal economic forces.

65 64

Share of GDP

63 62 61 60 59 58 57 1950s

1960s

1970s

1980s

1990s

2000s 2010−2014

Figure 7.3  Share of Labor Income in GDP (%) Source: Federal Reserve Bank of St. Louis, Share of Labour Compensation in GDP at Current National Prices, LABSHPUSA156NRUG.

116  Returns to the Factors of Production How are wages determined if not by marginal product? Given the difficulty of ascertaining marginal product, firms satisfice in order to find a viable solution. They use heuristics and signals to determine wages. Of course, education, diplomas, work experience, age, gender, ethnicity, and physical appearance all play a role. (Better looking people earn more while women and minorities earn less.28) That does not mean that anticipated productivity is not part of the consideration, but the above signals are used as rough gauges of expected productivity. In addition to the above attributes, the history of wages, custom, the degree of unionization, concentration within the industry, the rate of profit of the firm, and the institutional structures in place also matter.29 While education does play a role in determining wages, it does not explain much of the differences in income. According to Freeman, “education may explain five per cent of the variation and education and years of experience may explain 15 per cent in total.”30 The institutional setting is also crucial. Some 40% of wages in the powerful oligopolistic finance sector is actually rent, that is, that much above the wage of comparable employees in other sectors. The extra earnings of those employed in finance were linked to the era of deregulation beginning in the 1980s, that is to say, to the changes in the institutional framework.31 In other words, the employees in those sectors are able to capture a share of the extraordinary profits being earned by these oligopolists. In short, “financiers are overpaid.”32 Custom also has a role to play, for example in the male-female wage gap and the lower salaries of minorities.33 Part-time employees also earn less per hour than full-time ones even if they work for the same firm in the same occupation and have the same education and other characteristics.34 Such wage gaps have historical roots: it has been customary to pay part-time women workers less insofar as their work used to be supplementary to the salary of the head of household. Students and mothers worked part time and were willing to do so at a lower wage than the main breadwinner, because their income was considered a supplement to the household’s budget. This is no longer the case; millions of part-time workers are unable to find full-time employment and thus become one of the working poor. In July 2017 5.3 million people were working part time against their will.35 Obviously, the wage is a payment for services rendered. However, what is being paid for is less obvious. The payments are for the time spent at work, the effort expended (which is more difficult to ascertain and is initially uncertain), and the skill, education, and experience of the employee, since these affect productivity (also difficult to determine; that is why the diploma is used as a signaling device). These aspects are not controversial. However, part of the wage is a return on the employees’ natural intelligence, physical features, and inborn talent. While these attributes might enhance productivity, the difference between these and the former set of attributes is that employees did not have to do anything to acquire those characteristics. Instead, it was a matter of luck that they were born with those characteristics. According to political philosopher John Rawls, employees do not deserve to receive compensation for those traits inasmuch as those payments are pure rent, that is, they did nothing to acquire them (Chapter 5).36 Hence, paying for those attributes is not an incentive to supply more of them; their supply is fixed. There are few self-made man and women among the elite as their career paths were determined mainly by circumstances outside of their control, such as luck or innate talent.37 For instance, it appears as though Bill Gates would be a self-made man, but he had

Returns to the Factors of Production  117 a privileged start in life. His father was a prominent lawyer and his mother, the daughter of a wealthy banker, was on the board of directors of a bank. His parents were wealthy enough to enrol him in an exclusive private preparatory school that provided access to a mainframe computer. How many 14-year-olds had unrestricted access to a computer in the late 1960s? Obviously, Gates was born smart, but his greatest achievement was to choose the right parents. His achievements are by no means proportional to his amassed wealth of $90,000,000,000, that is, $90 billion. He received the initial impetus from his parents, from his school, and from the IT revolution that was in progress, but he also benefited greatly from plain luck insofar as IBM’s negotiations with another potential provider of a PC operating system broke down and IBM approached Gates, who ultimately provided them with one, although he did not write most of the program himself.38 Gates served as a middleman. Hence, in a Rawlsian just state, he would not have been granted his current riches. It was the way in which his life unfolded, the way the legal institutions function that protected his patents, and the winner-take-all economic system that granted rights that enabled him to become the richest man on the planet. In other words, the market magnified his gains based on first-mover advantages out of proportion to his contribution to social welfare.39 This is not the system we would have devised behind a veil of ignorance if we had started from scratch. Yet, another major issue is that firms benefit from public goods such as basic research or satellites used for internet communication created at the taxpayers’ expense. For example, the basic research for the Internet and the whole IT revolution was initiated in the 1960s by the government at taxpayers’ expense; so a substantial portion of the benefits derived from the innovation should have accrued to taxpayers rather than to private individuals. Technological change associated with the IT revolution has generally benefited some occupations and not others. For instance, in 1980, major league baseball players earned about ten times as much as K-12 teachers. However, by the year 2000 the salary of the average baseball player increased to 45 times that of teachers, because the Internet enabled a much larger audience to view the games.40 This is obviously way out of line, because the contribution of teachers to social welfare is considerably larger than that of sportsmen, and the only reason that they could earn such humongous salaries is that the market for sports enjoys a number of privileges including exemptions from antitrust laws as well as public subsidies to sport stadiums and communications networks and technology. In other words, the value of baseball players—and this is true for CEOs and other celebrities—is not determined only by their own efforts but is also on the contributions of society which also owns the airwaves through which the signals travel. So it would be justified to put a surtax on those occupations that benefited from basic research sponsored by government so that the taxpayers earn a return on their investment. The value created by a football game is produced jointly by the players and the society. Therefore, income distribution is not determined by market forces alone but also by institutional structures and prevailing laws. If sport is treated as a privileged industry and is exempt from antitrust legislation, the ten players in the NBA who earned more than $27 million in salary alone in 2017 should not reap the monopoly rents of that legislation.41 They would not be earning such astronomical salaries without these laws. Their salaries are not the product of free-market supply-anddemand forces but of the laws that allow sport associations to be legal cartels. The structure

118  Returns to the Factors of Production of these mega-sports protects the teams from competition and allows them to have monopoly power and earn monopoly rents. Of course, they can earn extraordinary salaries from these monopoly rights. Is that privilege for sports fair? Even if this might be a reasonable way to organize sports, there is no reason why the players should profit from the legislation. Their salaries are not the outcome of their own achievements alone. Sportsmen should not profit from the Internet more than average workers. They are lucky that their occupation benefited from the Internet, and in a fair society wages would not be a function of chance, according to Rawls. The argument applies to Hollywood celebrities as well as to the Lords of Wall Street. The annual compensation (in millions) earned in 2016 by the likes of Lloyd Blankfein ($20), Jamie Dimon ($27), or Marissa Mayer ($27) were not even at the top of the list. Many earned two to three times as much (all with taxpayers’ assistance).42 Even college presidents have joined the millionaires club.43 Their salaries would not be on that order of magnitude if the market for CEOs or college presidents were perfectly competitive. They are not paid their opportunity cost. Even those CEOs who ran their companies into the ground received astronomical salaries and bonuses. For instance, John Thain received $83 million just before Merrill Lynch became insolvent.44 His predecessor left the firm with a golden parachute of $159 million although the firm was losing some $8 billion.45 This evidence defies the theory that the wages of these CEOs equal the value of their marginal product. Entrepreneurs are not producing by themselves, and they do not deserve all that they earn as their output is produced jointly with the social and institutional capital that belongs to society. How that joint product should be apportioned is essentially a collective political decision. Markets ought not decide that by themselves. If they do, then the distribution will depend on the power and influence of the parties involved. People who preceded us often even sacrificed their lives to create and defend those institutions that are now public goods. Yet, everyone uses and benefits from them. There is no ethical reason people should be paid for the portion of their productivity derived from public goods. These were created by the blood and sweat of prior generations. In short, we are all benefiting from the sacrifices men made at Gettysburg, Guadalcanal, and the beaches of Normandy. How much should celebrities compensate the descendants of those men who fought in those places for not having had to fight there? Moreover, it became a social norm to pay CEOs enormous salaries, and deviation from that norm becomes difficult due to expectations and peer pressure. CEOs have inside information, so they can use their power to exert undue influence on the board of directors. In addition, they can appoint their own friends to the board, thereby making sure that their salaries are assured independently of their productivity. If the market were competitive, salaries would decline markedly, because the current salaries are way above opportunity costs. Kenneth Lewis, CEO of Bank of America (2001–2009) received an average salary of $30 million per annum during the six years he was guiding the bank to the brink of bankruptcy in the run-up to the financial crisis.46 Just consider if one could find someone to replace Bank of America’s current CEO, Bill Moynihan, for less than his compensation of $15 million, that is about $7,000 per hour.47 I’d bet there are thousands of executives who would run it as efficiently for say a tenth of that amount, still a substantial sum. All one would have to do is to advertise the position. I’d do it pro bono. Even during the Great Recession when the only reason the big banks were not

Returns to the Factors of Production  119 insolvent is because they were propped up by Uncle Sam, their CEOs were getting away with millions: Lloyd Blankfein of Goldman Sachs, $25.8 million; Ken Lewis of Bank of America, $9 million; Jamie Dimon of JPMorgan Chase, $8.5 million; Vikram Pandit of Citigroup $2.9 million; to name a few.48 Even the CEO of General Motors went to the bank with $2.3 million while the company was in Chapter 11 bankruptcy and was being propped up at taxpayer expense. According to Ariely, “The fact that these high earners failed so miserably should add to the evidence against a direct link between higher rewards and better performance.”49 No wonder so many citizens lost confidence in the establishment and revolted by voting for Donald Trump. The customary argument that capping salaries would be inefficient does not hold in this case, because most of the salaries are rents. So supposed incentives do not bring forth more talent or intelligence. Rest assured that the CEOs would work as hard at 10% of their current salary provided the cap were economy-wide. What else would they do? It would still be the most they could earn. CEOs in other countries earn substantially less. The marginal tax rate in the top income bracket under the Eisenhower administration was about 88%, and under President Nixon it was still around 70%, and yet there was no shortage of CEOs or of celebrities or football players. Note that the U.S. President earns $400,000 a year and there are plenty of applicants. In contrast, Angelo Mozilo of Countrywide Financial, a major culprit in the subprime mortgage crisis, earned around $500 million between 2000 and 2008. He was fined $67 million for fraud, but Bank of America payed for it since it took over his bank.50 Human beings are different from the other factors of production in that they are sentient—­ they have feelings and a sense of fairness. Moreover, they have basic needs without which they are unable to survive. A machine can stand idle some time without much attention, but labor cannot. Labor needs nourishment every day. To treat labor and capital symmetrically is unethical. Labor should not be treated as an object. In order to improve the welfare of society it is crucial to treat workers with dignity appropriate for human beings and not dehumanize work by treating it as any other factor of production.

The Returns on Capital The cost of capital depends on the stock of capital, the rate at which it depreciates, its price, and the interest rate. That requires that we add different kinds of capital, which cannot be done in physical units. This is different from a resource such as oil, which can be calculated in barrels, or labor, which can be measured in hours worked. Instead, capital includes hammers and computers which cannot be aggregated in physical units. However, they can be valued in monetary terms using either historical cost or the present value of their future marginal product. The historical cost of capital is its price at the time of purchase. However, capital depreciates. Therefore, its annual cost depends on δ, the rate of depreciation, and on r, the rate of interest on corporate bonds, and on p, price of the physical capital; r: cost = (r + δ)p. r depends on the funds rate set by the Federal Reserve; thus, the cost of capital is not determined by the market alone but is also influenced by a government-sponsored institution. To be sure, the market value of the capital stock would generally be less than the

120  Returns to the Factors of Production historic cost as the secondary market in most physical capital has more imperfect information than for new products. Just as new cars lose value immediately upon being driven from the dealership’s parking lot, a computer has the same properties. In contrast, real estate might appreciate in value, in which case the market value might be more appropriate to use (except during a bubble). However, if we calculate the value of the capital stock using the discounted expected future value created by the capital stock—as mainstream economists suggest—we run into the following problem. First, we need the future real interest rate to be able to discount the future income stream produced by the capital stock, but we know neither future income nor future interest rate. We can only make rough guesses about future production, prices, and interest rates. Thus, this is not a realistic way to determine the value of the capital stock.51 This is a bit complicated, so an example should help. Suppose a firm pays $1 wages annually and buys a machine for $1 that lasts one period. So, the rate of depreciation is 100%. Suppose the rate of interest is 5% and that the machine and worker produce goods worth $3.05. In order to determine profits, we have to subtract all the expenses: $1 for the usedup capital, 5 cents for the opportunity cost of capital invested in the machine, plus $1 for wages. This leaves $1 for profit (calculated as profit = revenue − expenses). Yet, mainstream economists would argue that the value of the machine was really $2 and profit was actually zero, because the historical cost of capital is immaterial: what counts is the value produced by the machine; the owner of the firm would have been able to sell the machine for $2 so that determines its market value (the rate of return on the $1 invested would then be 100%). However, why would anyone pay $2 for a machine that could be purchased for $1? So, the real value of the machine at the beginning of the period was the historic price; it could not be a function of an unknown entity—future revenue. In any case, there is no good reason why the $1 profit should be attributed to capital rather than to labor. The $1 profit was produced jointly. The issue of how to calculate profits and the value of capital is a major conundrum in economics known as the Cambridge capital controversy.52

Profits Profits are the residual from revenues after the costs of labor, raw materials, and capital are subtracted. In perfect competition, there are no profits at all, but that is irrelevant to today’s economy as most of production is concentrated in oligopolies and profits have been humongous and persistent as labor costs were squeezed to the bare minimum. For example, Apple’s earned profits between $39 and $54 billion annually between 2012 and 2016,53 a profit margin of around 20%.54 Fannie Mae earned profits of $86 billion in 2013. Other examples of profits in 2016 include (in billions): JPMorgan Chase $24, Berkshire Hathaway $24, Wells Fargo $23, Google $19, Verizon, $18, Microsoft $17, Citigroup $16, Bank of America $16, Exxon $16, Walmart $15, AT&T $13, Facebook $10, General Motors $9, Goldman Sachs $7, Coca-Cola $6.55 Profit margins of most of the giants were near 20%.56 The profitless long run of mainstream economics has never arrived for these multinationals. To be sure, mainstream economists would ascribe these profits to the reward of entrepreneurship, but there were no entrepreneurs in the above list of companies merely

Returns to the Factors of Production  121 employees. Alternatively, they might want to assign it to the returns to risk taking, but there is no evidence for that. That is just an accounting abstraction used to obscure the reality that these profits are not being competed away. In sum, total U.S. pre-tax corporate profits in 2016 added up to $2.3 trillion, i.e., 12.2% of GDP.57 Corporate after-tax profits have been rising since the 1980s when it was 4% of GDP. In contrast, between 2010 and 2016 they averaged 7% of GDP. As labor’s share in GDP was squeezed, profits’ share nearly doubled and with the tax decreases of 2017 it will no doubt continue to rise. Another anomaly is that the financial sector accounted for 27% of all corporate profits in 2016.58 One would not expect an intermediary sector to be able to capture such a large chunk of total profits. As a whole, the U.S. commercial banks earned a 14% return on equity between 1994 and 2007.59 Even during the Great Recession (in 2009), the profits of the financial sector were $242 billion, due to the taxpayer bail-out.60 No wonder so many people are frustrated by the system.

Institutions as Capital The market would not work without government-sponsored institutions that provide a wellfunctioning legal system to guarantee property rights and mechanisms to enforce contracts. Institutional capital constitutes the framework crucial for the operation of the economy. Everything depends on it. The legal system provides enforcement mechanisms for laws and regulations without which the incentive structure of the society would not be compatible with an efficient economy. These intangible factors of production have the unique characteristic that they cannot be created by markets but develop through social, political, and cultural processes over time. These evolve slowly out of historical experience and the value system of the population. This is just one example of how markets depend in crucial ways on the institutional and legal framework and, in fact, cannot exist without them.61

Intangible Forms of Capital Intangible forms of capital—social capital, institutional capital, and knowledge in general—­ differ from the common factors of production insofar as they are public goods, that is, they are not the property of any individual or firm, and no one can be excluded from their use. The whole community benefits from having a functioning legal system or a constitution, for instance, and does not have to pay for benefiting from it. How much is the legal system worth? Just consider if each generation had to pay for its creation anew. The costs would be prohibitive. While we are unable to repay this valuable gift to those who came before us, we can honor their legacy by passing it on to subsequent generations. This aspect of institutions becomes important in discussing productivity, because it is impossible to measure individual productivity accurately if public goods—including institutions—are used extensively in the process of production. Knowledge embodied in people is called human capital. This concept also includes health, since health also increases productivity. In other words, knowledge in libraries is a public good but what you learn in the library becomes part of human capital. Knowledge differs from physical capital in that it does not diminish through use. On the

122  Returns to the Factors of Production contrary, its productivity increases with use, through learning-by-doing, although it can become obsolete through the discovery of new knowledge.62 Similarly, cultural attributes such as “trust” and the ability to cooperate without costly bargaining play an important role in economic performance.63 We found it out in September 2008, when trust suddenly evaporated from financial markets and banks were unwilling to lend money even to other banks overnight. They did not know if they would reopen in the morning. It is a lot more efficient to instill in everyone the propensity to honor their obligation. The feeling of community and the network of friends and acquaintances are referred to as social capital. The disaster of 2008 might have been avoided if the culture within which the financial sector operated had taken the interests of the community into greater consideration. Social capital based on mutual sympathy, social cohesion, and shared cultural norms and values fosters trust and cooperation within the community and thereby lowers transaction and enforcement costs. In sum, intangibles also have an enormous effect on economic processes.

Natural Resources Natural resources are also important inputs into the production process. Some are reproducible, such as trees and fisheries, while others are exhaustible, such as minerals. While the total amount available is unknown, it is clear that the supply is finite and therefore exhaustible. The atmosphere and oceans had not been seen as a valuable resource until the realization that their capacity to absorb carbon dioxide and carbon monoxide without major changes in the weather system is limited. Natural resources differ from the other factors of production in that they are either essential for life (i.e., water, air, earth) or for production (i.e., iron, oil), yet many of them are non-renewable and many are being depleted at an accelerated rate since the Industrial Revolution. In addition, there are many ominous developments in climate change, water and air quality, biodiversity loss, and loss of ecosystems. This is a considerable challenge to humankind, as the depletion of natural resources and changes in weather patterns are not accounted for properly in GNP accounts and, in addition, threaten our economy as we know it. This is a potential time-bomb of mass-destruction intensity.

Income Distribution The conventional theory of income distribution is straightforward: both labor and capital receive the value of their marginal product, and since profits are zero, distributing the rewards is child’s play. However, as we have seen, labor does not receive its marginal product and profits are far from zero. In today’s economy with its predominantly oligopolistic structure, the distribution of income is derived essentially from the distribution of power. The profit that accrues to the residual claimant is also a matter of the legal and institutional structure; the distribution cannot be derived from economic theory. For instance, the monopoly granted to sports franchises or drug companies obviously grants them extraordinary profits based on the law. In our current system corporate profits accrue to the shareholders, after management skims off their share and that share depends on

Returns to the Factors of Production  123 9 8

Percent of Households

7 6 5

White Black

4 3 2 1

198

500

188

178

168

158

148

138

118

128

108

98

78

88

68

58

38

48

28

18

0

8

0

Household Income in 1000s of dollars

Figure 7.4  Distribution of Household Income by Ethnicity, U.S., 2009 Note: First and last categories are open ended. Source: U.S. Department of Commerce, U.S. Census Bureau, 12s0693.xls. Table 693: Money Income of Households—Number and Distribution by Race. Origin: 2009.

corporate governance. Insofar as the power of labor has been declining, the share accruing to workers has been declining in tandem, although output is obviously produced jointly by workers, management, and capital. In principle, the value of their contribution is difficult to disentangle theoretically since it is a joint product. How much of the profits is contributed by management and how much by workers is a conundrum. It is common knowledge that the U.S. income distribution has become skewed since the 1980s (Figure 7.4). While 19% of households in 2016 lived below or near the poverty level— $26,000 for a family of four—(that makes about 60 million people),64 1.2 million households or 1% earned an average of $1.5 million pre-tax (Table 7.2). This deep divide between the ultra-poor and the ultra-rich is the root of most of our problems including the widespread discontent, the political disarray, and especially the rise of a plutocracy.65 There is also a spatial aspect to income distribution, because both poverty and affluence are concentrated in enclaves—often in close proximity—referred to as slums and as upscale neighborhoods respectively.66 It is also common knowledge that minorities are highly concentrated in the left tail of the income distribution as a lingering heritage of the evils of slavery and subsequent discrimination.67 The income of 39% of African American

124  Returns to the Factors of Production

Illustration 7.2  Life Would Just Not Be the Same If I Had to Travel on a Commercial Airline. Credit: iStock.com/Extreme-Photographer.

households is less than $25,000 (Figure 7.4). That means that they are barely eking out a living. Moreover, they are overrepresented in every income category below $43,000 and underrepresented thereafter, especially in the over $500,000 annual income category. However, Hispanics fared somewhat better than blacks but were still below average: 32% lived below $25,000 per annum while Asians fared better than average: only 20% lived below the $25,000 threshold.68 Differences in median incomes by ethnicity are substantial and mostly unchanged since 1997 (Table 7.3). African Americans households’ median income was $28,000 less or just 60% of that of whites and that has remained unchanged since the end of the twentieth century. Hispanics had a similar experience although their gap decreased by $1,700, while Asian fared best, earning $6,700 more than whites.

Table 7.2  The Tax Returns of the Superrich

1) 2) 3=1+2) 4) 3+4)

% of All Returns

Number of Returns (000)

Total Income ($ trillions)

Average $ Income (000)

% of Total Income

Top 0.33% Next 0.60% Top 1% Next 3.4% Top 4.4%

410 835 1,245 4,979 6,224

1.36 0.56 1.92 1.42 3.34

3,300 674 1,547 285 538

14.0% 5.8% 19.8% 14.5% 34.3%

Source: IRS SOI Tax Stats—Individual Statistical Tables by Size of Adjusted Gross Income. www.irs.gov/statistics/ soi-tax-stats-individual-statistical-tables-by-size-of-adjusted-gross-income.

Returns to the Factors of Production  125 Table 7.3  Racial Gaps in Median Household Incomes in 2014, Dollars Income

Whites Blacks Hispanics Asians

Relative to Whites

1997

2014

1997

2014

70,000 42,000 40,000 70,000

71,300 43,300 43,000 78,000

−28,000 −30,000 −

−28,000 −28,300   +6,700

Source: Pew Research Center, Social & Demographic Trends: 1. Demographic Trends and Economic Well-Being.

Figure 7.4 depicts the income distribution in $10,000 intervals (except in the tails). These smaller groups can be aggregated into quintiles which are one-fifth (20%) of the 126 million households in the U.S. Each of the five quintiles represents about 25 million households that include roughly 65 million people. The income received by the lowest fifth of households makes up just 3.1% of total income generated in the economy, while the top quintile receives 51% (Figures 7.5a and 7.5b). So, the top quintile receives as much income as the rest of the 260 million people. Moreover, the top 5% of households received 22.6% of total income, i.e., just a bit less than the bottom 60% of households (Figure 7.5b). This implies that the richest 16 million households had as much income as the bottom 195 million households. Tax returns enable us to examine the (taxable) income of the superrich a bit closer. The top 1% of taxpayers had an average income of $1.5 million for a total of $1.9 trillion, or 20% of total (taxable) personal income (Table 7.2). This $1.9 trillion equals the amount reported by the bottom 61% of all taxpayers. Put another way, in 2014 the total (taxable) income of the richest 1.2 million taxpayers equaled that of the bottom 90 million.69 Such a lopsided distribution is unreasonable and an unjust division of the total output of society. Consider that the $5 per day paid to workers by the Ford Motor Company in 1914 (Figure 7.6) would be worth about $123 today (or $15.4 per hour).70 Among the 75 million members of the U.S. labor force who work for an hourly wage, only 40% earn more than the Ford workers earned in 1914, adjusted for inflation (Figure 7.6).71 Actually, 85% of the 13 million employees in the “Food Preparation and Serving Related” occupation and 65% of the 4 million workers in the “Healthcare Support” sector earn less in real terms than Ford workers did in 1914.72 In other words, for many in the lower classes the standard of living has not increased at all in these 100 years. Thus, the distribution of income matters a lot.73

The Second Gilded Age The trends in income distribution indicate that only the ultra-rich (top 5%) and the rich (80–95%) increased their share of total income. These two groups combined captured more than half (28% + 23%) of aggregate income by 2016. The rest of the 80% of the society (260 million people) have lost share since 1980 (Figure 7.7). The inflection point is again 1981. Until then the share of the income of the superrich was equal to that of the middle class: about 16.8%. The subsequent rapid divergence is referred to as the “hollowing out of the middle class”.74 By 2016 the top 5% was 8.4% ahead of the middle class! That was a redistribution of about $800 billion from the middle toward the peak of the income pyramid.

3% 8% 14% Quintiles

51.5

0−20% 20−40%

23%

40−60% 60−80% 80−100%

Percent of Total Income

50 40 30 20 10 0 0−20%

20−40%

40−60%

60−80%

80−100%

Figures 7.5a and 7.5b  Distribution of Household Income by Quintiles, U.S., 2016 Source: Department of Commerce, U.S. Census Bureau, table H-2. Share of Aggregate Income Received by Each Fifth and Top 5 percent of Households. www.census.gov/data/tables/time-series/demo/ income-poverty/historical-income-households.html.

50

45.45

45 Dollars per Hour

40 35

28.92

30 Ford Workers, 1914

25

17.81

20 15 10

9.27

11.6

5 0 10

25

50

75

90

Percentile of Distribution Figure 7.6  Distribution of Earnings in 2016 Compared to Ford Workers of 1914

Percent of Total Income

Source: Bureau of Labor Statistics, “Occupational Employment Statistics,” Table National_M2016dl, www.bls.gov/oes/2016/may/oes_nat.htm#00-0000.

30

Rich, 80− 95%

25

Upper Middle Class

20

Top 5% 15 10 5 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Middle Class Lower Middle Class Poor

Figure 7.7  Trends in the Share of Total Income by Households, 1967–2016 Note: the first four quintiles are referred to as the Poor, Lower Middle Class, Middle Class, Upper Middle Class and fifth quintile is divided into the Rich who are in the 80–95 percentile and the ultra-rich who are in the top 5%. Source: Department of Commerce, U.S. Census Bureau, Table H-2. Share of Aggregate Income Received by Each Fifth and Top 5 percent of Households. www.census.gov/data/tables/time-series/demo/ income-poverty/historical-income-households.html.

128  Returns to the Factors of Production Note that, in the 1970s, the trends were still mixed and there were no major discrepancies between the ultra-rich and the middle classes. Their share changed slightly in either direction: some went up a bit but the top 5% was actually losing share (Figure 7.8). The ultra-rich were obviously not yet in full control. However, the share of the top 5% exploded at the end of the twentieth century: it jumped by a full five percentage points from 16.5% to 21.5% of total income! In fact, almost all of the gains of the ultra-rich were obtained between 1980 and 1999. The only other group that registered an increase in the income share was the rest of the fifth quintile, i.e., those who were between the 80th and 95th percentiles, but their increase was less than half as large (2.5%) as that of the top 5%. The share of all other income groups declined. This is another perspective on the “hollowing out of the middle class,” although obviously it affected the poor as well.75 The poor are usually invisible in public discussion of the income distribution. During the period considered, all quintiles, except the top fifth, experienced a decline in their share of U.S. aggregate household income (Table 7.4, column 5). The largest declines were experienced by the middle class and the lower-middle class. Hypothetically, the mean income of the lower-middle class would have been $10,000 or 23% larger if its share of aggregate income had remained at the 1967 level76 (Table 7.4, columns 8 and 9). The average of the first four quintiles in column 8 is $8,000. That means that if their share of total income had remained at the 1967 level, their annual income would have been $8,000 greater in 2016. To be sure, there is large variation across quintiles with the 1st and 4th losing the

4.7

Poor

Percent

3.7 2.7

Lower Middle Class

1.7

Middle Class

0.7

Upper Middle Class

−0.3

Rich

−1.3 −2.3

1967−1980

1980−1999

1999−2016

Ultra-Rich

−3.3

Figure 7.8  Changes in the Share of Total Income in Three Epochs, by Quintiles Note: The fifth quintile is divided into the Rich (80–95th percentile) and the Ultra-rich (top 5%). Source: see Figure 7.7

Returns to the Factors of Production  129 Table 7.4  Share of U.S. Aggregate Income by Quintiles, 1967–2016 1

2

3

4

5

6

7

Average Income (dollars) Quintile Percentile % in % in Change 1967a 1967 2016 % Poor Lower-Middle Class Middle Class Upper-Middle Class Rich Ultra Rich

2016

8

9

Difference (49 Years) Dollars

Percent

1 2

0–20 20–40

4.0 10.8

3.1 8.3

−0.9 −2.5

16,637 44,920

12,894 34,522

−3,743 −10,398

−22.5 −23.1

3 4

40–60 60–80

17.3 24.2

14.2 22.9

−3.1 −1.3

71,955 100,654

59,062 95,247

−12,893 −5,407

−17.9 −5.4

5 5

80–95 Top 5%

26.4 28.9 17.2 22.6

+2.5 +5.4

146,406 160,271 +13,864 286,158 375,998 +89,840

++9.5 +31.4

Average income 1967 is calculated by multiplying 2016 total income by 1967 shares in total income (column 3). It is the hypothetical value that would have obtained if shares had remained as they were in 1967.

a

Source: see Figure 7.7.

least and the 2nd and 3rd quintiles losing the most in absolute terms (Table 7.4, column 8). However, the top 5% benefited by $90,000 per household from the redistribution effect. The income of the top quintile was $800 billion more than it would have been if incomes were distributed as they were in 1967.77 There is no economic or ethical justification for such a redistribution of income to the rich and ultra-rich. The above data pertain to market incomes. Another way to analyze the data is to consider post-tax, post-transfer incomes 1979–2011.78 This disposable income metric subtracts taxes from market incomes and adds transfers from governments to individuals such as food stamps and unemployment benefits. A shortcoming of this approach is that, given the endemic government budget deficits, most of the transfers are from future generations to today’s living generation. That implies that an increase in government debt adds to the disposable income of the current recipients, but the burden of paying the interest on that debt falls on generations yet unborn whose welfare is not considered. Thus, the transfers appear to be a net increase in income. While this is not good accounting practice, this income measure does afford another perspective on the current purchasing power and welfare of the various classes of the society. This conundrum enables us to realize that there is no single good measure of income distribution. There are multiple ways that provide different perspectives on the economic condition of the society. This disposable income measure corroborates that income inequality rose substantially at the end of the twentieth century and continued into the twenty-first.79 The three middle-­class quintiles of the income distribution have fallen well behind the rich and especially the ultrarich.80 In Figure 7.9 we divide the rich 5th quintile into four groups including the super-rich top 1% of the income distribution. The “disposable” income of the three middle-class quintiles has grown negligibly in the 32 years under consideration. The lower-middle-class (2nd quintile) was hit the hardest by the decline in manufacturing, followed by the middle class.

130  Returns to the Factors of Production 3.5

Upper Middle Class

Percent per annum

3.0 2.5

Rich & Super-Rich

Middle Class

2.0

Lower Middle Class

1.5 1.0

Poor 0.5 0.0 0−20% 21−40% 41−60% 61−80% 81−90% 91−95% 96−99% Top 1% Quintiles

Percentiles

Figure 7.9  Growth of Income by Quintiles and Percentiles, 1979–2011 Source: John Komlos, “Growth of Income and Welfare in the U.S., 1979–2011,” NBER working paper, 2016, no. 22211.

Their income increased by $38 and $91 per year respectively (Table 7.5). The growth of income of the upper-middle-class (4th quintile) was not much better at $362 per annum. The poor did gain an average of $85 per year, but their annual income of $18,000 still barely sufficed to keep body and soul together. To reiterate, this includes the value of food stamps they receive, and we should note that this household income is more often than not gained by more than one member of the labor force. Thus, the real gains were reserved for the rich, i.e., those in the 5th quintile but even within this group only the top 1% stood out as the sole real beneficiaries of growth. A bit did trickle down to the other three groups within the 5th quintile, but they also failed to make great strides forward. Those in the 80–99th percentile gained between $768 and $2,500 per annum. In contrast, the after-tax income of the top 1% grew at a rate of 3.4% per

Table 7.5  Real Disposable Income, 1979–2011, Thousands of 2011 Dollars

1979 2011 Increase (‘000) Per annum % of top 1%’s gain

0–20%

21–40%

41–60%

61–80%

81–90%

91–95%

96–99%

Top 1%

15.2 17.9 2.7 $85 0%

29.9 31.1 1.2 $38 0%

43.1 46.0 2.9 $91 0%

56.7 68.3 11.6 $362 2%

72.9 97.5 24.6 $768 4%

87.9 129.2 41.3 $1,291 7%

122.9 202.8 79.9 $2,496 13%

318.7 918.2 599.4 $18,732 100%

Note: 1979 income was divided by 1.04 in order to standardize for changes in household size. Source: see Figure 7.9.

Returns to the Factors of Production  131

40

Upper Middle Class

35

2013

Rich & Super-Rich

Ratio Multiple

30

Middle Class

25 20 15

1979

Lower Middle Class

10

Poor 5 0 0−20% 20−40% 40−60% 60−80% 80−90% 90−95% 95−99% Top 1%

Figure 7.10  Ratio of Group’s Income to That of the Poor Source: see Figure 7.9.

annum, which translates into an astronomical gain of some $18,000 per annum. In other words, each year they added as much to their income as the poorest 25 million households (or 65 million people) earned per annum in total. Hence, this analysis also confirms that only the richest 20% of households reaped the benefits of economic growth, and within this group mainly the top 1% (1.2 million households) were the real beneficiaries. Their average after-tax income increased by a walloping $600,000 in the interim 32 years to reach $916,000 (Table 7.5). This is in stark contrast to the $1,200 gain of the average lower-middle class family. The tax cuts of December 2017 will exacerbate the inequality. They are supposed to decrease middle-class taxes by $930 while decreasing taxes of the rich, i.e., the top 1% whose income is above $730,000 by $51,000. The ultra-rich, i.e. those whose income is above $3.4 million will gain a whopping $193,000, further exacerbating an already obnoxious level of inequality.81 We can also compare each group’s average income to that of the 1st quintile (Figure 7.10). This indicates that in 1979 the ratio of the income of the top 1% was 20 times as large as that of the 1st quintile, but by 2013 it had reached a multiple of 38. Yet, none of the other groups increased their income substantially relative to that of the poorest segment of the society. This is yet another indication not only of the gaping inequality but also how little of the income growth trickled down to even the richest quintile beyond the top 1%.82 They managed to keep it all to themselves.

132  Returns to the Factors of Production

Growth in Welfare So far, we have considered growth in real income (I); many people assume that income is identical to welfare (W). W = I is a common mistake: they neglect that the marginal utility of income diminishes with income: $10,000 increase in the income of one of the three Walmart siblings whose net worth is some $38 billion each would be meaningless to them, whereas the same increment to the income of a typical household in the South Bronx, say, would be a heaven-sent game changer. This implies that the growth rate of median (after tax) household income of 0.9% per annum (1979–2011) is not an accurate reflection of most people’s welfare. There are many functions that would plausibly translate income into welfare in such a way that the marginal utility of income is diminishing. We choose a simple one: welfare is the square root of income: W = I . That would mean that if income increased from 1 to 4, welfare would increase from 1 to 2. With such a function the growth rates of welfare averaged across the five quintiles becomes 0.3% per annum with the middle class and lower-middle class welfare growing at a negligible 0.1% per annum, hardly noticeable.83 Unfortunately, reality is even more complicated. Although W = I is an improvement on the common assumption that W = I, there are still more realistic approaches. The reason is that it supposes that all that matters to one’s welfare is one’s own real income: W(i) = I(i), where (i=1, . . . 4) now refers to one of the first four quintiles. We did not include (i) in the equation above, because it was obvious that W above was a function of one’s own real income. But what really matters to one’s welfare is not only one’s own income but also the income of a reference group. Put another way, the social norm or relative income is what really matters to one’s sense of well-being. This means that if some people are buying the newest iPhone, poor people are going to covet it and feel frustrated by not being able to afford it. Without enough rich people Apple Inc. would not come out with several new iPhones annually. So, the existence of the wealthy provides the incentive for Apple Inc. to bring out new products, which in turn creates dissatisfaction and lowers the welfare of those who desire it but are unable to afford it. That is the idea of a reference-dependent utility function, also called interdependent utility function. There are many ways to define such a welfare function. We use one that uses the 5th I(i) (i=1, . . . 4). The intuition behind this function is I(5) – I(i) that the further one is from the 5th quintile, the larger is the denominator and the smaller is one’s own relative income and therefore the smaller is the welfare generated by one’s own income. This is the case because the denominator is determined by calculating the difference between the average real income of the 5th quintile and that of the 1st quintile. We do the calculation four times, i.e., for each quintile separately. We next take the square root of the denominator. Then we divide the income of the first four quintiles by their respective denominator and take the square root of that number as well. We do this for all of the first four quintiles but not for the 5th quintile, because it is its own reference group. We do these calculations for 1979 and again for 2011. Next, we calculate the growth rates of W between the two values obtained 32 years apart for each of the quintiles. The result yields that the growth of welfare is negative in all first four quintiles, because the 5th quintile’s income grew faster than that of the other quintiles (Figure 7.11). quintile as a reference group: W(i)=

Returns to the Factors of Production  133

0.8

Percent per annum

0.6 0.4 0.2

Poor

Lower Middle class

Middle Class

Upper Middle Class

0 Rich

−0.2 −0.4 −0.6 0−20%

21−40%

41−60%

61−80%

81−100%

Quintiles Figure 7.11  Growth of Welfare by Quintiles, 1979–2011 Source: see Figure 7.9

This is a crucial result because it helps us understand the widespread discontent in the U.S. Otherwise it would make little sense, since growth was positive in all quintiles (Figure 7.9). Why would positive growth induce discontent? One infers that relative incomes do matter to welfare. According to Figure 7.11, every group’s welfare declined except that of the upper class, and that implies that we should pay more attention to the distribution of income and not focus solely on growth itself. Repeated surveys have found that in spite of growth, life satisfaction (or happiness) has not increased at all since 1946.84

Ethics and the Skewed Distribution of Income The political philosopher John Rawls argued that the current distribution of income is unjust, because “no one deserves his place in the distribution of talents, nor his starting place in society.” Rewarding talent is rewarding our random genetic configuration or the luck of having been born into a well-endowed family. He continued, “In the light of what principle can free and equal moral persons permit their relations to be affected by social fortune and the natural lottery?”85 By “natural lottery” he meant that we did not earn our initial endowment in life that plays an important role in determining our life course. It was a matter of luck that we were born with a particular genetic code into a particular family. The substantial advantages or disadvantages those provide were not earned through our own effort, hence are not deserved, and there is no reason to be rewarded for them. The initial endowments were distributed randomly. Nonetheless, these talents, wealth, and other privileges obtained at birth, or the lack thereof, play an immense role in one’s economic prospects.86 We do not

134  Returns to the Factors of Production deserve to be born into a rich or into a poor family, or to be smarter or better looking than average, or to be of a certain skin color or ethnicity. We have not done anything at all for these attributes and therefore our reward is an economic rent; we should not be rewarded for a random allocation. The assignment of property rights in these attributes is arbitrary. Hence, the privileges of the moneyed elite are not very different from those of the aristocracy of the feudal age. Neither class deserved its riches, as both were based more on birth than on merit. In short, the extensive economic inequality has no moral basis, as people’s “life prospects are significantly affected by their family and class origins,” that is, through no action of their own. Rawlsian considerations, as well as commonsense, suggest that immense income inequality is neither justified nor healthy for the stability of the socioeconomic system.87 Stiglitz argues that while those at the top in the U.S. enjoy the best health care, education, and other benefits of wealth, they fail to realize that “their fate is bound up with how the other 99 percent live.”88 The founding fathers also knew all too well that democracy turns into oligarchy if the distribution of wealth and power and the privileges that accompany them become disproportionate. Even conservative Republican Alan Greenspan, an ardent advocate of free markets, admitted that inequality is a threat to the system: [y]ou cannot have the benefits of capitalist market growth without the support of a significant proportion, and indeed, virtually all of the people; and if you have an increasing sense that the rewards of capitalism are being distributed unjustly the system will not stand.89 Zbigniew Brzezinski, also a staunch anti-socialist, expressed very similar concerns a few years before Trump’s arrival in the White House.90 In other words, there were enough observers who had a bad feeling about the way markets distributed income and their corrosive consequences on the social fabric. There are no legitimate reasons for such hyper-discrepancies.91 The current level of inequality was not brought about by a simple market mechanism and does not reflect the social values of the citizens, even if the myth of the “self-made man” is widespread and embedded in the folklore of the American Dream. Billionaire legendary investor Warren Buffett explains his fortune this way: I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.92 Buffett, who has been on the board of some 19 corporations, describes the “boardroom atmosphere” as follows: Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance . . . Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements . . . If able but greedy managers over-reach and try to dip too

Returns to the Factors of Production  135 deeply into the shareholders’ pockets, directors must slap their hands. Over-reaching has become common but few hands have been slapped. Why have intelligent and decent directors failed so miserably? The answer lies . . . in what I’d call “boardroom atmosphere.” . . . When the compensation committee—armed, as always, with support from a high-paid consultant—reports on a mega-grant of options to the CEO, it would be like belching at the dinner table for a director to suggest that the committee reconsider . . . My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence . . . In recent years compensation committees too often have been tail-wagging puppy dogs meekly following recommendations by consultants, a breed not known for allegiance to the faceless shareholders who pay their fees . . . This costly charade should cease.93 This is not a blackboard economist writing, or an anti-globalization radical, but one of the most successful investors and richest men in the world, who spent his career in the corporate world and is an ardent advocate of free markets. But he was an eyewitness to the operation of many boardrooms and has sufficient commonsense to recognize when a manager is being overpaid. Lower managerial salaries have not hurt German, Swiss, French, or Japanese firms even though their CEOs earn a fraction of their counterparts in the U.S. (Table 7.6). Nowhere in the developed world is the ratio of CEO compensation to average employee pay as high as in the U.S. Today a CEO of a major corporation earns more than 300 times the earnings of a typical worker. In 1980 the comparable ratio was closer to 50.94 It is extremely unlikely that the productivity of CEOs increased six times more than that of the rest of the workforce.95 In Germany, the ratio is 175.96 These distortions are due to “deficiencies of corporate governance.”97 In Germany union representatives have a seat on the board of directors and so do representatives of local government who also have a stake in the future of the enterprise.98 They also sit around the table when CEO salaries are discussed. In the Netherlands, Sweden, Norway, and Switzerland shareholders have a binding vote on CEO compensation.99 This provides countervailing power to keep CEO greed within bounds. There is no evidence that U.S. CEOs are that much more productive than their foreign counterparts.100 Capping U.S. executive salaries at European levels would be a Table 7.6  International Comparison of CEO Compensation, 2015 Compensation

% of U.S.

CEO-Worker Ratio

62 56 55 49 17 14

300 180 230 200 175 70 60

$ millions U.S. Switzerland UK Canada Germany France Japan

17.0 10.6 9.6 9.3 8.4 2.8 2.4

Source: Wei Lu and Anders Melin, “The Best and Worst Countries to Be a Rich CEO,” Bloomberg News, November 16, 2016.

136  Returns to the Factors of Production reasonable start to turn the tide. Of course, this would not work unless it were applied generally throughout the U.S. The new privileged class is no longer the owners of capital (the shareholders), as in the nineteenth century, but those who are in control of capital and near the check book, namely the executives. Even William F. Buckley, Jr., a prominent conservative commentator, referred to CEO pay as “extortion.”101 So the executives can basically determine their own salaries as though they were the owners of the corporation.102 As a consequence of its institutional, legal, and tax structures, the U.S. is the most unequal society among developed countries. Table 7.7 compares the ratio of the total income received by the top 10% of the income distribution to that of the bottom 10%. Evidently, the top 10% of the U.S. income distribution receives the most in the developed world and the bottom 10% the least. So the ratio of their incomes is, at 18.3, the largest, and three times as high as in Norway or Sweden! In contrast, in the Scandinavian countries, this ratio is between 5.3 and 6.5. In the UK, Canada, New Zealand, and Australia it is between 8.3 and 10.6. Moreover, the less inequality there is in a society the happier are the members of that society (Figure 7.12). The happiest people are in Scandinavia: Finland, Denmark, Norway, and Sweden. They also have the lowest inequality ratio (Table 7.7). The U.S. poverty rate among children is 20%, six times as high as in Denmark. It is also noteworthy that child poverty is also lower than total poverty in Scandinavia. This is an indication of the extent to which children’s welfare is guarded by the state. There are those who argue that all we need for a just society is equality of opportunity, but there are others who believe that it is not enough to have legal equality if people are disadvantaged de facto through no fault of their own by having been born on the wrong side of the tracks.103

Table 7.7  International Comparison of Inequality, 2014 % of Income

U.S. Spain Italy UK Australia Canada New Zealand Switzerland France Netherlands Germany Sweden Norway Denmark Finland

Ratio

Bottom 10%

Top 10%

1.6 2.0 2.1 2.7 2.8 2.6 3.1 3.4 3.5 3.3 3.5 3.5 3.4 4.0 4.0

29.3 24.7 24.4 28.6 26.1 24.2 25.7 24.1 24.2 22.7 23.5 22.6 20.6 21.2 21.2

18.3 12.4 11.6 10.6 9.3 9.3 8.3 7.1 6.9 6.9 6.7 6.5 6.1 5.3 5.3

Poverty Rate

Happiness

Total

Children

Difference

Ranking

17.5 15.9 13.3 10.4 12.8 12.6 9.9 8.6 8.0 8.4 9.1 8.8 7.8 5.0 6.8

20.2 23.4 17.7 9.9 13.0 16.5 12.8 7.1 11.3 11.2 9.8 8.5 6.8 2.7 3.6

2.7 7.5 4.4 −0.5 0.2 3.9 2.9 −1.5 3.3 2.8 0.7 −0.3 −1.0 −2.3 −3.2

10 14 15 12 8 6 7 3 13 5 11 9 1 2 4

Sources: Jon Clifton, “The Happiest and Unhappiest Countries in the World,” Gallup News, March 20, 2017; October 3, 2017 http://news.gallup.com/opinion/gallup/206468/happiest-unhappiest-countries-world.aspx; OECD, “Income Inequality Update,” November 2016; www.oecd.org/social/OECD2016-Income-Inequality-Update.pdf.

Returns to the Factors of Production  137

20 18

Inequality Ratio

16 14 12 10 8 6 4 2 0

1

3

5

7 9 Happiness Rank

11

13

15

Figure 7.12  Inequality Is Inversely Related to Happiness Source: see Table 7.7.

Notes 1 B. Ravikumar and Lin Shao, “Labor Compensation and Labor Productivity: Recent Recoveries and the Long-Term Trend,” Economic Synopses, Federal Reserve Bank of St. Louis, 16 (2016). 2 The gap is even wider in some sectors: in manufacturing the productivity grew 4 times as fast as wages, in the IT sector by 3.6 times as fast, and in the retail trade by 14 times as fast. Michael Brill, et al., “Understanding the Labor Productivity and Compensation Gap,” Bureau of Labor Statistics, Productivity, 6 (2017), 6. 3 Economic Policy Institute, “Worker Rights Preemption in the US.” 4 Rachel Abrams, “Why Aren’t Paychecks Growing? A Burger-Joint Clause Offers a Clue,” The New York Times, September 27, 2017. 5 Federal Reserve Bank of St. Louis, “Total Current Account Balance for the United States.” https:// fred.stlouisfed.org/series/BPBLTT01USA637S. 6 Wikipedia contributors, “History of Apple Inc.,” Wikipedia; IBM archives, “1981.” www-03.ibm.com/ ibm/history/history/year_1981.html. 7 “The PATCO strike signalled a profound decline in organized labor’s power in the late twentiethcentury United States,” Joseph McCartin, “Professional Air Traffic Controllers Strike (1981),” in Eric Arnesen, Encyclopedia of U.S. Labor and Working-class History, Volume 1 (New York: Taylor and Francis, 2007), p. 1126. 8 Ibid. 9 Bureau of Labor Statistics, “Table 1. Union Affiliation of Employed Wage and Salary Workers.” www. bls.gov/webapps/legacy/cpslutab1.htm. 10 Lawrence Mishel, “Unions, Inequality, and Faltering Middle-Class Wages,” Economic Policy Institute Report, August 29, 2012. 11 Louis Uchitelle, “How the Loss of Union Power Has Hurt American Manufacturing,” The New York Times, April 20, 2018. 12 Wikipedia contributors, “Raymond J. Donovan.” 13 Josh Bivens, et al., “Raising America’s Pay. Why It’s Our Central Economic Policy Challenge,” Economic Policy Institute, June 4, 2014.

138  Returns to the Factors of Production 14 Official economic statistics are often misleading because they try to paint a rosier picture on the economy in order to boost confidence. 15 William Lazonick, “Profits Without Prosperity: How Stock Buybacks Manipulate the Market, and Leaves Most Americans Worse off,” Harvard Business Review, September 2014. 16 Lawrence Mishel and Jessica Schieder, “CEO Pay Remains High Relative to the Pay of Typical Workers and High-Wage Earners,” Economic Policy Institute Report, July 20, 2017. 17 Julian Bebchuk and Jesse Fried, Pay Without Performance. The Unfulfilled Promise of Executive Compensation (Cambridge, MA: Harvard University Press, 2004). 18 Nikolaos Balafas and Chris Florackis, “CEO Compensation and Future Shareholder Returns: Evidence for the London Stock Exchange,” Journal of Empirical Finance 27 (2014): 97–115. 19 U.S. Census, Historical Income Table P36. Full-Time, Year-Round Workers by Median Income and Sex. 20 Weekly earnings show the same pattern. Federal Reserve Bank of St. Louis. “Employed Full Time: Median Usual Weekly Real Earnings.” U.S. Department of Labor, Bureau of Labor Statistics, Weekly and Hourly Data from the Current Population Survey, Series ID LEU0252881900. The difference between the two data sets is that for weekly wages the worker may work part of the year. 21 The reason is that the median can remain unchanged even as high earners increased. The median is the typical employee. Half of the them are below and half are above the median. 22 Federal Reserve Bank of St. Louis. “Activity Rate: Aged 25–54: Males for the United States.” 23 Francine Blau and Lawrence Kahn, “The US Gender Pay Gap in the 1990s: Slowing Convergence,” Industrial & Labor Relations Review 60 (2006): 45–66. 24 Bureau of Labor Statistics, “Weekly Earnings by Educational Attainment in First Quarter 2016.” www.bls.gov/opub/ted/2016/weekly-earnings-by-educational-attainment-in-first-quarter-2016.htm. 25 Daron Acemoglu, David Autor and David Lyle, “Women, War, and Wages: The Effect of Female Labor Supply on the Wage Structure at Midcentury,” Journal of Political Economy 112 (2004) 3: 497–551, here p. 544. 26 In 2015 prices. Economic Policy Institute, “Data Library. Wages by Education.” www.epi.org/ data/#?subject=wage-education. 27 Lawrence Mishel, et al., “Wage Stagnation in Nine Charts,” Economic Policy Institute Report January 6, 2015. 28 Daniel Hamermesh, Beauty Pays: Why Attractive People are More Successful (Princeton, NJ: Princeton University Press, 2011). 29 Efraim Benmelech, Nittai Bergman, and Hyunseob Kim, “Strong Employers and Weak Employees: How Does Employer Concentration Affect Wages?” National Bureau of Economic Research Paper No. 24307, February 2018. 30 Richard B. Freeman, “Labour Economics,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 31 Thomas Philippon and Ariell Reshef, “Wages and Human Capital in the U.S. Financial Industry: 1909–2006,” Quarterly Journal of Economics 127 (2012): 1551–1609. 32 Philippon and Reshef, “Wages and Human Capital.” 33 Among men, the white–black wage gap in the same occupation after accounting for the usual determinants of wages such as education is about 16% while the gap among women is smaller and statistically less significant. William M. Rodgers and John Holmes, “New Estimates of Within Occupation African American-White Wage Gaps,” The Review of Black Political Economy 31 (2004) 4: 69–88. 34 Michael K. Lettau, “Compensation in Part-Time Jobs Versus Full-Time Jobs: What If the Job Is the Same?” Bureau of Labor Statistics (BLS) Working Paper 260, December 1994. 35 Federal Reserve Bank of St. Louis, “Employment Level: Part-Time for Economic Reasons, All Industries.”. 36 John Rawls, A Theory of Justice (Cambridge, MA: Harvard University Press, 1971). 37 Malcolm Gladwell, Outliers: The Story of Success (New York: Little, Brown, 2008). 38 Wikipedia contributors, “Bill Gates.” Wikipedia: The Free Encyclopedia. 39 Mark Zuckerberg’s history is similar. He basically expropriated the idea for Facebook from fellow students. 40 John Siegfried and Wendy Stock, “The Labor Market for New Ph.D. Economists in 2002,” American Economic Review 94 (May 2004) 94: 272–285. 41 Wikipedia contributors, “Highest-paid NBA Players by Season,” Wikipedia. There were nine baseball players who earned more than $25 million. Wikipedia contributors, “List of Highest-Paid Major

Returns to the Factors of Production  139 League Baseball Players,” Wikipedia. In the NFL 39 players earn more than $10 million. “NFL 2017 Player Salaries,” Pro Football Reference. 42 CEOs of Goldman Sachs, JPMorgan Chase, and ex-CEO of Yahoo, respectively. Jon Huang and Karl Russell, “The Highest-Paid C.E.O.s in 2016,” The New York Times, May 26, 2017. Marissa Mayer is said to have received a golden parachute of $186 million. Berkeley Lovelace Jr., “Ex-Yahoo President Sue Decker Rips Marissa Mayer’s $186 Million Exit Package,” CNBC, May 5, 2017. 43 Stephanie Saul, “Big Jump in Million-Dollar Pay Packages for Private College Leaders,” The New York Times, December 10, 2017. But not only at private colleges: eight executives at public colleges also earned more than $1 million. Dane Bauman, Tyler Davis, Ben Myers, and Brian O’Leary, “Executive Compensation at Private and Public Colleges,” The Chronicle of Higher Education, December 10, 2017. 44 “25 Highest-Paid Men, 8. John Thain,” Fortune, 2008. 45 Andrew Clark, “Merrill Lynch, the Firm Lost $8bn and the Chief Executive Had to Go—With $159m,” The Guardian October 30, 2007. 46 The annualized six-year-total return was 16%. Forbes Staff, “By the Numbers: Overpaid Bosses,” Forbes, April 22, 2009. 47 The bank’s chief operating officer received $15 million, the chief financial officer received $10 million, the vice chairman $9.6 million, and the chief risk officer $9.5 million. www1.salary.com/ Brian-T-Moynihan-Salary-Bonus-Stock-Options-for-Bank-Of-America-Corp.html. 48 Forbes Staff, “By the Numbers: Bailout Bosses,” Forbes, April 22, 2009. www.forbes.com/2009/04/22/ tarp-bailout-companies-leadership-compensation-best-boss-09-tarp_slide_2.html. 49 Dan Ariely, “Mo’ Money, Mo’ Problems,” Forbes, February 20, 2009. 50 Gretchen Morgenson, “Lending Magnate Settles Fraud Case,” The New York Times, October 15, 2010. 51 Avi Cohen and G. C. Harcourt, “Whatever Happened to the Cambridge Capital Theory Controversies?” Journal of Economic Perspectives 17 (2003) 1: 199–214. 52 Piero Sraffa, Production of Commodities by Means of Commodities: Prelude to a Critique of Economic Theory (Cambridge, UK: Cambridge University Press). 53 Wikipedia contributors, “List of Largest Corporate Profits and Losses.” 54 That means that for every dollar’s worth of sales the profit after all expenses was 20 cents. YCharts, “Apple Profit Margin,” https://ycharts.com/companies/AAPL/profit_margin. 55 Fortune “Global 500,” http://fortune.com/global500/list/. 56 Katie Sola, “Ranking the Top 20 Global 2000 Companies by Profitability,” Forbes, June 9, 2016. 57 After tax, it was $1.8 trillion. That means that they paid roughly $500 billion in taxes with an effective tax rate of 20%. Federal Reserve Bank of St. Louis, “National Income Corporate Profits before Tax,” https://fred.stlouisfed.org/series/A053RC1Q027SBEA. 58 This does not include profits made abroad, just domestic profits. U.S. Department of Commerce, Bureau of Economic Analysis, “Table 6.16D Corporate Profits by Industry,” https://bea.gov/iTable/ iTable.cfm?ReqID=9#reqid=9&step=1&isuri=1. 59 Morten L. Bech and Tara Rice, “Profits and Balance Sheet Developments at U.S. Commercial Banks in 2008,” Federal Reserve Bulletin, June 2009. 60 U.S. Department of Commerce, Bureau of Economic Analysis, Fixed Assets Accounts Tables: Table 12. Chain-Type Quantity Indexes for Net Stock of Government Fixed Assets, last revised August 15, 2012. In 2007 it had $323 billion profit. 61 Daron Acemoglu of Harvard University suggests that “well-designed institutions and regulation are necessary for the proper functioning of markets.” Daron Acemoglu, “Structural Lessons for and from Economics,” January 12, 2009. 62 This generalization may not hold for professional athletes, who can be injured or whose capabilities decline with age. 63 Robert Putnam, Making Democracy Work (Princeton, NJ: Princeton University Press, 1993); Francis Fukuyama, Trust: The Social Virtues and the Creation of Prosperity (New York: Free Press, 1995). 64 14% below poverty and 5% near poverty. Those within 25% poverty income, i.e., between $25,000 and $31,000 are considered near poverty. U.S. Census Bureau, “Poverty Thresholds;” U.S. Census Bureau, “Income, Poverty, and Health Insurance Coverage in the United States: 2016,” September 12, 2017; Charles Hokayem and Misty Heeness, “Living in Near Poverty in the United States: 1966–2012,” Current Population Reports, May 2014. 65 Ganesh Sitaraman, The Crisis of the Middle-Class Constitution: Why Economic Inequality Threatens Our Republic (New York: Knopf, 2017); Ronald Formisano, Plutocracy in America: How Increasing

140  Returns to the Factors of Production Inequality Destroys the Middle Class and Exploits the Poor (Baltimore, MD: Johns Hopkins University Press, 2015). 66 In 2016 the income of the top 5% of the population was more than 14 times as high as that of the bottom 20% in Atlanta, Washington, DC, Providence, New Orleans, Miami, San Francisco, Boston, and New York. Alan Berube, “City and Metropolitan Income Inequality Data Reveal Ups and Downs through 2016,” Brookings Reports, February 5, 2013. 67 William Darity Jr., and Patrick Mason, “Evidence on Discrimination in Employment: Codes of Color, Codes of Gender,” Journal of Economic Perspectives 12 (1998) 2: 63–90. 68 These data come from the same source as the data in Figure 7.4 but are not shown in the figure. 69 There were 149 million tax returns in 2014 because there was often more than one tax return per household. 70 The price index increased by a factor of 24.6 between 1914 and 2017. The $5/hour meant $0.625 per hour. So 24.6∗0.625=$15.4 dollars per hour. 71 Given that $15/hour is about $30,000 per annum implies that the inclusion of salary workers would mean that 60% of the total labor force earn more than the Ford workers of 1914 earned. “United States Income Brackets and Percentiles in 2017,” DQYDJ, January 15, 2018. 72 Bureau of Labor Statistics, “Occupational Employment Statistics,” Table National_M2016dl. www. bls.gov/oes/2016/may/oes_nat.htm#00-0000. 73 Barbara Ehrenreich, Bait and Switch: The (Futile) Pursuit of the American Dream (New York: Metropolitan Books, 2005). 74 Elizabeth Warren, “The Coming Collapse of the Middle Class: Higher Risks, Lower Rewards, and a Shrinking Safety Net,” YouTube video, posted by “UCtelevision,” January 31, 2008. Elizabeth Warren, “The Vanishing Middle Class,” in Ending Poverty in America: How to Restore the American Dream, ed. John Edwards, Marion Crain, and Arne L. Kalleberg (New York: New Press, 2007). 75 Desilver, Drew. 2015. “America’s Middle Class is Shrinking. So Who’s Leaving It,” Pew ResearchCenter, December 14. 76 Aggregate personal income was $10.5 trillion in 2016. 77 This is obtained by multiplying $13,864 by 18.9 million rich households and also multiplying $89,840 by 6.3 million ultra-rich households and summing those two products. 78 John Komlos, “Growth of Income and Welfare in the U.S., 1979–2011,” NBER Working Paper no. 22211, 2016. 79 Joseph Stiglitz, “Of the 1%, by the 1%, for the 1%,” Vanity Fair, May 2011; Pew Research Center, “America’s Shrinking Middle Class: A Close Look at Changes Within Metropolitan Areas,” May 11, 2016. www.pewsocialtrends.org/files/2016/05/Middle-Class-Metro-Areas-FINAL.pdf. 80 Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2015); Peter Temin, The Vanishing Middle Class: Prejudice and Power in a Dual Economy (Cambridge, MA: MIT Press, 2017). 81 Tax Policy Center, “Distributional Analysis of the Conference Agreement for the Tax Cuts and Jobs Act,” December 18, 2017, www.taxpolicycenter.org/publications/distributional-analysis-conferenceagreement-tax-cuts-and-jobs-act/full. 82 William Lazonick, “Labor in the Twenty-First Century: The Top 0.1% and the Disappearing MiddleClass,” Institute of New Economic Thinking, Working Paper No. 4, February 2015. 83 John Komlos, “Growth of Income and Welfare in the U.S., 1979–2011,” NBER Working Paper no. 22211, 2016. 84 Richard Easterlin, “Does Economic Growth Improve the Human Lot?” in Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz, ed. Paul David and Melvin Reder (New York: Academic Press, 1974); Bruno S. Frey and Alois Stutzer, “What Can Economists Learn from Happiness Research?” Journal of Economic Literature, 40 (2002) 2: 402–435. Robert H. Frank, “How Not to Buy Happiness,” Dœdalus 133 (2004) 2: 69–79. 85 By “social fortune” he means the family into which one is born, and by the “natural lottery” he means the accident of being born with certain talents. John Rawls, “Some Reasons for the Maximin Criterion,” American Economic Review 64 (1974) 2: 141–146. 86 John Rawls, A Theory of Justice (Cambridge, MA: Harvard University Press, 1971). 87 Edward N. Wolff, “Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-Class Squeeze—an Update to 2007,” Levy Economics Institute of Bard College Working Paper No. 589, March 2010. 88 Joseph Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future (New York: W.W. Norton, 2012).

Returns to the Factors of Production  141 89 “Alan Greenspan on Income Inequality,” YouTube video, posted by “johnklin,” September 28, 2007, @ 2:36. www.youtube.com/watch?v=oqx88MyUSck. 90 “The Great U.S. Wealth Gap Could Cause a Social Conflict: Zbigniew Brzezinski—Fast Forward,” Reuters TV video, 4:12, July 18, 2012. 91 Joan Robinson, An Essay on Marxian Economics (London: Macmillan, 1960), p. 67. 92 Wikipedia contributors, “Warren Buffett,” Wikipedia: The Free Encyclopedia. 93 “Berkshire’s Corporate Performance vs. the S&P 500,” Berkshire Hathaway, Inc., February 21, 2003. 94 Sarah Anderson, John Cavanagh, Chuck Collins, Sam Pizzigati, and Mike Lapham, Executive Excess 2008 (Washington, DC: Institute for Policy Studies and United for a Fair Economy, 2008); G. William Domhoff, “Wealth, Income, and Power,” Who Rules America? www2.ucsc.edu/whorulesamerica/ power/wealth.html. 95 Randall S. Thomas and Jennifer G. Hill (eds.), Research Handbook on Executive Pay (Cheltenham, UK: Edward Elgar, 2012). 96 Franz Christian Ebert, Raymond Torres, and Konstantinos Papadakis, “Executive Compensation: Trends and Policy Issues,” International Institute for Labour Studies, Geneva, Discussion Paper No. 190, 2008, p. 6. 97 A bizarre example of the brazen misuse of power is the use of a back-up airplane to follow the travels of Jeff Immelt, CEO of General Electric, just in case the airplane in which he was flying broke down. James Stewart, “Metaphor for G.E.’s Ills: A Corporate Jet with No Passengers,” The New York Times, November 2, 2017. 98 For the Swedish case see Peter S. Goodman, “The Robots are Coming, and Sweden is Fine,” The New York Times, December 27, 2017. 99 Raghavendra Rau, “Transparency and Executive Compensation,” in Jens Forssbaeck and Lars Oxelheim (eds.), The Oxford Handbook of Economic and Institutional Transparency (New York: Oxford University Press, 2015), pp. 413–433, here p. 419. 100 C-Span, “A Conversation on the State of the Economy with Paul Krugman and Joseph E. Stiglitz,” October 23, 2012. www.c-span.org/video/?309551-1/conversation-state-economy. 101 “That money was taken, directly, from company shareholders. But the loss, viewed on a larger scale, is a loss to the community of people who believe in the capitalist free-market system. Because extortions of that size tell us, really, that the market system is not working—in respect of executive remuneration. What is going on is phony. It is shoddy, it is contemptible, and it is philosophically blasphemous,” William F. Buckley, Jr. “Capitalism’s Boil,” National Review Online, April 20, 2005, as cited in John Alexander Burton and Christian E. Weller, “Supersize This: How CEO Pay Took Off While America’s Middle Class Struggled,” Center for American Progress, May 2005. 102 Ebert, Torres, and Papadakis, “Executive Compensation,” 13–14. 103 John Roemer, Equality of Opportunity (Cambridge, MA: Harvard University Press, 2000).

8 The Case for Oversight, Regulation, and Control of Markets

There are many aspects of markets that are generally hidden from students in introductory textbooks. These deviations from ideal markets are called, obliquely, imperfections. I refer to them as the “Achilles heels” of markets. Whenever markets deviate from perfect markets that exist exclusively on academic blackboards, the community has an incentive to impose oversight and regulation because otherwise market outcomes diminish our welfare. This chapter explores associated problems.

Principal-Agent Problem When people work for themselves they are considered self-employed. They capture all the value they produce. There are no intermediaries. However, the self-employed are 10% of the U.S. labor force.1 So 90% are employees who work for someone else; they are considered “agents” of the principal (the owners), generally the shareholders of the corporation. They do not capture all the value they produce so their incentives to exert themselves are not identical to those of the self-employed. This is the “principal-agent” problem. It is a subset of the information asymmetry problem (Chapter 5). It arises because the principals do not have information on all attributes of the agents that are important for the success of the firm, such as their honesty, their knowledge of the operation of the firm, commonsense judgement under pressure and uncertainty, or the amount of effort they are willing to expand on behalf of the firm. Insofar as it is impossible to write perfect contracts to align the incentives so that they benefit both parties in all circumstances, agents can often manipulate outcomes so that they benefit even if the principals do not. Many CEOs have walked away from their firms with golden parachutes after bringing their firms to the brink of bankruptcy. Maurice Greenberg retired from AIG with a ridiculous $4.3 billion before it became insolvent.2 Stanley O’Neal brought Merrill Lynch to the brink of bankruptcy yet received a golden parachute compensation package worth $160 million plus a salary for 2006 of $91 million.3 James Cayne, CEO of Bear Stearns, was named one of the “Worst American CEOs of All Time,” but retained $61 million just as the firm was falling on hard times.4 The list of modern-day robber barons and their chicanery could be extended ad infinitum.5 It is not as though these captains of finance were the brightest in the room. Rather, they had the character to elbow their way into the corner office. For instance, Dick Fuld was arrogant and displayed a lot of “misguided bravado,” and a “pathetic display of macho arrogance.”6 Hubris was ubiquitous.

Oversight, Regulation, Control of Markets  143 To the extent feasible, employees will advance their own financial advantages even at the expense of their employers if they have a reasonable chance of not being held accountable. Obviously, this introduces inefficiencies into the relationship. For instance, during the run-up to the financial crisis many CEOs and mortgage brokers took advantage of information asymmetries to enrich themselves to the detriment of the shareholders or customers, because many intangibles such as risk were hidden from investors. Dick Fuld walked away from the bankrupt Lehman Brothers with $250 million. His employers—the shareholders— walked away with next to nothing. If the risks pay off, the agent gains; if not, the principal loses and not the agent. There is a problem of short-term vs long-term profits. In wake of the financial crisis, the Dodd-Frank Act of 2010 mandated that a clawback provision be included in all CEO contracts. That means that if the profit statements change in the long run, the firm can recoup the bonuses paid to the CEOs. This is hardly a modern problem. Adam Smith was well aware of it: The directors of such companies . . . being the managers . . . of other peoples’ money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery [partnership] frequently watch over their own . . . Negligence and profusion, therefore, must always prevail more or less, in the management of the affairs of such a company.7 If we presume that people are selfish, then why do we suppose CEOs are willing to work for the shareholders’ benefit rather than their own? The two assumptions are inconsistent. Thus, the “principal-agent” problem implies that executives want to maximize their own well-being rather than that of the shareholders. Although there are incentives that attempt to bring the two interests in line, it is not easily accomplished. The world is too complex to be able to write perfect contracts with every eventuality specified, since many aspects of the future are unpredictable and we do not know what we do not know. Agents’ decisions might well harm others, but they do not have to bear responsibility for the consequences of those actions. This can occur in cases when (a) there is a conflict between short-term gains at the expense of long-term losses; (b) agents benefit from decisions involving risks if the outcome is positive but eventual losses can be transferred to others; (c) the losses are uncertain and can be hidden for a while; and (d) the responsibility is diffused in a group. The challenge within an organization at every level is to supervise the subordinates efficiently to ensure the timely flow of information up the chain of command. The agents (the CEO or lower-level executives) often cannot be held responsible for their actions. Consequently, such an economy has too many frictions and will be inefficient as a rule.8 For example, John Thain, CEO of Merrill Lynch, spent $1.2 million renovating his office (and a reception area) just a few months before the firm had to be bailed out at taxpayers’ expense. He also had the commonsense to pay $4 billion in bonuses days before the U.S. government forced a shotgun marriage between Merrill Lynch and Bank of America. Of course, the $4 billion was not his money, and it made no difference to him at all. He was not penalized for his bad judgment.9 Another example: AIG spent some $86,000 on partridge hunting while the government was pumping $186 billion into the company to keep it afloat. Clawback clauses in executive compensation is a way to counteract the principal-agent problem,

144  Oversight, Regulation, Control of Markets but the SEC has issued weak regulations in this regard. Clawbacks become effective in case of an error in the financial statement, but some corporations are also adopting it in case of misconduct or of errors in judgment.10 The research on contract theory concludes that profit maximization is essentially unattainable under such circumstances. As in consumption, the principals can satisfice, that is, search for a satisfactory solution to the problem. Contracts and performance incentives are unable to dissuade managers from maximizing their own utility (salaries), even if it is to the detriment of their firms, as was demonstrated during the Great Meltdown of 2008. Greenspan disregarded completely the conflict of interest inherent in the principal-agent problem during the run-up to the financial crisis and believed that the bankers could be trusted to look out for the long-run interests of their shareholders. This assumption proved to be catastrophic, because employees maximized their own bonuses, which did appear to align with the shareholders’ interest in the short run but not in the long run. Their immediate bonuses conflicted with the firm’s long-run viability because the accumulated risks were not recognized. The profits of the banks appeared as though they were pure profits but were not. Instead, they were returns to their accrued risks. So, the blackboard conceptualization of the modern firm makes little sense without incorporating the principal-agent problem and its inherent conflict of interest.

Moral Hazard Moral hazard is another subset of the imperfect information problem. It occurs when the two sides to a contract do not have the identical information [asymmetric information] and the existence of the contract might alter the behavior of one of the contracting parties, for example in an insurance contract. The insurance company does not know as much about insured persons’ health or driving habits as the persons themselves. So healthier people or more careful people are less likely to buy insurance while accident-prone people are more likely to do so. This is challenging for the insurance companies because they have to offer a price although they do not know much about the insured. Furthermore, once people buy insurance, they might be less careful, because they then have the incentive for riskier behavior since they can pass their adverse consequences onto others. Hence, insurance contracts include co-payments to reduce moral hazard.

Transaction Costs Transaction costs are an important hindrance to efficiency, because usually we have to search first in order to discover what the alternatives are. Searching is costly and consumers have limited time, energy, and money to spend on searching especially if the alternatives are not obvious. In such cases, intuitive judgment, experience, and intelligence are all important, as consumers have to make important decisions along the way with incomplete information. Transaction costs hamper trade and therefore put a damper on welfare and pose an impediment to attaining efficient outcomes. There are search, information, policing, and enforcement costs.11 Furthermore, search costs can limit competition and thereby lead to excessive prices.12

Oversight, Regulation, Control of Markets  145 Transaction costs hurt the most those who can least afford them. Searching for information takes money, time, and patience, and the results are uncertain. No wonder that the poor are in a disadvantaged position to spend money searching. Businesses, from health insurance companies to car dealerships, all impose such costs when it is in their interest to do so to make it difficult to compare their products to those of their competitors.13 The price of automobiles is seldom advertised, for example, making it more difficult to comparison shop. Health insurance companies make their contracts so complicated that searching is extremely time-consuming so that consumers give up and simply buy the product without being adequately informed of the alternatives (see Figure 4.1 in Chapter 4). One does not know how costly it would be to acquire further information and how much success one would have with finding a better alternative. Only in the process of search does one begin to ascertain incrementally what costs are involved.14 These imposed costs make it much harder for consumers to reach an efficient level of consumption. Clearly those who cannot afford to search, or do not have the patience to wait until a better alternative is reached, are much more likely to end up with inferior outcomes.

Opportunistic Behavior Opportunistic behavior means deception or manipulation. Free markets open up a myriad of possibilities for people to take advantage of counterparties in an immoral, unprincipled, cunning, crafty, unlawful, or dishonest manner or with guile.15 Given that contracts are generally incomplete, there are many opportunities to take advantage of contingencies that were not foreseen when the contract was written.16 In addition, opportunism frequently stems from information asymmetries. People might also take advantage of ambiguous or inadequate laws or their absence, thereby enabling them to profit in ways unforeseen by lawmakers by disregarding moral norms. Opportunistic behavior occurs when people take advantage of incomplete contracts, asymmetric information, lack of knowledge, gullibility, cognitive biases, or the inferior mental ability of counterparties. The inherent propensity of many business people to disregard the social contract and to overreach or deceive in an unscrupulous fashion implies that markets ought not be free of oversight: we need to have constraints on people’s actions such that they deter them from taking advantage of the weaknesses of others, for instance, by selling contaminated drugs or eggs. (There were no less than 3,000 deaths from food poisoning in 2011 in the U.S.17) In other words, free markets would implode without adequate oversight and regulation. Freedom begets opportunistic behavior. In the past, the belief in an afterlife and faith in an all-knowing deity limited opportunistic behavior much more than today. People did not expect to benefit in the long run from greedily profiting at the expense of others. The decline in such a belief system and the concomitant increase in opportunistic behavior necessitated the increase in government control of markets. A generation ago, old-fashioned bankers would have been much less willing to sign up people for variable-rate mortgages that they themselves knew they would be unable to repay. However, there was plenty of “irresponsible lending,” fraud, and opportunistic behavior in the run-up to the Great Meltdown.18 The propensity for opportunistic behavior is determined to a large extent by the culture. An economy in which the culture of fraud is widespread experiences higher costs of doing business

146  Oversight, Regulation, Control of Markets and monitoring contracts. The contemporary world has also seen an epidemic of fraud: executives are being jailed and companies are fined for fraud practically daily. In 2012 GlaxoSmithKline was fined $3 billion,19 a Citibank executive received an eight-year sentence for embezzling $22 million,20 and 324 people were convicted of fraud since the Meltdown, all of them small fries. No senior Wall Street executive has been prosecuted.21 Too big to jail! However, some have been caught for insider trading including hedge-fund billionaire Raj Rajaratnam, sentenced to 11 years in prison and Rajat Gupta sentenced to a two-year term.22 In addition, many banks have been fined. In total the government collected some $150 billion in fines and consumer relief. Moreover, Barclays has been fined $450 million for rigging interest rates. Allen Stanford was sentenced to a 110-year term in a $7 billion Ponzi scheme. Dennis Kozlowski, former CEO of Tyco International, served an 8-to-25-year sentence. He was released in 2014. Jeff Skilling, former president of Enron, is serving a 24-year sentence, later reduced and is scheduled for release in 2019; Bernard Ebbers of WorldCom, a 25-year sentence. Oliver Schmidt, a Volkswagen executive was sentenced to seven years in prison for his role in the company’s violation of the Clean Air Act. The fraud cost the company $20 billion in fines and settlements.23 And these are only the people who were caught—the tip of the iceberg. There were 1 million fraud complaints in 2010.24 The FBI made 241 convictions in 2011 for corporate fraud. This is not the characteristic of an efficient market. In short, the corporate world is replete with corruption and opportunistic behavior. Between 1991 and 2015 pharmaceuticals paid $36 billion fines for illegal activities such as off-label marketing or for overcharging Medicare.25 Household names such as Enron, Arthur Andersen, WorldCom, or Adelphia Communications have disappeared in the wake of fraud, embezzlement, insider trading, or obstruction of justice.26 A recent estimate puts the number of firms with ongoing fraud at about 12% of major publicly traded corporations. A survey of MBA students with an average of two years’ work experience found that 15% had been asked to do something illegal.27 Consequently, capitalism will have a hard time sustaining itself with an elite that does not believe in norms which in earlier generations built trust and lowered the enforcement costs of contracts. Fraud has a deleterious effect because it increases transaction costs insofar as it destroys trust and cooperation, and induces people to take extra precautions in business to safeguard against losses. Fear of carrying cash is an inducement for people to pay with credit cards, costing consumers $100 billion annually. Because of opportunistic behavior, there is an optimum level of freedom in the marketplace, a level beyond which the expenses associated with opportunistic behavior outweigh the benefits of lack of regulation (Figure 8.1). Welfare and efficiency increase as freedom increases until the “optimal level;” thereafter, as freedom continues to increase, however, welfare and efficiency decreases, because there is excessive opportunistic behavior and the damage it does outweighs the benefits of increased freedom. Daron Acemoglu suggests that economists have been complacent about opportunism: “The capitalist economy lives in an institutional-less vacuum where markets miraculously monitor opportunistic behavior.”28 This is an enormous problem in the real economy because the temptation of extra profits is high so that deceptive practices are rampant. With the decline in the belief in the Ten Commandments the intrinsic value of truth has been declining. In the U.S. 49% of the population thinks that morals are “poor.”29 Opportunistic behavior adds an additional layer of inefficiency to the economy.

Oversight, Regulation, Control of Markets  147

Figure 8.1  The Optimum Level of Freedom in an Economy

Regulation in the Public Interest Government regulation increases exponentially with the complexity of markets to maintain institutions that work in the public interest; otherwise markets would become chaotic. There is a large scope for governmental regulation in areas in which markets are not aligned with social interests. This is especially the case if intangibles are involved. Impersonal markets are not designed to provide safe products. The invisible hand does not work with intangibles without ample regulation and enforcement because they are elusive and difficult to recognize. Instead of regulation, governments can nudge people into doing the right thing thereby improving their lives.30 This is also called libertarian paternalism, because it influences behavior without coercion. People can be cajoled into complying with some commonsense behavior that they do not have sufficient self-control or foresight to choose by themselves voluntarily unless they are motivated to do so. For example, some employers give an option to their employees to save for retirement. In that case the default option makes a world of difference. Far fewer save for retirement if the default option is zero unless the employee checks one of the other boxes than if the default option is 5% unless the employee chooses otherwise. Such a default option lowers the transaction cost of making such a choice and also gives the employee a feeling that it is the sensible thing to do. People make predictable but avoidable mistakes that an expert can help them correct. Insofar as it is a good thing if people save for retirement, a nudge to make the right choice makes sense from the point of view of the society. Putting healthy foods in easy-to-reach

148  Oversight, Regulation, Control of Markets places while making junk food harder to reach in school cafeterias is another example of how authorities can intervene to nudge students to improve their diet. It is ethical to help people avoid fallacious choices in order to improve their lives in a large number of areas from health, finance, and the environment.31 Of course, there are also transactions that are prohibited because culturally they are considered repugnant; these include selling organs, selling oneself into slavery even for a limited time, or selling babies.32 Deregulation often poses risks to the stability of markets, as we witnessed in 2008 (Chapter 14).33 Similarly, the deregulation of the electricity market in the 1990s led to the Enron bribery scandal and its ultimate bankruptcy. Regulation is needed to stop abuses, for example, manipulation of students by for-profit colleges.34 Negligence is not a benign matter; unregulated markets can be dangerous. Safety issues need oversight to prevent disaster—from bus companies to blood supplies.35 For instance, France prohibits the employment of fashion models who are less than 121 lbs.36 Chinese drywall was imported for eight years and contaminated 100,000 homes before they were found to emit noxious gases.37 Legal remedies seldom bring satisfaction in such cases because the cost of reaching, say, Chinese companies is prohibitive and because it is easy for “unscrupulous” business people to disappear.38 Economists often use the metaphor of people voting with their dollars for what is to be produced, claiming this is a “democratic” process. This is not logical, because dollars are not equally distributed; some people are born with the privilege of having a lot more of such “votes” than others, so the process cannot possibly be democratic.39 That is another argument for taking some decisions out of the realm of markets and into the political realm. In the market, the rich have more votes than the poor, hence their wants dominate. The political process could redress this imbalance.

Regulatory Capture However, given the immense concentration of income and wealth, regulation in the public interest is hardly straightforward, because lobbies spend an immense amount of money and effort to influence politicians to serve their parochial interests. Consequently, the common interest suffers as lobbies extract benefits for their members at the expense of society.40 Moreover, the wealthy generally invest heavily in political campaigns which influence the political process while ordinary citizens exert a miniscule influence despite their far greater numbers.41 This unbalanced incentive structure makes it possible for multinationals to gain the upper hand and to persuade regulators to tilt the playing field in their favor (Figure 8.2). The advancement of private interest in place of public interest by government is called regulatory capture; it has taken on immense proportions. The business community can provide another kind of incentive to regulators who cooperate—­high-paying jobs after they leave government service.42 The public interest loses as government agencies become subordinated to corporate interests, such as in the case of the financial bailout.43 The practice of people shuttling back and forth between being government functionaries and corporate executives is called the “revolving door.” For example, Timothy Geithner as Treasure Secretary fought tooth and nail to bail out the financial sector

Oversight, Regulation, Control of Markets  149 Basic Needs Children Youth

Adults

$300 Billions of Persuasion

g in rd He

Pavlovian Conditioning

Producers

WANTS

Output Legislation favoring $ Lobbies $ Billions Government

Consumption

In the real economy, tastes are endogenous, moneyed elites influence government, and there is herding behavior

Figure 8.2  Corporations Invest Heavily in Order to Tilt the Playing Field in Their Direction

in such a way as to favor the bankers with wanton disregard of Everyman on Main Street.44 He was handsomely rewarded after he left government by landing a major job at a hedge fund in which his annual salary is probably well above his previous life-time earnings. And that is not all. JPMorgan Chase, a bank he previously regulated, extended a line of credit to him so that he could increase his personal investments.45 In other words, one hand washes the other . . . and it is all legal if not moral. His policies as Treasury Secretary were likely colored by the anticipation that he would be well rewarded only if he played his cards right. Everyman on Main Street had nothing to offer him.

Moral Constraints The free market does not function well without moral constraints because laws are insufficient to maintain orderly exchange. Without widespread trust the transaction costs of enforcement increase rapidly. Hence, capitalism was well served by the Ten Commandments, which kept opportunistic behavior from running amok. People internalized the belief that lying, cheating, stealing, and deceiving were immoral. One could not deceive God, the allknowing, and if one broke the Commandments one would pay for it in the afterlife by going to Hell or getting stuck in Purgatory. That was an unpleasant prospect and raised the cost of opportunistic behavior thereby increasing trust and lowering transaction costs. The disappearance of moral constraint brought about the diminution in trust, thereby increasing the cost of doing business. It also meant an increase in fraud.

150  Oversight, Regulation, Control of Markets Examples abound. Verizon Communications overcharged customers;46 foreclosures were carried out illegally; banks broke rules without scruples.47 The Libor rigging scandal is just one example of the epidemic of opportunistic behavior: Barclays was fined $450 million, United Bank of Switzerland was fined $1.2 billion, and the Royal Bank of Scotland was fined $610 million for manipulating the Libor interest rate.48 The British bank Standard Chartered paid a $340 million fine for money laundering.49 ING also paid laundering fines of $619 million and Barclays paid $298 million in 2010.50 “GlaxoSmithKline agreed to pay $750 million to settle criminal and civil complaints that the company for years knowingly sold contaminated baby ointment and an ineffective antidepressant.”51 Referring to one of the mortgages sold by his bank, Angelo Mozilo wrote in an April 17, 2006, email: “In all my years in the business, I have never seen a more toxic product.”52 Yet that did not deter him from marketing and profiting from it. CNN named him one of the ten biggest culprits of the financial crisis.53 Wells Fargo Bank created millions of fake accounts to bolster the executives’ bonuses.54 Then it defrauded customers by failing to refund insurance money, and then it was found manipulating foreign exchange.55 This frenzy of fraud involved thousands of employees.56 The list could continue ad infinitum. The takeaway is that when iconic companies such as Wells Fargo and Volkswagen maximize profit by boldly cheating their customers, you know that something is awry with turbocapitalism. This was not run-of-the-mill finagling. These were brazen violations of the law with a low probability of success for an extended period of time. Yet, these executives were willing to take the chance and had thousands of collaborators willing to execute their directives. Such brazen deceit of millions of customers would not have been possible in an age when moral restraint was still binding.

Market Failures Market failure exists if markets are inefficient, i.e., do not achieve optimal production and optimal consumption: someone could be made better off without making anyone else worse off. Such situations are brought about by missing markets (human capital), common property (atmosphere, ocean), externalities (pollution), imperfect information, collusion, transaction costs, opportunistic behavior (deception), corruption, discrimination, market power, illicit activity, imperfect capital markets (insufficient collateral), monopolies, oligopolies. Thus, it is fair to say that most real markets, as opposed to imaginary ones, are inefficient.57 Many make the mistake of thinking that competition suffices to make markets efficient. It is not a sufficient condition for the above reasons. Once we accept this commonsense inference, we can work on devising means to improve market outcomes and move closer to the social optimum. That is the task ahead of us. One of the main goals of policy should be to make the economy more efficient. Markets alone will not suffice. It requires concerted community effort. Market failure afflicts also the U.S. educational system because so many students are unable to obtain a decent education because they attend mediocre schools. The students are helpless because they are unable to borrow against their future earnings in order to be able to afford better schools. That is inefficient and a huge waste of human resources because their net lifetime earnings are less than they could have been.

Oversight, Regulation, Control of Markets  151

Exploitation The concept of exploitation does not exist in conventional economics. However, to the extent opportunistic behavior and asymmetric information exists in markets, and since IQ is normally distributed, it is a useful concept to understand how some people are taken advantage of. If one party knowingly deceives or misleads the other in order to increase profits, the exchange is said to be exploitative. The person who takes advantage of a counterparty in such an unfair manner can be said to be exploiting the weaknesses of the other. The weakness can stem from asymmetric information or from asymmetric cognitive ability. Such relationships form the basis of predatory capitalism.58 It is like playing poker with a stacked deck without scruples. People with more reliable information and who are smarter have an advantage in the marketplace and can use that advantage to their benefit.59 Such unequal exchanges were rampant during the run-up to the crisis of 2008. Predatory lending involved “balloon payments with unrealistic repayment terms,” “excessive fees not justified by the costs of services provided and the credit and interest rate risks involved,” “abusive collection practices,” “excessive interest rates,” “fraud,” “lending without regard to ability to repay,” and “equity stripping.”60 Ameriquest Mortgage, the largest subprime mortgage lender, was accused of having broken the law, “deceiving borrowers about the terms of their loans, forging documents, falsifying appraisals and fabricating borrowers’ income to qualify them for loans they couldn’t afford.”61 It was fined $325 million. Yet, nobody was charged with fraud.

Illustration 8.1  Doctors for Camel Exploit the Gullibility of Consumers. Source: From the collection of Stanford Research into the Impact of Tobacco Advertising (tobacco. stanford.edu).

152  Oversight, Regulation, Control of Markets

Time and Space The importance of time and space are not fully appreciated. Yet, they are essential to understanding why real markets are generally inefficient because they impose transaction costs and make it more difficult to acquire information. The recent development of the new economic geography, which emphasizes the clustering of economic activity and consequent and regional disparities, is important.62 Time is a resource with six unique features unlike any other resource: (a) it is distributed democratically throughout the life course, (b) it is an essential element in every economic transaction, (c) it has no substitutes, (d) it cannot be borrowed, (e) it cannot be accumulated, and (f) it moves only in one direction. These unique attributes pose insurmountable obstacles to the smooth and efficient functioning of markets: they lead to inefficiencies, to regrets, and to path dependence.

Path Dependence Path dependence, or sequential decisions, is influenced not only by objective conditions today but also by irreversible decisions that were made yesterday without knowing what today would be like. Consequently, our investment or consumption decisions may not be efficient because of limitations imposed by earlier decisions. Prior decisions act as a constraint on decisions today. The implementation of new technologies, the creation of institutions, and the adoption of laws or new social norms are generally not a single event. Rather, they involve a series of events over time. The problem is that consumers and producers face an uncertain future as neither possesses perfect foresight and hence neither knows how technologies, institutions, laws, regulations, or other features of the economy will develop over time. They therefore base their decision on current knowledge, and these initial choices may lock them into a developmental path such that in the future the optimal technology or the optimal institution is no longer attainable. Hence, free markets, even with perfect competition, may not lead to optimum outcomes. The orthodox hype is that competition guarantees that the best technologies will prevail and therefore an optimum outcome is assured. Inferior technologies are supposed to become unprofitable and lose out. However, this theory overlooks the complex, uncertain, and sequential nature of technological change in real time with imperfect information and without perfect foresight. Technological change is an evolutionary process; hence, a model based on a static single decision is unrealistic; the future offshoots of the initial technology are not yet evident when initial crucial decisions are made. Time only moves in one direction and most processes are irreversible. Once investments are made in large infrastructure projects such as highways, railroads, or dams, it is impossible to change them. The usual assumption is that firms decide to invest at time T and expect a payoff in the future, say at time T + 2 two years later (Figure 8.3). With such perfect foresight, the optimal choice is a “no brainer:” firms will choose technology A, the one with the greatest payoff. Most Econ 101 problems are structured in this simple way. However, the outcome is different if at time T, the technologies that will exist at T + 2 are yet unknown. Suppose only the options at T + 1 are known at time T and one has perfect

Oversight, Regulation, Control of Markets  153

Figure 8.3  Investment Decision with Perfect Foresight Two Periods Ahead Is Easy

foresight only until T + 1 (Figure 8.4). In other words, firms make an investment decision without knowing the technological offshoots of technologies E and F. In this case, the optimal choice is clearly F. The difference between the perfect foresight model and the path-dependent (sequential choice) process becomes evident at time T + 1, because at T + 1 the two technologies E and F have offshoots A, B, C, and D, which were unknown at time T (Figure 8.5). Having chosen F, the firm is unable to adopt the optimal technology A and is thus “locked” into a choice between C and D. In this case, the rational choice becomes C insofar as A is unreachable (Figure 8.5). In short, although one chose the optimum in each period, with only one-period-ahead foresight one is locked into an inferior technology, C.63 This is quite different from the neoclassical assumptions that optimizing rational investors will achieve an optimum outcome. In the path-dependent framework, the equilibrium reached might well be inefficient. For instance, arguably the Windows operating system is not the best in the world. Yet, it won the competition because of chance and an early-mover advantage. To be sure, there might be cases in which the decision to choose F is reversible and the firm could switch to technology A at time T + 2, provided it pays for the investments necessary to accomplish this. But the switching is worthwhile only if it costs less than $20, the value of the difference between using technology C and technology A. Furthermore, vested

Figure 8.4  Investment Decision with Perfect Foresight One Period Ahead Is Also Easy

Figure 8.5  With Sequential Decision, Optimum Technology “A” Is No Longer Feasible

Oversight, Regulation, Control of Markets  155 interests might be able to prevent the switch to the social optimum at E (through political lobbying), regardless of the switching costs. This path dependent model is applicable beyond technological change to other kinds of consecutive decisions, including institutional change or investment in education. Suppose 30 years ago high school graduates decided not to go to college because decent-paying jobs were available without a college degree. However, they might find out 30 years later that the decision was suboptimal because the evolution of technologies devalued their high school diploma. At the age of 50 it is usually not feasible to reverse the decision and go back to college. This did happen to millions of people. Hence, there is no guarantee that people will be able to make optimal investment decisions in a sequential-choice framework without perfect foresight. Another issue is that network externalities also imply that the early adoption of a technology can provide sufficient benefits even if it is inferior, so that it can win the competition with a latecomer that is higher cost because of the small number of adopters. The reason for this is that as people adopt the early technology, its production costs decline, and the first-mover advantage persists and is a barrier to entry to other technologies that come on the market later even if they were superior. Learning to plan sequentially is an important part of growing up to succeed in the economy. Choosing a job, for instance, starts many years earlier in high school when one chooses courses that one will need subsequently. Students must work appropriately so that the grades suffice for the level of aspirations. The decision to become a doctor is not made on the spot. Its realization takes years of planning and making appropriate choices. Investment strategies such as buying a house require planning years in advance for a down payment and imply making many sacrifices along the way. The strategic planning and perseverance needed to reach these goals must be learned and practiced over an extended period of time. Such decisions are much more complex than a typical one-period optimization problem. The poor are trapped in a culture of poverty partly because they do not have the opportunity to learn these skills early in life, particularly those who grow up in dysfunctional families living in dysfunctional neighborhoods with dysfunctional school systems.

Limits and Standards Setting limits and standards by decentralized markets is extremely difficult. The inability of markets to set limits gives us too big portions at restaurants that fuel the obesity epidemic, and too many retail stores, most of which are practically empty most of the time. The underutilization of so many resources is inefficient. Moreover, the common wisdom is that the more choices offered by the market the better it is for us. However, psychologist Barry Schwartz documents that too much of a good thing can turn into a negative—that, for example, having hundreds of salad dressings on the shelf is excessive choice and actually detracts from our ability to make wise choices and thus decreases welfare.64 He suggests that having “more is less,” as the conventional thinking does not take into consideration the confusion created by too much choice and the time and effort needed to learn about the products offered. Generally, markets are incapable of finding adequate limits. The Aristotelian golden mean (between the two extremes of excess and deficiency) is unattainable as a competitive

156  Oversight, Regulation, Control of Markets equilibrium in real markets. That is why we have too many products, too many choices, too large portions in restaurants, too much credit on our credit cards, too much debt, and so forth. Competition makes it so.

Notes 1 Steven F. Hipple and Laurer A. Hammond, “Self-Employment in the United States,” U.S. Bureau of Labor Statistics, March 2016. 2 Mary Williams Walsh, “Insurance Giant A.I.G. Takes Ex-Chief to Court,” The New York Times, June 14, 2009. 3 When Stanley O’Neal left Merrill Lynch in 2007, it was obvious that the firm was on the brink. 4 “Portfolio’s Worst American CEOs of All Time,” CNBC. 5 “The 15 Worst CEOs in American History,” Business Insider, May 4, 2010. 6 William D. Cohan, “Lehman E-Mails Show Arrogance Led to the Fall,” Bloomberg View, May 6, 2012. www. bloomberg.com/view/articles/2012-05-06/lehman-e-mails-show-wall-street-arrogance-led-to-the-fall. 7 Adam Smith, “Of the Expenses of the Sovereign or Commonwealth,” Book V, Chapter I, Section 107 in An Inquiry into the Nature and Causes of the Wealth of Nations, ed. Edwin Cannan (London: Methuen & Co., 1904). 8 Richard J. Arnott and Joseph E. Stiglitz, “Labor Turnover, Wage Structures, and Moral Hazard: The Inefficiency of Competitive Markets,” Journal of Labor Economics 3 (1985): 434–462. 9 His current annual salary is still in the $6 million range though he did repay the million dollars he spent renovating the office he soon had to vacate. 10 Wayne Carnall and Veronica Uwumarogie, “Dodd-Frank Clawback Rule: Recovery of Erroneously Awarded Compensation,” PwC, July 8, 2015. 11 Jürg Niehans, “Transaction Costs,” in The New Palgrave Dictionary of Economics, 1st ed., ed. John Eatwell, Murray Milgate, and Peter Newman (Basingstoke, UK: Palgrave Macmillan, 1987). 12 Joseph Stiglitz, “Information and the Change in the Paradigm in Economics,” American Economic Review 92 (2002) 3: 460–501, here p. 477. 13 Sharon Begley, “Looking for a Good Doctor? Good Luck,” Reuters, September 27, 2012. 14 Oliver Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: The Free Press, 1975). 15 Wikipedia contributors, “Opportunism,” Wikipedia: The Free Encyclopedia. 16 Oliver Hart, Firms Contracts, and Financial Structure (Oxford, UK: Oxford University Press, 1995). 17 There were also 48 million cases of food poisoning and 128,000 hospitalizations. Center for Disease Control and Prevention, “Estimates of Foodborne Illness in the United States.” 18 Paul Krugman, “Wall Street Whitewash,” The New York Times, December 16, 2010. 19 The company discovered that its diabetes drug Avandia posed risks to the heart. “But instead of publishing the results, the company spent the next 11 years trying to cover them up.” Gardiner Harris, “Diabetes Drug Maker Hid Test Data, Files Indicate,” The New York Times, July 13, 2010; Peter Landers and Jeanne Whalen, “Glaxo to Plead Guilty, Pay $3 Billion to U.S. to Resolve Fraud Allegations,” The Wall Street Journal, July 2, 2012. 2 0 “Gary Foster, Ex-Citigroup Exec, Headed to the Slammer,” Huffington Post, June 29, 2012. 21 Kara Scannell and Richard Milne, “Who Was Convicted Because of the Global Financial Crisis?” Financial Times, August 9, 2017. 2 2 Michael Rothfeld, “In Gupta Sentencing, a Judgment Call,” The Wall Street Journal, October 10, 2012. 23 Bill Vlasic, “Volkswagen Official Gets 7-Year Term in Diesel Emissions Cheating,” The New York Times, December 6, 2017. 2 4 U.S. Department of Commerce, U.S. Census Bureau, The 2012 Statistical Abstract. 337: Fraud and Identity Theft—Consumer Complaints by State: 2010. 25 Sammy Almashat, Sidney Wolfe, and Michael Carome, “Twenty-Five Years of Pharmaceutical Industry Criminal and Civil Penalties: 1991 Through 2015,” Public Citizen, March 31, 2016. 26 Wikipedia contributors, “List of Corporate Collapses and Scandals,” Wikipedia: The Free Encyclopedia. 27 Alexander Dyck, Adair Morse, and Luigi Zingales, “How Pervasive Is Corporate Fraud?” www.haas. berkeley.edu/groups/finance/DyckMorseZingales20130306.pdf. 28 Daron Acemoglu, “The Crisis of 2008: Structural Lessons for and from Economics,” January 11, 2009. https://economics.mit.edu/files/3722.

Oversight, Regulation, Control of Markets  157 29 Justin McCarthy, “About Half of Americans Say U.S. Moral Values Are ‘Poor,’” Gallup News, June 1, 2018. 30 Richard Thaler and Cass Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press, 2008). 31 Cass Sunstein, The Ethics of Influence: Government in the Age of Behavioral Science (Cambridge, UK: Cambridge University Press, 2016). 32 Alvin Roth, “Repugnance as a Constraint on Markets,” Journal of Economic Perspectives, 21 (2007) 3: 37–58. 33 Hyman Minsky, Stabilizing an Unstable Economy (New York: McGraw-Hill, 1986). 34 Editorial, “Let the Students Profit,” The New York Times, September 11, 2010. 35 Contaminated supplies of Heparin, an anticoagulant, were exported from China, killing 81 people. Gardiner Harris, “U.S. Identifies Tainted Heparin in 11 Countries,” The New York Times, April 22, 2008. 36 Laura Stampler, “France Just Banned Ultra-Thin Models,” Time, April 3, 2015. Other countries that have similar regulations include Israel, Italy, and Spain. Five models died after dieting excessively. Eric Wilson, “Health Guidelines Suggested for Models,” The New York Times, January 6, 2007. Wikipedia contributors, “List of Deaths from Anorexia Nervosa,” Wikipedia. 37 Years of litigation followed problems with Chinese drywall. Andrew Martin, “Drywall Flaws: Owners Gain Limited Relief,” The New York Times, September 17, 2010. Greg Allen, “Toxic Chinese Drywall Creates A Housing Disaster,” National Public Radio, October 27, 2009. 38 Patrick McGeehan, “Federal Officials Shut Down 26 Bus Operators,” The New York Times, May 31, 2012. 39 Tibor Scitovsky, “On the Principle of Consumers’ Sovereignty,” American Economic Review 52 (1962) 2: 262–268. 40 Mancur Olson, The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities (New Haven, CT: Yale University Press, 1982). 41 Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, MA: Harvard University Press, 1971). 42 One of the thousands of examples is Wendy L. Gramm, who granted Enron an exemption from regulation in trading of energy derivatives while she headed the Commodity Futures Trading Commission. After she left the commission she was appointed to Enron’s board of directors and received between $1 and $2 million in compensation before the firm went bankrupt. Her husband, Phil Gramm, was also well treated by Enron. This is nothing less than corruption of a lawful sort. Wikipedia contributors, “Wendy Lee Gramm,” Wikipedia: The Free Encylopedia; Bob Herbert, “Enron and the Gramms,” The New York Times, January 17, 2002. 43 Neil Barofsky, Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street (New York: Free Press, 2012). 44 John Komlos, “The Banality of a Bureaucrat, Timothy Geithner and the Sinking of the U.S. Economy,” Challenge: The Magazine of Economic Affairs, 57 (2014) 5: 87–99. 45 Lucinda Shea, “Timothy Geithner Got a J.P.Morgan Credit Line for His Investments,” Fortune, February 8, 2016. 46 Editorial, “Verizon Wireless Says Oops,” The New York Times, October 5, 2010. 47 David Streitfeld and Gretchen Morgenson, “Foreclosure Furor Rises; Many Call for a Freeze,” The New York Times, October 5, 2010. 48 Simon Johnson, “The Market Has Spoken: And It Is Rigged,” Baseline Scenario, July 12, 2012. 49 Jessica Silver-Greenberg, “British Bank in $340 Million Settlement for Laundering,” The New York Times, August 14, 2012. 50 Ibid. 51 “The latest in a growing number of whistle-blower lawsuits that drug makers have settled with multimillion dollar fines,” Gardiner Harris and Duff Wilson, “Glaxo to Pay $750 Million for Sale of Bad Products,” The New York Times, October 26, 2010. 52 Gretchen Morgenson, “How Countrywide Covered the Cracks,” The New York Times, October 16, 2010. 53 “Celebrity Net Worth.” Wikipedia contributors, “Angelo Mozilo,” Wikipedia: The Free Encyclopedia. Condé Nast Portfolio ranked Mozilo second on their list of “Worst American CEOs of All Time.” 54 Gillian B. White, “One Year After Its Fake-Accounts Scandal, Wells Fargo Isn’t a Better Bank,” The Atlantic, October 3, 2017; The bank was punished by not allowing it to grow beyond its size at the end of 2017. Emily Flitter, Binyamin Appelbaum, and Stacy Cowley, “Federal Reserve Shackles Wells Fargo After Fraud Scandal,” The New York Times, February 2, 2018.

158  Oversight, Regulation, Control of Markets 55 Gretchen Morgenson, “Wells Fargo, Awash in Scandal, Faces Violations Over Car Insurance Refunds,” The New York Times, August 7, 2017; David Z. Morris, “Wells Fargo Scandals Expand with Firing of Foreign Exchange Bankers,” Fortune, October 21, 2017. 56 Emily Glazer, “Wells Fargo’s Sales-Scandal Tally Grows to Around 3.5 Million Accounts, Wall Street Journal, August 31, 2017. 57 “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices,” Adam Smith, “Of Wages and Profit in the Different Employments of Labour and Stock,” Book I, Chapter X, Section 82 in An Inquiry into the Nature and Causes of the Wealth of Nations (London: W. Strahan and T. Cadell, 1776). 58 The Editorial Board, “Predatory Colleges, Freed to Fleece Students,” The New York Times, May 28, 2018. 59 “Today, we understand that the market is rife with imperfections—including imperfections of information and competition—that provide ample opportunity for discrimination and exploitation,” Joseph Stiglitz, “When Shall We Overcome,” Project Syndicate, March 12, 2018. 60 FDIC, Office of Inspector General, “Challenges and FDIC Efforts Related to Predatory Lending,” Report No. 06–11, June 2006. 61 Mike Hudson and E. Scott Reckard, “Workers Say Lender Ran ‘Boiler Rooms,’” Los Angeles Times, February 4, 2005. 62 Anthony J. Venables, “New Economic Geography,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008). 63 Brian Arthur, “Competing Technologies, Increasing Returns, and Lock-In by Historical Events,” Economic Journal 99 (1989): 116–131; Paul A. David, “Clio and the Economics of QWERTY,” American Economic Review 75 (1985) 2: 332–337. 64 Barry Schwartz, The Paradox of Choice: Why More Is Less (New York: Ecco, 2003). “Barry Schwartz: The Paradox of Choice,” YouTube video, 20:23, posted by “TEDtalksDirector,” January 16, 2007; “The Paradox of Choice: Why More Is Less,” YouTube video, 1:04:08, posted by “GoogleTalksArchive,” April 27, 2006.

9 Microeconomic Applications on and off the Blackboard

We now analyze typical issues in real-world economics. Standard textbook analysis of these problems applies the perfectly competitive model, whereas we consider such models irrelevant in today’s economy and use models characterized by imperfect competition. The conclusions differ markedly.

Minimum Wage Is Good Economics The minimum wage has a bad reputation. Mainstream textbooks contend that, because it is an interference in markets, it leads to inefficiencies. It raises the price of unskilled labor, therefore firms will demand fewer workers leading to unemployment among low-wage workers. It is a simple matter of supply and demand. In perfectly competitive markets in which there are no profits and no unemployment, this would be correct. However, that model is inappropriate for today’s economy, dominated by oligopolistic firms that do make profits. In such markets, increases in wages come out of profits and do not create unemployment.1 No wonder there is no empirical evidence that the minimum wage causes unemployment.2 The federal minimum wage peaked at $11.20 in 1968 (in 2017 dollars) but is merely $7.25 in 2017, a decline of 35%. This is so low that it is not even binding in many localities since many states and cities set the minimum wage above the federal level.3 Oligopolies hire the 2.2 million people who work at or below the minimum wage.4 While McDonald’s competes with other fast-food chains it still makes profits because of its wellchosen locations, brand recognition, and unique menu. Hence, it did not raise the price of its Big Macs when the minimum wage increased by $0.70 in July 2009 to $7.25. It could absorb a tiny increase in wages into profits (perhaps 2 cents per Big Mac). It knows that it sells, say, 3,000 Big Macs a day (“Q” in Figure 9.1). It knows that it needs 40 employees to produce 3,000 Big Macs. As long as it wants to meet its demand of 3,000 Big Macs, it would still need the 40 workers. Hence, it would not decrease its labor force (Figure 9.1). Hence, a more realistic model implies that the minimum wage does not lead to unemployment in an oligopolistic industry but leads to a redistribution of income from profits to wages. Thus, a model with imperfect competition provides more insight into the working of today’s lowwage sector than the perfectly competitive model does. Adam Smith recognized that business people tend to complain about the effect of wages on sales without recognizing that CEO pay and profits have the same effect:

160  Microeconomic Applications Our merchants and masters complain much of the bad effects of high wages in raising the price and lessening the sale of goods. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people.5 Those who complain about the minimum wage are silent about the exorbitant earnings of CEOs. McDonald’s CEO, Steve Easterbrook, got away with $15 million in 2016.6 That was not too much for the mainstream, but a raise above the current pittance of $7.25 per hour for his employees would be considered excessive. At or near the minimum wage the working poor live a miserable life of bare subsistence anyhow.7 A full-time annual income at minimum wage would be around $15,000, which is below the poverty level ($16,000) for a single mother with a child.8 In addition, there are exemptions to the minimum wage laws. In 2016 there were 0.7 million people who worked for the minimum wage, while 1.5 million others were employed for less than the minimum wage, many of them receiving tips, which hopefully made up the difference.9 It is illuminating, however, to consider that about 20 million workers in 2017 earned less than the minimum wage of 1968. That would be $11.20 (in 2017 dollars). That indicates the extent to which we have been stuck in a low-wage economy. The existence of market power by firms who hire at the minimum wage at the local level is another aspect of imperfect competition in the labor market. It implies that many teenagers, poor people, those who do not have transportation, and those looking for part-time work are often unable to commute outside of their neighborhoods. They generally search for work near home. That means that local businesses hiring those workers have a captive market

Figure 9.1  Profit of a Quasi-Monopolist Without Fixed Costs

Microeconomic Applications  161 and exert market power in setting wages. This is called monopsony power. It is analogous to monopoly except that the market power is not used in setting prices of goods but in setting wages in employment. Monopsonists offer wages below the market rate because they know that the local workers cannot afford to look for work outside of their immediate vicinity.10 This problem has become more pervasive, particularly in rural areas, where “concentration increases labor market power,” depressing wages by as much as 15–25%.11 The minimum wage is basically an income redistribution policy, transfering money from profits and giving it to workers. In addition to raising some households above utter destitution, the minimum wage has other positive effects on the labor market because it is used as a benchmark to which other wages are pegged. An increase in the minimum wage therefore leads also to a rise in the wages of other workers near the poverty line.

Price Controls Can Be Good Price controls are similarly harmful in the mainstream’s view. Mainstream economists argue that such controls create shortages and/or lower the quality of products concerned. But meeting the basic needs of all is a legitimate social and political concern and a function that the market by itself cannot always guarantee. For example, it does not seem fair that the rich are more advantaged at obtaining gasoline during an oil embargo, such as the one in 1973. The increase in the price of basic necessities, such as food or gasoline, affects the welfare of the poor much more than that of the rich. Hence, the concern of government to modify unacceptable aspects of market outcomes is legitimate. Additionally to moral aspects, the uneven distribution of basic goods can be socially destabilizing. In the case of a gasoline shortage, using the queuing mechanism for rationing seems fairer insofar as time is equally distributed, whereas money is unevenly distributed. Using time as a rationing device is fairer in such emergencies. Competition for gasoline would then be on a more level playing field. Although the wealthy would be aggravated at having to queue for gasoline, the working poor would be aggravated as well if they were unable to get to work at Walmart because they could not afford to buy gasoline at exorbitant prices.12 In sum, in case of a shortage in supply, it is undesirable to let the market allocate basic needs. This is also the case with health care.13 Price ceilings can also induce monopolists and oligopolists to lower their price, increase output, and produce closer to the socially optimum output, thereby increasing social welfare (Figure 9.2). This would be appropriate in case of the rampant price gouging in the pharmaceutical industry. The industry is exploiting its monopoly power and causing untold harm to those who need the drugs but cannot afford them. Martin Shkreli infamously increased the price of a malaria drug overnight from $13.50 to $750 and is now facing seven years in prison for an unrelated crime of defrauding investors. Heather Bresch similarly raised the price of EpiPen, an anti-allergy injection, from $100 to $600 for no apparent reason.14 Such abuse of monopoly power that takes advantage of people’s dire needs is scandalous. One lawmaker called the price gouging “sickening.”15 Such exploitation can be countered with price ceilings. Figure 9.2 depicts the profits of such a monopolist. The initial profit-maximizing quantity of the medicine produced by the firm is Q(1). Its revenue is P(1)×Q(1) and its profit is the

162  Microeconomic Applications

Figure 9.2  The Effect of a Price Ceiling on a Monopolist Without Fixed Costs share of its revenue above the marginal cost of production. It is made up of the area of the rectangles A+B. If the government were to impose a price ceiling, profits would decrease by the area of rectangle B. However, the firm realizes that at the new price it would be advantageous to increase production, because the price is still above marginal cost. Consequently, production would increase to Q(2); this brings with it additional profits, C, which, however, is smaller than the area lost, B. So, profits decline by (C−B). Yet, consumers gain because more people benefit from the lower price of the medicine. Area B is a transfer of money from producers to consumers. In addition, consumers also gain the triangle, D. So a price ceiling: (a) decreases profits of pharmaceutical firms by the amount B−C; (b) transfers B dollars from firms to consumers; (c) consumers would gain B+D; and (d) social welfare of the society would increase by D, which is the net gain of the society.

Unions and Countervailing Power Unions usually get short shrift in Econ 101. Like the minimum wage, they are depicted as bogeymen, i.e., an unwarranted intervention in the labor market by special interests. Raising the wages of their members above the “correct” rate determined by the market is inefficient and increases unemployment.16 Again, such logic is pertinent only in perfectly competitive markets, but unions never existed in such markets. Rather, they have been confined to sectors dominated by oligopolies, sectors in which substantial profits were generated. They have also been successful in the public sector—where wages are determined administratively and not through the monetary value of output. Firms with a handful of competitors are oligopolies and earn profits. Apple earned $48 billion in 2017 and Walmart earned $15 billion. The profit of such a firm is illustrated

Microeconomic Applications  163 in Figure 9.3. The demand for the firm’s product is such that it can be produced by seven workers. Because the firm has market power, it is producing fewer goods than a perfectly competitive firm would in order to be able to charge a higher price for them. Workers receive a wage of $8 per hour even though their marginal product ($12) is greater than their wage. The role of a union is to extract some of the profit, the difference between $8 and $12 and the bargaining table to increase wages to, say, $9 per hour. Note that for this oligopolist, the number of workers would remain at seven, because this number depends on the quantity of output demanded and that would not change. Thus, the increase in the wage to $9 would not affect the level of employment; it would only decrease the firm’s profit. Hence, unions use their countervailing power to enable workers to gain some of the profits thereby defending a more equitable distribution of income. There is no evidence at all that unions cause unemployment. The fluctuations in the unemployment rate depend on the business cycle and not on unions. Note that the decline of unions since 1981 redistributed power and profits to the corporate world. As discussed in Chapter 7, the decline in union bargaining power is the most plausible explanation for (a) the divergence in productivity and wages after 1980 (Figure 7.1 in Chapter 7); (b) the stagnation in median income of men since about 1973 and of women since the year 2000 (Figure 7.2 in Chapter 7); and (c) the stagnation in median household incomes since the year 2000. Median household income increased by only $495 in the first 16 years of the twentyfirst century and that of African American households has even declined (Table 9.1). Oddly,

Figure 9.3  Profit of an Oligopolist Employing Seven Workers

164  Microeconomic Applications Table 9.1  Change in Household Income Since the Year 2000 in 2016 Dollars Year

All

White

Black

Asian

Hispanic

2000 2016 Growth Annual

58,544 59,039 495 31

61,229 61,858 629 39

41,363 39,490 −1,873 −117

77,738 80,822 3,084 193

46,244 47,675 1,431 89

Source: U.S. Census Bureau, Table H-5. www.census.gov/data/tables/time-series/demo/income-poverty/historicalincome-households.html.

household income declined in the same period in every educational group (Figure 9.4). The slight increase must therefore be due to an increase in the higher educational group in the total number of households. Consider Apple Inc.’s wage structure. Its CEO, Tim Cook, has a net worth of some $400 million. He received a salary of $900,000 in 2011 and a $500 million stock bonus over a tenyear period. Thus, his annual earnings were about $51 million. Several vice presidents of the company received salaries of $700,000 with stock bonuses of around $30 million—again over a ten-year period.17 Contrast this to the wages of Jordan Golson, a salesman, who sold $750,000 worth of Apple products in a three-month period and earned $11.25 per hour (in 2012), received no incentive pay, and no bonuses or stock options.18 We do not know if Cook’s or Golson’s salary comes close to their marginal product, and I doubt that Apple Inc. could either. But commonsense tells me that neither wage is plausibly close to the value of their marginal product because output is a joint product: Apple could not exist without Cook or without salespeople like Golson. The latter’s salary is low because the underemployment

1,40,000 Professional

1,30,000 1,20,000

Master's Degree

1,10,000 1,00,000

College Degree

90,000 80,000

Associate Degree

70,000

Some college

60,000 50,000

H.S. Diploma

40,000 30,000 20,000 1990

No H.S. Diploma

1995

2000

2005

2010

2015

Figure 9.4  Real Median Household Income by Education, 2016 Dollars Source: U.S. Census Bureau, Table H-13. www.census.gov/data/tables/time-series/demo/income-poverty/ historical-income-households.html.

Microeconomic Applications  165 rate keeps a ceiling on his wages, while Cook’s salary is protected from competition, although many would be willing to do the job for much less. When it was time to fill Cook’s job, it was not advertised. There was no search for a competitive bid. There was no auctioneer trying to find the lowest qualified bidder. Moreover, neither salary is fair. Golson’s salary was just 0.7% of the value of the merchandise he sold. If there were a union at Apple, it would have been able to increase Golson’s salary to, say, that paid by Tiffany’s for their salespeople: $15.60 an hour. That would increase Golson’s wage to just 1% of his sales, not an inordinate amount by any means and not enough to catapult him into the middle class, certainly not enough to support a family, but 40% more than the subsistence wage he was getting. Suppose the union had been able to increase each salesperson’s salary by $4.35, and furthermore that the 40,000 sales force worked 2,000 hours per annum. That would mean an additional expense for Apple of a mere $350 million, reducing profits from $48 billion to $47.65 billion—that is, by a trifle.19 Conclusion: without the help of a union, the sales force is kept at a living standard of the working poor. Not a fair outcome. If John Rawls were to design the system behind a veil of ignorance, he certainly would not design one with a difference in incomes ranging from $11.25 to $25,000 per hour. If labor unions had depressed the wages of the rest of the labor force, as argued by the mainstream, one would expect that average salaries of the nonunionized workers would increase with the decline in labor unions. Of course, nothing could be further from the truth—only women’s wages have been increasing. Yet, even women’s wages have been practically stagnating since 1998. The inference is warranted that incomes have been stagnating because the weak labor unions has meant that workers had to fend for themselves in a labor market in which endemic underemployment was putting a downward pressure on wages, which enabled corporations to obtain a bigger share of profits. Another important role of unions was to support government vis-à-vis big business and thereby maintain a balance of power. As long as organized labor was powerful they could unite with government and keep big business from gaining the upper hand. Government by itself cannot maintain the balance of power in the economy. Unless corporate power is kept in check by a countervailing power, its political influence naturally grows because of its massive financial resources. However, as the power of unions vanished, government by itself was unable to keep big business from gaining the upper hand. The reason is straightforward: big business had something politicians needed for re-election—money; and politicians had something to offer in exchange—namely accommodating regulations. So corporate wealth was used to lobby and bribe and make government subservient to its interests. The drug industry, for instance, spent $106 million lobbying Congress between 2014 and 2016. Congressman Tom Marino (R-Utah) and Senator Orin Hatch (R-Utah) received $100,000 and $177,000 respectively in order to push a bill through Congress to make it increase the profits of opioid producers in spite of the wanton epidemic that has claimed 200,000 lives by 2016.20 That is called regulatory capture. In the colloquial one would just call it bribery or legalized corruption. Once big labor was defeated, the balance of power was shattered and there was no other institution to take its place. Over time, wealth begat wealth and power begat power, both economic and political, so that economic inequality begat political inequality. Big business gained a strategic advantage, and flush with funds, the wealthy were able to sway

166  Microeconomic Applications politicians, hire economists to support their ideology, and deregulation could proceed in full swing. Thus, by the twenty-first century, lawmakers could safely disregard the general will and cater to the preferences of the affluent.21 This is the making of a plutocracy.22

The American Medical Association Is a Cartel A cartel is an organization that pools collective effort to foster its competitive economic advantage in the marketplace. The influential American Medical Association (AMA) is a cartel that restricts competition in the name of fostering excellence in medical care.23 Its effect is the same as that of any other cartel: by restricting the number of doctors it increases doctors’ salaries above competitive levels. Despite the shortage of doctors (Figure 9.5), only half of those applying to medical school are accepted although no doubt only the most qualified apply to begin with.24 Consequently, U.S. doctors earn between two and five times as much as doctors in other rich countries. To increase the number of physicians per capita to Norway’s level, for example, the number of doctors in the U.S. would have to be increased by no less than 600,000!25 Compared to the 820,000 physicians (in 2016), this would be a 75% increase in the number of doctors.26 No doubt that would put a downward pressure on medical costs and improve the health of the U.S. population to European levels.

Austria Norway Switzerland Sweden Germany Italy Spain Iceland Denmark Australia Netherlands Israel Finland France Belgium New Zealand Ireland UK Canada U.S. 0

1

2

3

4

5

Figure 9.5  Physicians per 1,000 Population, 2016 Source: OECD Health Data 2016. www.stats.oecd.org/Index.aspx?DataSetCode=HEALTH_REAC.

Microeconomic Applications  167

Figure 9.6  The Supply and Demand for Doctors with Supply Constraint Brought About by the American Medical Association

The AMA constrains the number of medical schools as well as the number of students they can admit (Figure 9.6). With the AMA constraining the number of doctors to N=820,000, there are fewer doctors than there would be in competitive equilibrium N′ =1.4 million; consequently, the income of medical doctors is above the competitive level: $200,000 vs $100,000 in Germany and Canada.27 The median salary of Medical School Deans is $400,000 and 25% earn more than $500,000.28 While the number of law schools has been increasing, the number of medical schools has had the opposite tendency. There are just 141 medical schools in the U.S., and the number of students admitted is kept to 20,000 per annum.29 In contrast, there are 205 law schools and the salaries of lawyers are about half of those of doctors.30 The AMA has been able to achieve this by restricting the supply of doctors.31

Discrimination Is Pernicious According to blackboard economists, discrimination is benign, because the magic of competition will ultimately defeat it. The neoclassical assumption is that those who are discriminated against are willing to work for less and will be hired by firms that are not discriminating and who, thus, will be able to offer their product at a lower price, thereby driving the discriminating firms out of the market.32 So the magic of the market is such that discrimination is self-correcting. In this “Alice in Wonderland” economy there is no peer pressure to maintain a united front against the group who is being oppressed, such as the African American community, which experienced centuries of not-so-benign discrimination. One reason for the persistence of discrimination is that it begins early within the educational system so that minorities enter the labor force at a distinct disadvantage, that is,

168  Microeconomic Applications if they do not get caught up in the school-to-prison pipeline. Moreover, social pressures to enforce the norm of discrimination are often so strong that there may not be any nondiscriminating firms in the first place to compete with discriminating firms. Certainly, there were no bus companies that competed with the ones that made Rosa Parks sit in the back of the bus in Montgomery, Alabama. There were no firms competing with Woolworth that would serve both whites and blacks in Greensboro, North Carolina. Moreover, the black-white wage gap not only persists but has even become wider. In 1979 black men earned 20% and black women earned 5% less than their white counterparts, but by 2016 the gap increased to 30% and 18% respectively. What is more, while a part of the gap can be explained by educational attainment, much of the gap is due to discrimination.33 To be sure, differences in educational attainment are also due to discrimination and poverty. Discrimination also affects intergenerational mobility.34 So, the empirical evidence contradicts the fantasy tale created by mainstream economists.35 Joseph McNeil, Franklin McCain, Ezell Blair, Jr., and David Richmond were not served coffee at the Woolworth’s lunch counter in downtown Greensboro, NC. It is very strange that free markets would be structured in such a way that the ability to buy a coffee sitting down depended on the skin color of the consumer. It took the Civil Rights Act of 1964 for them to buy coffee in the shop of their choice in a supposedly free market.36 These rights were not obtained through competition from non-discriminating entrepreneurs who wanted to profit from the discrimination of others. It is nothing less than ridiculous to concoct a theory to suggest otherwise.37

Redistribution Would Help Poverty can be both absolute and relative deprivation. It is absolute if a household is unable to meet its basic needs. Disregarding such a possibility would be unethical.38 In addition, one can feel disadvantaged relative to the conspicuous consumption of a reference group even if one’s basic needs are met. This is relative deprivation and is just as much of a threat to social order as the poverty of the first kind. A policy of redistribution toward the poorer segments of the society might be supported out of a feeling of moral obligation, a sense of fairness, empathy for their plight, or because of concern for social upheaval. The feeling of discomfort among third parties created by the suffering of the poor in a wealthy country is a negative externality. So the urge to ameliorate inequality can also come from a desire to overcome such emotions. One need not be a purist and strive for perfect equality but merely to create a fairer distribution of income that is less skewed and that ensures that at least basic needs—including health and education— are adequately met for all of the population, especially for children, who are not accountable for the circumstances into which they are born. This is basically the Scandinavian model of capitalism with a human face. It makes little sense to allow 45% of single mothers to be poor39 while the top 50 hedge fund managers have a combined income of $29 billion, or about $600 million each.40 Such astronomical salaries are, in reality, rents, that is to say, not deserved: these individuals would have done their job at a small fraction of that salary. In contrast, to stand by quietly amidst this plenty, while 20% of children grow up in poverty, that is to say, deprived of a

Microeconomic Applications  169 decent upbringing including education, will weigh heavily on the rest of their lives and also affect adversely the whole society in the future. It also leads to a waste of human resources, increases the population in jail and on welfare, and, therefore, the social cost of such neglect of the plight of children is undeniable. Because of the decreasing marginal utility of income, the total utility of the society could be increased greatly if we were to redistribute income from the wealthy to the poor (Figure 9.7). The length of the X-axis (OC) symbolizes the total income in the economy. The two marginal utility curves translate these dollars into utility. Total income is divided between two persons. Initially poor Person 1 receives the segment OA while the rich Person 2 receives the segment AC. The initial distribution implies that Person 1 enjoys total utility represented by the trapezoid OAED while the total utility of Person 2 is ACHF. Total utility is made up of these two trapezoids. But this is not the maximum utility that could be generated with total income OC. The maximum utility would be reached if the income were equally divided so that the amount of dollars represented by the segment AB would be transferred from Person 2 to Person 1. Then the total utility of Person 1 would increase to OBGD and that of Person 2 would decrease to BCHG. So, the total utility of Person 1 would increase by ABGE and that of Person 2 would decrease by ABGF. Note that the gain of Person 1 is greater than the loss of Person 2 by the triangle FEG. That is the net gain in utility of the society. The area ABGF would be the transfer of utility from Person 2 to Person 1. However, the argument against redistribution is that we are unable to compare utility levels across individuals. While it is true that some may adore the flavor of fresh oranges just as others might well find it distasteful, it is safe to assume that people do not differ in their basic needs substantially. The pangs of hunger for one cannot possibly be that much different from those of others. A broken bone, a heart failure, or toothache for one is much like that of anyone else. This implies that the distribution of income should be such that all members of the society can at least meet their basic needs. Yet we back away from such assumptions, even though we have no qualms assuming that a single agent can represent everyone in our macroeconomic models, an assumption that implies a homogeneous society. The habit of using these two sets of assumptions is inconsistent.

Figure 9.7  Redistribution Increases Total Utility and Social Welfare

170  Microeconomic Applications

Notes 1 David Card and Alan Krueger, “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic Review 84 (1994) 4: 772–793. 2 John Schmitt, “Why Does the Minimum Wage Have No Discernible Effect on Employment?” Center for Economic and Policy Research, February 2013. 3 The minimum wage in Seattle is being raised to $15. Its effective date depends on the size of the firm. By 2021 it will apply to all firms. San Francisco’s minimum wage became $14 in 2017. 4 Bureau of Labor Statistics, “Characteristics of Minimum Wage Workers, 2016,” BLS Reports, no. 1067, April 2017. 5 Adam Smith, “Of the Wages of Labour,” Book I, Chapter VIII, Section 24 in An Inquiry into the Nature and Causes of the Wealth of Nations, ed. Edwin Cannan (London: Methuen, 1904), available online at Library of Economics and Liberty. 6 Samantha Bomkamp, “McDonald’s CEO Easterbook Sees Pay Package Nearly Double to $15.4 Million,” Chicago Tribune, April 13, 2017. 7 In the words of Franklin Roosevelt, “Liberty requires opportunity to make a living—a living decent according to the standard of the time, a living which gives man not only enough to live by, but something to live for,” Franklin D. Roosevelt, “Speech Before the 1936 Democratic National Convention” (Philadelphia, PA, June 27, 1936). 8 U.S. Department of Commerce, United States Census Bureau, “Poverty Thresholds, 2016.” 9 Bureau of Labor Statistics, “Characteristics of Minimum Wage Workers, 2016,” BLS Reports, no. 1067, April 2017. 10 Efraim Benmelech, Nittai Bergman, Hyunseob Kim, “Strong Employers and Weak Employees: How Does Employer Concentration Affect Wages?” National Bureau of Economic Research, Working Paper No. 24307, February 2018. 11 José Azar, Iona Marinescu, Marshall Steinbaum, “Labor Market Concentration,” National Bureau of Economic Research, Working Paper no. 24147, December 2017; José Azar, Iona Marinescu, Marshall Steinbaum, Bledi Taska, “Concentration in US Labor Markets: Evidence From Online Vacancy Data,” National Bureau of Economic Research, Working Paper no. 24395, March 2018; Simcha Barkai, “Declining Labor and Capital Shares,” London Business School Working Paper, 2016; Noam Scheiber and Ben Casselman, “Why is Pay Lagging? Maybe Too Many Mergers in the Heartland,” The New York Times, January 25, 2018. 12 To be sure, the super-rich could still send their servants to stand in the queue but they would still not be able to outcompete the poor for gasoline. 13 A monopolist drug maker is charging $28,000 for a vial of medication that cost $1,650 in 2007 and costs just $300 to produce. Andrew Pollock, “Questcor Finds Profits, at $28,000 a Vial,” The New York Times, December 29, 2012. 14 Ben Popken, “Martin Shkreli Weighs in on EpiPen Scandal, Calls Drug Makers ‘Vultures,’” NBC News, August 19, 2016. 15 Jill Disis, “Lawmakers Say EpiPen Hikes Made Mylan Executives ‘Filthy Rich,’” CNN, September 22, 2016. 16 Paul Samuelson and William Nordhaus, Economics, 19th ed. (New York: McGraw-Hill, 2009), p. 260. 17 Simon Gerard, “Apple CEO Tim Cook Made $378 Million in 2011,” Celebrity Networth, January 14, 2012. 18 David Segal, “Apple’s Retail Army, Long on Loyalty But Short on Pay,” The New York Times, June 23, 2012. 19 Nasdaq, “AAPL Company Financials,” www.nasdaq.com/symbol/aapl/financials?query=incomestatement. 2 0 Scott Higham and Lenny Bernstein, “The Drug Industry’s Triumph over the DEA,” The Washington Post, October 15, 2017. 21 Martin Gilens, Affluence and Influence: Economic Inequality and Political Power in America (Princeton, NJ: Princeton University Press, 2012). 2 2 Demos, “Stacked Deck: How the Dominance of Politics by the Affluent & Business Undermines Economic Mobility in America.” www.demos.org/stacked-deck-how-dominance-politics-affluent-­ business-undermines-economic-mobility-america. 23 Milton Friedman called the AMA the strongest trade union in the country. The AMA is for doctors what OPEC is to the gasoline market. Mark J. Perry, “The Medical Cartel: Why Are MD Salaries So High?” Wall Street Pit, June 24, 2009. 2 4 The AMA opposes the internships of foreign doctors. Anemona Hartocollis, “Medical Schools in Region Fight Caribbean Flow,” The New York Times, December 22, 2010.

Microeconomic Applications  171 25 World Health Organization, World Health Statistics 2010 (Geneva: WHO Press, 2010); Organization for Economic Cooperation and Development (OECD), OECD Health Data 2012—Frequently Requested Data. 26 In the first edition of this book the number of doctors in the U.S. was lagging by 480,000 or 60%. So the U.S. has fallen further behind Norway in this respect. 27 Mark Perry, “The Medical Cartel: Why are MD Salaries So High?” Wall Street Pit, June 24, 2009. www1. salary.com/Professor-Medicine-salary.html and www1.salary.com/Medicine-salary.html. James Hamblin, “What Doctors Make,” The Atlantic, January 27, 2015. 28 www1.salary.com/Dean-of-Medicine-salaries.html. The argument is sometimes made that the reason doctors’ salaries are so high is that Medical School is so expensive. I think it is the other way around. Medical Schools want to capture a share of the rents earned by doctors and hence increase the tuition accordingly. 29 Joanna Broder, “Record Number of Med Students, but More Needed to Help Physician Shortage,” Medscape, October 29, 2013. List of Medical Schools and the number of students enrolled can be found on the Website of the Association of American Medical Colleges, Table B-1: Total Enrollment by U.S. Medical School. 30 American Bar Association, “ABA-Approved Law Schools. 31 Other countries have been able to cap costs by adopting a more efficient system because administrative costs are much less and costs are kept down by the bargaining power of government so that medicine does not become a business and excessive profits are not generated. Hence, a single notfor-profit entity organizing the medical care system is more efficient than navigating through the confusing array of offerings of a free-market for-profit system. 32 Samuelson and Nordhaus, Economics, p. 262. 33 Mary Daly, Bart Hobijn, and Joseph Pedtke, “Disappointing Facts about the Black-White Wage Gap,” Federal Reserve Bank of San Francisco Economic Letters, September 5, 2017; Mary Waters and Karl Eschbach “Immigration and Ethnic and Racial Inequality in the United States,” Annual Review of Sociology 21 (1995): 419–446. 34 Raj Chetty, Nathaniel Hendren, Maggie R. Jones, Sonya R. Porter, “Race and Economic Opportunity in the United States: An Intergenerational Perspective,” National Bureau of Economic Research Working Paper No. 24441, March 2018. 35 William Darity and Patrick Mason, “Evidence on Discrimination in Employment: Codes of Color, Codes of Gender,” Journal of Economic Perspectives, 12 (1998) 2: 63–90. 36 Wikipedia contributors, “Greensboro Sit-Ins,” Wikipedia: The Free Encyclopedia. 37 George De Martino, The Economist’s Oath. On the Need for and Content of Professional Economic Ethics (Oxford, UK: Oxford University Press, 2011). 38 Famines are special cases analyzed in detail in the Amartya Sen classic Poverty and Famines: An Essay on Entitlement and Deprivation (Oxford, UK: Oxford University Press, 1981). 39 Karen Christopher, “Welfare State Regimes and Mothers’ Poverty,” Social Politics 9 (2002): 60–86. 40 Jenny Anderson, “Wall Street Winners Get Billion-Dollar Paydays,” The New York Times, April 16, 2008.

10 What Is Macroeconomics?

In the long run we are all dead. John M. Keynes1

Until now our analysis has focused on microeconomics—economics considered from the bottom up, from the view of individual consumers and producers. We now turn to a bird’seye view of the economy that considers aggregate aspects of economic activity such as gross national product (GNP), the stock of money, or aggregate demand. So our perspective changes to the opposite end of the telescope.

Keynes the Savior John Maynard Keynes is the father of macroeconomics. The revolution his genius sparked in the 1930s saved the intellectual foundations of capitalism from the then competing totalitarian ideologies of Nazism, fascism, and communism by turning squarely against his neoclassical forerunners. His genius was to be revolutionary in thought while maintaining the basic structure of liberal democracy, that is, he upheld two basic pillars of the established capitalist order: private property and the free market with its price mechanism. His basic insight was that with massive persistent unemployment in the industrialized world in the Great Depression, it was obvious that free markets were not self-regulating, and it would be ludicrous to continue to wait for the economy’s self-correcting mechanism to eliminate the massive unemployment, as the classical economists unrelentingly maintained. There were too many impediments preventing the simple feedback mechanisms—which were supposed to reinstate equilibrium—from eliminating the “general glut.” The obstacles to the establishment of a new macroeconomic equilibrium included longterm contracts such as mortgages and leases, which bound individuals and firms to a series of payments in nominal terms. They were unable to adjust these commitments, and as prices declined the real value of these payments ballooned. Deflation—a decline in the general price level—meant that debt became a bigger burden to households and a drag on the economy as people in debt had less purchasing power for consumer goods, thereby exacerbating the downturn and preventing the return to equilibrium. The diminution in aggregate demand meant that prices would decline further, thereby establishing a vicious circle that extinguished the momentum of economic growth and made it impossible

What Is Macroeconomics?  173 to reduce unemployment. Moreover, because the real value of debt increased, many firms and individuals found it increasingly difficult to meet their commitments and a wave of defaults and bankruptcies ensued. Needless to say, that increased the unemployment lines and prolonged the Great Depression. In short, unemployment led to the accumulation of frustration and despair while the conventional economists lacked a recommendation besides waiting patiently for the markets to adjust. But years passed without improvements, thereby posing a threat to the whole capitalist system. In addition, Keynes fundamentally rejected the homo oeconomicus model. Rather, both investors and consumers were subject to so-called “animal spirits:” they were prone to psychological swings of optimism and pessimism.2 Herding behavior meant that these mood swings were contagious. Therefore, Keynes thought that it was fallacious to consider aggregate demand—the value of all goods and services produced in the economy—as a stable function of prices. Rather, aggregate (or effective) demand was unstable, as the Great Recession of 2008 also demonstrated. Consumer confidence and expectations could swing wildly (Figure 10.1). This implies that aggregate demand fluctuates for psychological reasons, causing GNP and unemployment to vary with it. To be sure, the demand for basic necessities does not vary much due to animal spirits, but the demand for business investments and big-ticket consumer items such as furniture, automobiles, and houses does (Figure 10.2). For instance, the demand for automobiles declined from 4.5 million units to 1.1 million units in 1932, but even in “normal” times demand could be quite volatile: from 7.9 million units in 1955 to 4.5 million units in 1958 (Figure 10.3). Expectations also play a role in aggregate demand: as long as prices were expected to decrease, consumers would not buy consumer durables but would wait until prices stopped

Figure 10.1  U.S. Consumer Confidence Index, 1996=100 Source: University of Michigan: Consumer Sentiment [UMCSENT], FRED, Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/series/UMCSENT.

174  What Is Macroeconomics?

Figure 10.2  Fluctuating Demand During the Great Depression

falling. Moreover, nominal wages were inflexible downward for psychological reasons. Workers were accustomed to their nominal income and declining wages were resisted vehemently, often violently. Many contracts including rents and mortgages were denominated in nominal terms, and a decline in nominal wages would have meant that workers would be unable to meet those obligations. Yet, constant nominal wages and a decline in the price level meant that real wages—of those employed—actually increased at a time when they should have been declining, thereby contributing to ominous levels of unemployment. That is why deflation has such a negative impact on the macroeconomy and why

Figure 10.3  Automobile Production in the U.S., 1900–1970

What Is Macroeconomics?  175 the Federal Reserve tried to avoid it after the Meltdown in 2008. In short, Keynes argued that the economic system was not as flexible as neoclassical economists pretended, and a new equilibrium would not be attained at a lower level of prices within the relevant time frame. Economists call this sticky wages. Thus, aggregate demand could persist indefinitely below full-employment level. Furthermore, these problems would not remain confined to the economic realm; they might infect the political arena. The hungry and destitute threatened the stability of democracy and might even overturn it as in Russia, Germany, and Italy. The legitimate fear was that the social order would unravel faster than the economic system would repair itself.3 Politics and economics are inexorably intertwined as was evident with the triumph of Trumpism.

Keynesian Fiscal Policy Keynes understood that dramatic reforms were needed to avoid catastrophe. His ingenious and revolutionary insight was to realize that GNP was made up of personal consumption (C), investment of firms (I), government expenditures (G), and exports minus imports (X−M): GNP=C+I+G+(X−M). This amazingly simple insight created macroeconomics. Economics would never be the same. Keynes argued that C would not increase by itself because unemployment remained high and confidence was low. Similarly, businesses had access capacity: they lacked enough demand for their products. So, they would not increase investments (I). The whole world was in depression, so X would not increase either. Hence, only G remained on the right-hand side still capable of increasing demand and GDP. Under such conditions it would be irresponsible to let the market continue to flounder. Government expenditures needed to be increased and a new equilibrium would be established. When the private sector fails to spend enough and a gap exists between actual and potential output, the public sector should make up the difference through deficit spending. This key insight became the birth of fiscal policy. Moreover, public spending—particularly on infrastructure—would have a magnified impact through the multiplier: the initial beneficiaries of government expenditure would spend their income, thereby increasing the income of others. This was a simple but brilliant insight: the multiplier was crucial in breaking out of the downward spiral of unemployment and deflation, thereby re-establishing a new full-employment equilibrium. It was also bold for abandoning the classical framework and not relying on the private sector to realign through price and wage adjustments. The system was so out of kilter that, left to themselves, markets were unable to establish a new equilibrium or at least not quickly enough to matter to the lives of most people suffering since 1930. Recent estimates of the multiplier is about 1.6 if spent on food stamps, unemployment benefits, or on infrastructure.4 This means that $1 spent by government for these items would increase GNP by $1.6. The economic system created by this new activist government would be a more humane form of capitalism, which—unlike socialism or communism—retained private property rights as well as the social pecking order but would crucially alleviate the scourge of unemployment and the misery and political instability associated with it. These brilliant insights made Keynes one of the greatest economists of all time.

176  What Is Macroeconomics?

Monetary Policy Another major Keynesian innovation was in the realm of monetary policy. Monetary policy is an important instrument by which the Federal Reserve (or any central bank) influences the economy. By setting the discount rate—the interest rate it charges on loans to member banks— it can increase or decrease the amount of money in circulation. By lending money to banks, the Federal Reserve is increasing the money supply. By buying Treasury securities (known as open-market operations), it puts more money into circulation, while if it sells securities, it is decreasing the quantity of money in circulation. In addition, the Federal Reserve can influence the money supply indirectly by setting reserve requirements: the lower they are, the more money banks can lend. While the Federal Reserve controls the monetary base (currency and banks’ reserves), commercial banks influence the money supply by lending money. Under normal circumstances, a decrease in the discount rate if the economy is slowing down has a stimulating effect because the banks will also decrease the interest rate they charge borrowers. Consequently, consumers will be incentivized to buy more durable goods on credit such as cars and houses. At the same time, businesses will find it more lucrative to borrow in order to invest in new equipment, thereby also increasing economic activity and lowering unemployment. Thus, the interest rate is like an accelerator of the economy. By lowering the interest rate, the Federal Reserve basically steps on the accelerator. But if it fears that inflation will be above the 2% benchmark, it will increase the interest rate to dampen economic activity. It is like taking its foot off the accelerator and stepping on the brakes instead. This is the monetary mechanism in normal times. However, it does not work in a financial panic. Firms and consumers have to be willing to borrow in order for the interest rate accelerator to work. If consumers are overextended and have too much debt relative to income and are trying to deleverage and lower their debt burden, then lowering the interest rate is not effective. Similarly, if businesses have excess capacity and sluggish demand for their products, they are not going to invest in new plants and equipment even with lower interest rates. That is exactly why monetary policy was ineffective in 2008, even though the Federal Reserve pumped about $3.6 trillion (a trillion is a million millions and thus has 12 zeros) into the economy between 2008 and 2014, and even though the real interest rate (nominal interest rate minus the rate of inflation) in the U.S. was near zero for more than a decade. During the recent financial crisis there was a lot of deleveraging, which meant that banks were reluctant to lend and instead accumulated excess reserves. This is one reason many economists were baffled by the low inflation rates and the sluggish lending after the Meltdown despite the Fed’s easy money policy. The monetary school holds that the quantity of money in circulation (M) is directly proporpY tional to nominal GNP: MV=pY, or V= where M is the supply of money, p is the price level, M Y is the real GDP, and V is the velocity of circulation.5 The velocity, V, is the number of times a dollar changes hands annually. The faster money circulates, the larger is the velocity, and the more income is generated because every time a dollar changes hands it becomes someone’s income. Just before the 2008 Meltdown, velocity was above 10; this meant that a dollar changed hands 10 times annually, but V declined to 5.5 in 2017, implying that the frequency had halved. So it would be a mistake to think that V is a constant (Figure 10.4).

What Is Macroeconomics?  177

Figure 10.4  Velocity of Circulation of M1 Source: Federal Reserve Bank of St. Louis, series M1V.

A reason why V is unstable is that people can purchase goods and services on credit cards and are therefore not constrained by the money stock. Moreover, how much money individuals and banks hold in their accounts or in reserve depends on the uncertainties in the economy—how likely it is that they will lose their job, for instance—implying that thethen Federal Reserve Chairman Ben Bernanke’s insistence on pumping money into the economy (2008–2014) did not affect the real economy to any meaningful extent. Instead, it merely lowered the velocity of circulation. People were not spending their money as quickly as before but were holding on to it for longer. In addition, the Fed was still finding it difficult, a decade after the crisis, to get back to normal business and not subsidize the financial sector with low interest rates. When the Fed will get back to normal interest rates of 5% is an open question.

The Liquidity Trap Thus, in normal times, expansionary monetary policy helps the economy recover from a recession. However, Keynes realized that there is a catch, namely, when the interest rate is already so low that it cannot be lowered further. When the nominal interest rate reaches zero, as it did for seven years between January 2009 and January 2016, the economy is in a liquidity trap (Figure 10.5). At the zero lower bound the Fed loses its ability to influence monetary policy because it cannot lower the nominal interest rate any further. Monetary policy becomes ineffective at that point. The discontinuity at zero interest rate is crucial since then only fiscal policy can impact aggregate demand. Fiscal policy is still effective because it does not work through the interest rate. It depends on direct government increase of aggregate demand.

178  What Is Macroeconomics?

Figure 10.5  The Interest Rate Charged by the Federal Reserve Source: Federal Reserve Bank of St. Louis, Series FEDFUNDS.

Out of frustration, the Fed tried new policies after 2008 to stimulate the economy, known as “quantitative easing” (QE) hoping thereby to overcome the limitation of the zero lower bound. QE is merely a euphemism for money creation. It sounds more neutral and less worrying to the public. Through this expansionary monetary policy, the Fed pumped trillions of dollars into the financial sector by purchasing assets, including bonds of commercial firms and mortgage-backed securities, hoping that this would induce banks to invest more freely in the economy. However, that remained wishful thinking as QE led primarily to an inflation of asset prices rather than to investments in the real economy, as banks invested in the stock market. However, investment in the real economy continued to flounder because of the weakness in aggregate demand. Monetary policy was ineffective, although Bernanke increased the Fed’s holdings from $900 billion to $4.5 trillion or by a factor of five (Figure 10.6). In just one week after the collapse of Lehman Brothers on September 15, 2008, Bernanke increased the assets of the Fed by $300 billion, and by the end of October the increase was an amazing $1 trillion. So, within five weeks he had doubled the assets of the bank pouring an unprecedented amount of money into the banking system. He expanded the money supply in three waves. While QE1 was quite necessary to stabilize the imploding financial system, QE2 and QE3 did not have the awaited impact. GNP continued to grow, to be sure, but there was no evidence that the monetary expansion impacted output (Figure 10.6). Bernanke’s leaning against the Keynesian liquidity trap was mere wishful thinking—like pushing on a string.

Neoclassical Synthesis After World War II, Keynesian economics became dominant through the neoclassical synthesis popularized by Paul Samuelson. The synthesis was the basis of mainstream economics

What Is Macroeconomics?  179 55,000

4,500

50,000

4,000

QE3

3,500

40,000

3,000 2,500

35,000

QE2

2,000 1,500

30,000

QE1

25,000

1,000 500 36,500

45,000

GNP per capita

Assets Billions of Dollars

5,000

20000 38,500

40,500

Total Assets, Federal Reserve

42,500 GNP per capita

Figure 10.6  Quantitative Easing and GNP Per Capita Source: Federal Reserve Bank of St. Louis, Series WALCL and A791RX0Q048SBEA.

between circa 1950 and 1980, combining Keynesian macroeconomics with neoclassical microeconomics. It assumed the existence of Homo oeconomicus at the microeconomic level but not at the macroeconomic level. In this framework, individuals are assumed to be rational (and to maximize utility) when it comes to consumption, but at the aggregate level markets do not adjust as smoothly as in the neoclassical model.6 For instance, the price of labor is not as flexible as prices in the product market. As a consequence, there can be involuntary unemployment in the Keynesian model: wages fail to adjust within the relevant time frame as they would in the standard demand and supply analysis. They can be above the equilibrium wage for an extended period. Hence, this synthesis was incoherent because the microeconomic section remained neoclassical, while in the macroeconomic section employees were not well informed about the price level and hence their real incomes. One of the key ideas of Keynesian macroeconomics was the “Phillips curve,” which postulated that there was a trade-off between unemployment and inflation.7 When inflation increased unemployment decreased and when inflation decreased unemployment increased. According to this theory, as prices rose, the real wages of workers declined, but they were willing to continue to work for the same nominal wage because they were not well informed about the price index. This is called “money illusion.” Firms benefited because they knew that they were receiving higher prices for their products, but their wages bill remained unchanged. Thus, their profits rose, inducing them to expand production and hire more workers at the same nominal wage. Because of money illusion, they continued to work for the same nominal wage even though their real wage was declining. However, it should have been clear that money illusion would not last forever. After a while workers signed new rent contracts for their apartments or bought a new car that made

180  What Is Macroeconomics? them realize that their nominal wages had eroded. So the Phillips curve depended on the context and worked only in the short run and—as Milton Friedman famously argued—money illusion could not go on forever. Eventually workers would realize that their real wages were eroding and therefore would demand higher nominal wages, thereby erasing firms’ profits. Inflation cannot create jobs permanently. This is exactly what happened in the 1970s when an extended period of inflation was accompanied by unemployment and a period of “stagflation.” The price level doubled between 1973 and 1981 and unemployment also doubled from 5% to 10%, the opposite of the Phillips curve’s prediction. This was a major conundrum for Keynesian economics, but of course, there was nothing in the model that would imply that the Phillips curve was valid during such a rapid sustained inflation. When prices were increasing so rapidly for so long, workers would not be subject to money illusion. So, context matters. Nonetheless, as a consequence of this experience in the 1970s, Keynesian policies fell out of favor and the dominance of neoclassical macroeconomics began.

The Monetarist Counterrevolution There were five elements in Keynesianism that were anathema to neoclassical economists. The key objections were that (a) Keynes’s theory was not conceived (from the bottom up) on classical microfoundations; the theory was not based on rational economic agents; money illusion, sticky wages did not fit into mainstream microeconomics; (b) it prescribed too large a role for government, thereby appearing to limit individual freedom; (c) it suggested that the amount of money mattered to aggregate output whereas the classical school contended that money played a passive role by determining only the price level but not real output; (d) it assumed that people were not always rational, that consumption was influenced by emotion, i.e., optimistic or pessimistic moods; and (e) it was not a perfectly-competitive equilibrium model: markets existed which included wages that did not adjust sufficiently to demand conditions. These five points provoked a monetarist backlash that came to a head with the stagflation of the 1970s. While the Keynesians were analyzing aggregate economic behavior starting with economy-­wide variables such as total output, unemployment rate, and aggregate demand, Keynes’s detractors were intent on beginning the analysis with individuals and arriving at these variables by aggregating them from the bottom up—all the time maintaining the fiction of rational utility maximizing economic agents. This group—the real-business-cycle school—begins its inquiry by specifying standard microeconomic foundations of aggregate behavior. They assume that everyone in the society can be represented by a single person, a representative agent—an odd assumption to make for those who assert in other sections of their textbook that utility functions cannot be compared because everyone is different. In any event, as far as neoclassical macroeconomics is concerned, everyone is supposed to be the same. For several decades before the Meltdown of 2008, mainstream macroeconomics was dominated by this school. However, they have shown the utter emptiness of their theories by having absolutely nothing relevant to say about either the financial crisis or its aftermath.8 Its proponents neither warned us of the coming of the crisis nor were they able to prescribe

What Is Macroeconomics?  181 remedies on how to extricate ourselves from its anaemic aftermath. They are incapable of policy prescription, because such crises are not supposed to occur in their framework. According to these models, the economy and all of its component markets are always and everywhere in perfect equilibrium except if technological change surprises people. Otherwise, aggregate demand equals aggregate supply, and prices adjust instantaneously to bring the two into line.9 There is no unemployment by definition just random changes in some real variables such as technology that at times perturb the simple system. According to their logic, some can choose not to work because they prefer to watch television rather than flip hamburgers at McDonald’s, but that is their choice. It is a free country. Moreover, the financial sector as well as debt, public or private, were absent from these models. They are convinced that methodological individualism is the right way to analyze the macroeconomy and contend that the representative agent—a Homo oeconomicus—is the essential unit of analysis rather than higher-level units such as the society as a whole.10 However, such fantasy models defy commonsense. Can one individual really represent the 323 million people in the U.S. economy?11 With a single individual representing the whole economy, the problems associated with the distribution of income, animal spirits, or with financial panics cannot be included.12 It takes a lot of hubris to build an axiomatic framework around such propositions.13 The analysis of macroeconomic phenomena assuming that the society is a collection of identical individuals without interaction effects is known as the “fallacy of composition,” or the “aggregation problem.” What is true for the one individual is not necessarily true for the society.

A Macroeconomic Policy Void As a consequence of the above ideological schism, macroeconomics is in intellectual disarray.14 The utter inadequacy of macroeconomic theories is illustrated vividly by the news conference held at Princeton University to honor Christopher Sims and Thomas Sargent who had just received the 2011 Nobel Prize for their work on macroeconomics.15 A reporter asked them their “opinion about what the government has done so far in the United States to support the economy. If you think it has been appropriate. How can we actually support the economy, create jobs? You know those questions everybody [is] asking themselves.” Their response, after a prolonged nervous laughter during which the two scholars looked at each other seemingly amused, indicated all too clearly that these two macroeconomists were clueless about the application of economic policy off the blackboard. Sims finally said: I think part of the point of this prize and the area that we work in is that answers to questions like that require careful thinking, a lot of data analysis, and that the answers are not likely to be simple. So that asking Tom and me for answers off the top of our heads to these questions is . . . You shouldn’t expect much uh from us [Laughter].16 To which Sargent boldly added: “I don’t have much to add to that . . . I was hoping you’d ask me about Europe [Laughter].”

182  What Is Macroeconomics? Great fun! Four years into the most severe economic crisis in 80 years, two Nobel Prize winning macroeconomists had not yet had enough time to think about solutions to the problems confronting the nation and were unable to respond cogently and coherently “from the top of their heads.” They had nothing substantial to say. They were lost outside of the classroom. Instead, the best they could do is to trivialize a crucial and very serious issue. This is indicative of the confused state of macroeconomics at the beginning of the twenty-first century. Macroeconomics has been in disarray for some time, but the Meltdown of 2008 and its aftermath demonstrated vividly that in the absence of a consensus within the elite of the economics profession there cannot be effective government policy. The macro-quants have dominated the field using dynamic stochastic general equilibrium models. As the name implies, these are highly abstract, computer-driven, complex mathematical models far removed from reality. They work well on the blackboard, but because of their abstract nature they have been useless for policy purposes. The critiques point to the unrealistic “mathiness” of these models.17 Joseph Stiglitz, describes the staggering shortcomings of the fantasy world these models create this way: “the heart of the failure [of macroeconomics] were the wrong microfoundations, which failed to incorporate key aspects of economic behaviour.”18 Others suggested that these models “may have set back by decades serious investigations of aggregate economic behaviour and economic polity-relevant understanding. It was a costly waste of time and resources.”19 These brilliant mathematical analysts left out so many attributes of the real world that they were merely playing intellectual computer games without much relevance to the actual economy. As Stiglitz suggests, they failed to incorporate: [i]nsights from information economics and behavioural economics. Inadequate modelling of the financial sector meant they [the models] were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant they were ill-suited for analysing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality. Another critique suggested that: [i]t is as if the information economics revolution, for which George Akerlof, Michael Spence and Joe Stiglitz shared the Nobel Prize in 2001, had not occurred. The combination of assumptions, when coupled with the trivialisation of risk and uncertainty . . . render money, credit and asset prices largely irrelevant . . . [they] typically ignore inconvenient truths.20 With such a disarray, politicians are free to pick the economist who suits their ideology, thereby fueling the political dysfunction and contributing to the deep anxiety within the population. During the debate over the tax bill of 2017 conservative economists supported the bill and progressives strictly opposed it, adding to the confusion.21 We would need a new Keynes for our times. While Keynesian policies made a brief comeback during the early phases of the 2008 crisis, they turned out to be politically unsustainable

What Is Macroeconomics?  183 and fell out of favor yet again. The real-business-cycle school is silent. So we are left with short-term palliatives like Bernanke’s printing press, Trump’s lower taxes, and a lot of wishful thinking that these measures will jumpstart an economic boom that for a change will trickledown to the middle class. They won’t, and the medicine will turn bitter when the burden of servicing the national debt increases. The upshot is that we need to think about new macroeconomic perspectives. The German, Scandinavian, or Swiss models of capitalism might well be a good place to start thinking about a new form of Keynesianism for our time, as their economies are still characterized by the virtues of discipline, thrift, concern for the environment, free college education, universal health care, less inequality, a more vibrant democracy, with a sprinkling of the old-fashioned Protestant ethic.22 Underemployment there is not a problem, the social safety net is tighter, people are less anxious and are able to lead a more dignified life. Instant gratification, greed, debt, and lower taxes in the U.S. will not be able to provide the political, social, and economic stability that we crave. What the U.S. needs is universal health care and universal college education because educated healthy people are more productive, cause fewer social problems, and lead a more satisfied life. By not providing for adequate educational opportunities for all the U.S. is wasting an incredible amount of human resources. Such waste is a blatant contradiction for a society that prides itself on efficiency. We can just imagine what an impact the $1.5 trillion would have had for the long-term growth of the U.S. economy if spent on education instead of tax cuts.

GNP Is an Estimate of Production and Not of Welfare GNP is the total amount of goods and services produced in the economy. While it is a useful indicator of productivity, when used as a measure of welfare it is misleading because the welfare generated by GNP depends on its distribution. Moreover, production also includes products that detract from welfare, such as pollution, which is not subtracted from GNP.23 We do not charge for carbon dioxide emissions into the atmosphere. Officially, the Gulf oil spill increased GNP rather than diminished it. A correct accounting of GNP would deduct the value of environmental degradation. Consequently, products that pollute are mispriced, implying that all products are mispriced, and consequently GNP estimates are inaccurate. Other factors also lead to errors such as health care, which was 18% of U.S. GDP in 2016. The system is inefficient compared to Western Europe, because its administration is so much more convoluted and imposes substantial transaction costs. So immense amounts are wasted but they nonetheless add to GNP. The wasted dollars do not increase welfare of the sick. How does health care improve welfare? Suppose I am healthy and have a welfare index of 100. Then I catch an infection so my welfare decreases to 70. So I see a doctor and pay the $20 co-pay and buy the antibiotic for $30. My health improves and welfare swings back to 100. My spending $50 increased GNP by an equal amount, but my welfare has not increased. Rather, it was restored to what it was before my infection. This is another reason that GNP and welfare differ.

184  What Is Macroeconomics? Table 10.1  Increase in Disposable Income of U.S. Households by Quintiles, 1979–2011 Quintile

Increase

0–20% 20–40% 40–60% 60–80% 80–100% Top 1%

2011 Dollars 2,700 1,200 2,900 11,600 69,000 599,000

Source: Table 7.5 in Chapter 7.

The fashion industry has a similar effect. The infection reduced my welfare, while a new style of clothing similarly reduces my welfare: it devalues the clothing that I already possess as I no longer appear up-to-date. When I buy the new styles GNP increases, but my welfare is merely restored to the level that prevailed before the new style became fashionable. GNP increased but welfare did not. Consider that pre-term births cost ten times more than full-term infants; they added $26 billion to U.S. GNP in 2010 and have increased by one-third since 1980. Yet, it is absurd that phenomena associated with harm and the lack of precautionary measures increased GNP and makes it appear as though welfare has also increased.24 In addition, average growth rates obscure the rise in inequality. The benefits of GNP growth have accrued almost entirely to the top 1% of U.S. households, whose incomes increased by $600,000 between 1979 and 2011 (Table 10.1). In contrast, the income of lowermiddle-class second quintile increased by a negligible $1,200 in the same period. In short, despite all the hype about economic growth, a substantial segment of the U.S. population has not benefited from growth for more than a generation.25 The implication is that average growth rates are a misleading measure of welfare of the typical person. Household production is excluded from GNP, which includes only paid market activity. As long as we focus on GNP, all the important unpaid activity that takes place within families, from child rearing to meal preparation, is disregarded. However, work within the household does enhance welfare. Yet, the emphasis on GNP growth is a central tenet of our culture even though we have been growing for years without increasing the subjective life evaluation of people.26 Our focus should be to increase the life satisfaction, a more difficult project. Unfortunately, the standard of living is not even discussed in mainstream textbooks, although it is among the more important concepts in economics.

Production Possibilities Frontier The production possibilities frontier (PPF) describes the maximum quantity of goods that can be produced efficiently in an economy with the given amount of resources, know-how, technology, labor, effort, and human as well as physical capital. However, the concept is ambiguous insofar as the maximum depends on factors that are flexible—effort, labor force participation rate, and cultural norms. For example, during World War II the mobilization of

What Is Macroeconomics?  185 female labor increased the amount of goods the economy could produce. The PPF shifted out because patriotism induced women to enter the labor force. Similarly, the cultural change that induced more women to participate in the labor market beginning in the 1970s increased the PPF substantially, inasmuch as market-produced goods were substituted for home-produced ones and the latter are not considered in GDP. The PPF also depends on the prevailing laws. Prohibition of child labor, for instance, shifts the PPF inward in the short run and increases it over time as the children’s education increases their productivity. In short, the PPF is by no means a concept carved in stone. The economy is supposedly producing efficiently if it is producing on its PPF. However, that is hardly ever obtained except in times of war as there are always unemployed resources in a modern economy. With chronic unemployment of both labor and capital, the concept of PPF loses its significance. In February 2018 the underemployment of labor was around 8%, while factories were producing at 78% of capacity (Figure 10.7).27 That means that 22% of the capital stock in the private sector was unemployed, implying that we are not producing as much as our resources would allow—as at point P(1) in Figure 10.8. In other words, at P(1) production is inefficient as it is inside the PPF because of underemployment and lack of aggregate demand. Institutions and cultural factors can also impede the economy from reaching the PPF. Laws, for instance, can impose inefficient structures on firms in the health care industry, which implies that a segment of the PPF curve is unattainable because of institutional constraints such as at P(2). At P(1) the institutional constraint is not binding: the constraint does not affect production. However, at P(2) the institutional constraint is binding and the efficient level of production is unattainable. Examples of institutional constraints include the

Figure 10.7  Capacity Utilization All Industries Source: Federal Reserve Bank of St. Louis, FRED, series TCU.

186  What Is Macroeconomics?

Figure 10.8  Production Possibilities Frontier with Institutional Constraint

organization of the medical system (Chapter 9). Breaking the stranglehold of the American Medical Association and of big Pharma would remove these institutional constraints, thereby allowing the economy to grow toward its PPF.

Notes 1 John Maynard Keynes, A Tract on Monetary Reform (London: Macmillan, 1923), p. 80. 2 In Keynes’s own words, “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our . . . activities depend on spontaneous optimism . . . Most, probably . . . our decisions to do something . . . [are] the result of animal spirits—a spontaneous urge to action rather than inaction,” John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), pp. 161–162. 3 There are two murders per day in places of work in the United States. “Violent workers today are triggered by losing their jobs,” Dan Fastenberg, “Workplace Violence: Is the Recession Inspiring Worker Rage?” AOL Jobs, August 3, 2012. Reuters, “Workplace Shooting Leaves 5 Dead in Minnesota,” AOL Jobs, September 28, 2012. 4 Mark Zandi, “A Second Quick Boost from Government Could Spark Recovery.” Testimony before the U.S. House Committee of Small Business, July 24, 2008. Christina Romer and Jared Bernstein also argue for a multiplier of similar size in “The Job Impact of the American Recovery and Reinvestment Plan,” January 8, 2009. www.economy.com/mark-zandi/documents/The_Job_Impact_of_the_

What Is Macroeconomics?  187 American_Recovery_and_Reinvestment_Plan.pdf. Paul Krugman accepts 1.5 as the fiscal multiplier in “Multipliers and Reality,” The New York Times, June 3, 2015. 5 M1 is currency+demand deposits; M2, another measure of the money supply, includes savings deposits and money market deposits. 6 Bruce C. Greenwald and Joseph Stiglitz, “Externalities in Economies with Imperfect Information and Incomplete Markets,” Quarterly Journal of Economics 101 (1986): 229–264. 7 Irving Fisher, “A Statistical Relation Between Unemployment and Price Changes,” International Labour Review 13 (1926) 6: 785–792; reprinted in the Journal of Political Economy 81 (1973) 2: 496–502. 8 In his Nobel Prize lecture, “A Statistical Modeling of Monetary Policy and its Effects,” of December 8, 2011, Christopher Sims admits as much: “The recent financial crash and recession was not predicted by the DSGE models.” DSGE models are real business cycle model. www.nobelprize.org/nobel_prizes/ economic-sciences/laureates/2011/sims_lecture.pdf. 9 In some “New-Keynesian” real-business-cycle models, prices adjust slower. 10 George Akerlof, “Behavioral Macroeconomics and Macroeconomic Behavior,” American Economic Review 92 (2002) 3: 411–433. 11 Christopher Carroll writes, “Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science,” Christopher D. Carroll, “Punter of Last Resort,” VoxEu, March 13, 2009. 12 George A. Akerlof and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton, NJ: Princeton University Press, 2009). 13 Lawrence Summers, “Some Skeptical Observations on Real Business Cycle Theory,” Federal Reserve Bank of Minneapolis, Quarterly Review 10 (1986) 4: 23–27. 14 “Economists Still Lack a Proper Understanding of Business Cycles,” The Economist, April 19, 2018. 15 Princeton University, “Princeton News Conference with Nobel Prize in Economics Winners Sims, Sargent,” YouTube @ 14:11 minutes. www.youtube.com/watch?v=bVIOClT4Rws. 16 To which he added the mundane observation: “My own view is that what we ought to do is the kind of thing that Chairman Ben Bernanke urged the U.S. government to do: make good long-run plans for resolving our budget difficulties without imposing severe fiscal stringency in the short run and accommodating monetary policy is a good idea. But these are not very original ideas.” Obviously . . .  17 Paul Romer, “Mathiness in the Theory of Economic Growth,” American Economic Review: Papers & Proceedings 105 (2015) 5: 89–93. 18 Joseph Stiglitz, “Where Modern Macroeconomics Went Wrong,” National Bureau of Economic Research, Working Paper No. 23795, September 2017; published in Oxford Review of Economic Policy 34 (2018) 1–2: 70–106. 19 Willem Buiter, “The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics,” Vox, CEPR’s Policy Portal, March 6, 2009; David Hendry and John Muellbauer, “The Future of Macroeconomics: Macro Theory and Models at the Bank of England,” Oxford Review of Economic Policy 34 (2018) 1–2: 287–328. 2 0 John Muellbauer, “Household Decisions, Credit Markets and the Macroeconomy: Implications for the Design of Central Bank Models,” Bank for International Settlements Discussion Paper 306, March 2010. 21 Patricia Cohen, “Who Gains from the Tax Plan? Economists Face Off,” The New York Times, December 1, 2017; “An open letter to Congress signed by 137 economists supporting GOP tax reform bill,” CNBC, November 29, 2017. James Galbraith, “What Trump’s Tax Cut Really Means for the US Economy,” Project Syndicate, January 19, 2018; Robert Barro, “How US Corporate Tax Reform Will Boost Growth,” Project Syndicate, December 13, 2017; Jason Furman and Lawrence Summers, “Robert Barro’s Tax Reform Advocacy: A Response,” Project Syndicate, December 15, 2017; Simon Johnson, “America’s Tax-Cut Peronists,” Project Syndicate, October 31, 2017. Martin Feldstein, “Cutting US Corporate Tax Is Worth the Cost,” Project Syndicate, November 27, 2017; Joseph Stiglitz, “The US Donor Relief Act of 2017,” Project Syndicate, January 2, 2018. 2 2 Only 7.4% of transactions in Germany are paid by credit cards and two-thirds of Germans don’t even have a credit card. Tom Fairless, “Germans Warm to Credit Cards—Slowly,” The Wall Street Journal, October 17, 2012. 23 The Allocation of Economic Resources (Stanford, CA: Stanford University Press, 1959).

188  What Is Macroeconomics? 24 Christopher P. Howson, Mary V. Kinney, and Joy E. Lawn, eds., Born Too Soon: The Global Action Report on Preterm Birth (Geneva: World Health Organization, 2012). 25 This pattern obtained even though more people were working in 2004 than in 1979. In 1979, 64% of the population was working, while in 2004, 66% was. U.S. Department of Labor, Bureau of Labor Statistics, “Labor Force Statistics from the Current Population Survey,” Series ID: LNS11300000. 26 Gallup, “What Happiness Today Tells Us About the World Tomorrow,” 2017. 27 Federal Reserve Bank of St. Louis, series U6RATE and TCU. Textile product mills are at 58% of capacity. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release, G.17 (419) Supplemental Tables, August 15, 2012.

11 Macroeconomics Part II

When my information changes, I alter my conclusions. What do you do sir? John Maynard Keynes1

We begin with an extensive discussion of the labor market, which has such a big impact on our lives. We suggest that the organization of the labor market is unfair because the available work is distributed unevenly: some people work 70 hours weekly while others are completely excluded.

Unemployment and Underemployment The official unemployment rate is misleading because: (a) it considers those part-time workers who would like to work full-time but cannot find a full-time employment as “employed.” It thereby conflates full-time with part-time workers which is inaccurate; (b) persons are only considered officially unemployed if they looked for a job during the last four weeks. This is restrictive and makes the unemployment rate appear less than it actually is. The real unemployment rate should count the involuntary part-time workers as half unemployed (they work about 20 hours weekly). A more realistic measure of nonemployment would include those who have not looked for a job recently because they have been so discouraged by prior failures that they are no longer capable—psychologically or financially—to put up with the frustrations of searching. Officially 6.7 million people were unemployed in January 2018 or 4.2% of the labor force (Table 11.1, row 6; Figure 11.1). However, 5 million of the 27.3 million part-time workers would have liked to work full-time2 (18.3%) (Rows 5 and 7). So we consider them half unemployed and add 2.5 million to the unemployed (Row 7). Furthermore, there were 1.6 million people who were considered “marginally attached to the labor force.” Although, they have not looked for a job within the last four weeks, they would like to work and have searched within the last 12 months.3 They added 1% to the true unemployment rate (Row 8). Furthermore, 3.3 million people (2.0 %) would like to work but have not searched even within the past year (Row 9).4 They are not even “marginally attached” to the labor force according to the statisticians. These contributed to the dropouts from the labor force reported in Row 9. Many of these dropouts were between the ages of 25 and 54, in their prime: they have finished school and are not yet retired. Yet, since 1998 no less than 3% of this age group—close to 5 million adults—has dropped out permanently of the labor force.5

190  Macroeconomics Part II Table 11.1  The Official and Real Unemployment Rate in the U.S., January 2018 Millions   1 Adult population 2 Civilian labor force 3 Employed 4 Full-time 5 Part-time 6 Unemployed (Official)   7 Part-time involuntary 8 Marginally attached 9 Want job, did not look 10 Real Unemployment 11 Hidden Unemployment

Percent

256.8 161.1 154.4 127.1 27.3 6.7 2.5 1.6 3.3 14.1 7.4

5.0

62.7% 95.8% 82.3% 17.7% 4.2% 1.6% 1.0% 2.0% 8.6% 5.5%

Source: Bureau of Labor Statistics, Table A-1. Employment Status of the Civilian Population by Sex and Age; Table A-8. Employed Persons by Class of Worker and Part-Time Status; Table A-15. Alternative Measures of Labor Underutilization; series LNS15026639.

Thus, there were 14.1 million people who were truly unemployed or 8.6% of the labor force (Table 11.1, Row 10).6 That is twice the official rate, hiding some 7.4 million people (Row 11). Full employment seems out of sight even if Martin Feldstein claims the opposite.7 This makes it clearer why wages have not been rising in a supposedly low-unemployment environment: hidden unemployment (not reported in the official statistics) keeps pressure on wages. The situation is worse among minorities, In May 2017 the official unemployment rate among blacks—usually twice that of whites—was still at 7.5%, but their underemployment rate was at 14.6%, which reflects much better their real pain.8 The underemployment rate among Hispanics was 12.5%.

Figure 11.1  The Official Unemployment Rate and the Official Underemployment Rate Source: Federal Reserve Bank of St. Louis, FRED, series UNRATE and U6RATE.

Macroeconomics Part II  191

25% 23% 21% 19% 17% Black

15% 13%

Hispanic

11% 9%

White

7% 5% 1990

1995

2000

2005

2010

2015

Figure 11.2  Official Underemployment Rate (U6) by Ethnicity Source: Economic Policy Institute. www.epi.org/data/#/?subject=underemp&r=*.

The Bureau of Labor Statistics does publish a more accurate unemployment rate that it euphemistically calls the “Alternative Measure of Labor Underutilization” or “U6” (Figure 11.2). However, it is less well known and is still low as it reported only 8.2% underemployed, 0.4% below the estimates in Table 11.1. Yet, even Table 11.1 leaves out 2.3 million incarcerated persons although they were not working. They would increase nonemployment to 16.4 million or 9.8% of the labor force.9 In other words, the official statistics are inadequate. Moreover, 21% of the official unemployed have been without a job for more than half a year.10 The median duration of unemployment was 9 weeks and the average was 23 weeks. Yet, those who do have full-time jobs work an average of 46.7 hours weekly and 39% work more than 50 hours.11 In contrast to the unemployed, there are 7.5 million people who held two jobs.12 And Americans work 400 hours more annually than their Western European counterparts, even though U.S. incomes are higher and one would think that they would be able to afford to work less.13 Thus, it is puzzling that at a time of endemic and extensive underemployment, many U.S. workers are overworked, working nearly as much as in 1960s and struggling with work-life balance.14 Keynes was wrong in thinking that his grandchildren’s generation would be working 15 hours per week.15 With higher incomes one would expect people to enjoy more leisure, since leisure is a normal good.16 The main reason why they do not is that people work harder just to “keep up with the Joneses” in competition for status.17 Therefore, the available amount of work—like wealth and income—is also unevenly distributed.18 Part of the problem lies in the organization of the labor market: fluctuations in the demand for workers bring about adjustments in which workers are dismissed, causing their labor time to fall suddenly from 40 hours to zero. We call this institution a binary labor market: one either has a job or one does not. Would anyone in their right mind design a rigid system with such extremes—with working times ranging from 0 to 70 hours per week—if they

192  Macroeconomics Part II were to design it from scratch, “behind a veil of ignorance” not knowing if they would end up among the ranks of the overworked or those of the underemployed? Risk-averse people would be too apprehensive about ending up among the group that loses their job periodically. It would be much more equitable to have the adjustment occur in the number of hours worked so that instead of laying off workers, the available work would be divided among the labor force. A work-sharing program would be a much more flexible shock absorber of fluctuations in the demand for labor.19 We could thereby eliminate the very concept of unemployment.20 Instead of accepting underemployment as normal, we could reduce the number of hours worked by everyone by roughly an hour a day from eight to seven. Given that the underemployment rate is 8.6%, a reduction of work hours by 40 minutes a day would distribute the available work more equitably.21 Such a system would also increase the quality of life, because it would reduce the psychological burden of unemployment, increase leisure time, and reduce envy by reducing conspicuous consumption. In addition, it would be a much fairer method of distributing the pain of the economic rollercoaster than the prevailing binary system. Profit-sharing wages would also diminish underemployment. Wages would increase in good times and decrease in downturns, so that workers would not have to be fired, keeping the share of total wages in revenue unchanged.22 Cooperatives are also less likely to fire members. Instead, they adjust pay to fluctuations in demand.23 Another possibility is for governments to become the employer of last resort just as central banks have become the lender of last resort.24 No reason to confine government’s role to maintaining only the stability of the financial sector. Labor market stability and real full employment, should also be put on the agenda.25 In sum, one could introduce different shock absorbers into the system instead of the crude binary one. It would be much more reasonable to distribute the burden of cyclical economic downturns more equitably than concentrating it among 14 million people. Full employment would also be better than the basic income policy advocated by some, because it would gain wider support among the electorate.26 Unemployment has many adverse side effects such as an increase in criminality and in stress. It has a destabilizing effect on society both politically and socially. For example, arguably, the Nazis might never have come to power if unemployment had not reached onequarter of the labor force in Germany. Work is also important from a psychological perspective: the unemployed are excluded from the labor market and therefore feel degraded and unwanted. They do not consider themselves useful members of society and lose self-esteem. Their skills depreciate over time so that they become unemployable. In other words, unemployment increases misery. The underemployed are twice as likely to be sad or depressed as the employed and 50% more likely to be angry.27 They are also more likely to be struggling financially (54%) than the employed (38%). Thus, the lack of full-time jobs is a huge burden and also for dependents and for the community. Moreover, it is not distributed evenly either spatially or across ethnic groups. Rather, whole neighborhoods, towns, and regions are affected, and minorities are especially disadvantaged.

Macroeconomics Part II  193

The Natural Rate of Unemployment Economists consider the natural rate of unemployment the minimum level of unemployment attainable without accelerating inflation, given the institutional aspects of the labor market. These structural characteristics include the cost of searching for a job or the time needed to find a match between suppliers and demanders of labor. Theoretically, a lower rate of unemployment would be possible temporarily but at a cost of increasing the rate of inflation, and in the long run unemployment would return to its “natural” level at a higher inflation rate. Thus, it would be futile to use monetary or fiscal policy to force the unemployment rate below its natural rate. It would only lead to inflation. Thus, the natural rate of unemployment is the non-inflationary equilibrium in the labor market, according to conservative economists such as Ben Bernanke or Martin Feldstein, who confidently refer to 5% level of unemployment as “full employment.”28 At the January 2016 meeting of the American Economic Association in San Francisco, Feldstein declared that “Fortunately, the U.S. economy is now in very good shape. We are essentially at full employment with the overall unemployment rate at 5%.” Ten months before Trump’s triumph, he neglected the frustration of the underemployed masses. Thus, 5% unemployment must be tolerated since it is inevitable.29 That makes the natural rate of unemployment a disingenuous concept; it merely rationalizes the inability of the labor market to provide jobs for everyone.30 It does not allow for the possibility that new institutions and policies could be created to achieve real full employment; it is a natural phenomenon inherent to the economy. Moreover, the Federal Reserve arbitrarily increases the natural rate in times of high unemployment and lowers it when times are good (Figure 11.3). It was as high as 6.2% and

Civilian Unemployment Rate Natural Rate of Unemployment (Long-Term) 11 10 9

Percent

8 7 6 5 4 3 2 1950

1960

1970

1980

1990

2000

2010

Figure 11.3  The “Natural” Rate of Unemployment Compared to the Official Unemployment Rate Source: Federal Reserve Bank of St. Louis: Series NROU and UNRATE.

194  Macroeconomics Part II as low as 4.7%. Inexplicably, the official unemployment rate has been below the natural rate since March 2017. In May 2018 the official unemployment rate (3.8%) was 0.9% below the supposed natural rate of unemployment of 4.7%. And yet, accelerating inflation was nowhere in sight.31 How can we be below full employment? That invalidates the concept of the natural rate of unemployment, or the official unemployment data, or most likely both. To be sure, it is clear that unemployment cannot be eliminated entirely or even lowered permanently using monetary policy. However, our goal should be to create new labor-market institutions that will eliminate unemployment. In the age of the information technology revolution it ought to be possible to match vacancies to willing workers instantaneously, thereby eliminating frictional unemployment. The government could subsidize the cost of searching and relocating for a job and provide reskilling as needed. Moreover, if the above-mentioned work-sharing and profit-sharing strategies are adopted along with the government’s taking on the task of being the employer of last resort, we would be able to eliminate underemployment in its entirety. We do not have to accept 5% unemployment as natural. After all, the UN’s Universal Declaration of Human Rights states that, “Everyone has the right to work . . . and to protection against unemployment.”32 It is time to implement that right.

Economic Growth Economic growth has been an important goal of macroeconomic policy. Insofar as growth has been practically continuous in the West for 250 years—since the Industrial Revolution—it is a natural assumption that it will continue indefinitely as inherent capitalist development. However, there is no such economic law. Some argue that we have reached a stage of development such that further growth is superfluous.33 Whether growth will continue depends on how the factors that determine growth—­ capital, land, labor, and resources—evolve. New institutions and their ability to adapt to new circumstances are also important. The education of the labor force is crucial. Technological change, determined by the creativity, culture, entrepreneurship, and willingness to bear the risk of innovation, is also vital. The government plays an essential role since it provides infrastructure, the educational system, basic research, an essential public good. These are the ingredients of growth.

Economic Growth Does Not Increase Life Satisfaction We have been putting too much emphasis on growth without acknowledging—as discussed in the previous chapters—that it has not brought us the kind of Nirvana that we thought it would.34 In fact, it has disappointed because it did not raise our sense of well-being. Only 55% of the population considers itself thriving, while 42% are struggling and 3% are suffering.35 Moreover, survey research estimating subjective life satisfaction suggests that increases in income do not translate into life satisfaction if two conditions are met: (a) the income of the society meets basic needs and (b) average income also increases. However, increases in income increase life satisfaction for individuals living below subsistence, and if income increases relative to a benchmark such as the average. So, in rich societies increases in absolute income do not increase subjective well-being if average income rises proportionally also. Thus, if relative income does not increase, life satisfaction

Macroeconomics Part II  195 does not increase either. That is why average life satisfaction has not increased over time. However, if our social status improves, we do feel better. That is why richer people in a society are happier on average than poorer ones. Their income is higher relative to the average. The U.S. is 15th in the world ranking of happiness (Table 11.2). On the basis of its average income one would expect it to rank higher: only Norway has a higher per capita income than the U.S. on that list. It is noteworthy that all the countries above the U.S. on the happiness scale have universal medical care and have higher tax rates. Obviously, the security of the safety net means a lot to people. All four Scandinavian countries are in the top eight on the scale. Worry is not something that economists consider important, but it subtracts from our subjective evaluation of well-being. In the U.S. 32% of adults worried during “a lot of the day.”36 Thus, the Scandinavian welfare states are exemplary at providing for a thriving society that supports its members in need. This leads to the following assessment: [t]he United States has achieved striking economic and technological progress over the past half century without gains in the self-reported happiness of the citizenry. Instead, uncertainties and anxieties are high, social and economic inequalities have widened considerably, social trust is in decline, and confidence in government is at an all-time low. Perhaps for these reasons, life satisfaction has remained nearly constant during decades of rising Gross National Product (GNP) per capita.37 According to Peter Whybrow: It is the paradox of modernity that as choice and material prosperity increase . . .  personal satisfaction decline[s] . . . And yet it is the rare American who manages to step back from the hedonic treadmill long enough to savor his or her good fortune.38 Moreover, the life satisfaction of women relative to that of men has been declining in the U.S. since the 1970s, despite the women’s liberation movement and despite the rise in Table 11.2  Ranking of Happiness, 2012–2014 Rank 1 2 3 4 5 6 7 8

Rank Switzerland Iceland Denmark Norway Canada Finland Netherlands Sweden

9 10 11 12 13 14 15 16

New Zealand Australia Israel Costa Rica Austria Mexico U.S. Brazil

Source: John Helliwell, Richard Layard, and Jeffrey Sachs (eds.), World Happiness Report, United Nations, 2015. Source: Bureau of Labor Statistics, Table A-1. Employment Status of the Civilian Population by Sex and Age; Table A-8. Employed Persons by Class of Worker and Part-Time Status; Table A-15; Table 35. Persons Not in the Labor Force by Desire and Availability for Work, Age, and Sex. Federal Reserve Bank of St. Louis, Alternative Measures of Labor Underutilization; series LNS15026639.

196  Macroeconomics Part II women’s income.39 If absolute income were so important, why are today’s women not happier than prior generations?40 In sum, it is important to realize that growth is not the answer to our problems. Additional material goods advocated by Madison Avenue have rapidly diminishing returns. Rather, we need to feel good about ourselves and about our place in society, which we can only achieve if we are healthy (physically and mentally), have financial security with dignity, and nourishing personal relationships. We need to learn how to squeeze more happiness out of current income in order to catch up with the Scandinavian countries in life satisfaction (see Table 9.2 in Chapter 9).

Technological Change Is a Two-Edged Sword Economic growth is fueled by technological change, but not all of it is productive; they also hide destructive forces that detract from its benefits. Aldous Huxley’s Brave New World (1931) was among the early warnings of the dangers of technological change, dehumanizing effects, and unintended consequences.41 For instance, the recent wave of innovation with financial technology posed humongous systemic risks (negative externalities), as we belatedly found out. Innovation generally involves what Joseph Schumpeter called “creative destruction”— the new brings about the obsolescence of old technologies.42 Creativity is constructive but also destructive: progress creates winners and losers. Thus, innovation is never “Pareto efficient”—often leading to social dislocation.43 While mainstream economists argue against redistribution of wealth because it is not Pareto efficient, even if it would increase output, they nonetheless venerate technological change, even though it is also not Pareto efficient. This is another blatant inconsistency in mainstream canon. A major shortcoming of our economic system is that losers are not compensated by the winners, although it is not fair to have people benefit at others’ expense.44 Until we can create institutions that compensate the losers adequately, the economic system will not be able to improve life satisfaction, as technical progress is obtained at the cost of inflicting pain. A negative externality is inherent in creative destruction. If an innovation creates a new product valued at $10, but replaces an old one valued at $5, its contribution to GNP is not $10 but $5. While GNP is correctly measured, the appearance is that the innovation is more important than it actually is. Another kind of externality falls on consumers. For instance, a new generation of iPhones makes the previous version unfashionable and wrenches consumers out of their equilibrium. The fashion industry has similar properties. By creating and promoting new fashion, our current clothes are devalued. Buying the new just brings us back to our old level of welfare. We relieved the discomfort created by the new, but by buying the new we did not achieve a higher level of welfare than what we had before it came onto the market. So, a new product renders obsolete a consumption good that leads to an over-estimation of the welfare created by GNP, since it does not subtract from it the value of the product that was prematurely replaced. Furthermore, not all new products are actual improvements. Windows was a great technical achievement, but several subsequent versions such as Vista or Windows 8 were

Macroeconomics Part II  197 released mainly to enrich Microsoft and were not worthy improvements. This strategy of planned obsolescence is profitable for the firm because the quality of a new product is not immediately obvious. There are hidden qualities that are not apparent until one has some experience with it.45 Consider that tablet computers expanded to the detriment of laptop computers; Amazon replaced countless local bookstores as well as Borders, which in 2003 had more than 1,200 stores. Furthermore, the smartphone replaced simple cell phones and traditional cameras. The “selfie” replaced the “Kodak moment,” but Kodak employed 86,000 in 1998 and 145,000 at its peak (and paid them mostly middle-class wages), while in 2014, after emerging from bankruptcy, it has a skeleton workforce of 8,000.46 We live in a culture that venerates innovation while overlooking its destructive aspects including technological unemployment. The people hurt by technical change are often displaced workers who are unable to find employment in other sectors of the economy or have to take employment at a lower salary. Consider moreover, that Uber, founded in 2009 as a mobile ride request company, has a market capitalization of some $68 billion, which is greater than that of Ford Motor ($42 billion).47 Its success is based primarily on extracting economic rents generated in the taxi business. The gains in productivity associated with the firm are small, but it diminishes taxi drivers’ incomes. Net financial gains are slight and spread out over many consumers while the pain is great and concentrated among a few drivers. A driver earns only $9.20 per hour. Uber is not a job creator either. It accounts for merely 91,000 full-time equivalent workers.48 Pharma companies also try to extend their monopoly rents on their patented drugs in the guise of innovation. They protect their market share by patenting new ways to administer a known compound that can demonstrate some advantages such as reduced dosage or ease of use.49 Minor changes in formulations can also extend a drug’s patent as can new uses different from the one originally patented. Another creative defence of monopoly rents is to combine two drugs into one tablet and apply for a new patent. Such strategies have more to do with rent seeking than with Schumpeterian innovation.50 That is also ex-Federal Reserve Chairman, Paul Volcker’s, assessment of financial innovations: the only innovation that raised productivity was the automated teller machine, and that was designed in the 1960s in England by mechanical engineers and not on Wall Street.51 Oddly, in spite of the IT revolution, the productivity of the financial sector has not increased.52 The myriad of so-called financial innovations culminated in an immense “biteback” which threatened the global economy and had to be propped up with $7 trillion of support from the government in the U.S. alone.53 The developed world is threatened by technological unemployment unless far-reaching policies are enacted.54 Technological unemployment does not appear clearly in the official statistics, because people become so discouraged that they stop looking for work (Figure 11.1 and Table 11.1, rows 8 and 9). Because of new technologies, GDP growth has been decoupled from employment, insofar as firms substitute robot labor for human labor. Nearly a half of all U.S. employment is at risk.55 This is going to persist for the conceivable future.56 Perhaps we should start thinking about taxing robots. The iconic firms today employ far fewer people than their counterparts of yesterday. Apple employs 125,000; Google 72,000; Microsoft 120,000; Netflix 3,500; Amazon 341,000;

198  Macroeconomics Part II Twitter 3,600; eBay 12,600; Facebook 17,000.57 Altogether they do not employ as many as the U.S. automobile industry did (1 million) in the 1970s without even considering the 300,000 jobs in related industries.58 Amazon employment numbers stand out, but its employees are mostly low-wage warehouse workers at $12.40 an hour.59 Ford Motor Company was paying $15 per hour in 1914 (in today’s prices). In short, we need to make contingency plans on how to allocate the benefits of the economy.60 Fair and equitable distribution of available work should not be left up to happenstance. Technological change also creates negative externalities called “bite-backs”: “most technologies developed in the 20th century had unanticipated side effects, most of them negative,” says even Joel Mokyr who is otherwise optimistic about the effects of technology on productivity.61 Innovations such as DDT, chlorofluorocarbons, carbon fuels, leaded gasoline, fast food, asbestos, and lead-based paint all generated major negative externalities whose true costs were discovered long after they were implemented and therefore created an illusion of productivity increases. Mokyr continues, “It is thus now plain we have overestimated the productivity gains associated with technological change in the 20th century . . . This means the social costs of new techniques (as opposed to the costs captured in market prices) are systematically underestimated.”62 Such unanticipated costs are: [v]ery common; indeed, it is hard to come up with examples of a major breakthrough in technology in which it was not later realized that the accompanying “creative destruction” included some of the uncreative sort. Unfortunately, correcting national income calculations to account for such effects is difficult.63 Nonetheless, we should estimate such negative externalities including the impact of these “bite-backs” otherwise GNP estimates will continue to remain upwardly biased. The alleged misuse of social media platforms by Russian infiltrators to manipulate the 2016 U.S. presidential election is the most recent scary example of such a humongous biteback. Its apparent damage would be astronomical since it would undermine the foundations of our democracy using new technologies in unimagined ways with pernicious consequences. Facebook’s and Twitter’s contribution to GNP is therefore illusory. Equally scary is the unwillingness of Internet powerhouses Facebook, Google, and Twitter to devise adequate safeguards that might affect their bottom line, as is the reluctance of the government to defend our political institutions.64 This is a novel kind of technological servitude, the likes of which Huxley and Orwell warned us about.65

Missing Markets Missing markets pose an existential challenge to our welfare and that of future generations.66 No one owns the atmosphere, the oceans, the ecosystems, and, consequently, pollution and global warming have become a threat to the globe (Figure 11.4).67 They are public goods. Coastal regions, river deltas, small islands, and much of Florida are likely to be inundated.68 The sea level has risen in Norfolk, Virginia, by a threatening 14.5 inches, causing tidal flooding. The expenditures needed to protect the residents will be considerable.69 Future generations are unable to influence our decisions even though they will be affected by them.70 Moreover, the U.S. has been transferring a growing national debt onto

Figure 11.4  Global Warming NASA Goddard Institute for Space Studies. http://data.giss.nasa.gov/gistemp/graphs/, Public Domain, https://commons.wikimedia.org/w/index.php?curid=24363898.

Illustration 11.1  You Did Not Bleed on Omaha Beach on June 6, 1944. The Least You Owe to the Memory of Those Who Did Is to Leave the Earth as Nice as You Found It.

200  Macroeconomics Part II generations as yet unborn.71 These future generations cannot implore us not to live beyond our means at their expense.72 Those who advocate that “greed is good” fail to comprehend that it leads to disregard for the welfare of future generations.73 Ecological problems can lead to political and social tensions of tectonic-force proportions.74 Two hundred and fifty years after the Industrial Revolution, economic growth has brought us to a watershed. The free market is incapable of solving the ecological problem and incapable of caring for the welfare of generations as yet unborn.75 There are efforts to create markets to trade CO2 pollutants. Whenever the cost of pollution is not incorporated into the price system, markets are inefficient. Those who pay for the pollution are not compensated for it. The social cost of carbon emission is between $50 and $100 per ton, but currently CO2 emission into the atmosphere is free. That leads to uneconomic growth.76 So, markets, by themselves, produce too much pollution and too few public goods.77 It is unacceptable, for example, that the standard diagram of the circular flow of macroeconomic activity often pays little or no attention to the contribution of the environment to the economy.78 This is foolhardy, insofar as the contribution of the world’s ecosystem services and natural capital to the economy is both substantial and essential.79 One problem is that with fewer people having children in the developed world, fewer people care deeply about the plight of future generations. So, protecting the environment is becoming a more difficult task although the developed world could afford to clean up the environment. In addition, the incentive for any one individual to decrease the amount of pollution he or she is putting into the atmosphere is negligible. It has to be a collective effort.

Environment Extreme weather events have become more frequent and costlier in lives and destruction.80 In 2017 three hurricanes, Irma, Harvey, and Maria, caused $366 billion in damages and killed 300 people, making the year the most expensive disaster year on record.81 There were 16 disasters causing more than $1 billion in damages each. In 1980 there were only three disasters of comparable size. Superstorm Sandy—the largest Atlantic hurricane on record—killed 147 people and caused $75 billion in damages; Hurricane Katrina killed 1,836 and caused $108 billion in damages.82 The damages were not subtracted from GDP. On the contrary, all the expenditures to repair the damages were added to GDP. On the global scale, estimates of annual environmental damage run as high as 11% of the world’s GDP. It would be inexcusable to destroy this beautiful and unique habitat on earth. There are many other types of disasters: tornadoes, heat waves, floods, mud slides, wildfires, blizzards.83 Between 2000 and 2017, 3,631 people were killed by natural disasters in the U.S.84 The Fukushima nuclear disaster displaced 160,000 persons and will take 40 years to clean up. The Chernobyl nuclear disaster killed 4,000. The BP oil spill in the Gulf of Mexico in 2010 polluted 68,000 square miles of ocean with 175 million gallons of oil.85 The damage was not confined to the environment: 11 people perished, and the psychological toll was also substantial; the number of people with a clinical diagnosis of depression increased from a pre-spill level of 5.6% to 20.4% among coastal residents.86 We ignore this threat at our peril: as President Macron of France said, “There is no Planet B.”

Macroeconomics Part II  201

Notes 1 Reply to a criticism that he changed his position on monetary policy as quoted in Paul Samuelson, “The Keynes Centenary,” The Economist 287 (1983): 19. 2 The remaining 22.3 million part-time workers prefer not to work full-time because of other commitments such as school or family obligations. 3 Or actually did work within the past 12 months. U.S. Department of Labor, Bureau of Labor Statistics, “Glossary.” www.bls.gov/bls/glossary.htm#M. 4 This includes those who would like to work but have not looked for work within the last year. The marginally attached did look for work within the last year but not within the last month. Bureau of Labor Statistics, Table 35. Persons Not in the Labor Force by Desire and Availability for Work, Age, and Sex. The monthly data not seasonally adjusted are at www.bls.gov/web/empsit/cpseea38.pdf. See also Federal Reserve Bank of St. Louis, series NILFWJN. This series includes those in Rows 8 and 9. 5 Federal Reserve Bank of St. Louis, “Civilian Labor Force Participation Rate: 25 to 54 years,” https:// fred.stlouisfed.org/series/LNS11300060. 6 Rows 8–15 use the augmented labor force to calculate the percentages. It subtracts half of the 5 million part-time workers who would like to work full-time (Row 7) and adds those in rows 8 and 9 because the official labor force does not include them. So the size of the augmented labor force becomes 161.1−2.5+1.6+3.3=163.5. 7 “The U.S. Economy is in Good Shape,” Wall Street Journal, February 21, 2016. 8 Economic Policy Institute, “Underemployment by Race.” www.epi.org/data/#?subject=underemp&r=*; Bureau of Labor Statistics, “Employment Situation—May 2017;” It is revealing that the Bureau of Labor Statistics does not publish U6 by race; I suspect because of the inconvenient mirror it holds to the labor market. The Economic Policy Institute publishes it, however. So it is not well known. 9 The augmented labor force is used for this calculation that includes an additional 2.3 million in jail and 1.3 million people in the military: 163.5 +2.3+1.3=167.1 million. 10 U.S. Department of Labor, Bureau of Labor Statistics, “Table A-12. Unemployed Persons by Duration of Unemployment,” February 2, 2018. 11 Jena McGregor, “The Average Work Week is Now 47 Hours,” The Washington Post, September 2, 2014. Lydia Saad, “The 40-Hour Workweek is Actually Longer—by Seven Hours,” Gallup, August 29, 2014. Managers and professionals worked an average 45 hours per week in the 1990s, and the share working more than 49 hours was 38%. U.S. Department of Labor, Bureau of Labor Statistics, “Are Managers and Professionals Really Working More?” Issues in Labor Statistics, May 12, 2000. 12 4.5 million of them hold a part-time job in addition to their full-time employment, 2 million work two part-time jobs, 0.3 million hold two full-time jobs, and 1 million have variable hours on both jobs. U.S. Department of Labor, Bureau of Labor Statistics, “36. Multiple Jobholders by Selected Characteristics.” www.bls.gov/cps/cpsaat36.pdf. 13 Organization for Economic Cooperation and Development (OECD), “OECD Statistical Extracts.” The time worked by married couples combined increased by 11 hours within a generation at the end of the twentieth century from 56 to 67 hours per week. Bureau of Labor Statistics, “Working in the 21st Century.” www.bls.gov/opub/working/page17b.htm. 14 Juliet Schor, The Overworked American: The Unexpected Decline of Leisure (New York: Basic Books, 1993). “Average Usual Hours Worked on the Main Job.” https://stats.oecd.org/Index.aspx?DataSet Code=ANHRS#. In 1961 they worked 40.5 hours per week. Federal Reserve Bank of St. Louis, Data series M08354USM310NNBR; U.S. Department of Labor, Bureau of Labor Statistics, “Current Employment Statistics-CES (National): Technical Notes to Establishment Survey Data,” May 8, 2012. 15 Keynes, Economic Possibilities for our Grandchildren (Seattle, WA: Entropy, 1930). 16 Juliet B. Schor, The Overworked American: The Unexpected Decline of Leisure (New York: Basic Books, 1993). 17 Robert H. Frank, Luxury Fever: Why Money Fails to Satisfy in an Era of Excess (New York: Free Press, 1999). “People are happier when they spend money on experiences instead of material objects, when they relish what they plan to buy long before they buy it, and when they stop trying to outdo the Joneses,” Stephanie Rosenbloom, “But Will It Make You Happy?” The New York Times, August 7, 2010. 18 John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), chapter 24, p. 372.

202  Macroeconomics Part II 19 Dean Baker, Work Sharing: The Quick Route Back to Full Employment (Washington, DC: Center for Economic and Policy Research, June 2011). 2 0 Some tentative steps in this direction were taken in the 2012 “Job Creation Act.” Such a program works in Germany where total employment did not decrease at all during the meltdown. Paul Krugman, “Kurzarbeit,” The New York Times, September 2, 2010. 21 The reduction of the workweek in France from 39 to 35 hours in large firms in the year 2000 is estimated to have reduced the unemployment rate by 1.6% by 2002. Zaichao Du, Hua Yin, and Lin Zhang, “The Macroeconomic Effects of the 35-Hr Workweek Regulation in France,” B.E. Journal of Macroeconomics 13 (2013) 1: 881–901. 2 2 Martin Weitzman, The Share Economy (Cambridge, MA: Harvard University Press, 1984). 23 John Pencavel, Worker Participation. Lessons from the Worker Co-ops of the Pacific Northwest (New York: Russell Sage Foundation, 2002). 24 Pavlina Tcherneva, “Beyond Full Employment: The Employer of Last Resort as an Institution for Change,” Levy Economics Institute, Working Paper No. 732, September 2012. Sakia Klosse and Joan Muysken, “Curbing the Labour Market Divide by Fostering Inclusive Labour Markets Through a Job Guarantee Scheme,” Psychosociological Issues in Human Resource Management 4 (2016) 2: 185–219. 25 Colander, David, “A Guaranteed Jobs Proposal,” in David Colander (ed.), Solutions to Unemployment (New York: Harcourt Brace Jovanovich, Inc., 1981), pp. 204–208; Dean Baker, “Work Sharing: The Quick Route Back to Full Employment,” Center for Economic and Policy Research, June 2011. 26 Peter Goodman, “Finland Has Second Thoughts About Giving Free Money to Jobless People,” The New York Times, April 24, 2018. 27 Jenny Marlar, “The Emotional Cost of Underemployment,” Gallup, March 9, 2010; Anna Manchin, “Depression Hits Jobless in UK, U.S. More than in Germany,” Gallup, November 21, 2012. 28 Martin Feldstein, “Dealing with Long-Term Deficits,” American Economic Review: Papers & Proceedings 106 (2016) 5: 35–38; Martin Feldstein, “What is Full Employment?” Project Syndicate, June 29, 2015. 29 Roger Farmer, “The Natural Rate Hypothesis: An Idea Past Its Sell-By-Date,” Bank of England Quarterly Bulletin 3 (2013): 244–256. 30 William Mitchell and Joan Muysken, Full Employment Abandoned: Shifting Sands and Policy Failures (Cheltenham, UK: Edward Elgar, 2008). 31 The average in 2017 was 2.1%, the Federal Reserve’s target rate. The Federal Reserve Bank of St. Louis, Economic Data series CPIAUCSL. 32 United Nations, “The Universal Declaration of Human Rights,” adopted in 1948. 33 Yuval Rosenberg, “Forget GDP: The Radical Plans to Go Beyond Growth,” Fiscal Times, April 5, 2012. This is also the message of the steady-state-economy movement. Center for the Advancement of the Steady State Economy. Research & Degrowth. Nicholas Georgescu-Roegen, The Entropy Law and the Economic Process (Cambridge, MA: Harvard University Press, 1971). Barry Commoner, Making Peace with the Planet (New York: Pantheon, 1990). 34 Joseph Stiglitz, “GDP Fetishism,” Project Syndicate, September 7, 2009. A fetish is an irrational reverence or obsessive devotion—a fixation—an almost superstitious belief in something like a totem pole, or in this case, the free market. 35 Dan Witters, “Americans’ Life Evaluations Improve During Obama Era,” Gallup-Healthways Well-Being Index, August 30, 2016. 36 Alyssa Davis, “U.S. Daily Worry Easing, but Still Up Since Trump Election,” Gallup-Sharecare WellBeing Index, August 4, 2017. 37 John Helliwell, Richard Layard, and Jeffrey Sachs, “World Happiness Report, 2012,” p. 3. 38 Peter C. Whybrow, “Dangerously Addictive: Why We Are Biologically Ill-Suited to the Riches of Modern America,” The Chronicle of Higher Education, March 13, 2009. 39 Betsey Stevenson and Justin Wolfers, “The Paradox of Declining Female Happiness,” American Economic Journal: Economic Policy 1 (2009) 2: 190–225. 40 Rosenbloom, “But Will It Make You Happy.” 41 “Mike Wallace interviews Aldous Huxley,” May 18, 1958, YouTube video. www.youtube.com/ watch?v=HSx91KiNyFU. 42 Schumpeter, Joseph, Capitalism, Socialism and Democracy (New York: Harper, 1942). 43 John Komlos, “Has Creative Destruction Become More Destructive?” B.E. Journal of Economic Analysis and Policy 16 (2016), no. 4.

Macroeconomics Part II  203 44 Some argue that hypothetical compensation should suffice for efficiency. According to this theory, compensation does not actually have to take place, but the mere possibility of compensation suffices. Thus, as long as gainers gain more than losers lose, the policy is efficient, but of course the theoretical possibility of compensation does not help the lives of the losers and is therefore not a humane approach to economic policy, as losers are never compensated by the winners. 45 For instance, it took some years before the new financial instruments became toxic so they were very profitable until some of their inferior characteristics (and negative externalities) came to light. 46 Teather, David, “Kodak Pulls Shutter Down on Its Past,” The Guardian, January 22, 2014; Pearlstein, Steven “Review: ‘The Second Machine Age,’ by Erik Brynjolfsson and Anderew McAfee,” The Washington Post, January 17, 2014. 47 Natalie Walters, “How Much Uber is Worth after its Rough Year,” Business Insider, December 13, 2017. www.businessinsider.com/how-much-uber-is-worth-after-its-rough-year-2017-12. 48 Lawrence Mishel, “Uber and the Labor Market,” Economic Policy Institute, May 15, 2018. 4 9 Himanshu Gupta, Suresh Kumar, Saroj Kumar Roy, and R.S. Gaud, “Patent protection strategies,” Journal of Pharmacy and Bioallied Sciences 2 (2010) 1: 2–7. 50 George Akerlof and Robert Shiller, Phishing for Phools: The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press, 2015); Paul Heidhues, Botond Kőszegi, and Takeshi Murooka, “Exploitative Innovation,” American Economic Journal: Microeconomics 8 (2016) 1: 1–25. 51 “Paul Volcker: Think More Boldly,” The Wall Street Journal, December 14, 2009. 52 Thomas Philippon, “Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation,” American Economic Review 105 (2015) 4: 1408–1438. 5 3 Moreover, the rise in the financial sector can hinder productivity growth in other sectors by attracting highly skilled employees at the expense of the R&D intensive industries of the real economy. Stephen Cecchetti and Enisse Kharroubi, “Why Does Financial Sector Growth Crowd Out Real Economic Growth?” Bank of International Settlement, Working Papers no. 490, February 2015. 54 Erik Brynjolfsson and Andrew McAfee, Race Against the Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy (Cambridge, UK: Digital Frontier Press, 2012); Robert Skidelsky, “Racing the Machine,” Project Syndicate, December 22, 2017; “Jobless Future.” www.amazon.com/Rise-Robots-TechnologyThreat-Jobless/dp/0465097537. 5 5 Carl Benedikt Frey and Michael A. Osborne, “The Future of Employment: How Susceptible are Jobs to Computerisation?” Technological Forecasting and Social Change 114 (2017): 254–280. 56 Erik Brynjolfsson, and Andrew McAfee, The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: Norton, 2014). 5 7 The Statistics Portal. www.statista.com/. 58 Christopher Singleton, “Auto Industry Jobs in the 1980s: A Decade of Transition.” www.bls.gov/opub/ mlr/1992/02/art2full.pdf. 59 Glassdoor. www.glassdoor.com/Hourly-Pay/Amazon-Hourly-Pay-E6036.htm. 60 Sean Patrick Farrell, “The Robot Factory Future,” The New York Times, video, 3:58, August 18, 2012. 61 Joel Mokyr, “Riding the Technology Dragon,” Milken Institute Review 2 (2014): 87–94. 62 Ibid. 63 Ibid. 64 Matthew Rosenberg, Nicholas Confessore and Carole Cadwalladr, “How Trump Consultants Exploited the Facebook Data of Millions,” The New York Times, March 17, 2018. 65 Natalia Osipova and Aaron Byrd, “Inside Russia’s Network of Bots and Trolls,” The New York Times, November 1, 2017. 66 Herman Daly, “Economics in a Full World,” Scientific American 293 (2005) 3: 100–107. Wikipedia contributors, “Global Warming,” Wikipedia: The Free Encyclopedia. 67 Intergovernmental Panel on Climate Change, “IPCC Fourth Assessment Report: Climate Change 2007.” 68 Benjamin Strauss, Scott Kulp, and Peter Clark, “Can You Guess What America Will Look Like in 10,000 Years? A Quiz,” The New York Times, April 20, 2018. 69 The city is now spending $1.25 million on a short stretch of the shoreline to help protect a single neighborhood. Leslie Kaufman, “Front-Line City in Virginia Tackles Rise in Sea,” The New York Times, November 25, 2010.

204  Macroeconomics Part II 0 Natural Resources Defense Council, “The Cost of Climate Change,” last revised May 21, 2008. 7 71 Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays, and When, for What We Spend (New York: Free Press, 1992). 72 Ibid. 73 Paul Krugman, “Greed is Bad,” The New York Times, June 4, 2002. 74 Emilio F. Moran, People and Nature. An Introduction to Human Ecological Relations (Oxford, UK: Blackwell, 2006); Herman Daly, Steady-State Economics: The Economics of Biophysical Equilibrium and Moral Growth (New York: W.H. Freeman, 1978). 75 Diane Coyle, The Economics of Enough: How to Run the Economy as if the Future Matters (Princeton, NJ: Princeton University Press, 2011). 76 Martin Weitzman, “On Modeling and Interpreting the Economics of Catastrophic Climate Change,” Review of Economics and Statistics 91 (2009) 1: 1–19. 77 Joseph E. Stiglitz, Making Globalization Work (New York: W.W. Norton, 2006). 78 Herman E. Daly and Joshua Farley, Ecological Economics: Principles and Applications (Washington, DC: Island Press, 2004). Herman E. Daly, Ecological Economics and Sustainable Development (Northampton, MA: Edward Elgar, 2007). 79 By some estimates it is as high as $50 trillion a year. This is roughly the value of the world’s total gross domestic product at the beginning of the twenty-first century. Paul C. Sutton, Sharolyn J. Anderson, Benjamin T. Tuttle, and Lauren Morse, “The Real Wealth of Nations: Mapping and Monetizing the Human Ecological Footprint,” Ecological Indicators 16 (2012): 11–22. 80 Brad Plumer and Nadja Popovich, “How Global Warming Fueled Five Extreme Weather Events,” The New York Times, December 14, 2017. 81 Kendra Pierre-Louis, “These Billion-Dollar Natural Disasters Set a U.S. Record in 2017,” The New York Times, January 8, 2018. Search the website of the National Oceanic and Atmospheric Administration of the U.S. Department of Commerce for “disasters.” Referring to Harvey’s devastation of Houston, Joseph Stiglitz wrote, “It is ironic, of course, that an event so related to climate change would occur in a state that is home to so many climate-change deniers—and where the economy depends so heavily on the fossil fuels that drive global warming.” Joseph Stiglitz, “Learning from Harvey,” Project Syndicate, September 8, 2017. 82 Sandy had a diameter of 1,100 miles, and it devastated the U.S. mid-Atlantic region. Wikipedia Contributors, “List of Natural Disasters in the United States.” 83 Jennifer Medina, Thomas Fuller, and Tim Arango, “Mudslides Strike Southern California, Leaving at Least 13 Dead,” The New York Times, January 9, 2018. 84 Tornadoes alone in 2011 claimed the lives of 500. The Chicago heat wave of 1995 killed an amazing 739 people. Wikipedia Contributors, “List of Natural Disasters in the United States,” “2018 Southern California mudflows.” 85 Wikipedia contributors, “Deepwater Horizon Oil Spill,” “List of Oil Spills.” 86 Dan Witters, “Gulf Coast Residents Remain Worse Off Emotionally Post-Spill,” Gallup, May 7, 2012.

12 Macroeconomics Part III

No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable. Adam Smith1

We continue our examination of the bird’s-eye view of the economy by examining several additional macroeconomic policies such as the role of taxes, national debt, and savings. We argue that taxes are essential because they pay for public goods that the private sector does not supply. The government’s role in the economy is further enhanced by its use of fiscal and monetary policy to influence aggregate demand and thus reduce the volatility of the business cycle.

The Government Is Part of the Solution The economy could not function well without an effective government. In economies which deliver a decent standard of living, for instance, in Scandinavia, Germany, and Switzerland, as well as those economies that were able to catch up with the West, for example South Korea, Taiwan, Japan, and Singapore, the government has played a major role in their success. Governments not only spend and provide a safety net, they also invest in infrastructure, education, and basic research, which is extremely important because they are the lifeblood of the economy. In 2017, state, local, and federal governments invested some $633 billion; that is 17% of all investments.2 In the U.S. government expenditure was about 17% of GDP in 2017, the lowest share since 1950.3 In many European developed countries it is as high as 40% to 50%.

The Challenges of Keynesian Fiscal Policy Keynesian fiscal policy is the “steering wheel” of the economy. However, the steering should be against the wind and not with it. Keynesian fiscal policy should be countercyclical: expansionary in downturns but contractionary in upswings. Thus, government budgets would be balanced over the business cycle. Keynes did not want government debt to accumulate. It should borrow and spend during recessions, and it should pay it back by increasing taxes or by cutting back government

206  Macroeconomics Part III

110 100

Nixon Ford Carter

Reagan

90

Bush Sr.

Clinton

Obama

Bush Jr.

80 70 60 50 40 30 20 1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Figure 12.1  U.S. National Debt as a Percentage of Gross Domestic Product Source: Federal Reserve Bank of St. Louis, series GFDEGDQ188S.

expenditures. Unfortunately, countercyclical fiscal policy to “fine tune” the economy became impractical in practice, and U.S. debt continued to accumulate beginning with the Reagan administration (Figure 12.1). Deficit spending or cutting taxes during a recession is easy, but cutting expenditures to limit aggregate demand toward the peak of the business cycle was impractical. Elected politicians would lose popularity and campaign contributions with policies aimed at cooling the economy. However, a handful of countries, including Switzerland, enacted balanced-budget laws so that deficits would not accumulate.4 (The 50 U.S. states also cannot run deficits.) This was partly why Friedrich Hayek and Milton Friedman were critical of Keynesian macroeconomics. Another problem was that many mistook Keynesian theory as a prescription for economic growth. It wasn’t. His goal was to bring the economy out of the glut of the depression and thereby alleviate the worst shortcomings of capitalism. To be sure, his prescription would make the economy grow out of its doldrums, but budget deficits would not bring about long-run economic growth after the depression was over. Rather, that would come from the usual sources: innovation, education, technical change, and capital accumulation. Growth in the long run was not his immediate concern, as captured by his famous saying, “in the long run, we are all dead.” His focus was on shortening the breadlines.

Crowding Out Prior generations of economists believed that public borrowing crowds out private investment and is therefore counterproductive. However, this does not hold when underemployment is endemic or when the government invests in public goods that foster economic

Macroeconomics Part III  207 growth, such as the Eisenhower Interstate Highway System. Investment in education, public health, basic research, and renewable energy has similar multiplier effects and is a complement to private business investments. Lately, however, economists have been less worried about government borrowing having a negative effect on private business investment because there has been an elastic supply of savings available globally due to the savings glut. The significant increase in the supply of global savings is due to the high savings rate in China based on their large trade surpluses. Because their domestic economy is unable to absorb these savings, the funds flow back into the U.S. where the government deficit soaks up much of it. But also private corporations, which used to borrow from banks in order to invest, are now flush with profits and have difficulty finding sufficient lucrative investments, so that also adds to the global savings glut. Microsoft and Apple, for example, are sitting on $126 billion and $256 billion respectively, not knowing what to do with it. Even a none-IT company, such as Coca-Cola, has $25 billion in the bank.6 So the concept of crowding out is no longer worrisome. 5

The Threat of a Mushrooming National Debt However, that does not mean that the accumulating national debt is benign, as the low interest rates and the easy access to credit might lead one to believe. The national debt is $20 trillion (100% of GNP) of which $6.3 trillion is held by foreigners.7 (Foreign holdings have increased by a factor of six since the beginning of the twenty-first century.) Interest payments on the debt were a substantial $460 billion in 2017.8 That is two-thirds of the cost of the military. In other words, it is a major portion of the budget (12%), even though interest rates were near historic lows (2.4%). There are several hidden dangers in this development. First, there is no way of knowing how long interest rates will remain low. If they were to increase, servicing the debt could become a major burden on the U.S. government budget already strapped for revenue. Second, the Chinese holdings of U.S. debt amounted to $1.3 trillion in 2017. The question naturally arises how long will they continue to lend us money on favourable terms and finance our living beyond our means, especially since they are a rising power and want to expend globally? There is no way to know. However, being so dependent on an adversary is imprudent. If the Chinese politburo were to change its mind, the U.S. economy would be in difficulties. Third, the deficit will mushroom due to the further lowering of the tax rates in December 2017.9 The deficit is projected to increase to $1 trillion a year in 2018. Thus, balancing the budget at anytime in the future will be impossible. Generations as yet unborn will not be inclined to change course. They will feel betrayed by the rising burden of the debt and will also want to pass it onto future generations. That implies that the debt will snowball. These three factors project an ominous future for the U.S. economy. These endemic deficits cannot be sustained in the long run. How different would it be if we had invested the $1.5 trillion in education, infrastructure, or renewable energy that would bear dividends instead of the tax cuts? Then we would have additional income in the future to finance the additional debt. This way, however, it will lead to more conspicuous consumption, greater uncertainty, and greater dependence on foreign loans. I think that only Dr. Pangloss would think that the Chinese politburo will support the U.S. lifestyle indefinitely.

208  Macroeconomics Part III Other countries are more prudent. Government debt as a percentage of gross domestic product (GDP) is small in Sweden (38%), New Zealand (38%), Australia (34%), Norway (34%), Switzerland (16%), and South Korea (34%).10 In contrast, the U.S. federal debt is 106% of GDP, the highest level since the end of World War II.11

Taxes Are Good for Us U.S. popular culture has been adamantly against paying taxes. The feeling was strengthened after Ronald Reagan asserted that government “is not the solution to our problem, government is the problem.” Taxes are seen as a diminution of freedom to do what one wants with one’s money, a threat to “rugged individualism” that keeps people from reaching their “American Dream.” Econ 101 textbooks feed on this stereotype with assertions such as “taxation subtracts from incomes, reduces private spending, and affects private saving. In addition, it affects investment and potential output.”12 However, this is biased, because it fails to mention that the taxes are used to provide the essential services mentioned earlier. Hence, citizens of high-tax countries with a strong welfare system are the happiest in the world. The reason is simple: they have less anguish about their future, they do not worry about paying for their children’s schooling, they do not worry about their medical bills, and they have less worries about unemployment, retirement, or other unpredictable events in their lives. In fact, those nations whose populations are happier than those of the U.S. all have higher tax rates and all have universal health coverage, shielding their citizens from many unwarranted anxieties (Table 12.1).13 The mainstream view also overlooks that governments are established to avoid the chaotic state of nature. Without taxes there can be no government, and without government life would be miserable. Thus, the introduction of taxation is Pareto optimal since all members of society benefit from it. Table 12.1  Happiness Rank and Average Tax Rates Rank

Country

Tax Rate %

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Norway Denmark Iceland Switzerland Finland Netherlands Canada New Zealand Australia Sweden Israel Costa Rica Austria U.S.

38.0 45.9 36.4 27.8 44.1 38.8 31.7 32.1 28.2 44.1 31.2 n.a. 42.7 26.0

Note: Tax rates are federal government revenue as a percentage of GDP. Sources: United Nations, World Happiness Report, 2017, p. 20; OECD Revenue Statistics. http://stats.oecd.org/Index. aspx?DataSetCode=REV.

Macroeconomics Part III  209 However, taxation has four problems to solve: (1) how much government services to provide; the rich advocate for less because they can provide for themselves while the poor rely on government-sponsored schools and hospitals; (2) free riding is attractive as people justify their benefiting from government services without paying their fair share of taxes; this is what Warren Buffett meant by saying “there’s been class warfare going on for the last 20 years, and my class has won;”14 (3) it becomes tempting to pay for government services by borrowing against the earnings of generations as yet unborn; since they are unable to defend themselves, there is pressure for government debt to grow; and (4) the distribution of the tax burden is contentious. Since income is distributed unequally, taxes should be progressive so that the utility of after-tax income across households is ethically defensible. The declining marginal utility of income implies that the wealthy should face a higher tax rate than the poor, not a straightforward goal to achieve in practice if the wealthy have more political power. Because of the controversial nature of these four issues the determination of how the burdens and benefits of government taxation are distributed is controversial. In the twenty-first century U.S., the conflict has become ideologically insurmountable. In textbooks taxes are collected only to be given back to the citizenry. That is a silly way to model taxation. Instead, we should acknowledge that citizens obtain essential goods and services in return, and that the government is either the only institution able to provide those services or is able to obtain them at a lower cost—because of economies of scale or because of bargaining power—than if individuals were to obtain those services in the open market. Taxes obviously pay not only for vital services of policemen, firefighters, teachers, and judges but also for infrastructure, basic research, and other public goods. Moreover, they support health and unemployment insurance, pay for pensions of the retired, and care for the disabled. They provide food for the needy, without which the social order would be threatened, and support those who have been excluded from the labor market. Most importantly, taxes are also used to pay for such investments as harbors, roads, airports, bridges, satellites, and dams, without which the economy would become catatonic. Consider, for example, that taxes paid for the basic research for the Internet, for rocket science—making satellite communication possible—and for biotechnology that has revolutionized medicine. Some 4.2 billion people use the Internet.15 This would not be possible without government investments. So, taxes do not only subtract from income. They also add an immense amount of income, laying the foundations of long-run economic growth. Today’s technological revolution would be impossible without government support. So, taxes grow the economy, support domestic tranquility, and lower the anxiety level of the population. These are three crucial roles of taxes that are overlooked in blackboard economics. Low taxes is one reason for the anaemic growth of the U.S. economy, because it led to the neglect of education, basic research, and infrastructure the economy needs. The Society of Civil engineers gives the U.S. a D+ grade on its infrastructure.16 Transit was rated the lowest with a grade of D−; aviation, dams, inland waterways, drinking water, levees, and roads all received a grade of D, while energy, schools, hazardous waste, public parks, wastewater received a D+. They all need upgrading, maintenance, and expansion valued at $3 trillion. They have been neglected for decades. It is obvious in the state of our roads but also on the outdated railroad technology, the tainted water system in Flint Michigan, and broken dams

210  Macroeconomics Part III in California.17 The National Academy of Sciences estimates that in 2015, 21 million people were exposed to unsafe drinking water.18 This will be a major burden on the economy. Arthur Laffer argued that lowering tax rates increases government revenue. But the evidence does not support his contention.19 The income tax rate could be as high as 70% without having a negative effect on either revenues or output. In addition, the consumption tax-revenue curve does not have a peak at all.20 That means that taxes on consumption could be increased without having a negative effect on total revenues collected. Moreover, the economy grew just fine when the top tax rates were multiples of the current levels. In short, there is no relationship between top tax rates and economic growth: [t]he reduction[s] in the top tax rates have had little association with saving, investment, or productivity growth. However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution. The share of income accruing to the top 0.1 percent of U.S. families increased from 4.2 percent in 1945 to 12.3 percent by 2007 before falling to 9.2 percent due to the 2007–2009 recession.21 (Table 12.2) The reason for the lack of relationship between the top tax rates and economic performance is that labor services are supplied inelastically and investments are related more closely to profit opportunities than to tax rates. Furthermore, higher tax rates on millionaires lower the pursuit of rent seeking and thereby improve efficiency.22 After all, “the most rapid grossdomestic-product growth achieved in the United States took place in the 1950s, 1960s and 1970s, when top tax rates were nearly twice as high as now.”23 Warren Buffett, the second richest man in the U.S. with assets worth $86 billion, concurs: he knows no one who makes investment decisions on the basis of the tax rate.24 The contention that the low tax rate of the top income earners induces economic growth, thereby benefiting the rest of the population, is also known as trickle-down economics or supply-side economics. Paul Krugman calls it “old voodoo economics—the belief, refuted by study after study, that tax cuts pay for themselves.”25 It is not based on either economic theory or empirical evidence (see Figure 7.7 in Chapter 7). The argument is to give money to the ultra-rich and they will invest it, create jobs, raise wages, and pretty soon the benefits will trickle down to the rest of the society. In the real world the benefits trickled like molasses: the ultra-rich 5% kept almost all of it; only a tiny bit trickled down to the rest of the top quintile

Table 12.2  There Is No Relationship Between Economic Growth and the Top Tax Rates Top Marginal Tax Rates

1950s 21st Century

GDP Growth

Income

Capital Gains

90% 35%

25% 15%

2.4% 1.0%

Note: 21st Century is 2001–2017; GDP Growth is per capita. Source: Thomas L. Hungerford, “Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945,” Congressional Research Service, September 14, 2012, 7–5700; Federal Reserve Bank of St. Louis, series A939RX0Q048SBEA.

Macroeconomics Part III  211 but the molasses stopped trickling at the 80th percentile (see Table 7.4 in Chapter 7). What matters for investment decisions is the incentive of potential profits to be earned and the degree of uncertainty associated with earning those profits. In the real world, the tax rate plays a minor role in that decision. About 130 millionaires signed a petition asking Congress to raise the tax rate.26 Buffett also thinks that the rich should be paying more taxes: “I think that people at the high end, people like myself, should be paying a lot more in taxes. We have it better than we’ve ever had it,” he said in an interview. When the interviewer pointed to claims that the very wealthy need tax cuts to spur business investments, Buffett replied: The rich are always going to say that, you know, “Just give us more money, and we’ll go out and spend more, and then it will all trickle down to the rest of you.” But that has not worked the last 10 years, and I hope the American public is catching on.27 Paul Krugman suggested that in 2007 the top 0.1% of taxpayers (that is about 150,000 people who earned more than $2 million a year) “had a combined income of more than a trillion dollars . . . It wouldn’t be hard to devise taxes that would raise a significant amount of revenue from those super-high-income individuals.”28 Moreover, the top 4.3% of U.S. taxpayers, some 6.2 million households, earned an income of $3.3 trillion in 2014 (see Table 7.3 in Chapter 7). They paid $802 billion taxes, a rate of 24%, leaving them a disposable income of $408,000 per household. It seems like the government could have collected an additional half trillion dollars from this privileged group without pinching their conspicuous consumption habits excessively. That would have still left them an after-tax income of some $2 trillion or $322,000 per taxpayer.29 They should be able to manage on that. Furthermore, corporate profits after taxes hit a peak of $1.8 trillion in 2017; one could easily raise a matching sum from this source.30 These policies combined would have erased most of the budget deficit; additional funds could be collected on a transactions tax on financial services, taxing Internet usage, and lowering military expenditures. While politically this is unfeasible, the point is that we could raise sufficient revenue to balance the budget without a substantial impact on either economic growth or the quality of life of the population. However, balancing the budget does not fit well into the Republicans’ agenda. President Ronald Reagan decreased the top tax rate from 70% to 38.5% and inaugurated the endemic of federal budget deficits, the main goal of which was to “starve the beast,”—to choke off government revenues in the hope that government expenditures would follow suit.31 That policy was flawed both because it failed to consider that vested interests (such as the military-industrial complex) would strongly resist lowering expenditures, and because the outcome of the strategy would be to take the road of least resistance, which led to deficit financing. The “starve-the-beast” policy was also unethical because it transferred the burden of financing current expenditures onto future generations. In addition, military expenditures increased substantially and reached $646 billion in 2011, which was about half of the deficit and a quarter of all revenues. Furthermore, the effective corporate tax rate was halved from about 40% in the 1950s to less than 20% in 2017. Corporate income taxes were a mere 1.2% of GNP in 2011 and merely 16% of individual income taxes.

212  Macroeconomics Part III Low taxes introduce inefficiencies that are associated with higher crime rates: many firms, including the McDonald’s near my house, hire private police in order to maintain safety. This is an extra expenditure that is superfluous in systems with higher public expenditures and a concomitant lower crime rate. The “starve-the-beast” strategy also deprives the schools of adequate funding, which, in turn, increases the crime rate leading to a myriad of hidden inefficiencies (the school-to-prison pipeline). Higher taxes would mean less income redistribution through robberies (and lower insurance costs); since taxes counterbalance inequality and lower the crime rate, they foster social capital, trust, and cooperation, all of which lower transaction costs and lead to a higher quality of life. The net burden of crime in the U.S. exceeds $1 trillion.32 This is a net burden of some $4,000 per capita. If this is not inefficient, I wouldn’t know what is. High-tax-rate countries generally rank near the top of surveys on the quality of life whereas the U.S. is usually at the low end of industrialized countries. Thus, by fostering equality in disposable income, taxes increase efficiency in a number of ways including by improving educational quality. Suddenly higher taxes do not seem so bad after all. as people live longer and more satisfactory lives. Europeans work less, have longer vacations, and are less harried; they are subject to less uncertainty and less criminal activity; they have fewer slums and dysfunctional schools and eliminate the need for such high levels of indebtedness among the young. The cost of college education in most European countries is borne by the society at large so that the burden is spread out and graduates leave university with zero debt, in contrast to the $37,000 debt of the class of 2016 in the U.S.; total outstanding student debt amounted to $1.5 trillion in the U.S.33 The tax cuts of 2017 are projected to increase the national debt to 150% of GDP by 2047.34 The extra deficits are likely to be greater than the forecasts. The actual deficits caused by the Reagan tax cuts of 1981 were 29% larger than projections, and those caused by the Bush Jr. tax cuts were 8.8% higher.35 Conventional economists argue that income redistribution generates inefficiencies. This efficiency-equity trade-off supposedly works by reducing the incentive of high-productivity workers to work and invest, thereby decreasing total income. However, this inference is based on inappropriate assumptions. It assumes, without empirical evidence, that people work less if the tax rate increases for everyone. So, they assert that if someone’s aftertax salary is $1,000 per hour, she will work less than if she were to earn $1,200 per hour. However, there is no evidence supporting such a claim.36 Would the 400 U.S. billionaires work less if their tax rate were doubled?37 Would Beyoncé sing fewer songs? Would LeBron James shoot fewer baskets? I doubt it. Instead, the only effect would be to reduce the intensity of conspicuous consumption and the negative externalities it causes. Consequently, the European economies have done well despite higher taxes. Thus, there is substantial real-world evidence that high taxes coupled with social spending fosters, rather than inhibits, economic welfare.38 The reason is that lower taxes are not crucial in creating incentives among the super-rich, while transfer payments provide social services, free college education, and universal health care, and thus increase the productivity of lower income groups who in the U.S. are unable to afford college. Hungry children attending inferior schools and growing up in dysfunctional families and neighborhoods are not likely to become productive members of the community. Thus, I think that the inefficiencies associated with redistribution are illusory.

Macroeconomics Part III  213

Savings or the Lack Thereof Savings are important for economic development and stability as they provide a cushion for unexpected expenditures for individuals, firms, and governments. Economic life becomes more volatile without that cushion. Yet, their importance is not adequately appreciated because it is inimical to the interest of corporations. Businesses want people to spend, thereby increasing sales and profits. No wonder there are few advertisements motivating people to be more frugal. “A penny saved is a penny earned” is no longer a U.S. cultural norm. Self-control—the ability to delay gratification—is a crucial precondition for a successful life. It was proven by the “Marshmallow Experiment,” in which children were offered the choice of eating a marshmallow immediately or two if they waited 15 minutes without eating the marshmallow in front of them. The key finding was that those children who resisted the temptation of immediate gratification had higher SAT scores, educational attainment, and income as adults.39 Persons not in control of their passions are unfree even if they do not recognize it. Yet, the obesity epidemic, the indebtedness, and low savings rate in the U.S. all point to the diminution in our ability to control our appetite and greed. Excessive borrowing is a sign of impatience. It exacerbates the impact of the lack of savings and increases the fragility of the financial system. It makes it more difficult for households to keep their heads above water in rough times. The increase in indebtedness played a substantial role in the run-up to the crisis of 2008. We were not always like this. Between 1950 and 1980, the saving rate was above 10% of disposable income, but the trend changed in the mid-1980s and began a long period of decline. In 2017 it was just 2.7% (Figure 12.2). No savings means that 40% of households would be unable to pay for an unexpected expense of $400.40

Figure 12.2  U.S. Personal Saving as a Percentage of Disposable Income Source: Federal Reserve Bank of St. Louis, series A072RC1A156NBEA.

214  Macroeconomics Part III Some ideologues argue that the decline in the saving rate was caused by the introduction of Social Security in 1935 and Medicare in 1965, which provided a small amount of financial security for people in retirement. However, the trend in savings does not support such a claim since the saving rate was unchanged after World War II, hovering around 10% well after the enactment of these social safety nets. The rate began to decrease only in 1985.41 Once again Reagan’s tax cuts had unforeseen consequences: the saving rate began a long period of decline. Is it a coincidence that this was when inequality began to increase and when wages began to lag the increases in productivity? I should think not. It appears plausible to infer that the middle class attempted to keep up with the consumption norm of the top earners by reducing savings and increasing debt, although by then many families had two earners instead of one, as was the case just a decade earlier. Moreover, this was the first generation to reach adulthood having been bombarded throughout their life by TV advertisements that hyped the wonders of consumption. So the puritan ethic of frugality turned into the post-modern ethic of instant gratification. We did not choose to be so. This culture was imposed on us by Madison Avenue, Wall Street, Hollywood, and Silicon Valley. Saving received bad publicity because of the paradox of thrift. In the standard Keynesian short-run models, an increase in savings implies that consumers spend less, thereby lowering GNP and increasing unemployment. Thus, politicians and business people are wary of increased savings as it seems to put a damper on growth, government revenue, as well as corporate profits. Of course, this is only true in the short run. In the long run, however, growth will continue to depend on innovation, government investment in basic research, and especially on human capital accumulation. But the anti-saving narrative fits well with the focus on the short-run and instant-gratification society.

Inflation and Deflation Inflation is harmful because it devalues savings and therefore is an invisible tax. By reducing the incentive to save, it lowers the savings rate and makes less money available to invest. It is also an inconvenience insofar as it makes it difficult to keep track of all the changes in relative prices in the economy, because not all prices change at the same rate. Deflation is the opposite of inflation and is also bad for the economy. Producers are engaged in long-range contracts with workers and suppliers, and if their product prices fall, profits decline and therefore reduce production, leading to layoffs and unemployment. Moreover, deflation increases the real value of debt such as mortgages, which are denominated in nominal terms, thus increasing the probability of default. The declining prices also put a downward pressure on wages implying that mortgage payments will account for a greater share of income, leaving less money to spend on everything else, thereby reducing aggregate demand. Thus, inflation and deflation are both nuisances to avoid, and their control is one of the two missions of the Federal Reserve (the other is to reduce unemployment—­called the dual mandate). The Fed has a target inflation rate of 2%. In their judgment that is the “most consistent with their mandate for price stability and maximum employment.”42 It is clear why the Fed would want to avoid deflation, but that does not explain why the Fed is more comfortable with a 2% inflation rate than with a 0.5% or 1% inflation rate. In any event, the Fed struggled

Macroeconomics Part III  215 to reach the 2% target even though it squeezed an immense amount of money into the financial system. The inflation rate was 1.3% between 2012 and 2016,43 even though M1 increased by a factor of 2.5 and the monetary base rose by $3 trillion, which is more money than the Fed created previously in its 94 years of existence.44 A reason for the low inflation despite the unprecedented money creation is that much of the money stayed in Wall Street creating asset inflation, which is not part of the consumer price index. Additionally, the money did not get to the people on Main Street, so it did not increase demand for goods and services. Third, the banks found it lucrative to park their money with the Fed because they received risk-free interest on their deposits. Until 2015 the interest rate was a meagre 0.25%, but by 2018 the rate had increased to 1.5%. Given that in early 2018 the commercial banks still had $2.2 trillion on deposit with the Fed, they gained $33 billion of easy profits.45 That was easier than looking for lucrative investments. The fourth reason for the low inflation is that hyperglobalization means that many products are supplied perfectly elastically. If demand rose for a product in earlier times, firms ran into labor supply or raw material constraints. They had to raise wages and prices in order to find more workers to work for them. No longer. With the integration of global markets, billions of workers are ready to produce to satisfy U.S. consumers’ desires. Consequently, the quantities supplied can be increased without having to increase the retail price. Consider, for example, the iPhone 5 retailing for $650. The cost of manufacturing it is $227.46 Suppose demand increases from 220 million to 250 million iPhones per annum. Apple would not have had to increase the retail price of the product. After all, they were making $300 profit per iPhone. Even if the manufacturers increased the price slightly, Apple could absorb it in their profits. So, inflation is a thing of the past. The new normal in a hyperglobalized world is that products are supplied elastically. Nonetheless, the Fed was finally able to reach its inflation target in 2017: prices rose by 2.1%.

Nominal vs. Real Wages The importance of nominal versus real wages is controversial. In the models of the realbusiness-cycle school, real wages matter to employment, whereas in the Keynesian models, nominal wages are important since employers set wages in nominal terms and workers do not know the price level. Thus, this is an asymmetric information problem. Firms know the price of their product and the wages of their employees. However, workers have a more difficult problem to know the prices of the hundreds of products they are buying to calculate their real wages. This is beyond their ability. Furthermore, nominal wages are downwardly inflexible because of psychological reasons such as fairness. No one likes their wages decreased. This is the case even if real wages remain constant. They think lowering wages is unfair and, in addition, they have long-range contracts, such as mortgages or car payments which remain unchanged even if the price level were to fall in general.

The Obama Stimulus What was the economic effect of Obama’s stimulus of February 2009? Analyzing such a question is controversial. It is not enough to know the actual performance of the economy

216  Macroeconomics Part III because there were other forces at work; we need to answer a counterfactual question: what would have happened without the policy? The unemployment rate had been increasing at a 0.5% monthly rate during the three months preceding the bill’s adoption. At its peak, in February, the economy was shedding 800,000 jobs monthly, pushing the unemployed numbers to 14 million.47 However, immediately after the bill’s adoption the increase in the unemployment rate slowed: first to 0.4% and in April to 0.3%. This could not have been a mere coincidence. By the summer the rate of increase was 0.1–0.2% and by November 2009 the tourniquet had worked; the bleeding was over. This was a major achievement of Keynesian engineering. Although a 79% decline in the rate of job losses is substantial by any standard, those who were ideologically antagonistic to Keynesian policies argued that the rate of increase in the number of unemployed was bound to decline through natural market forces. The sceptics argued that job loss could not possibly continue indefinitely at the 800,000 monthly rate. It defies commonsense to think that the shedding of jobs would have come to such a sudden stop without a stimulus. Liberal economists—not surprisingly—lined up in favor of the stimulus, complaining only that it was too small. Paul Krugman wrote that “It helped end the economy’s plunge; it created or saved millions of jobs; it left behind an important legacy of public and private investment.”48 The Congressional Budget Office—an independent governmental agency—estimated that GDP in 2009 was between 1.4% and 3.8% greater than it would have been without the stimulus.49 Moody’s Analytics, an independent forecasting firm, estimated that the stimulus saved 2.5 million jobs.50 Nonetheless, conservatives contest these numbers. Economics is not like a natural science. Ideology plays a major role in interpreting the evidence; rational arguments cannot overcome ideology. In January 2010 the official unemployment rate peaked at 10%, 15.3 million people.51 However, the real unemployment rate was 16.5%, and the black and Hispanic rate reached 23%. That implied that 25 million adults were not employed, and they had dependants, so close to 50 million people were leading precarious lives.

Notes 1 The Wealth of Nations, Book 1, chapter 8. 2 Bureau of Economic Analysis, Table 1.1.5 Gross Domestic Product. https://fred.stlouisfed.org/release/ tables?rid=53&eid=41047; Table 3.1 Government Current Receipts and Expenditures, www.bea.gov/ iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1921=survey&1903=86. 3 Federal Reserve Bank of St. Louis, series A822RE1A156NBEA and Table 1.1.5 Gross Domestic Product. 4 The budget does not have to be balanced each year but should balance over the business cycle. Wikipedia contributors, “Balanced Budget Amendment,” Wikipedia: The Free Encyclopedia. 5 Built at a cost of some $425 billion (2006 dollars), the system is 47,000 miles long. Wikipedia contributors, “Interstate Highway System,” Wikipedia: The Free Encyclopedia. 6 Laurie Meisler, “The 50 Largest Stashes of Cash Companies Keep Overseas,” Bloomberg, June 13, 2017. 7 Federal Reserve Bank of St. Louis, series FDHBFIN and GFDEBTN. 8 Drew Desilver, “5 Facts About the National Debt,” Pew Research Center, August 17, 2017. 9 Congressional Budget Office, “Federal Debt and the Risk of Fiscal Crisis,” July 27, 2010. 10 Wikipedia contributors, “Australian Government Debt,” Organization for Economic Cooperation and Development (OECD), “OECD Statistical Extracts.” 11 Congressional Budget Office, “The 2017 Long-Term Budget Outlook,” March 2017. www.cbo.gov/ system/files/115th-congress-2017-2018/reports/52480-ltbo.pdf. 12 Paul Samuelson and William Nordhaus, Economics, 19th ed. (New York: McGraw-Hill/Irwin, 2009), p. 376.

Macroeconomics Part III  217 13 United Nations, World Happiness Report, 2017; Tax Policy Center Briefing Book, www.taxpolicycenter. org/briefing-book/how-do-us-taxes-compare-internationally. 14 Greg Sargent, “There’s Been Class Warfare for the Last 20 years, and My Class Has Won,” The Washington Post, September 30, 2011. 15 “Internet Usage Statistics.” www.internetworldstats.com/stats.htm. 16 ASCE, “Infrastructure Report Card,” 2017. 17 Alan Blinder, Christina Caron, and John Jeter, “Fatal Amtrak Crash in South Carolina Is New Challenge for Rail Service,” The New York Times, February 4, 2018; Mike Hale, “Review: Tainted Water, Bad Science and 8,000 Children Exposed to Lead,” The New York Times, May 30, 2017; Kristine Phillips, “The Stunning Destruction at Oroville Dam and the Work Ahead,” The Washington Post, February 14, 2017. 18 Brad Plumer and Nadja Popovich, “Here Are the Places That Struggle to Meet the Rules on Safe Drinking Water,” The New York Times, February 12, 2018. 19 Don Fullerton, “Laffer Curve,” in The New Palgrave Dictionary of Economics, 2nd ed., ed. Steven N. Durlauf and Lawrence E. Blume (Basingstoke, UK: Palgrave Macmillan, 2008), p. 839. 2 0 Mathias Trabandt and Harald Uhlig, “The Laffer Curve Revisited,” Journal of Monetary Economics 58 (2011) 4: 305–327, p. 314. 21 Thomas L. Hungerford, “Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945,” Congressional Research Service, CRS Report for Congress, 7–5700, September 14, 2012. 2 2 “A Conversation on the State of the Economy with Paul Krugman and Joseph E. Stiglitz,” Institute for New Economic Thinking (INET), October 23, 2012. 23 Lawrence Summers, “The Trump Administration’s Tax Plan is an Atrocity,” The Washington Post, October 8, 2017. 2 4 Laura Saunders and Siobhan Hughes, “Buffett Builds His Tax-the-Rich Case,” The Wall Street Journal, October 13, 2011. 25 Paul Krugman, “The New Voodoo,” The New York Times, December 30, 2010. Luke Brinker, “Paul Krugman Has Bad News: Voodoo Economics is Poised for a Comeback,” Salon, October 16, 2014. 26 Including the well-known economist Nouriel Roubini. “Patriotic Millionaires for Fiscal Strength.” https://patrioticmillionaires.org/. 27 Joshua Miller, “Warren Buffett: Read My Lips, Raise My Taxes,” ABCNews, This Week, November 21, 2010; Why is Warren Buffett, who is the second-richest person in the United States, paying a lower marginal tax rate than his secretary? “Buffett isn’t the only billionaire who has argued for higher taxes. Both Microsoft co-founder Bill Gates and his father, Bill Gates, Sr., recently came out in support of a Washington state measure to ‘create a 5 percent tax rate on annual income exceeding $200,000 for individuals and $400,000 for couples, and a 9 percent tax rate on income that tops $500,000 for individuals and $1 million for couples.’” Amanda Terkel, “Warren Buffett: I ‘Should Be Paying A Lot More in Taxes,’” Huffington Post, November 21, 2010. “Executives Who Support Tax Increases to Fix the Deficit,” The Wall Street Journal, October 25, 2012. Ryan Grim and Sabrina Siddiqui, “Top Two Percent to GOP: Tax Us,” Huffington Post, December 5, 2012. 28 Paul Krugman, “Things to Tax,” The New York Times, November 27, 2011. 29 IRS SOI Tax Stats—Individual Statistical Tables by Size of Adjusted Gross Income. www.irs.gov/statistics/ soi-tax-stats-individual-statistical-tables-by-size-of-adjusted-gross-income. 30 Federal Reserve Bank of St. Louis, series CP. 31 The top tax rate was lowered in 1981 to 50% and in 1986 to 38.5%. 32 This does not include $600 million transferred from the victims to criminals. David A. Anderson, “The Aggregate Burden of Crime,” Journal of Law and Economics 42 (1999) 2: 611–642; Neil Schoenherr, “Cost of Incarceration in the U.S. More Than $1 Trillion,” the Source, September 7, 2016. 33 Federal Reserve Bank of St. Louis, series SLOAS. Some 14.4% of borrowers have past-due balances. Meta Brown, Andrew Haughwout, Dong-hoon Lee, Maricar Mabutas, and Wilbert van der Klaauw, “Grading Student Loans,” Federal Reserve Bank of New York, March 5, 2012. 34 Congressional Budget Office, “The 2017 Long-Term Budget Outlook,” March 2017. www.cbo.gov/system/ files/115th-congress-2017-2018/reports/52480-ltbo.pdf. 35 Nick Timiraos and Youjin Shin, “How Tax Cuts Affect Revenue,” The Wall Street Journal, December 21, 2017. 36 “Empirical evidence . . . suggests that the damage of taxes on work effort is limited . . . Most studies find that taxes have only a small impact on labor effort for middle-income and high-income workers,” Samuelson and Nordhaus, Economics, 19th ed., p. 333.

218  Macroeconomics Part III 37 Together their wealth adds up to $1.3 trillion. “In Pictures: Richest 25 American Billionaires,” Forbes, October 3, 2010. 38 Peter Lindert, Growing Public, vol. 1, Social Spending and Economic Growth Since the Eighteenth Century (Cambridge, UK: Cambridge University Press, 2004). 39 Wikipedia contributors, “Stanford Marshmallow Experiment.” 40 Board of Governors of the Federal Reserve System, “Report on the Economic Well-Being of U.S. Households in 2017,” May 2018. Jessica Dickler, “Most American Live Paycheck to Paycheck,” CNBC, August 24, 2017; Jim Forsyth, “More than Two-Thirds in U.S. Live Paycheck to Paycheck: Survey,” Reuters, September 19, 2012. 41 U.S. Department of Commerce, U.S. Census Bureau, The 2012 Statistical Abstract. Income, Expenditures, Poverty, & Wealth. 42 Board of Governors of the Federal Reserve System, “Why does the Federal Reserve Aim for 2 Percent Inflation Over Time?” 43 Federal Reserve Bank of St. Louis, series, CPALTT01USM659N. 44 Federal Reserve Bank of St. Louis, series, BOGMBASE and M1SL. 45 Federal Reserve Bank of St. Louis, series, WRESBAL and IOER. 46 Joshua Sherman, “Spendy But Indispensable: Braking Down the Full $650 Cost of the iPhone 5,” Digital Trends, July 26, 2013. See also Alicia Adamczyk, “The iPhone 7 Costs you 3x More Than It Costs Apple to Make,” Time, September 26, 2016. 47 Federal Reserve Bank of St. Louis, series, CLF16OV and UNRATE. 48 Paul Krugman, “The Stimulus Tragedy,” The New York Times, February 20, 2014. 4 9 Congressional Budget Office, “Estimated Macroeconomic Impacts of HR 1 as Passed by the House and by the Senate.” 50 David Leonhardt, “Economic Scene: Judging Stimulus by Job Data Reveals Success,” The New York Times, February 16, 2010. 51 Federal Reserve Bank of St. Louis, “Civilian Unemployment Rate.” https://fred.stlouisfed.org/series/ UNRATE.

13 International Trade Open Economy Macroeconomics

International trade is an important aspect of the macroeconomy. Remember the Keynesian equation from Chapter 10: GDP = C+I+G+(X−M) where X stands for exports and M for imports; (X−M) is the trade surplus or deficit. So trade is an important determinant of GDP and therefore of employment. We will analyze its impact on the economy especially in the presence of unemployment and endemic trade deficits.

The Theory of Comparative Advantage No other theorem is as firmly engrained in mainstream economics as that of comparative advantage. For Samuelson and Nordhaus it is not a theorem but a “truth.”1 Both sides benefit from trade if they specialize in the production and export of those goods and services in which they have a comparative advantage, i.e., which they can produce cheaper than their competitors. However, the theorem is misleading because it has many limitations that are concealed from casual students and can have deleterious consequences. The theorem’s secret assumptions include: (1) The theorem is actually about barter and not trade in the modern sense of using money. The introduction of money complicates things because of the possibility of trade deficits, credit, and exchange rate manipulation. (2) The theorem does not consider the possibility that trade deficits cause unemployment if the exchange rate does not respond to bring the trade account into balance. It assumes that those who lose their jobs as a consequence of trade will find employment in another sector. However, if trade does cause unemployment, the country might not benefit at all and might even lose. (3) It is well known that not everyone gains: some people lose.2 The decline in the relative price of unskilled-labor-intensive goods, for instance, will depress the wages of unskilled labor. This is what happened in the U.S. labor market because of the cheap import of manufactured goods. However, the ethical nature of this redistribution is disregarded. The question is framed in terms of the increases in total welfare, and that trade is not Pareto optimal is never mentioned. This is inconsistent since in other sections of the same textbooks some welfare-enhancing policies are prohibited because they are not Pareto optimal, while in this case, policies are advocated although they are not Pareto optimal.

220  International Trade (4) Crucially, the political and social implications of the income redistribution are disregarded. This ignores the elephant in the room and is counterproductive since it can lead to massive social realignments and political movements such as Trumpism with serious consequences. (5) The theorem is derived for two countries trading two goods being produced by two factors. However, the theorem no longer holds with many countries and many goods and many factors. In other words, the theorem is not applicable to the real world at all because more than two goods are being produced by more than two countries and more than two factors. (6) The theorem assumes that goods traded are produced under perfectly competitive conditions and disregards that most traded goods are being produced by oligopolies. That means that profits will be transferred to other countries. (7) Free trade is not a prescription for economic growth. The theorem considers trade from a static framework. The evidence indicates that free trade helps less developed countries more than developed ones. In sum, there are many caveats associated with the theorem of comparative advantage that may turn a supposed gain into realized losses. Yet, economists and policy makers pretend that it can be applied mechanically without thinking about its Achilles heels.

The Effects of Tariffs on Welfare Are Complicated by Underemployment According to the theory of comparative advantage, tariffs detract from welfare. Samuelson and Nordhaus offer a typical example of the consequences of a tariff as follows: suppose that the initial price of clothing is $4 per unit, domestic output is 100 units and consumption is 300 units, so that 200 units are imported (Figure 13.1). After a $2.00 per unit tariff is imposed, the domestic price increases to $6, domestic production increases to 150 units, and domestic consumption declines to 250 units so that imports fall to 100 units. They conclude that “the overall social impact [of the tariff] is . . . a gain to producers of $250, a gain to the government of $200, and a loss to consumers of $550. The net social cost (counting each of these dollars equally) is therefore $100.”3 These amounts are calculated as follows: the area of the trapezoid A equals the gain to producers ($2×100)+½($2×50)=$250. The first term is the area of the rectangle (the increase in price times the amount produced initially). The second term is the area of the contiguous triangle. Its area is the increase in production (50) times the tariff (2) divided by 2. However, the producers’ gain is at the expense of consumers who buy the product at higher prices. Hence, $250 is a transfer from consumers to producers and not a net gain. Area C is government tariff revenue, which is passed back to the consumers, so it is neither a loss nor a gain. The area of triangle B is ½($2×50)=$50. It is the value of labor and other resources competed away from other sectors of the economy in order to induce them to produce clothing instead of something else although the economy was better suited to the production of that something else. The diversion of resources into the production of clothing is inefficient since the economy could have obtained this quantity of clothing from

International Trade  221

Figure 13.1  The Effect of Tariffs on Domestic Production and Consumption

abroad cheaper. Therefore, B is a net loss to consumers. Furthermore, the area D (the same size as B) is also a net loss in consumers’ utility because they consume less clothing than before. So the tariff introduces a distortion between world price and domestic price and induces a net loss (called dead-weight loss) of ($50+$50)=$100. However, there are many hidden assumptions in this standard model. For instance, in the microeconomics section of the mainstream textbooks, economists argue that the utility of one individual ought not be compared to that of another. Yet in the macroeconomics section they stealthily do just that: they compare the income gained by producers to that lost by consumers. But incomes are not the relevant unit of comparison unless they are first converted into utility since a dollar produces more utility for a poor person than for a rich one. However, here economists find it convenient to “count each dollar equally.”4 Hence, this is an inconsistency between microeconomics and macroeconomics. One would have to consider how much utility is being produced by these different dollars. Thus, the distribution of gains and losses should be considered as well. The assumption of full employment in this model is never mentioned. However, with unemployment, B would not be a loss but a gain of $50 to workers who have a job after the tariffs are imposed. In addition, area E would also be a gain because these dollars would then accrue to workers who were previously idle, so they would not have to be diverted from other sectors of the economy. That would be a gain of $4×50=$200; this is a transfer

222  International Trade from foreign workers to domestic workers. Hence, the total gain to domestic workers is E+B=$50+200=$250 and the existence of unemployment turns the whole calculation on its head: it converts an alleged social loss of $100 to an actual gain of $250−$100=$150.5 The increase of $150 in the domestic economy would also have multiplier effects in the presence of unemployment, so the actual gain is greater.6 Another issue omitted is that the losses are spread among many consumers, but the gains are concentrated among a few workers. Assume that each dollar gain or loss in the example represented, say $1,000. Then if the $100,000 loss due to the tariffs were divided among, say, a million consumers, then the 10-cent loss per person would have a trivial impact on their utility. In contrast, if the gain to workers of $250,000 were divided among, say, five workers, then the gain per worker of $50,000 would mean their very livelihood and a substantial increase in their level of utility. Thus, measured in terms of utility, the cost-benefit calculation is even more in favor of a tariff. The aficionados of globalization overlook important aspects of international trade theory such as the factor-price equalization theorem, which has vital implications for wages.7 The theorem implies that there will be a tendency for wages to become equal across the countries trading with each other. Hence, the wages of unskilled labor will rise in China but will stagnate or decline in the U.S. Indeed, this is precisely the reason why unskilled wages have been declining among men in the U.S. (Figure 13.2). In fact, they have been affected most in areas hit hardest by trade with China.8 Obviously, this development has major ethical and political implications. If the tariffs are lowered instead of increasing as in the example above, the results are symmetric. A lowering of tariffs will induce a net loss to the society of (B+E−B−D) in case of unemployment, which in the above example amounts to $150. To be sure, economists assume that workers who lose their jobs because of the elimination of tariff protection can find a job somewhere else in the economy. In that case the net gain would remain $100 since the areas B and E would not be considered losses. That might have been true in the 1950s when jobs were plentiful but is no longer so. A decade after the Meltdown, the average length of an unemployment spell is still 23 weeks.9 How are workers with a high school education, displaced from low-skilled occupations supposed to find jobs in the expanding IT sector? The best they can hope for is to trade their lower-middle-class income for Walmart wages and join the ranks of the working poor on food stamps. Shouldn’t the loss of the wages of those who were displaced by the influx of foreign products be subtracted from the gains from trade? The argument is often made that free trade should be endorsed nonetheless since the gainers gain more than the losers lose and the latter could be compensated. Yet, that is little consolation for the losers. Generally, they are not made whole. So, one should ask if it is ethical to enact a policy that hurts some people even if the rest of society benefits. In short, the simplifications of the standard trade analysis overlook the main social, political, and ethical challenges of coping with the effects of factory shutdowns and wage realignments as a consequence of trade liberalization. Humanistic economics would prescribe not only that “the U.S. as a whole” benefits from trade but that no one in the U.S. is hurt as a consequence of international trade. In other words, the losers should be fully compensated by the winners. Then trade would be Pareto optimal. Without substantial

International Trade  223

College

$35

Hourly Wage

$30 $25

High School

$20 $15 $10 1970

No H. School 1980

1990

2000

2010

Figure 13.2  Men’s Hourly Wages by Education Source: Economic Policy Institute, “Data, Wages.” www.epi.org/data/#?subject=wage-education.

protection, neither the Asian tigers nor China would have been able to compete with the technologically advanced nations and their growth would have been stifled.

Free Trade Is Not an Engine of Growth Free trade is not a prescription for growth. Comparative advantage and gains from trade pertain to welfare in the static sense under special circumstances and are not at all relevant to economic development. The reason is that tariff reduction increases consumer welfare but says nothing about economic growth (Figure 13.1). While, production of textiles decreases, there is no axiom that another sector will expand. So long-term growth is another issue and depends on the usual factors (Chapter 11). No developing country— neither Germany nor the U.S. in the nineteenth century, nor Japan, Korea, Taiwan, Korea, Singapore, or China in the twentieth century—was able to catch up with developed countries without protecting its economy from competition from the most advanced country.10 In other words, the historical record indicates that free trade is hardly a formula for catch-up growth for developing economies. Even if international trade were to increase welfare and not cause unemployment, and if losers were fully compensated by the gainers, there is nothing in the theorem of comparative advantage that predicts that economic growth would accelerate in the wake of free trade. That depends on whether the gains are spent or invested. The Chinese were able to translate their gains into growth because they invested their profits, whereas the U.S. bought consumer goods that have no lasting growth effects. The cheaper shirts bought decades ago are no longer around, whereas the Chinese capital investments are still generating returns.

224  International Trade

The Protection of Infant Industries In the early stages of economic development industrial growth is fostered by subsidizing infant industries or by protecting them with tariffs. For example, suppose computers have just been invented in country A and a firm can produce them for $100. As it starts manufacturing them it accumulates knowledge about how to build them more cheaply—called learning by doing—and by next year can build them for $95. Now firms in country B see the opportunity but do not have the specific knowledge on the best practices, so they would have to start the process as a higher-cost producer at $100. So producers in country A enjoy a “first-mover advantage” and producers in country B will only produce computers if the government provides a $5 subsidy or levies a tariff of $5 on computers. First-mover advantage means that follower countries have to play catch-up and free trade would not work to their advantage. In this case country B would never be able to produce computers without protection. A current example is the penetration of the Chinese wind turbine manufacturers into the U.S. market, to the detriment of the fledgling home industry.11

Unbalanced Trade Creates Underemployment In the real world the existence of money and IOUs mean that exports and imports do not have to equal as they do on the blackboard: the U.S. balance of payments has been negative continuously since 1976 (Table 13.1). The floodgates were opened in 1980 with the endemic budget deficits.12 Then came two turning points: The North American Free Trade Agreement13 (NAFTA) in 1994 and China’s joining the Word Trade Organization (WTO) in 2001. In their wake, the deficits almost doubled and then more than doubled again after 2002. In 2006, they peaked at $761 billion and then settled down to just over $500 billion after the recession14 (Figure 13.3). This development means that the U.S. has been sending abroad more than half a trillion dollars annually instead of spending it domestically. This persistent deficit has been a major job destroyer: since the country imports products it otherwise would have produced, jobs are exported, and U.S. workers are either put on the unemployment rolls, retire on social security disability, go to jail, or accept a wage cut, but many also turn to opioids or commit suicide.16 The rule of thumb is that $1 million dollars of deficits destroys five U.S. jobs implying that a $500 billion import surplus leads to an export of 2.5 million jobs.

Table 13.1  U.S. Average Annual Current Account Balance (Billions of 2017 Dollars) Prices

1960–1979 1980–1993 1994–2001 2002–2009 2010–2017

Current

2017

−3 −76 −196 −600 −513

−3 −164 −288 −740 −540

Source: U.S. Census, Bureau, “Foreign Trade, Historical Statistics.” www.census.gov/foreign-trade/statistics/historical/ index.html.15

International Trade  225 0

Billions of Current Dollars

−100 −200 −300 −400 −500 −600 −700 −800 1960

1970

1980

1990

2000

2010

Figure 13.3  U.S. Trade Balance in Goods and Services Source: see Table 13.1.

Hence, the elimination of the deficits could reduce the estimated 14 million underemployed by 18% (see Table 11.2 in Chapter 11). Hence, the general rule should be that tariffs are lowered, and old industries phased out at a rate such that the displaced workers can be absorbed by expanding industries, or can be retrained, or that the unemployed are fully compensated for their losses by the gainers, making the policy Pareto optimal. In short, the losers should be made whole. Simultaneously, the accumulated trade deficit amounted to a $15 trillion stimulus to the rest of the world’s economy, which drained an immense amount of purchasing power from the U.S. economy (Figure 13.4).17 No wonder the Chinese economy has been booming with such a stimulus. It is quite doubtful that the benefits of lower-priced imported consumer goods outweigh the immense costs to the social fabric brought about by underemployment and stagnant or declining wages leading ultimately to political discontent and Trumpism. According to conventional thinking, the market should resolve the balance of payments problem by devaluing the dollar. But that failed to materialize because the dollar is a reserve currency, so foreign central banks, individuals, and firms want to own dollar-denominated assets as safe investments in a volatile world short of safe assets. This means that the U.S. is unable to devalue its currency and thereby eliminate its current account deficit. This imbalance has led to a massive export of government IOUs on which interest will accrue indefinitely.18 While this buoys up current U.S. living standards, it does so at the expense of generations as yet unborn. One should keep in mind that trade policy is path dependent (Chapter 8). So, one cannot simply turn back the clock on globalization and impose import tariffs to achieve balanced trade. The reason is that the other side can and most likely will retaliate, thereby reducing

226  International Trade

Billions of 2017 Dollars

16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1980

1990

2000

2010

Figure 13.4  U.S. Cumulative Balance of Payments Deficit Is $15 Trillion in 2017 Prices Source: see Table 13.1.

U.S. exports and sparking a retaliatory trade war with the most likely outcome being that both sides lose. However, there does exist a policy instrument that can achieve trade balance without the possibility of punitive measures: import certificates.

Import Certificates Are the Only Safe Way to Eliminate the Trade Deficit Warren Buffett implored policy makers to use import certificates to “halt this trading of assets for consumables.”19 This ingenious way would fix the problem of deficits without singling out any nation or putting tariffs on any single good. He warned that: The U.S. trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to political turmoil . . . Right now, the rest of the world owns $3 trillion more of us than we own of them. Buffett’s suggestion was that the U.S. government issue import certificates to firms exporting in amounts equal to the value of their exports. In turn, the exporters would sell these certificates to U.S. importers or to foreign exporters. They would have to buy the certificates in the appropriate amounts in order to gain access to the U.S. market. The price for the certificates would rise until trade would be balanced.20 If the U.S. is unable to devalue its currency to rebalance trade, it can raise the price of foreign products in this manner. With import certificates, the price of U.S. exports would also decline, making it easier for exporting firms to export their products, and thereby increase their hiring. Implicitly, that would be like a subsidy paid by importers. The 2.5 million U.S. jobs created would also generate additional tax revenues thereby easing the budget deficit. Admittedly, the price of

International Trade  227 imports would increase, but that would be worth putting so many people back on the payroll. Moreover, that inconvenience would be diffused throughout the population, whereas the gains would be concentrated among the underemployed, who really need their fortunes lifted.21 While increasing tariffs gives other nations the opportunity to retaliate, the certificates would not. Just the opposite, it would be inducements for foreigners to buy our products because the more they buy the more they can sell. This makes import certificates preferable to tariffs. In 2016, U.S. imports were $2.7 trillion, or 23% greater than the $2.2 trillion exports.22 The balanced trade policy could be phased in over several years by initially granting, say, $1.15 worth of certificates for every $1.00 worth of exports. That would cut the deficit by $170 billion to $330 billion, creating some 850,000 jobs.23 That would eliminate a third of the trade deficit and be a stimulus without costing the government anything, and we would ultimately eliminate all the deficits in three years with a substantial boost to the job market and the economy. Since Buffett wrote those lines foreign holdings of U.S. securities has risen to $18 trillion.24 To be sure the U.S. owns foreign securities also, so that the net international debt is $8 trillion. But its distribution within the U.S. is uneven. A third of U.S. indebtedness—$6.2 trillion—was in U.S. Treasury securities25 whereas the foreign assets were not held by a wide public in the U.S. So, in 2017, the typical taxpayer owed about $20,000 to foreigners but owned no foreign assets at all. Moreover, the foreign debt was concentrated: Japan owned U.S. Treasury securities worth $1.1 trillion, while China held $1.4 trillion. The interest on them will have to be paid in perpetuity. This large level of savings also enables state-owned Chinese companies to buy up U.S. businesses, including high tech companies such as Complete Genomics, a California DNA sequencing company, although they limit foreign direct investments to joint ventures with some minor exceptions.26 This implies that we are exchanging the ownership rights to firms for Chinese consumer goods, and obviously the profits from such firms will no longer accrue to U.S. citizens. This does not auger well for the future of the economy.

New Trade Theory The old trade theory of David Ricardo and its extensions were refuted by Paul Krugman, although most Principles textbooks disregard him, even if he received the Nobel Prize for it.27 Modern trade patterns are novel. Instead of trading Portuguese wine for British textiles based on factor endowment advantages, as in Ricardo’s famous example, today most advanced industrialized countries trade basically the same products among themselves: Volkswagen cars are sold in France while Citroen cars are sold in Germany. The motivation in such trade is not comparative advantage but the existence of economies of scale, quality, style, branding, patent rights, or diversity in consumption. If the two cars are close substitutes, meaning that if it makes little difference which car one drives, then both cars will find markets in both countries. In addition, these goods are produced not in perfectly competitive markets as supposed by Ricardo, but by oligopolies. No one else is allowed to produce cars with the VW logo on them and the perfectly competitive theory does not apply to branded products. This implies that there are profits to consider that are not part of the old trade theory but are crucial, for they are the source of taxes, future innovation, and growth.

228  International Trade Furthermore, there are economies of scale in production and first-mover advantages to consider. Once these brands are established, they become monopolies and the profits they generate are not easily competed away. Thus, Belgium has no particular comparative advantage in producing Godiva chocolates, but once they were produced there—through the historical happenstance of owning colonies that grew cocoa beans—they established a reputation that serves as the basis of trade and is not competed away easily. Other firms could make the same quality chocolate but will not have the reputation to be attractive to consumers, and consequently Godiva’s will retain its monopoly profits. Through first-mover advantage firms can produce at a lower unit cost, because of learning-by-doing, than firms which just entered the market—and these provide barriers to entry by competing firms, as in the infant industry example discussed earlier. The size of the domestic market also matters. The larger the domestic market, the greater quantities a firm will produce and benefit from lower unit cost of production. Thus, its competitive advantage of lower unit cost is not generated by factor or resource endowments but by economies of scale in production. The large domestic market in Germany for high-quality automobiles provided comparative advantages to BMW, Mercedes, Porsche, and Audi to compete successfully in the high-quality niche of the international automobile market. Increasing-returns technology also changes markedly the static analysis of tariffs. With the increase in tariffs (Figure 13.1), the firms increased domestic production of clothing, and, according to the conventional point of view, welfare decreased. That was the end of the analysis. However, if the good is produced with increasing returns to scale, the larger domestic production could mean that costs would decline, thereby changing the calculus depending on the size of the cost decline. In short, the new trade theory implies that there is room for trade policy through subsidies, tariffs, or import certificates. It is common knowledge that China did not become an economic power house through free trade.28 Rather it protected domestic industries while benefiting from the openings for its products provided by globalization.29 This is not different from other countries at similar stages of economic development. Even Britain, Germany, and the U.S. were protectionists before they became the technologically leading nation. There is also a role for industrial policy and government investment to help domestic firms capture economies of scale. Of course, there is reason to question the agility of government agencies to design and foster such trade-enhancing policies. Nonetheless, the theoretical case for free trade is no longer absolute; rather, Krugman’s new trade theory leads to the conclusion that context matters. The question remains: can we transition to a set of institutions that foster real full employment, which would have to include a trade policy that is much more nimble than the current one? These issues must be put on our agenda both academically and politically if we want to create a more balanced approach to solving the economic problems facing us.

Notes 1 Samuelson and Nordhaus state: “Notwithstanding its limitations, the theory of comparative advantage is one of the deepest truths in all of economics. Nations that disregard comparative advantage pay a heavy price in terms of their living standards and economic growth,” Paul Samuelson and William Nordhaus, Economics, 19th ed. (New York: McGraw-Hill/Irwin, 2009), p. 349. Perhaps they think it was God given as the 11th Commandment.

International Trade  229 2 Wolfgang F. Stolper and Paul A. Samuelson, “Protection and Real Wages,” The Review of Economic Studies 9 (1941) 1: 58–73. 3 Samuelson and Nordhaus, Economics, 353. 4 Samuelson and Nordhaus, Economics, 353. 5 Another way of seeing this is to subtract the $550 loss of consumers from the total amounts gained by producers, workers, and government: $250+$200+$250=700 and 700−550=150. 6 There have been a few observers who warned against the adverse consequences of free trade. John M. Culbertson, “The Folly of Free Trade,” Harvard Business Review 64 (1986) 5: 122–128. 7 Paul Samuelson, “International Trade and the Equalisation of Factor Prices,” Economic Journal June (1948): 163–184. 8 Efraim Benmelech, Nittai Bergman, Hyunseob Kim, “Strong Employers and Weak Employees: How Does Employer Concentration Affect Wages?” National Bureau of Economic Research, Working Paper No. 24307, February 2018. 9 In the 1950s it was half as long. Federal Reserve Bank of St. Louis, series UEMPMEAN. 10 Ha-Joon Chang, Kicking Away the Ladder: Development Strategy in Historical Perspective (London: Anthem Press, 2002); Ha-Joon Chang, Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism (New York: Bloomsbury Press, 2008). 11 “We cannot sit idly by while China races to the forefront of clean energy production at the expense of U.S. manufacturing,” said Senator Sherrod Brown, an Ohio Democrat. Tom Zeller, Jr., and Keith Bradsher, “China’s Push into Wind Worries U.S. Industry,” The New York Times, December 15, 2010. 12 B. Douglas Bernheim, “Budget Deficits and the Balance of Trade,” in: Lawrence Summers (ed.) Tax Policy and the Economy, Vol. 2 (Cambridge, MA: MIT Press, 1988), pp. 1–32. 13 NAFTA introduced free trade among Mexico, Canada, and the U.S. 14 President Trump has been saying incorrectly that the U.S. trade deficit is $800 billion. This is the deficit in trade in goods and neglects trade in services. In 2016 the U.S. had a $257 billion surplus in trade in services. Bureau of Economic Analysis, “2017 NIPA Annual Update Results Table.” www.bea. gov/national/pdf/NIPA-Revision-Table-9-11-17.pdf. 15 Slightly different data are found in: Federal Reserve Bank of St. Louis, series BPBLTT01USA637S. It ends in 2013, however. 16 Senator Byron L. Dorgan, How Corporate Greed and Brain-Dead Politics Are Selling Out America (New York: Thomas Dunne Books/St. Martin’s Press, 2006). 17 Board of Governors of the Federal Reserve System, “Industrial Production and Capacity Utilization—G.17,” last updated January 16, 2013. 18 U.S. Department of Commerce, Bureau of Economic Analysis, “U.S. International Transactions Accounts Data, Table 1, 2012.” 19 Warren Buffett, “America’s Growing Trade Deficit Is Selling the Nation Out from Under Us. Here’s a Way to Fix the Problem—and We Need to Do It Now,” Fortune, November 10, 2003. He reaffirmed his earlier stance in Warren Buffett, “Here’s How I would Solve the Trade Problem,” Fortune, April 29, 2016. 2 0 Robert E. Scott, “Re-balancing U.S. Trade and Capital Accounts: An Analysis of Warren Buffett’s Import Certificate Plan,” EPI Working Paper No. 286, December 2009. 21 There could be exemptions for strategic products such as oil. We could also have “threshold values” so small importers would be exempted. 2 2 Bureau of Economic Analysis, “2017 NIPA Annual Update Results Table.” www.bea.gov/national/pdf/ NIPA-Revision-Table-9-11-17.pdf. 23 Assuming that exports remained at $2.2 trillion, the 15% premium on the certificates means that (2.2×1.15)=$2.53 trillion imports would be allowed to enter the country. That means that the deficit would be reduced to ($2.53−$2.2)=$330 billion or by $170 billion. Assuming that an increase in domestic demand of $200,000 creates one job implies that 850,000 jobs would be created initially. 2 4 This does not include direct investments in which the U.S. international position is about even. Bureau of Economic Analysis, “U.S. Net International Investment Position, Third Quarter 2017.” www. bea.gov/newsreleases/international/intinv/intinvnewsrelease.htm. 2 5 U.S. Treasury, “Major Foreign Holders of Treasury Securities,” http://ticdata.treasury.gov/Publish/mfh.txt. 26 Michele Nash-Hoff, “Should We Allow the Chinese to Buy Any US Company They Want?” IndustryWeek, January 9, 3018; Stephen Gandel, “The Biggest American Companies Now Owned by the Chinese,” Fortune, March 18, 2016; Andrew Pollack, “U.S. Clears DNA Firm’s Acquisition by Chinese,” The New York Times, December 30, 2012.

230  International Trade 27 Paul Krugman, “Scale Economies, Product Differentiation and the Pattern of Trade,” American Economic Review 70 (1980) 5: 950–959. Elhanan Helpman and Paul Krugman, Market Structure and Foreign Trade (Cambridge, MA: MIT Press, 1989). 28 “When the U.S. allowed China to join the World Trade Organization in 2001 and gain much less restricted access to our markets, we gave China the right to keep protecting parts of its market— because it was a ‘developing economy.’” Thomas Friedman, “Trump Lies. China Thrives,” The New York Times, June 7, 2017. 29 It also used intellectual property theft to its advantage. That includes “counterfeiting American fashion designs, pirating movies and video games, patent infringement and stealing proprietary technology and software.” Dennis Blair and Keith Alexander, “China’s Intellectual Property Theft Must Stop,” The New York Times, August 15, 2017.

14 The Financial Crisis of 2008

At the turn of the twenty-first century, the economy was about to experience the worst economic crisis since the Great Depression. The Meltdown of 2008 became a crisis that shook the very foundations of liberal democracy. The 2008 collapse of the house of cards built on mistaken dogmas and excessive amounts of hubris will become a watershed moment on a par with 1929. This was caused by the confluence of the Dot-Com bubble, the tsunami of globalization, and the subprime mortgage crisis. Adding to these problems was terrorism and the subsequent senseless invasions of Iraq and Afghanistan which drained tremendous amounts of money from the U.S. economy. “These are times that try men’s souls.”1 Unfortunately, our souls were not prepared for these challenges and we lacked leaders with FDR’s vision to lead us to safer shores. Speaking of 1929, John M. Keynes’ words ring true for our own time: [t]o-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.2 What a poetic way to describe an economic slump! We, too, got ourselves into a “colossal muddle” and we, too, blundered in our economic policies, and we still do not understand or care to recognize the workings of the new economy. And yes, we have been wasting much of our productivity and will continue to do so for a long time. We would need a Keynes for our times, but one is not in sight. One serious problem was that by the twenty-first century the memory of the Great Depression had faded and consequently the accumulation of “irrational exuberance” was not taken seriously. That experience was no longer considered relevant. Even the Chairman of the Federal Reserve since 1987 and among the elders of finance, Alan Greenspan (who coined the above phrase), was barely a toddler in 1929. Anyway, we were so much smarter and more sophisticated that the past was irrelevant. Financial crises of the magnitude of 1929 or of 2008 are so powerful, because they hurt so many people: millions lose their job, are ruined financially, thrown out of their homes shattering dreams through financial losses. Wealth is destroyed, pensions lost, and savings accounts depleted. And even those who still have their job are anxious. The rise of Trumpism is hard to fathom without the dislocations of 2008. Similarly, the devastations

232  The Financial Crisis of 2008 of 1929 brought about the New Deal: a revolutionary set of policies. Hence, such financial crises are catalysts that create watershed moments in which history suddenly, violently, and unexpectedly, takes a different turn. Ironically, the crisis was preceded by the accumulation of a lot of hubris: to mainstream observers all seemed well. Nobel Prize winning macroeconomist Robert Lucas, for instance, conceitedly declared in 2003 that the “central problem of depression-prevention has been solved, for all practical purposes” in his presidential address to the American Economic Association.3 We have nothing to fear; economists know what they’re doing. A year later Princeton economist Ben Bernanke, soon-to-be Greenspan’s successor as the Chair of the Federal Reserve, declared with similar hubris, that a new era of “Great Moderation,” had arrived.4 This pronouncement affirmed that business cycles had smaller amplitudes since the mid-1980s due to improved demand management and monetary policy.5 The pre-­meltdown tranquility misled mainstream economists into thinking that business cycles were no longer a substantial threat to employment and welfare.6 They were dead wrong. One of the biggest crises in the economic history of the world was on the horizon even if they were blind to it: the “Great Moderation” lasted another three years. The Bible does warn that, “Pride comes before destruction, and an arrogant spirit before a fall.”7

Preliminaries Chairman Greenspan successfully overcame several crises in his tenure. For the peso crisis of 1994 Greenspan, Treasury Secretary Robert Rubin, and Larry Summers coordinated a $50 billion bailout for Mexico. Then came the Asian crisis of 1997 also based on a shortage of dollars, and the IMF came to the support of a number of economies from Thailand to South Korea whose currencies were losing value. In the ensuing recession, however, the price of oil declined and forced the Russian government into bankruptcy in 1998, which, in turn, brought down a major U.S. hedge fund, Long-Term Capital Management, heavily invested there. Again, Greenspan came to the rescue by organizing a $3.6 billion bailout. All this accentuated his reputation; on Wall Street this was referred to as “the Greenspan put,” i.e., no need to worry: if something goes awry Greenspan will help us.8 Hence, in 1999 Time magazine put the triumvirate of Greenspan, Rubin, and Summers on its cover as “The Committee to Save the World,” making them appear invincible.9 The article lavished praise on them, but it also smuggled in a few thoughts to express some reservations about their veneration: “By fighting off one collapse after another—and defending their economic policy from political meddling—the three men have so far protected American growth, making investors deliriously, perhaps delusionally, happy in the process (my italics).” Note that the stealthy use of “delusional” conjures up the possibility that it is all an illusion. The author cites Summers’ conceited statement, “we start with the idea that you can’t repeal the laws of economics. Even if they are inconvenient.” Sure, but they forgot the crucial role of asymmetric information, a concept for which Joseph Stiglitz, George Akerlof, and Michael Spence received the Nobel Prize. Their work showed that in the presence of asymmetric information—which is all the time in the real world of finance—markets are inefficient. That, too, is part of the “laws of economics” even if the triumvirate ignored it; yet, asymmetric information was at the center of the subprime crisis.

The Financial Crisis of 2008  233 Another takeaway from the bankruptcy of Long-Term Capital Management should have been that the quants of finance and their computer programs were fallible, i.e., that the assumed sophistication of the money managers was deceptive. After all, the two Nobel Prize winners who derived the Black-Scholes-Merton model for derivative pricing sat on the board of directors. The model worked well on the blackboard but not always in the real world: losses were $3.6 billion. But the upshot was not to generate scepticism about mathematical models but to reinforce instead faith in the “Greenspan put.” Then came the Dot-Com bubble. Basically, the fundamental value of equity is the discounted value of the dividends that shareholders expect to earn by owning the share from now until eternity. The problem is that investors do not know future dividends, only past ones. So, investors use past earnings as a guide to gauge current price. The price/earnings ratio is an indicator of the fundamental value of the share. Shiller considers that the best variant is the one that divides the current price with the average earnings over the past ten years. However, to calculate the value of Internet companies in this way was impossible because they did not yet have any profits. But their future was promising and the “new economy” was exciting. Some of the companies would become the next big disruptive tech firms earning super profits. Consequently, speculation about their future earnings took the upper hand. Keynesian “animal spirits,” the ebb and flow of optimism and pessimism fueled the speculative frenzy leading to the skyrocketing of stock prices beginning in 1995.10 The 138-year average price to earnings ratio (1880–2018) is 16.8 (Figure 14.1). Its inverse is the rate of return on those 1 investments:   =5.9%. At the peak of the Dot-Com bubble the ratio reached 43, almost 16.8 three times the average of the previous century, implying a rate of return of merely 2.3%,

50

2000

Price to Earnings Ratio

45 40

1929

35 30 25 20 15

Average

10 5 0 1880

1900

1920

1940

1960

1980

2000

Figure 14.1  Price to Earnings Ratio of S&P 500 Stocks Source: “Online Data from Robert Shiller.” www.econ.yale.edu/~shiller/data.htm.

2020

234  The Financial Crisis of 2008 an obvious sign of a major bubble.11 To be sure, a few firms did become iconic. However, hundreds failed when the bubble burst.12 A recession followed but it lasted but eight months as Greenspan lowered the interest rate and that accelerated economic activity. The economy came out relatively unscathed and Greenspan lived up to his reputation. But all was not well. Greenspan was steering the financial markets into a doom loop.13

Financial Innovations Financial innovations afforded new and exciting investment opportunities. Western culture is enchanted with innovation. In our irrational exuberance we tend to forget that, as Joseph Schumpeter emphasized, there is a destructive component to them as well.14 So, regulators followed strictly the received wisdom and cheered deregulation and financial innovation. One of the more important developments was the growth in securitization of mortgages. In the old model of financing a mortgage a bank would provide a loan for the purchase of a home. It scrutinized borrowers very closely, knowing that it would have to rely on their payments for 30 years. Did the person have a good track record, a job, assets, etc.? The downside to this model of mortgage lending was that the amount of funds available to local banks was limited by local savings. Hence, the mortgage market was ripe for an innovation that would solve this credit constraint. Beginning in 1968, the Government National Mortgage Association (GNMA), sponsored by the Department of Housing and Urban Development, started pooling a bunch of these mortgages and issued a new type of bond called a Mortgage-Backed Security (MBS). Securitization began. Soon Fannie Mae and Freddie Mac, two other government sponsored agencies, began to offer such securities.15 This was great, because it provided new and safe opportunities to investors with excess cash and enabled money to flow to local communities throughout the U.S. thereby eliminating shortage of credit in places such as Akron, Ohio. These agencies held the local banks to stringent underwriting standards, i.e., the buyer’s income had to be strictly documented. However, a decade later private banks wanted to get into this business, but regulations were in the way, so they lobbied Congress and in 1984 they succeeded.16 The Reagan administration supported privatization and the prohibition was lifted: private banks could also securitize mortgages as long as the rating agencies gave the bonds a top rating. The Securities and Exchange Commission (SEC) would regulate the trading of mortgaged-backed securities so there was no need to worry.17 The half-century period of boring banking was coming to an end. Investments were becoming more exciting. But the private banks were unable to compete with agencies backed by the full credit of the U.S. government. However, Fannie or Freddie accepted only prime mortgages where the borrower had solid credit and decent incomes. They did not accept subprime mortgages whose borrower’s credit rating was below 640. There the private banks would find a niche and make a market for themselves. However, who would invest millions into securities based on risky mortgages? This brought the banks to the next innovation in financial engineering: they could make at least a portion of this bond secure by dividing them into several portions called tranches (slices).

The Financial Crisis of 2008  235 Initially, there were just two parts: top and bottom. Later there were more slices: as many as 19 in the example below. The incoming payments of all the mortgages that were included in the MBS would be pooled, and the top slice would be paid first. Whatever money was left over from the monthly payments would go to the investors of the bottom slice. So, the top slice became a safe bet since not all borrowers would stop paying at once. They also paid the lowest interest rates. The bottom tranche received a higher interest rate because the investors had to bear a higher risk. For instance, a single MBS might incorporate as many as 4,500 mortgages worth $950 million. The senior tranches in this example were worth about $700 million. This part would receive an “A” rating from the credit agencies and paid the lowest interest returns because as many as 1,000 mortgagors (borrowers) could stop paying (out of the 4,500) and the investors in the top tranches would still receive their full amount due them.18 It was unthinkable that more than 1,000 mortgages would default out of the 4,500. Hence, the top portion of an MBS was considered a safe investment although it was based on risky assets. Thus, the financial engineers were like alchemists: they created “gold” out of subprime. Investors from around the globe bought the MBSs created by U.S. engineers. The example above, created by Citigroup, had investors from China, Germany, France, and Italy. However, as the market evolved, the effect of asymmetric information began to exert itself. The local banks, the originators of the mortgages, realized that it was superfluous to scrutinize the borrowers anymore because they would not be liable for 30 years’ worth of mortgage payments. Instead, they would sell the mortgage to Lehman Brothers immediately; so, it did not matter if the borrower could repay, and by the time the MBS reached investors in China they did not know where Akron was, let alone if the house value was assessed properly or if the borrower really did have the income stated on paper. So, the engineers injected a lot of asymmetric information into the system. The asymmetric information also provided incentives to finagle information. Fraud became commonplace and would prove to be the Achilles heel of financial engineering. In 1994 there came an additional innovation: credit default swaps (CDS). It was a contract that insured the owner of a security against default. Let us say Goldman Sachs (GS) invested $1 million in an MBS from Lehman Brothers. GS trusted Lehman, a 150-year-old institution, but if it wanted to be on the safe side it could buy insurance from American International Group (AIG) to eliminate any risk should Lehman default. In that unlikely case AIG would swap GS’s security for $1 million. The insurance contract was called a swap in order to get around the various Insurance Departments that oversee insurance contracts. After all, an insurance contract is like a swap. In case you total your car, you’ll swap it for money with the insurance company. However, you do want to make sure that in case of need your insurance company does have enough reserves on hand to make the payment. That is the purpose of the Insurance Departments; it provides oversight to avoid chicanery. But the CDS was a new form of insurance and firms could sell them without oversight. After all, it was just a swap contract and not insurance. In 2000 the Congress even prohibited the regulation of CDSs. Obviously, this was a major mistake, because CDSs were an important pathway through which the 2008 disaster was propagated. The existence of such insurance contracts also fueled the subprime mortgage pipeline because it made them

236  The Financial Crisis of 2008 appear safer than they actually were. Moreover, once Lehman became bankrupt, AIG, which sold $79 billion worth of CDS protection, should have paid the value of defaulted obligations.19 Insofar as it did not have enough cash to do so the whole system was threatened by collapse. So, AIG was bailed out with $186 billion at taxpayers’ expense, to stave off disaster.

Double Trouble: Greenspan’s Bubbles Bubbles do not occur in orthodox economics. The efficient-market theory dogmatically rules them out, because if every investor is rational then the market is running smoothly, bubbles cannot develop, and markets cannot crash. There are no speculative processes out of control based on emotions or herding behavior. No one is exploiting asymmetric information. Instead, the market delivers what investors want. If someone wants to pay a premium for a house, who are we to object? Therefore, bubbles and financial instability were not part of mainstream macroeconomic models that all banks, the Fed, and academics were using to forecast. Such real-business-cycle models were discussed in Chapter 10. The use of these blackboard models meant that those in charge of the economy failed to understand and could not interpret the real economy in real time. The fact that Wall Street crashed in 1929 and in 1987 was conveniently disregarded. Wall Street was assumed to be more sophisticated. A bubble is an episode in which the price of an asset drifts far above its fundamental value. An ingredient of a bubble is that it often involves a degree of novelty with which investors have not had much experience. It is hard to excite investors about an asset that has been around for a while, but it is relatively easy to do so about an entirely new investment opportunity such as the Internet stocks in the 1990s run-up to the Dot-Com bubble. The concept of “fundamental value” does not exist in orthodox economics. The reason is that the value of everything is defined by the amount of money people are willing to pay for it. So, there is only “market value” because people cannot make mistakes in blackboard economics. Yet, even a market aficionado like Greenspan quietly did refer to “irrational exuberance” in 1996. Then in 2005, as the housing market was overheating, even he could not avoid noticing that there was some “froth” in the market and “pointed to an increase in speculation in homes.” As a result, he said, there are “a lot of local bubbles” around the country.20 Nonetheless, he did not take seriously the threat of a national bubble being formed and consequently did nothing about it. However, in behavioral finance markets can make mistakes. Robert Shiller received a Nobel Prize for his pioneering contributions to this field.21 In 2009 he suggested that the 55% decline in the S&P stock-price index was due to a “speculative boom,” adding: [p]sychology really matters . . . you can’t ignore the psychology, which unfortunately the economics profession has tended to do with recent theorizing; the so called efficient market hypothesis which says that markets efficiently incorporate all information and work with precision which I think is one of the most remarkable errors in the history of economic thought. This is not efficient markets.22 “The most remarkable error” was to rely on efficient market theory during the formation of the housing bubble.23 Many economists supported Greenspan’s view that piercing bubbles

The Financial Crisis of 2008  237 was not part of his role. To be sure, the Fed has a mandate to “promote maximum employment, stable prices, and moderate long term interest rates.” Yet, arguably, maintaining the stability and integrity of the financial system should be considered an integral part of that mandate, because if finance careers out of control, unemployment will undoubtedly skyrocket, and the other aspects of the mandate will become untenable. So, piercing bubbles should be an integral part of the Fed’s agenda. And, of course, Greenspan and Bernanke had the means to stop the housing market from overheating. For example, they could have enforced laws and not allowed underwriting standards to deteriorate; they could have stopped predatory loans; they could have prosecuted fraudulent mortgage brokers; and so forth. They could have done a lot.24 How can we tell if prices are out of line? Admittedly, with some investments it is impossible to do so. We do not know what the right price of Bitcoin is, for instance. However, houses are different because they provide a real service whose value is the rent that people pay to live there. Hence, one can compare house prices to rents to ascertain if they are out of line with their fundamental value. The empirical evidence leaves no doubt that they were (Figure 14.2). The rent ratio “took off” in 1998; first it increased by 1% and then by 3% in each of the next three years. During the next four years it increased by 4%, 6%, 8%, and 10% respectively. By its apex in 2006 house prices increased by 41% more than rental payments, way out of line with fundamental values. That did not make any economic sense. The quants on Wall Street and the PhDs at the Fed should have taken notice. A similar pattern obtains in comparison of house prices to incomes: house prices increased 22% more than nominal incomes until 2006 (Figure 14.2). So, a bubble at the national level should have been obvious to anyone with an open mind. The Fed had 1,000 PhD economists working for it running the wrong models on high-speed computers. In short, commonsense was not all too common.

150 140

Ratio

130 Ratio to Rent

120 110

Ratio to Income

100 90 80 1995

2000

2005

2010

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Figure 14.2  Ratio of U.S. House Prices to Rents and to Nominal Income, Index 1995=100 Source: OECD Statistics, “Analytical House Prices Indicators.” http://stats.oecd.org/index.aspx? DatasetCode=HOUSE_PRICES.

238  The Financial Crisis of 2008

Early Warnings Fell on Deaf Ears Brooksley Born alone, chair of the Commodity Futures Trading Commission (CFTC), attempted in vain to regulate derivatives in 1998.25 When she came into office CDSs were new but growing and she was astute enough to recognize that they were futures contracts, so they should come under her regulatory umbrella. However, she ran into a solid wall of opposition. When in her congressional testimony she was asked “what are you trying to protect?” she answered, “We’re trying to protect the money of the American public.”26 She could have become the Joan of Arc of U.S. finance. Instead, Greenspan became livid and spread rumors that she was “irascible, stubborn, and unreasonable.”27 He ganged up with Robert Rubin, the ex-Goldman Sachs Co-Chairman who was Bill Clinton’s Treasury Secretary at the time, and she was run out of town. (At least she did not suffer Joan’s fate.) Clinton did nothing to support her. On the contrary, much to his discredit, he signed into law the Commodity Futures Modernization Act of 2000 which prohibited the CFTC from regulating CDSs. That was another step toward the Meltdown. No wonder the Time article referred to Greenspan, Rubin, and Summers as “a kind of free-market Politburo on economic matters.”28 They won that battle but lost control of financial markets.

Illustration 14.1  Brooksley Born Was a Hero, the Joan of Arc of the U.S. Financial Crisis. She Attempted to Save the System but Was Run Out of DC. In 2009 She Received the John F. Kennedy Profiles in Courage Award. Source: Larry Levanti.

The Financial Crisis of 2008  239 Nonetheless, Born, along with Sheila Bair, chair of the FDIC in the crucial period 2006–2011, were the only two heroes of the financial crisis. It seems like financial commonsense among those serving three administrations spanning this decade was confined to two women. In 2009 they both received the “John F. Kennedy Profiles in Courage Award” in recognition of the “political courage each demonstrated in sounding early warnings about conditions that contributed to the current global financial crisis.” According to Caroline Kennedy, “Brooksley Born recognized that the financial security of all Americans was being put at risk by the greed, negligence and opposition of powerful and well connected interests.”29 The next serious warning came from Warren Buffett in his 2002 annual report to his shareholders. He warned that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”30 Derivatives are contracts that derive their value from another, underlying financial instrument. So, MBSs are derivatives: they derive their value from the underlying mortgages. Among economists, Dean Baker was the first to recognize the housing bubble.31 House prices had increased by 30% by 2002. Were incomes increasing one could understand the increased demand for houses, but they were not. On the contrary, real household incomes were falling (see Figures 7.2, 9.4, 14.6, and 14.5 throughout this volume). So, the steep increase in house prices made no economic sense (Figures 14.2 and 14.3). Between June 1998 and October 2005 average house prices doubled and the median increased by 60% from $152,500 to $240,900. In 2004 The New Yorker, with a circulation of 1 million, ran an article with the ominous title, “Blowing Bubbles.” It reported that “even some of Greenspan’s colleagues are concerned that one bubble has given way to another . . . [Yet] Greenspan refuses to contemplate

210 190

Ratio

170 150 130 110 90

1995

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Figure 14.3  National Home Price Index, January 2000=100. Source: S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index [CSUSHPINSA], FRED, Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/series/CSUSHPINSA.

240  The Financial Crisis of 2008 such a catastrophe. On Capitol Hill recently, he insisted that the economy ‘seems to be on track.’”32 So the idea of a housing bubble was heard more frequently in public discourse. In 2005 an important warning came from inside the finance establishment from Raghuram Rajan of the University of Chicago Business School, who later served as the Governor of the Reserve Bank of India. At a symposium of the Federal Reserve at Jackson Hole, Wyoming, in honor of Greenspan’s impending retirement, Rajan warned about the accumulation of risk and cautioned that the nature of financial innovation was deceiving. He spoke of perverse developments so that managers have: [t]he incentive to take risk that is concealed from investors . . . A second form of perverse behavior is the incentive to herd with other investment managers on investment choices because herding provides insurance that the manager will not underperform his peers. Herd behavior can move asset prices away from fundamentals.33 In other words, finagling with information was leading to the mispricing of risks insofar as asymmetric information enabled this danger to persist and accumulate. In addition, groupthink was leading to dysfunctional institutional behavior leading to a bubble. Rajan continued: In fact, the data suggest that despite a deepening of financial markets, banks may not be any safer than in the past. Moreover, the risk they now bear is a small . . . tip of an iceberg of risk they have created . . . They [banks] also may create a greater (albeit still small) probability of a catastrophic meltdown. Listening in the audience were, besides Greenspan, Bernanke, and Timothy Geithner, then President of the New York Fed and subsequently the chief architect of the bailouts under the Obama administration, correspondents of major financial media such as the The Financial Times and The Wall Street Journal, governors of foreign central banks including those of Australia, Denmark, China, and Israel, chief economists of major banks such as Citigroup, and dozens of luminaries including establishment economists from academia.34 Rajan’s powerful warning fell on deaf ears. Then in 2006, Nouriel Roubini suggested that the housing market is going “through an ugly and nasty bust,” and a recession was around the corner.35 But none of these early warnings was taken seriously. Finance had a momentum of its own as Charles Prince—the CEO of Citigroup—quipped in July 2007, “as long as the music is playing, you’ve got to get up and dance.”36 And the music was still playing for a few months longer. Interviews with Bernanke are indicative of the mind-set that prevailed at the Fed. In 2005, when asked by a reporter about a possible housing-market bubble, he responded, “unquestionably housing prices are up quite a bit.” Not only did he mislead the public about the extent of the price increases—they had doubled since 1998—he proceeded to rationalize them away: I think it’s important to note that fundamentals are also very strong: we’ve got a growing economy, jobs, incomes; we’ve got very low mortgage rates; we’ve got demographics supporting housing growth; we’ve got restricted supply in some places; so it’s certainly

The Financial Crisis of 2008  241 understandable that prices would go up some. I don’t know whether prices are exactly where they should be, but I think it’s fair to say that what’s happened is supported by the strength of the economy.37 That was newspeak 20 years after 1984. He knew that housing prices had increased by a lot more than “some.” They had doubled. And he must have known that incomes were not up, and that no demographics supported the bubble. But he also must have realized, even if subconsciously, that if he crossed the party line he would be committing a “thoughtcrime” and would not become Greenspan’s successor. When another reporter asked him in July 2005 for his worst-case scenario, he responded disingenuously, “I guess I don’t buy your premise; it’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.” (He knew that we did have such a decline during the Great Depression?) “So what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit; I don’t think it will drive the economy too far from its full employment path though.”38 Note, that he was dead wrong about the economic situation and spoke of full employment at a time when there were 7.6 million people officially unemployed and another 9 million nonemployed.39 His misleading statement caused many people to feel safe about investing in property in 2005–2007 and then lose a lot of money in the Meltdown. Nonetheless, Bernanke did become Greenspan’s successor and was even reappointed in 2010 by President Obama.

The Minsky Moment: The Meltdown of 2008 The Meltdown was straight out of Hyman Minsky’s playbook.40 For decades, Minsky stressed in vain that the financial system was inherently unstable and warned about the dangers of debt accumulation, and the endogenous nature of financial crises.41 He was keenly aware of the role of the debt cycle in the business cycle and in financial crises. In contrast, the financial sector is often omitted in conventional macroeconomic models, and hence concepts such as leverage, debt, and default are dismissed completely or considered as an epiphenomenon. Minsky’s framework includes loan contracts, which commit firms to pay a stream of money out of their expected future profits. The question is to what extent were the future profits correctly anticipated, and what happens if those expectations are not realized.42 In his prescient words: [t]he greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable and financing regimes under which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. After a bubble bursts asset prices decline and the net worth of firms “will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling

242  The Financial Crisis of 2008 out position. This is likely to lead to a collapse of asset values.” Systemic risk implies that one bankruptcy brings about the bankruptcy of other firms so that a snowball effect develops and the whole economy spins out of control. This is the exact scenario of the Meltdown. Minsky’s other argument was that stability breeds instability. This does not make sense on first sight. However, he pointed out that long periods of stability enable entrepreneurs to learn how to circumvent regulation by innovating and by creating new business models outside of the purview of regulators. Furthermore, reinforcing this development, the stability deceives regulators into complacency, leaving room for money managers to undermine the very institutions that were responsible for the stability in the first place, thereby obtaining opportunities to engage in risky behavior. This is precisely what happened under Greenspan’s watch. The 45-year period between 1935 and 1980 has been dubbed a period of boring banking.43 All the stabilizers FDR put in place worked well and promoted a halfcentury of stable economic growth. For example, the Glass-Steagall Act of 1933 prohibited commercial banks from investing in the stock market, so banks could not speculate with other people’s money. This made sense, as bank deposits were backed by the government, so it would have been imprudent to allow banks to assume excessive risk by speculating with deposits backed by a third party. But the stability misled government to be complacent and relax its oversight, beginning with the Reagan administration. Of course, regulation is always costly in terms of profits in the short run. Its beneficial effects are obtained only in the distant future. This provides a powerful incentive for bankers to advocate deregulation. And beginning with the Reagan administration they were successful in doing away with the regulations that guarded the stability of the system. While the government oversight became more relaxed, the financial sector innovated, and the shadow banking system blossomed, outsmarting the regulations in place. Things were running smoothly, and naysayers—such as Brooksley Born—were mercilessly silenced and gotten out of the way. Minsky also emphasized that “euphoric” booms were the main cause of financial instability.44 Euphoric lending meant that both lenders and borrowers made systematic errors in judgment about the loans they contracted by undervaluing the probability of default. Expectations were biased. This framework—derived from the historical record rather than from a priori theorizing about idealized markets—did not fit well into the popular rational-agent models. Consequently, Minsky’s ideas were cavalierly dismissed by mainstream economists and policy makers.45 Yet, his model predicted exactly what happened. Stability was deceiving as the financial sector evolved and, exactly as Minsky predicted, bypassed regulations. While the government relaxed regulation, the shadow banking system innovated and created new financial products. The innovations were not designed to improve the productivity of the real economy, i.e., to increase the efficiency of investments (and increase GNP); instead, they were designed for rent seeking (obtaining a bigger share of profits). Furthermore, the innovations injected immense amounts of asymmetric information and systemic risk into the macroeconomy. Another major problem was that the investors buying these new financial instruments had no experience pricing the risks associated with them: historical evidence of their volatility during a recession was non-existent. Therefore, during the euphoric years of easy money,

The Financial Crisis of 2008  243 the risks were woefully mispriced. The overall financial architecture was not designed to easily accommodate such innovations without adequate oversight. Thus, the extraordinary profits of the financial sector were deceptive since they were immediate and obvious, whereas the costs in terms of the risks associated with them were intangible, opaque, and uncertain. The extraordinary profits were paid out to the executives in bonuses. It was practically impossible to remain a prudent banker under such conditions. Moreover, the investment banks were highly leveraged and had to roll over their debt continuously to remain in business. When it became apparent that they had made systematic errors in pricing the risks, the flow of credit froze, and they were all threatened with insolvency. So, it was a risky business model with many hidden dangerous trigger points based on mispricing of risk and exposed to the shocks of negative externalities, i.e., systemic effects. Speculation was not confined to investment banks. There was also an abundance of consumers who assumed excessive risks, thereby falling prey to predatory lending in the housing market.46 The predatory practices included low teaser rates sometimes for as short as three months.47 In sum, risk was ubiquitous, intangible, ill understood, and under-priced. Consequently, instead of diversifying risk, the shadow banking system amplified it. Hence, the Meltdown of 2008 fit perfectly into Minsky’s model of financial instability. The regulations in place were not modernized to keep up with new business practices. Deemed archaic and superfluous, the Glass-Steagall Act itself was repealed in 1999. According to the dominant dogma of the time, the financial markets could regulate themselves and did not require oversight. Anyone who dared to bring up the possibility of creating new institutions to keep up with the evolution in the financial sector was vilified.48

Thirty-One Factors That Contributed to the Crisis 1.

Greenspan’s ideology was the main culprit. He was in charge of the financial sector and the most powerful economic czar in the world. He could have reined in the runaway financiers in the name of sustainable finance, but he did not believe in regulating. He had too much faith in the efficient market hypothesis and in the self-regulating mechanism of markets. He overlooked the principal-agent problem, moral hazard, systemic effects, asymmetric information, fraud in underwriting, predatory loans, and the mispricing of risk. Quite an oversight. 2. The financial innovations (MBSs and CDSs) introduced financial instruments with which investors did not have experience. Minsky referred to such innovations as “displacements,” i.e., they were new, exciting, and captured investors’ imagination. He argued that bubbles start with a displacement. These derivatives were not well understood but became popular and widespread. 3. The rise of the shadow banking system, largely outside the purview of regulators, grew immensely relative to the commercial banks which were under the umbrella of the Federal Reserve. In 1990 the shadow banking system had half the assets of commercial banks, but by 2000 the two were on par and on the eve of the crisis it was $3 trillion ahead ($13 vs $10 trillion).49 They were financial institutions that acted like a bank but were not regulated as banks and did not enjoy the safety net of the Federal Reserve

244  The Financial Crisis of 2008 system. These hedge funds, investment banks, money market mutual funds, and mortgage lenders could not borrow from the Federal Reserve. The Meltdown swept away all five of the big investment banks or at least their business model. The business model was faulty because the banks needed the inflow of millions of dollars every single day to sustain their day-to-day operations. At the end of 2007, for instance, Bear Stearns needed to borrow $70 billion overnight to finance operations.50 On account of their lack of transparency, these banks were subject to a crisis of confidence when the inflow of credit stopped suddenly. This was similar to a traditional bank run except that customers did not line up at the teller windows; instead depositors clicked on the “refund” button in cyberspace. 4. The neglect of systemic risk was Greenspan’s and Bernanke’s inexcusable mistake. Systemic risk is an amplification mechanism and a negative externality. Mistakes of one bank can lead to a liquidity or a solvency crisis that affects other banks. This also has elements of a contagion. The failure of one giant firm causes losses of asset values of other firms, causing panic, classic bank runs, and a cascade of insolvencies and bankruptcies. History is full of such episodes. Yet, the Fed was impervious to the threat. Bernanke remarked in May 2007, for example: Importantly, we see no serious broader spillover to banks or thrift institutions from problems in the subprime market; the troubled lenders, for the most part, have not been institutions with federally insured deposits . . . we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.51

In Bernanke’s view, we do not need to worry about banks like Lehman Brothers because their deposits were not federally insured. Pretty naïve view. Bernanke knew precious little about the systemic risk created by AIG’s sales of CDSs. He completely overlooked the important linkages between the shadow banking system and conventional commercial banks. When Lehman became bankrupt AIG would be next and that would have pulled down the whole system because many commercial banks had CDS insurance policies with them.52 So, Bernanke came to AIG’s rescue with $86 billion the day after Lehman’s bankruptcy. Another $100 billion came later. 5. However, groupthink rendered Greenspan’s view politically correct. Dissent from the party line was not tolerated. It is a commonplace that groupthink leads to dysfunctional group dynamics. So, Greenspan could declare that “no one saw the crisis coming.”53 Of course, he chose whom to listen to and those he did listen to knew full well what he would tolerate. He did not listen to Roubini’s warning that the recession was going to be “ugly.” He did not hear Rajan’s lecture at Jackson Hole, although he was in the audience. He did read Robert Shiller’s warning of 2005 that “the [housing] market is in the throes of a bubble of unprecedented proportions that probably will end ugly.”54 So what does he mean that no one saw it coming? 6. The Dot-Com Bubble was connected to the subprime mortgage bubble in a “doom loop.” The way Greenspan got out of the Dot-Com bubble brought us to the housing bubble. The Dot-Com bubble culminated in the recession of 2001. That prompted

The Financial Crisis of 2008  245 Greenspan, according to the standard policy playbook, to lower the interest rate from 6.5% in summer 2000 to 1.25% by the end of 2002.55 That had the desired effect and the recession was short lived and was over in eight months despite the shock of 9/11. The takeaway again was that Greenspan’s magic worked. The problem was that the Fed thought that the subprime bubble would be handled as easily as the Dot-Com bubble.56 This inference was mistaken because the two bubbles were entirely different. The ownership of internet stocks was limited to venture capitalists, hedge funds, and investment banks. In contrast, 73 million households held mortgages and a decline in home prices would have a dizzying impact on them. So, the scale of the economic impact on the population was on a different scale. Moreover, the Dot-Com IPOs amounted to $27 billion 1997–1999 whereas subprime mortgages added up to $3.5 trillion.57 Additionally, Dot-Com stocks were not insured by CDSs, as were the mortgage-backed securities, which meant that systemic effects were not powerful in the Dot-Com bubble. The Fed economists were mistaken to overlook these differences. 7. By lowering interest rates further to 1% in 2003 Greenspan made the mistake of his lifetime. This was unwarranted, because by the summer of 2003 real GDP was growing already at 3.2% per annum (Figure 14.4).58 Moreover, he kept it at that low level for another year! This was a tragic mistake because the economy overheated and by the end of 2003 was growing at 4.4% per annum.59 The low interest rate had powerful repercussions in the housing sector that was already in the throes of a major bubble. That is when subprime really exploded. So, Greenspan contributed to the ballooning of the subprime mortgage crisis. After 16 years being in charge of the world’s financial system, he committed one mistake that turned out to be tragic. So, 2004 became a watershed as subprime careered out of control.

2.25

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2004.5

Figure 14.4  Fed’s Interest Rates and GDP Growth Source: Federal Reserve Bank of St. Louis, “Effective Federal Funds Rate,” series FEDFUNDS and “Real Gross Domestic Product, Percent Change from Quarter One Year Ago, Quarterly, Seasonally Adjusted,” series A191RO1Q156NBEA.

246  The Financial Crisis of 2008 8. Credit rating agencies had perverse incentives to commit financial alchemy. By their seal of approval, they turned subprime mortgages into triple-A-rated mortgage-backed securities. They were paid by the banks and the banks could threaten to turn to the competition if they did not give them high ratings. There was no reason for the agencies to resist since due diligence would have decreased their profits. After all, they were not guaranteeing their ratings. So, Lehman’s ratings were not downgraded until its collapse was imminent.60 From 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple A. In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day. The results were disastrous: 83% of the mortgage securities rated triple A that year were downgraded ultimately.61 No one was watching the watchers. 9. There was excessive faith in quantitative finance and in financial engineering although they were not tested in a crisis. The “quants” of Wall Street had PhDs in physics from Harvard and MIT and built sophisticated computer models that seem to work really well. So why look over their shoulders? The sophisticated mathematicians and financial engineers should be able to calculate probabilities and manage risk with their computer models. However, they lacked experience, were insensitive to the fragility of the system, and knew nothing about the history of finance. Hence, they neglected the possibility of a financial panic. 10. Endemic trade deficits of half a trillion dollars annually gave the rest of the world a lot of dollars which were funnelled back into the U.S. financial system adding to the easymoney policy of the Fed. This contributed to the savings glut. 11. Minsky’s model of bubbles has money chasing assets in order to drive prices up. This is what happened not only because of the low interest rates but also because the Asian savings glut channeled a lot of money back into the U.S. banking system, adding to the excess supply of credit or easy credit. This led to asset inflation. 12. Flush with funds, banks lowered underwriting standards in order to find enough new customers to meet its profit goals. There was no other way they could profit from the excess supply of funds. So, underwriting standards deteriorated and fraud proliferated. 13. Expansion of subprime lending in 2004 was a big problem. Until 2003 subprime was between 7% to 10% of the mortgage market. That might have been manageable. But in 2004 subprime jumped to 21% and stayed at that level for two more years. In the three years 2004–2006, $1.8 trillion worth of subprime mortgages were processed.62 This was unprecedented and ominous. Thus, the financial sector had crossed the Rubicon. 14. Predatory lending added fuel to the fire. It manipulated consumers by enticing them with false or misleading promises of wealth. Countrywide was fishing for fools by signalling that they were willing to commit fraud by advertisements in which the announcer said, “I got them all approved,” even for a “business owner whose income was hard to document,” after no less than three banks had turned him down.63 Washington Mutual advertisements also boasted that their lenders “write their own approval rules,”64 or that they had “flexible lending rules” while the lending officer was breaking the rules symbolically with his hands.65 Innovations included variable rate mortgages that started at 1% and “NINJA loans” (“no income, no job, no assets”). These were no documentation loans implying

The Financial Crisis of 2008  247 that income was fictitious and doubtful if the loan would be repaid. These were fraudulent but of no concern to Greenspan because he believed that the market would price that risk into their models. Underwriting standards deteriorated further with pay-option adjustable-rate mortgages which allowed debtors to pay lower monthly amounts if they wished. The balance would be added to the outstanding loan. Greenspan was a veritable cheerleader of these innovations: “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”66 He put a Panglossian spin on predatory lending by asserting in 2005: “With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers.”67 15. All this created a humongous bubble in home prices. We know that prices were well above fundamental value because house prices rose 41% faster than rents (Figure 14.2). Between 1999 and 2005 housing prices doubled at a time when real median household income was still $1,730 below that of six years earlier (Figure 14.5).68 (House Prices continued to rise by another 14% before peaking in June 2006.) This defied common sense. Prices should not have been increasing at a time when incomes were sluggish. It was an obvious bubble based on the positive feedback loop (see Figure 4.12 in Chapter 4) and a deterioration in underwriting standards while Greenspan and Bernanke looked the other way. House prices reached a peak in the second quarter of 2006 and collapsed thereafter precipitously, falling at an average rate of 2.4% per quarter for a cumulative 30% by 2010.69 16. As Minsky warned, the illusion of tranquillity was deceptive since the Fed was delusional about the need for oversight. The bankers were sophisticated, so they could regulate themselves. In the meanwhile, the bankers innovated increasing the fragility in the system. This was one of the major causes of the crisis according to the IMF.70 17. This ideology led to deregulation, lax enforcement of regulations that were still on the books, lax oversight, and excessive trust in the banks and bankers. It started under the Reagan administration and continued through successive administrations. For instance, Reagan allowed private banks to securitize mortgages and to grant variable rate mortgages. He deregulated savings banks and allowed them to move into the commercial banking business. Clinton lifted the ban on interstate banking that led to the too-bigto-fail banks and, by repealing the Glass-Steagall Act, he declared how happy he was to discard “antiquated laws.” 18. A high debt burden is problematic because it limits the options in a crisis. It does not make for a “Black-Swan Robust” society as advocated by Nassim Taleb.71 This would be a society that can withstand difficult-to-predict adverse developments such as a recession or a crisis, financial or otherwise. Individuals in a recession without adequate savings find it difficult to meet commitments leading to bankruptcies, foreclosures, or evictions. That mortgage debt per household rose from $92,000 to $150,000 between 2001 and 2007 was a heavy burden at a time when household incomes were declining or stagnating at best.72 Similarly, high and rising debt to GDP ratio on a national level meant that it was difficult to pass legislation to stimulate the economy and overcome the headwinds of a

248  The Financial Crisis of 2008 recession. The national debt doubled under the Reagan and Bush Sr. administrations from 30% to 60% of GDP.73 By 2017 it exceeded an uncomfortable 100%. 19. Financialization refers to the growing importance of the financial sector in the economy at the expense of manufacturing.74 That implies that the economy lacks diversification and is tantamount to putting too many eggs into one basket. The financial industry accounted for just 4% of GDP and 17% of corporate profits in 1980, but its importance doubled by the early twenty-first century to 8% and the share of finance in total corporate profits averaged 27% between 2001 and 2007.75 This has ominous implications because the financial sector is not a job creator that could absorb the workers displaced from the manufacturing sector: finance employed just 5.3% of the labor force in 2016, a decline of 0.3% since 2006.76 This is not the making of a good economy. The financial sector is like a cocoon: [o]nly about 15 percent of the money coming out of the largest financial institutions goes to new business investment. The rest exists in a closed loop of trading: institutions facilitate and engage in the buying and selling of stocks, bonds, real estate and other assets that mainly enriches the 20 percent of the population that owns 80 percent of that asset base. This doesn’t help growth, but it does fuel the wealth gap . . . we [should] start talking about how to create a financial system that really serves society.77 20. Herd mentality meant that investors followed their peers in under-pricing risk. Competition meant a race to the bottom. As Keynes put it, for investors “it is better to fail conventionally than succeed unconventionally.” Roubini explains: Who wants to stick their neck out and call for a recession when your entire colleagues on Wall Street claim otherwise? If you follow the herd and you are wrong you can hide in the herd and everyone was wrong . . . There is a meaningful conflict of interest considering the costs and benefits of sticking one’s head out of the herd.78

Money managers taking excessive risks were earning extraordinary returns for a while without their clients knowing that those were not pure returns but returns on the intangible risks they were assuming for tail events.79 Competitors taking less risk could not have stayed in business because it would have seemed like they were underperforming rather than being more prudent. Herding behavior also meant that the speculative fever was contagious and induced people to assume that home prices were going to increase indefinitely; so many took chances and committed themselves beyond their means. 21. Mispricing of risk. Risk is an intangible and therefore difficult to price for infrequent event like the default of a major bank. The left tail of the probability distribution of Lehman defaulting was larger than the quants guesstimated. This is also referred to as “fat tails.” According to the price of CDSs, in 2005 the market estimated that the prob1 ability of Lehman defaulting was = (0.2%), i.e., would happen twice in a millennium. 500

The Financial Crisis of 2008  249 Three years later Lehman was gone. This does not seem like an efficient market. In March 2008, just prior to Bear Stearns’ demise, the market was still estimating 1 Lehman’s probability of bankruptcy as or 0.5%; a serious mistake.80 200 22. Leverage was out of control. The audio recording of a meeting of the SEC provides a good example of how nonchalantly the authorities viewed this threat to stability. In 2004 the SEC made a fateful change to rules governing the five largest U.S. investment banks. They had petitioned to increase their leverage by using their own computer models to assess risks instead of the existing rules of the SEC. Chairman William Donaldson opened the meeting with a dogmatic statement: If we do this wisely, and we and our fellow regulators listen to and learn from each other, we will help the investing public by using the best available tools to manage risk to the health of our markets . . . by allowing the market for financial services to continue to evolve.

Commissioner Harvey Goldschmid seemed to have some reservations: Is there any real . . . I mean, we said these are the big guys . . . but that means if anything goes wrong, it’s going to be an awfully big mess [laughter] and do we feel secure if there are these drops in capital and other things, we really will have investor protection?



Annette L. Nazareth, the director of market regulation answered, “We are going to be meeting with these firms on a monthly basis . . . we’ll have you know hopefully a lot of early warnings, and the ability to constrict activity that we think is problematic.” Harvey Goldschmid still had some second thoughts: “This is going to be much more complicated compliance inspection, understanding of risk than we’ve ever had to do. Mike, I trust you to no end, but I take it you think we can do this [much more laughter].” One of the staff said: “ We’re going to depend on the firms obviously. They’re in the front line. They’re going to have to develop their entire risk framework. We’ll be reading that first and they’ll have to explain that to us in a way that makes sense and then we’ll do the examination process in addition to approving their models and their risk control systems. So, I mean but it’s a large undertaking. I’m not going to try to do it alone [long laughter again].



“I..I..I’m very happy to support it,” said Commissioner Roel C. Campos, adding “And I keep my fingers crossed for the future.”81 The approval of the proposal was unanimous. “With that, the five big independent investment firms were unleashed.”82 Thereafter the SEC was relying on the firms to police themselves. Of course, they were not up to the task. Their leverage rose substantially: Morgan Stanley’s rose from 22 to 33, Bear Stearns’ from 27 to 33, Lehman from 22 to 32, Merrill Lynch from 16 to 32, and Goldman Sachs from 18 to 24.

250  The Financial Crisis of 2008 This means that their own capital made up but a tiny fraction (3%) of their total investments. (To make matters worse, they used creative accounting to hide their risky assets from investors.) If the value of their assets declined by just 3 percentage points, their capital would evaporate, and they would become insolvent. Obviously, this was an extremely risky business model and one prone to bank runs. Thus, as their balance sheets deteriorated, i.e., the value of their assets plummeted, investors were increasingly less willing to lend them the money they needed for their day-to-day operations. Only with government support was the system saved. That meeting with all its levity and cavalier handling of the very serious issue of risk management contributed much to the destabilization of the shadow banking system. After all, subprime became a big problem in 2004. That was a watershed moment. 23. Globalization magnified the problems in three ways: (a) through the savings glut that infused a lot of liquidity into the U.S. financial system; (b) by increasing the U.S. trade deficit which became a major source of the savings glut; and (c) by providing a global market for the financial products packaged by Wall Street engineers. By the time the securities reached them, the information was quite distorted. For instance, eight tiny municipalities in Norway (most above the Arctic Circle) lost investments of $75 million—­by speculating on highly leveraged, incredibly risky, and complicated Citibank bonds sold through a Norwegian broker. That the investors were clueless is suggested by the fact that their potential upside was tiny, but their downside was enormous and completely disproportional to their possible gains. Risk was obviously mispriced, the investors gullible, the documents mistranslated, and the broker was an opportunist taking advantage of asymmetric information.83 24. Moral hazard was accumulating. The market’s belief in the “Greenspan put” was excessive. As John Cassidy noted: “Given Greenspan’s role in promoting and prolonging the stock-market bubble that burst in 2000, the deference that surrounds him seems a little overdone.”84 This perception was reinforced when in March 2008 the Fed, by then under Bernanke’s leadership, subsidized Bear Stearns’s takeover by JPMorgan Chase with $29 billion. That is one reason why Lehman’s bankruptcy six months later caught the markets off-guard, creating such havoc. Moral hazard was rampant, and financiers panicked when they woke up to the realization that they had miscalculated and put too much faith in the Fed. 25. Lack of historical perspective was problematic because it contributed to the sense of infallibility. Wall Street forgot the past and was therefore condemned to repeat its mistakes. They were mesmerized by the quants, by the level of mathematical sophistication, by the amount of profits, by confidence in Greenspan. They were much smarter than their predecessors. With a few exceptions CEOs of the big financial institutions like Dick Fuld (Lehman Brothers), Jamie Dimon (JPMorgan Chase), Ken Lewis (Bank of America), John Thain (Merrill Lynch), or Lloyd Blankfein (Goldman Sachs) were all baby-boomers whose character bore the stamp of the heady days enjoyed after World War II and had nothing to do with the slump of the 1930s. And, of course, most of the traders and money managers on Wall Street were much younger; for them the Great Depression might as well have happened on another planet. History was completely irrelevant as far as they were concerned. So, history repeated itself.

The Financial Crisis of 2008  251 26. Hubris was ubiquitous. It is a hard-to-correct mental bias. Its incidence on Wall Street and in DC was high. It manifested itself in Bernanke’s pronouncement of the “Great Moderation.” It was demonstrated in daily exaltations of the sophistication of the financial engineers. It was revealed in Dick Fuld’s uncontrolled anger about short sellers who were depressing Lehman’s share prices in 2007. He said that he wanted to: [s]queeze some of those shorts . . . squeeze them hard . . . Not that I want to hurt them. Don’t get that please. That’s just not who I am. I’m soft, I’m lovable, but what I really want to do . . . is I want to reach in, rip out their heart, and eat it before they die.85 That’s the kind of guys who were in charge of our financial system.86 27. Culture also played a role. A culture that accepts greed as normal will be prone to bouts of instability. Greed is bad because it blinds the investor and fuels the spirit of irrational exuberance. It is beyond the normal limits of wanting to make a profit. It is egocentricity taken to an extreme: excessive selfishness. Because it knows no moral limits and because it usually hurts others, it is destabilizing and therefore deleterious. No wonder that greed was a mortal sin for a long time. 28. Inequality of income also played a role. The existence of the poor with poor credit ratings is what motivated the banks to provide predatory mortgages. The middle class already had mortgages. Having been shut out of the “American Dream,” the poor were manipulated into thinking that this is their once-in-a-lifetime opportunity to get a glimpse of it. At the same time, the top 1% had enormous amounts of excess cash with which to speculate in the financial sector, thereby fueling the asset bubble that was in progress. 29. Corporate governance was a contributing factor because the board of directors’ supervision of the financial institutions was lax; they failed to pay attention to the principal-agent problem. The remuneration structure incentivized the CEOs to reach for high yields in search of bonuses and pay little attention to the risks that were accumulating. The CEOs made out very well financially even as they were bankrupting their firms. As Daniel Kahneman pointed out, the firms were committing suicide, but the CEOs were not.87 The CEOs gained from the upside, but shareholders and taxpayers were responsible for the downside. Angelo Mozilo, for instance, CEO of Countrywide Financial, still has a net worth of $600 million; Dick Fuld of Lehman Brothers has $250 million; John Thain of Merrill Lynch has $100 million.88 Charles Prince received some $40 million for bringing Citigroup to the brink. None of them ended up in the middle class, let alone in poverty. They all maintained their status in the top 1%. 30. Revolving door refers to the tendency for executives in finance to be appointed to government positions after which they return to the private sector. This poses a problem because it means that government officials do not develop an independent view of finance and its social role. Instead, they view the world through Wall Street’s lens, not that of Main Street. It leads to cognitive capture insofar as the corporate world-view gains dominance. The revolving door also provides strong incentives for government officials to look ahead and support policy on behalf of corporations that might hire them once they leave government.

252  The Financial Crisis of 2008 This was the strategy followed by Timothy Geithner, Obama’s first Treasury Secretary. He was amply rewarded for this unrelenting support of the financial sector. He went from the Treasury directly to a private equity firm and became a millionaire. After leaving the Fed, Ben Bernanke is also earning millions from the largesse of the financial sector. 31. Media was not informing the population of the bubble. It was not presenting the facts that housing prices doubled, that incomes were not increasing, and that this could not go on forever. In sum, a confluence of 31 factors contributed to the Meltdown. No wonder that the crisis was so powerful. So, one should not single out any one of these factors as the main wrongdoer. Monocausal explanations do not fit the data, facts, and patterns well. The crisis was brought about and magnified by all the factors discussed here; they were intertwined into one convoluted “Gordian knot.” Some ultra-right-wing commentators would like to pin the crisis on Fannie Mae and Freddie Mac,89 two government-sponsored mortgage agencies. This is unfounded. They were not primarily responsible for the financial crisis. Of course, they participated in the frenzy but were not among the largest players in the subprime market any more than Countrywide Financial, Washington Mutual, or Ameriquest were. And they were not responsible for the spread of the CDSs either. To be sure, they did jump on the bandwagon, but were not the main culprits: the private firms were.90 Subprime lending was at its height between 2004 and 2006, and during those three important years Fannie and Freddie’s share of that segment of the market fell relative to the private firms.91 In 2006, 84% of subprime mortgages were issued by the private sector, for instance. In addition to Fannie and Freddie, these same government haters cite the Community Reinvestment Act of 1977 as a cause of the crisis.92 But the Act only specified that banks should invest also in the neighborhoods in which they operate retail outlets “so long as these activities didn’t impair their own financial safety and soundness.”93 Congress was concerned that the banks service underprivileged neighborhoods and do not syphon off capital from poor areas.94 The Act did not induce them to commit fraud in the process or to grant subprime mortgages, and culprits such as Countrywide Financial were not under the umbrella of the Act anyhow. These are silly arguments by ideologues who have no respect for the evidence. The roots of the crisis can be found in the “The Secondary Mortgage Market Enhancement Act of 1984,” which allowed private banks to securitize mortgages. The Financial Crisis Inquiry Commission rightly blamed Greenspan and Bernanke the most: “the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.” However, others blundered as well: [f]inancial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk.95

The Financial Crisis of 2008  253 The commission concluded that: The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble . . . To paraphrase Shakespeare, the fault lies not in the stars, but in us.96

The Bailout: A Crisis Obama Wasted The Great Recession followed the subprime mortgage bubble with a substantial decline in income, increases in nonemployment, a spectacular rise in foreclosures, pain, and suffering of the U.S. population. The investment in residential housing was cut by half between 2006 and 2009, which put a $400 billion hole in aggregate demand. Net investment in tangible assets (which includes housing) declined even more, dropping by 78%, or $614 billion.97 This was a major calamity that had not been seen in the U.S. since the Great Depression. By September 2008, all five big investment banks were history: Lehman Brothers was bankrupt; Bear Stearns was taken over by JPMorgan Chase with $29 billion worth of financial assistance from the Fed; Hank Paulson also blackmailed the management of Bank of America to take over Merrill Lynch and sweetened the deal by a $20 billion super-secret “exceptional” loan;98 while Goldman Sachs and Morgan Stanley sought the protection of the Fed’s umbrella by acquiring traditional bank charters and remained solvent with the help of billions of dollars from the taxpayers.99 Risky business models brought the end to these behemoth investment banks. Arch-conservative Paulson was quick to abandon the laissez-faire principles he advocated as CEO of Goldman Sachs and invoked the power of the state when it came to serving his and his friends’ interests by bailing out Wall Street.100 To paraphrase Joseph Stiglitz, capitalism remained the economic system for Main Street, while socialism was reserved for Wall Street.101 After all, Everyman on Main Street had to fend for himself: it was shown no mercy; while Wall Street relied on corporate welfarism, i.e., the generosity of the taxpayers. Its losses were socialized. By bailing out Wall Street, Paulson and Bernanke supported a fragile financial sector that many economists such as Simon Johnson, Nouriel Roubini, and Nassim Taleb believe increased moral hazard.102 By purchasing $3.6 trillion worth of toxic assets, the Fed resuscitated Wall Street, brought it back from the brink, but did so in such a way that it neglected the structural problems facing the U.S. economy and society. And at the same time, it introduced even more moral hazard into the system while the too-big-to-fail banks became even bigger to fail. By doing so the Fed destroyed the logic of Schumpeterian “creative destruction,” which is supposed to cleanse the economy of inefficient firms. The Fed also generated so much animosity within the society that the political system became dysfunctional and the social contract, the glue that keeps societies together, became frayed. With its no-strings attached bailouts, it left bonuses in place, which led to the greatest redistribution of wealth from the middle class to the top 1% in the history of humankind. Not even the building of the pyramids was on a comparable scale. It is questionable that such a system is sustainable in the long run with as much distrust, polarization, and anger as exists today. However, with endemic un- and

254  The Financial Crisis of 2008

Illustration 14.2  No Less Than Eight Million Families Lost Their Homes as a Consequence of the Financial Crisis, but the Financiers Who Caused the Crisis Were Not Among Them. Allowing This to Happen Is a Severe Blot on the Obama Administration. Credit: iStock.com/fstop123

underemployment103 and allowing 9 million families to be evicted, Obama, the Congress, the Fed, and the Treasury failed miserably in their declared goal of helping ordinary people. It was an unconscionable deception. If you really want to help someone, it is best to help them directly and not transfer the responsibility to third parties, such as the banks. The structural problems of the economy prior to the Great Meltdown included the immense trade imbalances, the endemic budget deficits, the skill mismatch because of the lack of educational opportunities, high health costs, deteriorating infrastructure, stagnating wages, growing student debt, obscene levels of inequality, and global warming. These weighed heavily on future growth and living standards. In addition, with rising inequality, people attempted to keep up with the Joneses by going into debt; so, the balance sheet of the households was not in good shape. Hence, the economic growth between the Dot-Com bubble and the 2008 Meltdown was a mirage underwritten by loans from the Chinese politburo. Yet, the Obama administration overlooked these structural imbalances and focused on overcoming the crisis as soon as possible. They did not realize that only in a crisis can one overcome the inertia inherent in such a complex economy with many powerful vested interests, and once Wall Street was resuscitated the government would no longer be able to reform the structural problems. They would not be able to overcome the lobbies. While the bankers were on their knees, the Obama administration, which promised change, after all, could have done it but not after the bankers were brought back to life.

The Financial Crisis of 2008  255 We have to keep in mind that in the U.S. economy in which big money plays such an overpowering role, the government cannot be reformed in the normal course of things. Only in a crisis can reforms opposed by so many vested interests be undertaken. That is why 2008 was a wasted crisis.104 Yet, Obama did nothing for education or for infrastructure, the two most pressing bottlenecks that hinder long-run economic growth, and by failing to support “green industries” sufficiently, the administration and Congress condemned the economy to linger. In an engaging article, Jeffrey Sachs concluded that the crisis was a culmination of an extended period of misplaced macroeconomic policies: The crash of 2008 exposed deep failures at the core of macroeconomic policymaking . . . in the United States . . . The American purveyors of the ancient régime hope that a few superficial fixes will get us back on our way. This is not to be. Sustained and widespread future prosperity will require basic reforms in global macroeconomic governance and in macroeconomic science . . . [requiring] new ways of thinking. Yet business as usual could prove calamitous.105 It was calamitous as it increased the already high level of frustration in the population. But it did not have to be that way. To its credit, the strategy of the Geithner-Bernanke-Summers triumvirate did stop the economy’s free fall, but at the cost of any chance of genuine reform, eradication of our structural problems, and the prospects of a solid recovery. Although GDP has been growing, the population grew as well so it took per capita GDP seven years to get back to its pre-crisis level (2007–2014).106 Moreover, real median household income in 2016 was just $374 ahead of its 1999 level, an increase of $22 per annum (Figure 14.5).

Figure 14.5  Real Median Household Income in the U.S. Source: Federal Reserve Bank of St. Louis, series MEHOINUSA672N

256  The Financial Crisis of 2008 80,000

Asian

75,000 70,000

White

65,000 60,000

All

55,000 50,000

Hisp.

45,000 40,000

Black

35,000 30,000 1980

1985

1990

1995

2000

2005

2010

2015

Figure 14.6  Median Household Income by Ethnicity, 2016 Dollars Source: U.S. Census Bureau, Table H-5. www.census.gov/data/tables/time-series/demo/income-­ poverty/historical-income-households.html.

African Americans have even experienced a decline in household income by $117 per annum since 2000 (Figure 14.6).107 No wonder the so-called recovery feels much more like a lingering slump, or what Krugman dubbed a “sour economy.”108 Larry Summers refers to it poignantly as secular stagnation.109

Nationalization of the Banks as Pre-privatization We could have bailed out the banks without bailing out the bankers and attached enough strings to the bailout package so that the taxpayers would have owned the upside as well, not only the downside. We could have bailed out Main Street, for instance, by helping homeowners to refinance their mortgages or helping them pay their mortgages so that 9 million families would not be evicted. A proposal of the Federal Reserve Bank of Boston suggested: “We propose a government payment-sharing arrangement that would work with the home-owner’s existing mortgage and significantly reduce monthly payments while the homeowner is unemployed.”110 The program would have cost merely $25 billion per annum. That is a tiny amount compared to the size of the bailouts. Bear Stearns alone cost the Fed $29 billion in March 2009 before the real bailouts even began. Lehman Brothers received billions of dollars in secret loans from the Fed months before its collapse.111 Total secret support to the banks was $1.2 trillion.112 Larger than the $700 billion aid of the Troubled Asset Relief Program funded by Congress that was dubbed the “Cash for Trash” program.113

The Financial Crisis of 2008  257 Why just provide zero percent loans to banks? Why not also give zero percent financing to homeowners or students? In short, much could have been done to make the bailouts more equitable so they not only helped Wall Street but also Main Street. The Fed had emergency powers to initiate such programs. Section 13(3) of the Federal Reserve Act stated: “Discounts for individuals, partnerships, and corporations. In unusual and exigent circumstances, the Board of Governors . . . may authorize to discount notes, drafts, and bills of exchange.”114 It is simply false that they lacked the instruments to help the small guys. They had extensive powers in an emergency and no one would deny that 2008 was an emergency. After all, “individuals” includes homeowners as well as students. Leaving it up to the bankers to “help the American people” was negligent. Even archconservative Alan Greenspan contemplated nationalization of the giant insolvent banks: “it may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.”115 Stiglitz also advocated the idea,116 as did Krugman117 and Roubini: [y]ou take banks over, you clean them up, and you sell them in rapid order to the private sector—it’s clear that it’s temporary . . . The idea that government will fork out trillions of dollars to try to rescue financial institutions, and throw more money after bad dollars, is not appealing because then the fiscal cost is much larger. So rather than being seen as something Bolshevik, nationalization is seen as pragmatic . . . The proposal is more market-friendly than the alternative of zombie banks.118 In a crisis banks and households want to deleverage. The amount of debt declines during deleveraging. This follows on the heels of a financial crisis. So, after the subprime housing bubble burst in 2008, those individuals who were deeply indebted, as well as most financial institutions, needed to reverse the process of leveraging by paying down their debt in order to bring their balance sheets back in order. Almost all the cash needed by the banks to deleverage was provided by the government. Deleveraging amplified the recession, because it meant that instead of lending, the banks were using the government subsidies to improve their portfolios. The outcome was a credit crunch and slower economic growth. Nationalization would have had immense advantages: the government could have broken up the big banks so there would have been no more too-big-to-fail banks, hence no more systemic risk; no bailouts without any strings attached to Wall Street, hence no bonuses and no moral hazard; no foreclosures, hence no more toxic assets; and, most importantly, President Obama could have directed the banks by executive order to lend again, to restructure the underwater mortgages, and to end homeowner-eviction policies the likes of which have not been seen in recent memory. Then the taxpayers could have scrapped the executive bonuses and we could have put people in charge who would have bailed out Main Street. Instead of providing loans to the banks at a zero interest rate, the nationalized banks could have refinanced troubled mortgages at a near-zero interest rate.119 Mortgaged-backed obligations would not have been toxic anymore. There would

258  The Financial Crisis of 2008 have been only a few foreclosures, and all the problems associated with them would have been mitigated. There would have been less anger and the “Tea Party” would not have gained momentum. Everyone would have benefited from near-zero interest rate financing instead of the banks. The recession would have been much milder and less prolonged. If, let us say, the government would have loaned 8 million homeowners an annual amount of $20,000 each as support for their mortgage payments, the total bailout would have amounted to merely $160 billion per annum, a small amount relative to the $3.6 trillion “printed” by the Fed. Such a bailout of Main Street would have been paid back as well when the homeowners regained their job or when they sold their homes. This would have had far greater beneficial effects for Everyman on Main Street as well as on the economy at large than the bailout of Wall Street. I think that would have been the first step toward overcoming the challenges of the crisis and getting the economy on the right track.120 This strategy would have meant that effective regulation of the financial sector, including the resurrection of the Glass-Steagall Act, could have become a reality. Much of the profits of the financial sector, hundreds of billions of dollars annually, would have accrued to—guess who?—Uncle Sam, and not to the likes of Jamie Dimon and Lloyd Blankfein. Add a substantial tax on financial transactions and the “starving beast” would have been no more. Instead of becoming subservient to the banks, Everyman would have tried on the shoes of the Lords of Finance and would have found the fit very comfortable, indeed. Obama would have been hailed by the masses not only as a knight in shining armor serving capitalism with a human face, but willing and able to wield his lance as well. The Democrats would have avoided the thrashing of 2010, a dysfunctional Congress, and the ultimate triumph of Trumpism. Bernanke was aware that such a scenario was feasible. An internal Fed memo concluded that helping homeowners would be a viable option: “The costs of the plan are moderate, and the benefits should help not only the participating homeowners but also the housing industry, the financial markets, and the economy more broadly.”121 But he found it more convenient to transfer the trillions to the same financiers whose greed had gotten the nation into the quagmire in the first place. A decade after the crisis, it does seem like bailing out Main Street would have been much better both politically and economically than bailing out Wall Street only. After all, as of this writing, we are still locked into a high level of endemic nonemployment. A further tax cut in 2017 repeated the mistake of Reaganomics. All this could have been avoided if 2008 had not been a wasted crisis. In sum, to implement the fundamental structural reforms that were urgently required, the country needed a leader with unflinching self-confidence backed by a creative team of experts. The deep structural imbalances of the U.S. economy could not be mended as a gentlemanly sport. The economy is path dependent: its institutions, as well as the momentum of the social, cultural, and political processes in which it is embedded, cannot be transformed easily. With the strategy and policies outlined here, we could have transitioned from turbo-capitalism to a capitalism with a human face, but only if a leader combining the tensile strength of Lincoln with the self-confidence of FDR and the political acumen of LBJ was occupying the Oval Office. Instead, President Obama protected the bankers declaring that he was the only thing standing between them and the “pitchforks.”122

The Financial Crisis of 2008  259

Notes 1 Thomas Paine, “The Crisis,” December 23, 1776. 2 John Maynard Keynes, The Great Slump of 1930 (London: The Nation & Athenaeum, 1930). 3 Robert E. Lucas, Jr. “Macroeconomic Priorities,” American Economic Review 93 (2003) 1: 1–14. 4 Ben Bernanke, “The Great Moderation,” speech at the meeting of the Eastern Economic Association (Washington, DC), February 20, 2004. 5 The standard deviation of real GDP growth in the U.S. declined from 2.7% between 1960 and 1983 to just 1.6% thereafter. James Stock and Mark Watson, “Has the Business Cycle Changed and Why?” in NBER Macroeconomic Annual 2002, vol. 17, ed. Mark Gertler and Kenneth Rogoff (Cambridge, MA: MIT Press, 2003), pp. 159–230. 6 Anya Schiffrin, Bad News: How America’s Business Press Missed the Story of the Century (New York: The New Press, 2011). 7 Proverbs, 16:18. 8 In 2001, 74% of the population trusted Greenspan to do the right thing for the economy. No one has come close. Bernanke’s highest rating was 50% just before the crisis and sank to 39% by 2012. Lydia Saad, “Americans Lack Confidence in Key Economic Leaders,” Gallup Politics, April 20, 2018. 9 Joshua Cooper Ramo, “The Three Marketeers,” Time, February 15, 1999; the author had a meteoric career thereafter. 10 For instance, Coca-Cola Co.’s stock rose from $7.2 in late 1994 when it paid $0.8 dividends, to $26 a share in the year 2000 without substantial change in dividends. So, its P/E ratio rose from 9 to 37 and the return on a share declined from 11% to 2.7%. 11 However, stock prices have remained permanently above their 138-year average since 1995. The probable reason is that Bernanke funneled enough money into the financial system ($3.6 trillion) so that it led to an inflation of asset values. He did not let stock prices get back to their historic average. The ratio in March 2018 is 32.8, implying a rate of return of 3.05% for stocks, which is very close to the 2.85% (risk-free) yield on 10-year government bonds. The implication is that equity values are once again overvalued because the premium of 0.2% for holding a risky asset is negligible. 12 Some iconic firms founded in those years which survived the bubble include Amazon (1994), Yahoo (1994), eBay (1995), PayPal (1998), and Google (1998). 13 Andrew Haldane “The Doom Loop,” London Review of Books, February 23, 2012; Andrew Haldane and Piergiorgio Alessandri, “Banking on the State,” presentation delivered at the Federal Reserve Bank of Chicago, September 25, 2009; Simon Johnson, “Is the Global Financial System in a ‘Doom Loop’?” MIT Sloan Management Review, November 18, 2009; Simon Johnson, “America’s Economic ‘Doom Loop,’” The New Republic, November 17, 2009. 14 Robert. J Shiller, Irrational Exuberance and the New Financial Order (Princeton, NJ: Princeton University Press, 2000). 15 Their full name is Federal National Mortgage Association and Federal Home Loan Mortgage Corporation. 16 The Secondary Mortgage Market Enhancement Act of 1984. 17 These were referred to as “private label” mortgage-backed securities as opposed to “agency” MBSs, those offered by Fannie and Freddie. 18 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. 116. 19 Ibid, p. xxiv. 20 Edmund Andrews, “Greenspan Is Concerned About ‘Froth’ in Housing,” The New York Times, May 21, 2005. 21 Among his earliest contributions is Robert Shiller, “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” American Economic Review 71 (1981) 3: 421–436. For an extensive (but not up-to-date) list of his publications, see www.econ.yale.edu/~shiller/publications. htm#1978. 22 YouTube, “Robert Shiller on How Human Psychology Drives the Economy, the New School,” July 16, 2009; @ 11.20 minutes. 23 “Markets can remain irrational longer than you and I can remain solvent,” John M. Keynes, as quoted in Roger Lowenstein, When Genius Failed. The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000), p. 123.

260  The Financial Crisis of 2008 24 “More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe.” The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. xviii. 25 Must watch: PBS, Frontline, “The Warning,” October 20, 2009. 26 PBS, Frontline, “The Warning,” Trailer. YouTube. www.youtube.com/watch?v=ACkiKVtF3nU. 27 According to Securities and Exchange Commission Chairman Arthur Levitt Jr.’s interview in “The Warning.” 28 The use of the word “politburo” means that they aggressively enforce the party line of laissez-faire economics. The politburo is the executive organ of a Communist Party, an authoritarian, dictatorial, institution. In the Soviet Union it was responsible for the concentration camps in the Siberian Gulag where upwards of a million people perished. Joshua Cooper Ramo, “The Three Marketeers,” Time, February 15, 1999. 29 John F. Kennedy, Presidential Library and Museum, Profile in Courage Award, Award Announcement, Brooksley Born. 30 Warren Buffett, Berkshire Hathaway Inc. 2002 Annual Report. 31 Dean Baker, “The Run-up in Home Prices: A Bubble,” Challenge 45 (2002) 6: 93–119. Steve Keen warned earlier about the dangers of the skyrocketing debt to GNP ratio. Steve Keen, Debunking Economics: The Naked Emperor of the Social Sciences (London: Zed Books, 2001). 32 John Cassidy, “Blowing Bubbles,” The New Yorker, July 14, 2004. Micheline Maynard, “Being Right Is Bittersweet for a Critic of Lenders,” The New York Times, August 18, 2007. 33 Raghuram Rajan, “Has Financial Development Made the World Riskier?” NBER Working Paper No. 11728, November 2005; published as “Has Finance Made the World Riskier?” European Financial Management 12 (2006) 4: 499–533. 34 Federal Reserve Bank of Kansas City, “The Participants, 2005.” www.kansascityfed.org/publicat/ sympos/2005/pdf/participants2005.pdf. 35 Nouriel Roubini, “How Much Will Home Prices Fall During This Housing Bust? At Least 20% to 30%!” EconoMonitor, September 10, 2006. 36 Prince still walked away with a $38-million severance pay in November of that year. This is just one example of the irresponsible way major CEOs were being rewarded for making cavalier decisions. 37 YouTube Video, “Ben Bernanke was Wrong.” www.youtube.com/watch?v=INmqvibv4UU&t=2s. 38 “Ben Bernanke Was Wrong.” 39 5 million wanted a job but were too discouraged to look for one and 4 million were working part time although they wanted full-time work. Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey. Characteristics of the Unemployed, Tables 1, 20, and 35; www.bls. gov/cps/cps_aa2005.htm. 40 Steve Keen, “Finance and Economic Breakdown: Modeling Minsky’s Financial Instability Hypothesis,” Journal of Post Keynesian Economics 17 (1995) 4: 607–635. 41 Hyman Minsky, “The Financial Instability Hypothesis: Capitalistic Processes and the Behavior of the Economy,” in Financial Crises: Theory, History, and Policy, ed. Charles P. Kindleberger and Jean-Paul Laffargue (Cambridge, UK: Cambridge University Press, 1982), pp. 12–29; Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crisis, 1st ed. (New York: Basic Books, 1978). 42 Hyman Minsky, “The Financial Instability Hypothesis,” The Jerome Levy Economics Institute of Bard College, Working Paper No. 74, May 1992. 43 Paul Krugman, “Making Banking Boring,” The New York Times, April 9, 2009. 44 Hyman Minsky, “Financial Instability Revisited: The Economics of Disaster,” unpublished manuscript (1966). 45 Ben Bernanke does make a fleeting reference to Minsky, but in a dismissive way: “Hyman Minsky (1977) and Charles Kindleberger (1978) have . . . argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior.” “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review (1983) 3: 257–276, at p. 258. Bernanke added in a footnote to the above statement: “I do not deny the possible importance of irrationality in economic life; however, it seems that the best research strategy is to push the rationality postulate as far as it will go.” I do not know on

The Financial Crisis of 2008  261 what basis he determined what the best strategy is. It just “seemed” to him that the best strategy was to disregard Minsky. 46 George Akerlof and Robert Shiller, Phishing for Phools. The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press, 2015). 47 Ruth Simon, “Teaser Rates on Mortgages Approach 0%,” The Wall Street Journal, February 15, 2005. 48 PBS, Frontline, “The Warning.” 49 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. 32. 50 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. xx. 51 A spillover effect is an externality. Ben Bernanke, “The Subprime Mortgage Market,” Board of Governors of the Federal Reserve System, May 17, 2007. 52 William Greider, “The AIG Bailout Scandal,” The Nation, August 6, 2010. 53 Michael Burry, “I Saw the Crisis Coming. Why Didn’t the Fed?” The New York Times, April 3, 2010. 54 “The Bubble’s New Home,” Barron’s, June 20, 2005; David Leonhardt, “Be Warned: Mr. Bubble’s Worried Again,” The New York Times, August 21, 2005; Paul Krugman, “That Hissing Sound,” The New York Times, August 8, 2015; “Peter Schiff on Kudlow & Co: Predicts the US Economic Collapse,” August 28, 2006. www.youtube.com/watch?v=LfascZSTU4o. 55 Federal Reserve Bank of St. Louis, “Effective Federal Funds Rate,” series FEDFUNDS. 56 This was when Bob Lucas gave his lecture about depressions being a thing of the past. 57 “The $1.7 Trillion Dot.Com Lesson,” CNNMoney, November 9, 2000. 58 Federal Reserve Bank of St. Louis, “Real Gross Domestic Product, Percent Change from Quarter One Year Ago, Quarterly, Seasonally Adjusted,” series A191RO1Q156NBEA. 59 John Taylor, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” Critical Review. A Journal of Politics and Society 21 (2009) 2–3: 341–364; NBER Working paper no. 14631 (January 2009). 60 Reuters Staff, “Moody’s, Fitch Slash Lehman Ratings on Bankruptcy,” Reuters, September 15, 2008; Roman Frydman and Michael D. Goldberg, “Lehman Brothers Collapse: Was Capitalism to Blame?” The Guardian, September 13, 2013. 61 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. xxv. 62 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. 70. 63 Jessica Sberlati, “Countrywide Commercial 3,” YouTube, October 26, 2007. 64 McCannSeattle, “WAMU—‘Roy’” YouTube, December 14, 2009. 65 McCannSeattle, “WAMU—‘Paul’” YouTube, December 14, 2009. 66 In a speech to the Credit Union National Association. Sue Kirchhoff and Barbara Hagenbaugh, “Greenspan Says ARMS Might Be Better Deal,” USA TODAY, February 23, 2004. 67 Adding: “The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.” The Federal Reserve Board, “Remarks by Chairman Alan Greenspan At the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, DC. April 8, 2005, 68 Federal Reserve Bank of St. Louis, FRED, S&P/Case-Shiller U.S. National Home Price Index, series CSUSHPISA; “Real Median Household Income in the United States,” series MEHOINUSA672N. Figure 14.2 based on OECD data must not be using the median household income figures, which would be more relevant to gauge the size of the housing bubble. 69 “S&P/Case-Shiller Home Price Indices,” MacroMarkets. 70 “What Went Wrong,” The Economist, March 6, 2009. 71 Nassim Taleb, “Ten Principles for a Black Swan-Proof World,” Financial Times, April 7, 2009. 72 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. xx.

262  The Financial Crisis of 2008 73 It reached 50% under Reagan, while Bush Sr. added another 10%. Federal Reserve Bank of St. Louis, “Total Public Debt as a Percent of Gross Domestic Product,” series GFDEGDQ188S. 74 It was a new form of capitalism in his view, a “money manager capitalism,” in which financial leverage became paramount. Instead of working with one’s own capital, one borrowed extensively and invested the borrowed sums at a higher rate of return. 75 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. xvii. Thomas Philippon, “Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation,” American Economic Review 105 (2015) 4: 1408–1438. Finance’s share peaked in 2002 at 37%. These data leave out of consideration profits generated abroad because those are not reported by sector. Bureau of Economic Analysis, Interactive Data, GDP & Personal Income, Section 6-Income and Employment by Industry, “Table 6.16D. Corporate Profits by Industry.” 76 Bureau of Labor Statistics, Table 2.1 “Employment by Major Industry Sector.” www.bls.gov/emp/ ep_table_201.htm. 77 Rana Foroohar, “How Big Banks Became Our Masters,” The New York Times, September 27, 2017. 78 Nouriel Roubini, “March 2001: 95% of Forecasters Predicted No Recession . . . Too Bad the Recession Had Already Started Then,” EconoMonitor, September 8, 2006. 79 This is different than pricing life insurance since a million deaths occur every week whereas a company the size of Lehman dies once in a blue moon. 80 Chenyu Zhang, “Empirical Essays on Inferring Information from Options and Other Financial Derivatives,” Unpublished PhD Dissertation, Lancaster University, UK, April 2017, pp. 23, 42; the month before Bear Stearns and Merrill Lynch became insolvent their bankruptcy probabilities were just 3.1% and 2.3%, calculated from option prices. Stephen J. Taylor, Chi-Feng Tzeng, and Martin Widdicks, “Bankruptcy Probabilities Inferred from Option Prices,” Journal of Derivatives 22 (2014) 2: 8–31, here pp. 13, 25. 81 Meeting was on April 28, 2004; the transcript is from the audio recording. “The Day the S.E.C. Changed the Game,” The New York Times, September 27, 2009. http://archive.nytimes.com/ www.nytimes.com/interactive/2008/09/28/business/20080928-SEC-multimedia/index. html. The agenda and synopsis of the meeting is at www.sec.gov/news/openmeetings/ agenda042804.htm. 82 Stephen Labaton, “Agency’s ’04 Rule Let Banks Pile Up New Debt,” The New York Times, October 2, 2008. 83 There were also problems with translation of the conditions into Norwegian. The details of this incredible case are worth reading in full. Wikipedia contributors, “Terra Securities Scandal,” Wikipedia: The Free Encyclopedia. 84 John Cassidy, “Blowing Bubbles,” The New Yorker, July 12, 2004. 85 The contortions on his face during the speech underlined his sociopathic nature. His nickname was “gorilla” for a reason. Nathaniel Sullivan, “Dick Fuld Rip Out Your Heart,” YouTube video, October 28, 2011. The video is a clip from the movie “Inside Job.” 86 Fuld’s congressional testimony: “I believed these decisions and actions were both prudent and appropriate,” and he never admitted to having made any mistakes. “Lehman Brothers CEO Testifies on Capitol Hill,” posted by “AssociatedPress,” www.youtube.com/watch?v=ZkEkxGsXmPI. 87 “There are executives making decisions, the interest of those executives and the interest of that abstract idea that we call a firm are clearly not aligned. And if we want to understand why firms are suicidal it is in part because the agents are . . . actually quite frequently not committing suicide. So, there is a mismatch between firms and the actors who act on their behalf.” FORA.tv, “Nassim Taleb and Daniel Kahneman: Reflections on a Crisis,” January 27, 2009 @ 19:28 minutes; http://library. fora.tv/2009/01/27/Nassim_Taleb_and_Daniel_Kahneman_Reflection_on_a_Crisis. 88 According to the website “Celebrity Net Worth.” 89 Their full name is Federal National Mortgage Association and Federal Home Loan Mortgage Corp. 90 Joe Nocera, “The Big Lie,” The New York Times, December 23, 2011; Paul Krugman, “Joe Nocera Gets Mad,” The New York Times, December 24, 2011. 91 David Goldstein and Kevin G. Hall, “Private Sector Loans, Not Fannie or Freddie, Triggered Crisis,” McClatchy Newspapers, October 12, 2008. 92 Political Correction, “Private Wall Street Companies Caused the Financial Crisis—Not Fannie Mae, Freddie Mac Or The Community Reinvestment Act,” October 14, 2011.

The Financial Crisis of 2008  263 93 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. 72. 94 Jill Littrell and Fred Brooks, “In Defense of the Community Reinvestment Act,” Journal of Community Practice 18 (2010) 4: 417–439. 95 Ibid. 96 The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (Washington, DC: Government Printing Office, 2011), p. xvii. 97 Board of Governors of the Federal Reserve System, “Flow of Funds Accounts of the United States. Flows and Outstandings Fourth Quarter 2010.” 98 Anne Flaherty, “Lawmakers: Bank of America, Merill (sic) Lynch Deal Was ‘Shotgun Wedding’, The Seattle Times, June 12, 2009; “Moynihands Full,” The Economist, April 15, 2010; 99 The literature on the crisis is extensive; see, for example, Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon, 2010); Robert Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It (Princeton, NJ: Princeton University Press, 2008); Paul Krugman, The Return of Depression Economics and the Crisis of 2008 (New York: W.W. Norton, 2009). 100 Paul Krugman, in an interview with Bill Maher on HBO’s “Real Time,” broadcast September 19, 2009. 101 Joseph Stiglitz, “America’s Socialism for the Rich,” The Guardian, June 12, 2009; Joseph Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy (New York: W.W. Norton, 2010). 102 Peter Boone and Simon Johnson, “The Doomsday Cycle,” CentrPiece (Winter 2009/10): 2–6. 103 In December of 2009 there were about 23 million people underemployed out of a labor force of 140 million. Economic Policy Institute, State of Working America Data Library, “Underemployment.” 104 Paul Starr, “A Wasted Crisis?” The New Republic, July 12, 2013. 105 Jeffrey Sachs, “Rethinking Macroeconomics,” Capitalism and Society 4 (2009) 3: 1–9. Bill McGuire, “Fed Loaned Banks Trillions in Bailout, Bloomberg Reports,” ABC News, November 28, 2011. 106 Federal Reserve Bank of St. Louis, “Real Gross Domestic Product Per Capita,” series A939RX0Q048SBEA. 107 Wikipedia contributors, “Household Income in the United States,” Wikipedia: The Free Encyclopedia; James Galbraith, Created Unequal: The Crisis in American Pay (Chicago, IL: University of Chicago Press, 2000). 108 Paul Krugman, End This Depression Now! (New York: W.W. Norton, 2012). 109 Lawrence Summers, U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound, Business Economics 49 (2014): 65–73; Lawrence Summers, “Demand Side Secular Stagnation,” American Economic Review: Papers & Proceedings 2015: 60–65. 110 Chris Foote, Jeff Fuhrer, Eileen Mauskopf, und Paul Willen, “A Proposal to Help Distressed Homeowners: A Government Payment-Sharing Plan,” Federal Reserve Bank of Boston, Public Policy Brief No. 2009–1. 111 It was brought to light by Bloomberg News’ Freedom of Information Act law suit against the Fed which fought releasing the information for a year and a half all the way to the Supreme Court but lost. Richard Blackden, “Lehman Brothers secretly borrowed from the Fed before collapse,” The Telegraph, July 8, 2011. Wikipedia contributors, “Bloomberg L.P. v. Board of Governors of the Federal Reserve System.” 112 “Federal Reserve Emergency Loans: Liquidity for Banks,” Bloomberg, www.bloomberg.com/datavisualization/federal-reserve-emergency-lending/#/overview/?sort=nomPeakValue&group=none& view=peak&position=0&comparelist=&search=. 113 Paul Krugman, “Cash for Trash,” The New York Times, September 21, 2008. 114 Board of Governors of the Federal Reserve System, “Federal Reserve Act,” www.federalreserve.gov/ aboutthefed/section13.htm. 115 Tunku Varadaraja, “‘Nationalize’ the Banks: Dr. Doom Says a Takeover and Resale Is the MarketFriendly Solution,” The Wall Street Journal, February 21, 2009. 116 “Stiglitz: Temporary Nationalization Necessary to Save Troubled Banks,” YouTube video, posted by ColumbiaBusiness, February 19, 2009. 117 Paul Krugman, “Banking on the Brink,” The New York Times, February 22, 2009. 118 Varadaraja, “‘Nationalize’ the Banks.”

264  The Financial Crisis of 2008 119 “Stiglitz Says U.S. Is Paying for Failure to Nationalize Banks,” Bloomberg News, November 1, 2009. 120 Allen H. Barton also advocated a bailout of the financial system from the bottom up by subsidies to homeowners, “Letter: Another Take on ‘Why Paulson is Wrong,’” The Economists’ Voice 5 (2008) 5: Article 9. 121 Chris Foote, Jeff Fuhrer, Eileen Mauskopf, and Paul Willen, “A Proposal to Help Distressed Homeowners: A Government Payment-Sharing Plan,” Federal Reserve Bank of Boston, Public Policy Brief No. 2009–1. 122 Lindsey Ellerson, “Obama to Bankers: I’m Standing ‘Between You and the Pitchforks,’” ABC News, April 3, 2009.

15 Conclusion The Foundations of Real-World Economics

Imaginary vs. Real Markets This book explores the differences between imaginary and real markets. While mainstream textbooks sing hymns to the invisible hand, this volume takes an empirical approach to analyze its actual effects in the real world rather than on academic blackboards.1 We thereby take economic principles beyond the basics by emphasizing aspects of real existing markets that deviate markedly from theoretical ones. We find that without well-designed institutions and incentive structures, real markets are inefficient and unstable, and accumulate and magnify inequities. Without adequate oversight and a regulatory structure, real markets can become dangerous, unstable, even chaotic. This is especially clear in today’s global economy, in which the degree of complexity poses a major challenge to our ability to navigate through the economic system. This implies, in turn, that there are too many possibilities for instability to develop. This includes the formidable challenges of imperfect information, opportunistic behavior, heterogeneous cognitive ability, externalities, safety, nonexistent markets, transaction costs, uncertainty, sustainability, too-big-to-fail oligopolies and monopolies, protection of children, power imbalances, nonrationality, and unequal distribution of wealth and income. These are exactly the topics that introductory mainstream textbooks are silent about and the concepts that are emphasized in this book. Mainstream textbooks fail to mention even the important breakthroughs of such Nobel Prize winning economists as Herbert Simon (1978, satisficing), Amartya Sen (1998, welfare economics), George Akerlof (2001, asymmetric information), Michael Spence (2001, signaling), Joseph Stiglitz (2001, information economics), Daniel Kahneman (2002, behavioral economics), Paul Krugman (2008, new trade theory), Oliver Williamson (2009, transaction costs), Robert Shiller (2013, behavioral finance), and Richard Thaler (2017, behavioral economics). Without these ideas textbooks irresponsibly mislead students into thinking that markets work flawlessly if only they are left to their own devices. The claim that these topics cannot be studied in Econ 101 because of their complexity or because of the lack of time is a pretext. Without them students gain a biased view of the way real markets work in real time and how they distribute the fruits of their products. This volume demonstrates that without this elaboration standard economics does not live up to Richard Feynman’s call for “utter honesty.”2 Wrong economics has led to wrong economic policies which led to a troubled economy.

266  Conclusion

The Inconvenient Truth about the Current State of the U.S. Economy 1.

Anaemic GDP growth is the new normal. In the twenty-first century per capita growth has been 1.1% compared to 2.0 to 2.2% during the final three decades of the twentieth century (Figure 15.1). 2. The U.S. is producing annually $1 trillion less than it is capable of producing even if it is difficult for mainstream economists to admit. That is an annual loss in productivity of nearly $4,000 for every man, woman, and child. The lighter line in Figure 15.2 is the extrapolation of the growth trend during the quarter century prior to the Meltdown of 2008. It is the potential output of the economy. The growth of GDP after the recession was over is perfectly parallel to this dashed line. It shows a discrepancy of more than $1 trillion. Initially, the official potential GDP was very close to this line, but over time the official statisticians bent the potential to approach the actual GDP. Hence, the inefficiency disappeared. But it did not do so because GDP accelerated as after previous recessions but because the statisticians finagled the potential GDP until the gap disappeared. They do have a rationalization: the people who became unemployed are no longer capable of working. Supposedly, their skills have depreciated, or they are receiving disability benefits, or they have gotten out of the habit of getting up in the morning on time. These are, of course, invalid rationalizations, because 4.9 million people who are not in the official labor force statistics say that they would like to work if the opportunity arose, and 2.5 million part-time workers would like to work full time but cannot (see Table 11.1 in Chapter 11, rows 7–9).3 But of course, it makes the economy look better to say

3.0

Percent

2.5 2.0 1.5 1.0 0.5 0.0 Growth

1950s

1960s

1970s

1980s

1990s

2000−2017

2.5

3.1

2.2

2.2

2

1.1

Figure 15.1  Average Annual Growth Rates of Real GDP Per Capita Source: Bureau of Economic Analysis, Table 7.1 Selected Per Capita Product and Income Series. www. bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1921=survey&1903=264.

Trillions of Dollars

Conclusion  267

18 17 16 15 14 13 12 11 10 9 8 7 6 1980

Actual GDP Official Potential GDP

1985

1990

1995

2000

2005

2010

2015

Figure 15.2  Real GDP and Potential GDP, 2009 Prices Source: Federal Reserve Bank of St. Louis, Series GDPCA and GDPPOT.

that there is no inefficiency. Note, furthermore, that after all the previous recessions like the ones in 1982, 1991, or 2001, actual GDP snapped back to potential. The statisticians did not have to finagle the potential by bending it. This time is obviously different: this is how the new normal looks like. 3. The productivity slowdown implies that anaemic GDP growth is going to be with us for the foreseeable future (Chapter 11). In 2014 productivity grew at around 0.2% per annum.4 Even those innovations that are still forthcoming are not likely to improve the quality of life of Everyman on Main Street. 4. The official unemployment rate is woefully inadequate because its definition is far too stringent (see Table 11.1 in Chapter 11). The real problem is the endemic nonemployment and underemployment leading to an unjust labor market in which at least 10% of those wanting to work are excluded from gainful full-time employment (see Figure 11.3 in Chapter 11). This is partly due to the fact that the economy is not producing enough fulltime jobs: the number of part-time workers jumped by 2.5 million during the Financial Crisis and then remained at that level thereafter (see Table 11.1 in Chapter 11, row 7). The large number for nonemployment is also due to the fact that 4.9 million adults are so frustrated that they have given up looking for work and dropped out of the labor force completely although they would like to work.5 Moreover, the lack of jobs affects minorities the most whose underemployment rate is usually twice that of whites. 5. Stagnating or declining wages across the board is frustrating and is creating distributional conflicts. Household income is essentially the same as it was in 1999 (see Figures 14.5 and 14.6 in Chapter 14); this is true even for those with a college

268  Conclusion

$30 College

Hourly Wage

$25 $20

High School

$15 No High School

$10 $5 1970

1980

1990

2000

2010

Figure 15.3  Women’s Hourly Wages by Education Source: Economic Policy Institute, “Data, Wages.” www.epi.org/data/#?subject=wage-education.

degree (see Figure 9.4 in Chapter 9); men’s wages have not changed since 1973 (see Figure 7.2 in Chapter 7) and those with a high school degree or less have actually declined (see Figure 13.2 in Chapter 13). College educated women fared the best of any demographic in the 1980s and 1990s, but their wage growth has also come to a standstill in the twenty-first century (Figure 15.3). At least those women without a college degree did not experience a decline in income. The only group that registered major gains is the executives of large corporations and the top 1% (see Figure 7.8 in Chapter 7). 6. Secular stagnation is the new normal. Former Treasury Secretary and economic advisor both to Bill Clinton and Barack Obama, Larry Summers, argues that “something is a little bit odd” about the performance of the U.S. economy in the twenty-first century. Furthermore, prior to the Financial Crisis in spite of the explosion of debt as people withdrew their savings from their home equity, and a “vast amount of imprudent lending” compounded by consumers giddy from the impression that they were wealthy “in excess of its reality,” the economy was by no means growing as rapidly as one would expect in a boom. Summers notes that despite all these factors that should have fueled aggregate demand, “Capacity utilization wasn’t under any great pressure. Unemployment wasn’t under any remarkably low level. Inflation was entirely quiescent. So somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.” Krugman thinks that this thesis is a “very radical manifesto,” as Summers is really saying that “we may be an economy that needs bubbles just to achieve something near full employment—that in

Conclusion  269 the absence of bubbles the economy” will continue to falter. In short, Summers is suggesting that the U.S. economy has morphed into one capable of mediocre performance only unless supported by unstable finance. Summers’ point is that it has been more than two decades since the economy grew at a hefty pace supported by sustainable finance.7 The expansion of the 1990s culminated in the Dot.Com bubble. Growth picked up after a short recession, but again was fueled by the Fed’s accommodating monetary policy including low interest rates, easy money, lower underwriting standards, and predatory lending, that culminated in the greatest crisis since 1929. Moreover, even in a bubble economy before the crisis of 2008, economic growth was slower than in the last decades of the twentieth century. Summers’ thesis is confirmed by the slowdown in GDP growth (Figure 15.1). Growth has decelerated by 45% to 50%. This is what the new normal of secular stagnation looks like.8 7. The level of inequality is unjust, untenable, damaging to the social fabric, and has not been seen since the Robber Barons ruled in the Gilded Age. The appetite of the superrich is insatiable. The top 1% earns an average of $900,000 per annum after tax and has captured 20% of total income (see Table 7.3 in Chapter 7). The top 20% of the income distribution earns one-half of total income (see Figure 7.5a in Chapter 7). Even archconservative Alan Greenspan realized that inequality was becoming untenable and feared that “the system will not stand.”9 And that came to be in the election of 2016: the system did not withstand Trump’s populism. The establishment was routed. 8. The U.S. has a $20 trillion economy that fails to satisfy. No matter what metric one chooses, the other developed countries do better: in longevity, life satisfaction, child welfare, poverty, educational attainment; the countries in which the quality of life is highest are those in which taxes are higher but the people have fewer anxieties about their health insurance, college education, and have a secure safety net in case of need (see Figure 2.2 in Chapter 2). Emotional prosperity continues to elude the U.S. A larger share of the population is on antidepressants than at any time in history. Some 2.3 million people are in jail. About 13% of the population is living in poverty, which is approximately what it was in the late 1960s. Median household income is almost the same as it was at the end of the twentieth century (see Figure 14.5 in Chapter 14). The typical American is now overweight and deeply in debt, unable to control either his/her finances or appetite. Thus, the inconvenient truth is that the U.S. economy is not in good shape. The reason is that it faces a lot of headwinds. 6

The U.S. Economy Is Facing 14 Headwinds, None of Which Is Fixable in the Foreseeable Future The U.S. economy faces 14 challenges that are responsible for the current economic malaise, as delineated above. There is no indication that any of these can be solved. Consequently, they will continue to restrict the economy from delivering a high quality of life to most of the population. These headwinds are:

270  Conclusion  1. An endemic budget deficit which deprives the government of funds that could solve any of the structural problems faced by the economy even if it wanted to. This also means that the interest payments on the national debt will continue to snowball. During 2018 the average interest rate on the debt was 2.3%, but if it increases to normal levels around 5%, the burden of debt would become precarious.10 The interest rate has already doubled between 2016 and 2018. So we are taking our chances. This is particularly troubling since as of 2017, foreigners owed $23.7 trillion worth of U.S. securities of all sorts on which interest will have to be paid in perpetuity.11 This implies that the disposable income of future generations is going to be lower than it would be otherwise.12 2. Private debt is also excessive including student debt ($1.5 trillion as of 2017) and credit card debt ($0.9 trillion); these mean that aggregate demand will be subdued in the future because people in debt will have to curtail their spending. 3. The savings rate is negligible, which means that during economic downturns people will not have sufficient savings to remain solvent. This adds to the fragility of the system, i.e., the U.S. is not a black-swan-robust society. The low savings rate also means that people are not planning adequately for retirement. 4. The continued trade deficit of $500 billion per annum means that we will continue to export jobs that will hinder inclusive economic growth. 5. We are beholden to the Chinese politburo for financing a goodly portion of the federal debt. How long will they continue to do so especially since they are indirectly contributing to funding the military expenditures of its main adversary? This is very difficult to say, but it does not take a lot of imagination to think of destabilizing scenarios in which a rising power confronts or challenges one that has been dominating the world order for more than half a century. If one day they change their accommodating policy, as they surely will, interest rates will rise and the burden of servicing the debt will become precarious. 6. Costly military commitments around the globe will continue to drain trillions of dollars from productive uses at home.  7. The U.S. has entered a new phase in its economic development which would require creative ideas to address the challenges it harbors. However, these are not within reach, because a new historical epoch is difficult to recognize and because the political system is closed to new ideas. 8. Mainstream economists are at a loss to propose a viable policy mix to put the economy back on the road to stable inclusive growth. The policy recommendations of academic economists are ideologically too divisive. Conservative politicians will turn to Marty Feldstein, Glen Hubbard, or Greg Mankiw while progressive ones to Joseph Stiglitz or Paul Krugman for advice which will differ considerably. Macroeconomics is particularly in crisis. 9. The financial sector is like a cocoon, decoupled from the real economy. Finance is making considerable profits without creating decent jobs or real investments. 10. GNP growth is decoupled from employment, at least from full-time middle-class employment. This is partly due to technological underemployment, partly because globalization means that low-skilled workers must compete with their lower-wage

Conclusion  271 counterparts around the globe, partly because the workers have no institutional support, and partly because educational opportunities are so limited for a large segment of the population that they do not have the skills necessary to take advantage of the new economy. 11. The primary and secondary educational system is mediocre overall, so it does not prepare the next generation for the requirements of the IT revolution. Furthermore, college education is very expensive, pricing a large share of the poor out of the market. Hence, the significant demand for IT professionals is unmet. Money is not available to bring the educational system up to par. That implies that the problem will continue to linger. A bill similar to the GI Bill after World War II is not on the horizon. 12. The infrastructure is depreciating and is not being upgraded. This will continue to weigh on the economy because infrastructure is its lifeblood. Yet, the returns on infrastructure investments are insufficient to be attractive to private investors and the federal government does not have the money to make the necessary investments after its tax giveaway. 13. Global warming is a major threat that will be increasingly costly in the future, detracting from the standard of living. 14. Political gridlock implies that none of these problems will be properly addressed. These are 14 gale-force headwinds. One can infer from them that there is no reason to think that the future economy will be socially more inclusive than it has been or that it will be able to satisfy the needs of most of the population. We would need an economy that works for the 99%.13 This also means that the distribution of income is not an epiphenomenon; it matters much more than hitherto thought and that average income is not the key determinant of the quality of life. Inequality is the central problem of market economies and its benign neglect is having disastrous consequences on the body politic. The hype of “making the economy grow” is both inapt and deceiving. It is crucial to recognize that most of the fruits of economic growth were captured by the top 1% of the population, or about 1.25 million households! Their average after-tax income of about $900,000 (in 2011) is in stark contrast to the average income of $18,000 of the bottom 20% of households (25 million households) (see Table 7.5 in Chapter 7).14 These developments do not augur well for the future stability of the U.S. or the globe. There is a macroeconomic stalemate about how to end the current malaise and return to “normal” levels of growth; this implies that high levels of nonemployment and underemployment are going to stay with us for the foreseeable future. With trade wars looming, the prospects of a real inclusive recovery are fading. The tax cut of December 2017 was exactly the wrong medicine for the economic malaise. It will increase the wealth of the millionaires significantly, but it will not solve any of the 14 problems. On the contrary, it will exacerbate them. The reason is that money begets power and lots of money begets lots more political power, implying that the oligarchy’s hold on the body politic will continue to increase. The tax giveaways also mean that the government will not have the funds to address any of the major headwinds, and private funds will not be invested into infrastructure, education, renewable energy, health, the things the economy would need to escape from its malaise.15

272  Conclusion This textbook accentuated the weaknesses of mainstream economic theory and underlined the need for a paradigm switch toward humanistic economics in which people count, the quality of life counts, and not an economy driven by greed. It is not that markets are bad, but that markets need the right set of institutions and the right culture in order to function properly, that is, in order that their participants can live carefree, dignified lives. It requires a great deal of insensitivity to evidence to continue to teach that markets are efficient after the greatest meltdown in the history of mankind. Hence, we need to reform the economics discipline so that it begins with empirical evidence as its basis rather than deductive theories written on college blackboards. I hope this volume can make a contribution toward creating a new approach to economics that will serve as a foundation for a new regime of capitalism with a human face.

Notes 1 “Economists focus too little on what people really care about,” The Economist, May 3, 2018. 2 Richard Feynman, “Cargo Cult Science,” Engineering and Science 37 (1974) 7: 10–13. 3 Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey, Series LNU05026639; this is the sum of rows 8 and 9 in Table 11.2 in Chapter 11. 4 Federal Reserve Bank of St. Louis, Private Sector Productivity Growth. 5 Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey, Series LNU05026639; this is the sum of rows 8 and 9 in Table 11.2 in Chapter 11. 6 Paul Krugman, “Secular Stagnation, Coalmines, Bubbles, and Larry Summers,” The New York Times, November 16, 2013. 7 Lawrence Summers, “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Business Economics 49 (2014): 65–73; Lawrence Summers, “Demand Side Secular Stagnation,” American Economic Review 105 (2015) 5: 60–65. 8 James Galbraith, The End of Normal. The Great Crisis and the Future of Growth (New York: Simon & Schuster, 2015). 9 “Alan Greenspan on Income Inequality,” YouTube video, posted by “johnklin,” September 28, 2007, at 2:36. www.youtube.com/watch?v=oqx88MyUSck. 10 Drew DeSilver, “5 Facts About the National Debt,” Pew Research Center, August 17, 2017. 11 U.S. Department of the Treasury, Total U.S. Banking and Securities Liabilities to Foreign Residents by Type of Liability and Holder, http://ticdata.treasury.gov/Publish/totalticliabs.txt. 12 To a few astute observers this decline was evident already in the 1970s. Christopher Lasch, The Culture of Narcissism: American Life in an Age of Diminishing Expectations (New York: W.W. Norton, 1979); Daniel Bell, The Cultural Contradictions of Capitalism (New York: Basic Books, 1976). 13 Oxfam International, An Economy for the 99% (Oxford, UK: Oxfam, 2017). 14 Edward N. Wolff, “Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-Class Squeeze—An Update to 2007,” Levy Economics Institute of Bard College Working Paper No. 589, March 2010; Edward N. Wolff, A Century of Wealth in America (Cambridge, MA: Harvard University Press, 2017). 15 John Komlos, “GOP Tax Cuts Would Make the Rich even Richer,” PBS, Making Sen$e, October 18, 2017.

Index

1984 53 ability 19; buyer’s 94; human 74; inferior mental 145 accessibility 66–68 Achilles heel of markets 31, 94, 142, 220, 235 addictive mania 51 Adorno, Theodore W. 53 adult economics 41 adverse selection 107 advertisements 43, 44, 46, 47, 66–67, 87, 93; 99, 103, 213, 246; desire-creating 39; tobacco 42, 48, 151; TV 214 affluence 25, 45, 52, 84, 123, 166, 170 Affordable Care Act 22, 28, 35n30 African Americans 16n19, 22, 25, 31–32, 34n5, 123–25, 138n33, 163–64, 167–68; see also blacks agents 142–43, 169, 262; representative 180–81 aggregate demand 172–73, 175, 177–78, 180–81, 185, 205–6, 214, 253, 268, 270; fluctuates 173 aggregate personal income 140 aggregation 110; problem of 181 AIG (American International Group) 50, 142–43, 235–36, 261n52, 261; rescue of 244 Akerlof, George 6, 17n33, 54n22, 98n81, 108n35, 182, 187n10, 187n12, 203n50, 232, 261, 265 alcoholism 22–23 altruism 86, 90–91, 98 AMA (American Medical Association) 35, 105, 166–67, 170, 186 Amartya Sen 17, 54, 59, 78, 171, 265 Amazon 53, 197–98, 203n59, 259n12; employment 198

American Dream 8, 28, 45, 85, 134, 140n73, 208, 251 American International Group see AIG American Medical Association see AMA Ameriquest Mortgage 103, 151, 252 anchoring 66, 68, 74, 105 animal spirits 187, 233 antidepressant 53, 56, 59, 150, 269 anxiety 9, 20, 22, 35, 52, 182, 195, 208–9, 269 Apple Inc. 103–4, 112, 132, 164; CEO Tim Cook 170; profit margin 139 Aristotle 4, 33, 86, 155 Arrow, Kenneth 6, 18n54, 28, 37 Arthur, Brian W. 11, 17n38, 158n63 assets, foreign 227; money chasing 246; prices 178, 182, 187, 240; safe 225; toxic 253, 257 asymmetric information 15, 28, 31, 50, 90, 93–94, 101, 107, 144–45, 151, 232, 235–36, 240, 242–43, 250, 265; cultural aspects 92, 122; intangible 30, 51, 94 attribute substitution 65 auctioneer 32, 106, 108, 165 automobiles 30, 45, 105, 110, 145, 173; high-quality 228; production of 174 babies 30, 49; selling of 32, 148 bailouts 1, 28, 34n7, 103, 139n48, 148, 157n43, 232, 240, 253–58, 261n52, 263n105, 264n120; cash for trash 256, 263; payment-sharing 256 Bair, Sheila 239 Baker, Dean 98, 202, 239, 260 Balanced Budget Amendment 216 balance of power 27, 112, 165 balance sheets 87, 250, 254, 257

274 Index bandwagon 84, 96, 252 bank deposits 27, 242 bankers 93, 144, 149, 242, 247, 254, 256–58, 263–64; old-fashioned 145 banking 234, 242, 272; deceptive 79; interstate 247; shadow 242–44, 250; system 27, 178, 246 Bank: of America 100, 118–20, 143, 250, 253, 263; Barclays 82, 96, 146, 150; of England 187, 202; failures 108n22; of International Settlement 203 bankruptcy 20, 119, 148, 173, 197, 232–33, 242, 244, 247, 249, 251, 261; brink of 118, 142; probabilities 262; statistics 35 banks 44, 89, 96, 100, 102–3, 108, 117–19, 122, 144, 146, 149–50, 157, 176–78, 207, 215, 234, 236, 240, 242–44, 246–47, 250–52, 254, 256–58, 263; big 118, 257, 262; classic 244; finagle 103, 240, 267; flexible lending rules of 246; insolvent 257; as intermediaries 142; local 234–35; major 240, 248; nationalized 257; private 234, 247, 252; savings 247; too-big-to-fail 8, 247, 253, 257; traditional 244; zombie 257 basic, goods 161; needs 5, 7, 22, 28, 39, 41, 45–46, 49, 89, 92; research 26–27, 117, 194, 205, 207, 209, 214 Bear Stearns 103, 142, 244, 249, 253, 262; subsidies to takeover 250 behavior: dysfunctional 240; human 17, 60, 77, 96; influences 147; perverse 240; reckless 103; unethical 103 behavioral, economics 37–38, 57, 65, 71, 74, 77–78, 157, 265; economists 64, 66; finance 74, 236, 265; game theory 97; macroeconomics 98, 187 belief system 16, 145 Bell, Daniel 87, 97, 272 Berkshire Hathaway Inc. 120, 141, 260 Bernanke, Benjamin 3, 13, 14, 18n50, 75, 100, 101, 107n9, 178, 187n16, 193, 232, 237, 240–41, 244, 247, 250, 251, 252–53, 255, 258, 259n4, 259n8, 259n11, 260n37, 260n38, 260n45, 261n51; printing money 177, 183 Beyoncé 212 bias 12, 17n46, 28, 57, 64–65, 66, 78n26, 81, 86, 89, 92, 145, 198, 208, 242, 265; mental 251; psychological 30, 74

billionaire 23, 36n40, 82, 95n2, 106, 212, 217, 218n37; Raj Rajaratnam 146 bitcoin 237 blackboard economics 3, 4, 6–8, 13, 16n11, 31, 61, 64, 109, 142, 144, 159, 181–82, 209, 224, 233, 236, 265, 272 Black Friday 106, 108; stampede 97 blacks 23, 35n22, 35n23, 123–25, 168, 190; black-white wage gap 138, 168, 171; males 29; poor 35; youth 35 Black-Scholes-Merton model 233 black swans 247, 261n71, 270 Blankfein, Lloyd 118–19, 250, 258 BLS see Bureau of Labor Statistics Board of Governors 188, 218, 229, 257, 261, 263 bonds 178, 234, 248; Citibank 250; corporate 119 bonuses 100, 102, 109–10, 113, 118, 143–44, 150, 243, 251, 253, 257; executive 257; stock 164 boom, economic 183; euphoric 242; speculative 236 Born, Brooksley 2, 16n5, 238–39, 242, 260n29 borrowers 93, 217, 234–35, 242, 261; fabricating 151; scrutinized 234 bottlenecks 255 brain 52, 58–62, 64–65, 68, 78, 80; activity of 60; circuits 77; early mammalian 59; mechanisms 61; research 91; reward circuits 60; systems 45 brand 43, 47, 99, 102, 105, 228; competing 52; differences 51; loyalty 78; recognition 159 Brave New World 45, 54 bounded rationality 31, 37n77, 61–62, 64, 78n16, 78n17, 78n27, 100 Bronx 4; South 89, 132 bubbles 98, 120, 234, 236–37, 239–41, 243–47, 252, 268–69, 272; asset price 11, 74, 76, 236–53, 254, 257, 259n12, 260n31, 260n32, 261n54, 261n68, 262n84, 268–69, 272n6; burst 241; housing 98, 236, 239–40, 244, 261; stock-market 250; subprime 244–45, 253, 257 Buckley, William F. 136, 141 Buddhist economist 45 budget 187, 207, 216; deficits 129, 206, 211, 224, 226, 229, 254, 270; household’s 116 Buffett, Warren 134, 141, 209–11, 217n27, 226–27, 229, 239, 260 Bush; George Jr. 28, 206, 212; George Sr. 28, 206, 248, 262n73

Index  275 business, cycle 163, 187, 205–6, 216, 232, 241; big 165; commercial banking 247; entrap 50, 76; taxi 197 buyer’s remorse 98 Cambridge capital controversy 120, 139 Canada 21, 25, 29–30, 51, 135–36, 166–67, 195, 208, 229 capabilities 46, 54, 139 capital 34, 109–10, 119–23, 136, 140, 185, 194, 249–50, 252, 262; accounts 229; accumulation 206; cost of 119–20; depreciation of 119; excess 89; gains 75, 210; human 138, 214; imperfect market 94, 150; institutional 118, 121; insufficient 89; intangible 121; market 89; natural 200; owners of 109, 136; physical 119–21, 184; shares 170; social 109, 121–22, 212; stock 110, 119–20, 185; tax 18 capitalism 17, 83, 97, 134, 146, 149, 168, 172–73, 175, 183, 202, 206, 229, 253, 258, 261–63, 272; contemporary 87; market 19; money manager 262; post-industrial 87; in praise of 26; predatory 151; Scandinavian 168; success of 87; sustaining 87 cartel 105, 166; legal 117; medical 170–71 Carter, James 9, 17n30, 112, 206 Case, Anne 36 caveat emptor 76, 94, 98n84 CDSs (credit default swaps) 235, 236, 243–45, 248, 252; regulating 238 Celebrities: Hollywood 48, 87, 118; idolized 41; trendsetters 87 central banks 176, 192; foreign 225, 240; models 187 CEO 50, 55, 83, 100–103, 105, 108–9, 113–14, 117–19, 135–36, 142–43, 159–60, 164, 250–51, 260; bank’s 103; clawback 143–44, 156; compensation 114, 135, 138; contracts 143; golden parachute 118, 139, 142; pay 138, 141, 159 CEO-worker salary ratio 135 CFTC (Commodity Futures Trading Commission) 157, 238 charitable contributions 88 children 29, 36–37, 42, 55, 122, 160, 266; deprivation of 90; health 49; hungry 212; labor 185; poor 22; poor black 35; poverty of 136;

rearing of 184; schooling of 208; welfare of 35, 269 China 29, 112, 157, 207, 222–24, 227–28, 230, 235, 240; capital investments of 223; companies of 148, 227; consumer goods of 227; economy of 225; politburo 207, 254, 270; toxic drywall of 148, 157; wind turbines 224 choice, excessive 155; optimal 152–53; rational 17, 77–78, 93, 153; reasoned 57; simple 61, 58, 93; sequential 155 cigarettes 27, 52, 54, 92 Citibank 119–20, 146, 235, 240, 251 Citizens United decision 37 civil rights 28, 37n73, 54n7, 168 class, lower 125; lower-middle 128; new privileged 136; new wealthy 81; upper 133 class warfare 209, 217 Clean Air Act 146 climate change 37, 122, 203–4; catastrophic 204 Clinton, Hillary 13, 28; William 206, 238, 247, 268 coalmines 272 Coase, Ronald 16n11 Coca-Cola Co. 120, 207, 259 cognitive 52, 60–61, 86; ability 61, 76–77, 79, 93, 151, 265; biases 66, 78, 145; capacity 63; endowment 76–77; errors 110 college 164, 212, 223, 268; degree 94, 155, 268; education 23, 212, 269, 271; free 183, 212; presidents 118 collusion 102, 150; tacit 105 Commandments 50, 146, 149, 228 commercial banks 121, 139, 215, 242–44 Commodity Futures Trading Commission (CFTC) 157, 238 Communism 17, 172, 175, 260 Community Reinvestment Act 262 companies: bus 148, 168; cigarette 44; credit card 51, 90, 97; drug 102, 122; high tech 227; iconic 150; mobile ride request 197; pharmaceutical 102; shareholders 141 comparative advantage 219, 227–28; theorem of 223; theory of 219–20, 228 compensation 109–12, 114, 116, 118, 135, 138, 157, 203; committees 135; gap 137; hypothetical 203; part-time jobs 138; and productivity gap 111; -wage gap 114

276 Index competition 28, 30, 50–51, 62, 85–86, 91, 94, 99, 101–03, 105–06, 109, 112, 118, 144, 150, 152–53, 155–56, 158, 161, 165–68, 191, 223, 246, 248; advantage 51, 228; intensifies 103; perfect i, 14, 15, 32–33, 101, 102, 120, 152 competitive markets 15, 49, 81, 101, 156, 162, 227; cost reductions 261; labor 109; models 99, 103, 105, 159 competitors 102, 104, 145, 162, 219, 248 complexity 27, 63, 147, 265 compulsive buying 55, 85 computer models 246, 249; sophisticated 246 computers 45, 48, 108, 110, 117, 119–20, 224; high-speed 237; laptop 197; mainframe 89, 117; personal 112; tablet 197 concentration 27, 83, 99–101, 116, 148, 161; increasing 210 conditioned response 47 conditioning see Pavlovian conditioning conflict, distributional 267 Congress 36, 77, 82, 97, 165, 187, 211, 217, 235, 252, 254–56, 260; dysfunctional 258; lobbies 83, 165, 234 conspicuous consumption 15, 31, 49, 95, 168, 192, 207, 211–12; and children’s playhouse 89; million-dollar bras 89–90 consumer 27, 173; behavior 66, 96; complaints 25, 156; confidence 173; conventional theory of 72; credit 97; debt 226; gain 162; loss-leader strategies entice 95; manipulated i, 5, 17n33, 42, 44, 54n22, 66, 67, 76, 78n20, 83, 145, 148, 203n50, 246, 261n46; maximize 57–58; outsmarting 62; preferences 83; price index 215; protection 15, 58, 76, 92, 94; relief 146; sentiment 173; sovereignty of 40–45, 48, 157 Consumer Financial Protection Bureau 27, 37, 77 consumer goods 172, 223; contaminated 150; durables 173; imported 225; safe cribs 30, 147 consumerism 10, 42–43, 51–53; addictive 54n30 consumption 15, 31, 39, 41, 45–46, 49, 52–53, 68, 81–98, 109–10, 144–45, 149, 168, 179–80, 192, 196, 207, 210, 212, 214, 220–21, 227; decisions 62, 92, 152; domestic 220; efficient 93; externalities 84, 96; habits 41, 84, 95, 211; inefficient 95; norms 214; optimal 150; personal 175; relative 84; taxes 85, 210

contaminated supplies 157 context 66–67, 78n14, 180, 228 cooperatives 192 corporate: after-tax profits 121; governance 123, 135, 251; jet 141; profits, 121–22, 211, 214, 248, 262; taxes 211; welfarism 17, 83, 253 corporations 17, 29, 37, 40–41, 47, 52, 57, 60, 62, 82–83, 87, 96, 100, 109, 112, 134, 136, 142, 144, 213, 251, 257, 259; large 53, 82, 88, 100, 113, 268; major 96, 135; private 207; profit-seeking 44 corruption 146, 150, 157; legalized 165 costs 15, 22, 93, 95, 100–101, 105–06, 109–10, 118–19, 121, 145, 148–49, 151, 153, 170–71, 187, 193, 196, 198, 200, 207, 212, 215–18, 225, 228, 243, 248, 255–56, 258, 261; social 169, 198, 200, 220; cost-benefit 222 counterfeiting 230 countervailing power 112–13, 115, 135, 162–63, 165 Countrywide Financial 103, 119, 251–52 crashes 74, 260 creative destruction 196, 198, 202n43, 253 credit 23, 43, 47, 95, 97, 124, 149, 151, 156, 176, 182, 207, 219, 234–35, 243–44, 246, 252, 254–55, 261; crunch 257 Credit Card Act 97 credit card 44, 51, 87, 93, 102, 108, 146, 156, 177, 187; debt 54 credit constraint 234 credit default swaps see CDS crime 20, 34, 212, 217; rate 212 criminals 150, 156, 217 crisis 16, 93, 100, 103, 139, 151, 156, 177, 213, 243–44, 246–47, 252, 254–55, 258–59, 262–63, 269–70; solvency 244 Cultural Contradictions of Capitalism 97n43, 272n12 culture 42, 44–45, 50, 85–88, 97, 109, 122, 145, 184, 194, 197, 214, 251, 272; dominant 41; frugality 47–48, 87, 213–14; industry 87; norms 46, 77, 81, 91, 184, 213; popular 17, 208; pornopop 87; shared 122; Western 234 curses of markets 31 customers defrauded 150; entrapped 28; frustrated 93; overcharged 150 Darity, William 171 David Cay Johnston 16, 96

Index  277 DDT 198 deaths of despair 23 Deaton, Angus 36–37 debt 38, 43–45, 129, 156, 172, 176, 181, 183, 206–07, 243, 254, 257, 268–70; accumulation 85, 241; burden 176, 247, 270; credit-card 76–77, 90, 108, 270; excessive 212–13, 227; federal 208, 216, 270; foreign 227; mortgage 247; real value of 173, 214; skyrocketing 260; trap 60; zero 212 deception 17, 50, 54, 76, 93, 103, 105, 145, 150, 203, 261 decisions 33–35, 60, 68, 74, 87, 262; complex 61, 65; complicated 15; consecutive 155; informed 93; irreversible 152; optimum 59, 60, 64; reasoned 62, 65; satisfactory 93–94; sequence of 58, 64; simple 58 deficit 206–07, 211–12, 217, 219, 224–27, 229; endemic 207; increasing 36; persistent 224; spending 175, 206 deflation 172, 174–75, 214 deleverage 176, 257 demand 39–56, 74, 76, 96, 99–100, 104, 106–07, 159, 163, 167, 173, 180, 191–92, 215, 271; curve 75; domestic 229; deposits 187; increased 175, 239; models 106 democracy 27, 83, 134, 175, 198, 202; liberal 172, 231; vibrant 183 Democrats 258 demographic 125, 240–41, 268 Denmark 20–22, 25, 29–30, 136, 166, 195, 208, 240 depression, economic 75, 173, 175, 206, 232, 261n56, 263; prevention 232; see also Great Depression depression, medical 22, 35n32, 35n33, 52, 75, 200 deregulation 34, 148, 166, 242, 247, 260; begin 116; cheered 234 derivative pricing 233 development economic 213, 223–24, 228, 270; capitalist 194; human 26; moral 48 deviation amplifying system 241 Dictator Game 80n44 Dimon, Jamie 100, 118–19, 250, 258 diploma 94–95, 116, 164 direct investments 229; foreign 227 directors 34, 135, 143, 157, 249, 251; board of 113, 117–18, 135, 233 disability benefits 266

disasters 31, 122, 148, 200, 204, 235–36, 260; BP oil spill 200; Exxon Valdez 31; Hurricane Katrina 200; natural 28, 200, 204; nuclear 200; superstorm sandy 200 discount rate 176 discrimination 79, 123, 140, 150, 158, 167, 171; bus companies 168; skin color 134, 168; Woolworth’s lunch counter 168 displacements 243 disposable income 21, 24–25, 129, 184, 211–13, 270 distribution 15, 272; current 89, 91–92, 133; equitable 31, 81, 88, 163, 198; fairer 168; initial 169; unequal 20, 26, 82, 93–94, 125, 133, 161, 265 divorce 22, 35n19 doctors 15, 66, 155, 166–67, 170–71, 183; foreign 170; supply and demand 167 Dodd-Frank Act 143 dogmas 243 domestic market 228 Donaldson, William (SEC) 249 doom loop 244, 259 doomsday cycle 263 Dot-Com bubble 231, 233, 236, 244–45, 254, 269 dropouts 35, 189 drug industry 165 drugs 34, 53, 63, 88, 97, 161, 197; antidepressant 56; contaminated 145; generic 101; overdose 20, 23; prescription 83 early-mover advantage 153 earnings 77, 79, 102, 117, 124, 127, 135, 138, 150, 209, 211, 233, 248; annual 114, 164; exorbitant 160; net lifetime 150 earth 44, 62, 80, 122, 199–200 Easterlin, Richard 18, 96, 140 Ecological Economics 204n78 Econ 101 6, 11–14, 78n3, 91, 94, 99, 101, 152, 162, 208, 265 economic, burden 22, 36; challenges 20; complex system 58; inequality 134, 165, 195; literacy 76; malaise 269, 271; mistake 57; model, standard 15; policies 90, 94, 97, 181, 187, 202–03, 231–32, 265; progress 35; system 22, 27, 39–41, 117, 175, 196, 253, 265; well-being 125, 218 economic geography, new 152, 158

278 Index economic growth 15, 131, 140, 157, 172, 184, 187, 194, 196, 200, 206, 209–11, 218, 220, 223, 228, 254–55, 269, 271; inclusive 270; stable 242 economics 15–18; adult 41; behavioural 33, 182; conventional 41, 44, 58, 84, 91, 151; discipline 33, 88, 272; experimental 33; free-market 17, 46, 48, 81; humanistic 16, 222, 272; ivory-tower 37; laws of 232; neoclassical 44, 64; normative 91; orthodox 76, 236; positive 91–92; profession 182, 236; science 37, 187; standard 85, 265; supply-side 210; textbooks 16, 44; trickle-down 15, 130–31, 183, 210–11; voodoo 210, 217 economic theory 33, 49, 77–78, 122, 139, 210, 272; conventional 83; super-individualistic 85; traditional 86; value-neutral 92 economists 15; academic 59, 270; blackboard 135, 167; classical 172; conservative 182, 193; conventional 173, 212; establishment 240; feminist 86; hired 112; neoclassical 175, 180 economy 19–20; actual 182; bubble 269; capitalist 146; complex 58, 254; developing 223, 230; domestic 207, 222, 226; efficient 121; fantasy 45, 85, 87, 109, 168; global 197, 265; growing 15, 240; low-wage 160; malaise, current 271; market 20, 22, 88, 271; modern 50, 77, 185; new 231, 233, 271; real 18, 101, 146, 177–78, 203, 236, 242, 270; sour 256; troubled 265 education 16n1, 20, 22, 23, 24, 26, 30, 34n1, 36n44, 36n45, 36n46, 45, 77, 89–90, 93–94, 115, 116, 134, 138n24, 138n26, 138n33, 139n43, 150, 155, 163–64, 167–69, 183, 185, 194, 205, 206, 207, 209, 212, 213, 222–23, 254, 255, 267–68, 269, 271; attainment 20, 77, 138, 168, 213, 269; children’s 185; efficient 90; higher 164; high school 23, 115, 222; policy 30; quality of 30, 150, 212; secondary 271; system 24, 150, 167, 194 efficiency 49, 81, 83, 87–94, 101, 104, 107, 144, 146, 183, 203, 210, 212, 242; and equity 212 efficient market hypothesis 236, 243 effort 46, 51, 62, 64, 66–67, 87, 93–94, 100, 104, 116– 17, 133, 142, 148, 155, 184, 200; collective 166, 200 Einstein, Albert 71 Eisenhower, Dwight 9, 17n31, 95n1; administration 119; warning 82 Eisenhower Interstate Highway System 207 elites 83–84, 88, 97, 116, 146, 182; moneyed 134, 149; new 49

emotions 3, 7, 8, 33, 39, 41, 44, 52, 53n1, 57–61, 66–8, 69, 71, 72, 74, 86, 168, 180, 202n27, 204n86, 236, 269 empathy 33, 77, 90–91, 168 employees 57, 82, 100, 107, 112–14, 116, 121, 125, 138, 142–44, 147, 150, 159–60, 198, 215; economist 101, 179; part-time 116; skilled 203; typical 113 employers 15, 94, 109, 143, 147, 192, 194, 202; set wages 215 employment 37, 140, 148, 161, 163, 170–71, 186, 190, 192–94, 197, 201–03, 215, 219, 221, 228, 232, 241, 262, 268, 270; full 175, 190, 192–93; full-time 116, 189, 201, 267; maximum 214, 237; middle-class 270 endowment, effect 79; initial 133 energy 62, 85, 144, 209; clean 229; derivatives 157; renewable 207, 271 enforcement, costs 122, 144, 146; mechanisms 27, 121 Enron 146, 157; bribery scandal 148; fictitious entities of 82; and the Gramms 157 entrepreneurs 118, 120, 242; non-discriminating 168 entrepreneurship 77, 103, 109, 120, 194 environment 15, 25, 27, 42, 77, 79, 148, 183, 200; damages 200; degradation 31, 183; ecosystems 122, 198; heat waves 200 epidemic 85, 146, 150; diabetic 60; opioid 20 EpiPen 101; price of 88, 97, 161; scandal 170 equality 54, 89, 136, 141, 212; legal 136; perfect 23, 168 equilibrium 75, 93, 99, 105–06, 153, 156, 172, 175, 196; competitive 167; full-employment 175; macroeconomic 172; models of 182; multiple 105; non-inflationary 193; perfect 181; price 106; wage 179 equity 81, 88, 121, 233; private 252; stripping 151; values 259 errors, systematic 242–43 establishment 95, 119, 172, 269 ethics 7, 9, 12, 17n45, 31, 37, 53n1, 86–87, 133–37, 157n31, 171n37; challenges 222; corporate 107; hedonistic 17; post-modern 214; Protestant 183; puritan 214 ethnicity 116, 123–24, 134, 256 Europe 21–22, 53, 105, 181; developed countries of 205; economies 212

Index  279 evolution 59–60, 65–66, 78, 80, 84, 90, 155, 243; advantage 65; biology 98; social 34 excess capacity 102, 176 excess reserves 176 exchange 32, 93, 149, 165, 257; economic 94; manipulating foreign 150; rate 219; repeated 50; unequal 151 executives 118, 136, 138–39, 143, 146, 148, 150, 217, 243, 251, 262, 268; compensation of 139, 141, 143; lower-level 143 expectations 74–75, 77, 86, 105, 118, 173, 241–42; cultural 85; formation 87; influences price 105 expected value 68, 72–73, 79 expenditures 16, 36, 45–47, 92, 198, 200, 206, 216, 218; current 211; cutting 206; health-care 28; public 212; unexpected 213 expense 16, 90, 94, 98, 117, 120, 139, 143, 145–46, 148, 156, 165, 196, 200, 203, 220, 225, 229, 236, 248; medical 20 experiments 43, 60, 68, 73, 79, 88, 90; altruism in 98; controlled 32; in economics 33; psychological 65 exploitation 94, 151, 158, 161 exports 219, 224, 225–27, 229 externalities 55, 58, 84, 150, 187, 196, 261, 265; negative 45, 75, 95, 101, 168, 198, 203, 212, 243–44; network 155 extortions 136, 141 exuberance, irrational 231, 234, 236, 251, 259 Exxon 120 Facebook 53, 120, 138n39, 198, 203 factor, payments 103; price equalisation 229 factors 15; cultural 185; intangible 109, 121; social 77 factory shutdowns 222 fads 47; fashion 87 fairness 38, 88–89, 91, 97–98, 119, 161, 168, 192, 215 fair share 209 fallacy of composition 181 falsifying appraisals 151 families 22–23, 26, 35–36, 40, 46, 49, 52, 79, 85, 89–90, 123, 133–34, 140, 165, 184, 201, 210, 214, 254, 256; dysfunctional 89, 155, 212; homeless 36; lower-middle class 131; poor 134; well-endowed 133

famine 105, 171 Fannie Mae 103, 120, 234, 252, 262 FBI 146 FDA 51 FDIC 158, 239 Federal Reserve Bank 33, 83, 103, 119, 171, 175–76, 187, 193, 214, 218, 231–32, 240, 243–44, 252, 257, 260, 261, 263; of Boston 256, 263–64; Emergency Loans of 263; of New York 217; secret loans of 256; target rate of 202 feedback effects 20, 82, 86 fees 105; credit card 44; excessive 151; hidden 51 Feldstein, Martin 16, 187, 190, 193, 202, 270 feminist 34, 79, 86 Feynman, Richard 12, 14, 17n44, 265, 272n2 finance 31, 62, 81, 94, 96, 116, 148, 207, 231–33, 238, 240, 246, 248, 251, 258, 260, 269–70; behavioral 74, 265; captains of 142, 253; careers in 237; dangers of 239; Empirical 138n18; Lords of 258; quantitative 246; share of GNP 262; sustainable 243, 269; unstable 269 financial 244; alchemy 246; architecture 243; engineers 235, 246, 251; gains 197; instability hypothesis 241, 260; institutions 243, 248, 250–51, 257, 260; instruments 203, 239, 242–43; intermediation 203, 262; officer 139; panics 176, 181, 246; products 50, 242, 250; resources 82, 165; sector 37, 74, 82–83, 101–02, 105, 121–22, 148, 177–78, 181–82, 192, 197, 203, 211, 234, 241–43, 246, 248, 251–52, 257–58; storm 100 financial crisis 18, 28, 37, 74, 96, 118, 143–44, 150, 176, 180–82, 231–32, 267–68, 272; global 239; warnings 16, 82, 92, 196, 238–40, 249; warnings ignored 253 Financial Crisis Inquiry Commission 252, 259–63 financialization 248 financial system 28, 178, 215, 237, 241, 244–46, 248, 250–51, 253, 259–60, 264; fragility of 31, 213, 246, 247, 253, 270 financiers 243, 250, 254, 258 fines 146, 157n151; laundering 150 fine tune 206 Finland 20–21, 25, 29–30, 136, 166, 195, 202, 208 firms 39–40; bend rules 102; big investment 249; brick-and-mortar 102; commercial

280 Index 178; competitive 102, 109, 228; discounts 105; discriminating 167–68; domestic 228; exporting 226; first-mover advantage 228; giant 100; iconic 197, 259; inefficient 103, 253; large 100, 202, 252; non-discriminating 168; oligopolistic 159; pharmaceutical 162; private 252; productive 103; representative 79; strategies 101; structured 103 First Amendment 37, 82 first-mover advantage 155, 224 flourishing 205; mass 16 food 39, 43, 45, 49, 54, 58, 161, 209; fast 198; healthy 147; insecurity 22, 35; junk 148; poisoning 145, 156 food stamps 129–30, 175, 222 Ford Motor Company 125, 197–98, 206 Ford Workers 125, 127, 140 foreclosure 25, 35n17, 150, 157n47, 247, 253, 257–58 foresight, imperfect 6–7, 31, 64, 147, 152–55 Foundations of Behavioral Economics 57 founding fathers 81, 134 framing effects 66, 74, 105 France 20–21, 25, 29–30, 135–36, 148, 157, 166, 200, 202, 227, 235 Frankfurt School 16 fraud 50, 55, 96, 119, 139, 145–46, 149–51, 235, 243, 246, 252; corporate 146, 156; cost of 146 Freddie Mac 234, 252, 259, 262 freedom 9, 10, 42, 44, 52–53, 145–46, 180, 208; unfreedom 44, 53 Freedom of Information Act 263n111 free markets 12, 14, 17n40, 19–27, 30, 37, 49, 93, 97, 100, 134–35, 141, 145, 149, 152, 168, 172, 200, 202, 263; ideology of 17; nirvana of 23 free trade 220, 222–24, 228–29 Freud, Sigmund 7, 8, 16, 38, 41–44, 96n11 Friedman, Milton 9, 170n23, 180, 206 Fromm, Erich 46, 52, 54n23 Fuld, Richard 50, 90, 103, 108, 142–43, 250–51; congressional testimony of 262; net worth 55 full employment 193–94, 202n19, 221, 228, 241, 268 funds 37, 61, 80, 83, 90, 165, 234, 245–46, 270–71; hedge 149, 232, 244–45; mutual 244; private 271 fuzzy logic 54

Galbraith, James 97, 187, 263, 272 Galbraith, John Kenneth 24, 36n48 Gallup 16, 188, 201–02, 204 games 83, 98, 112, 117, 262; ultimatum 33, 38; video 230; zero-sum 84 gasoline 15, 88, 161, 170; brands 51; leaded 198; shortage 161; stations 102 Gates, Bill 89, 116–17, 138, 217 GDP (gross domestic product) 17, 54, 115, 121, 175, 183, 185, 200, 204–06, 208, 212, 216n2, 219, 245, 248, 255, 261–63, 266–67; fetishism 202; growth 197, 210, 245, 266, 269; per capita 255; Potential 266–67; Real 176, 245, 267; real growth 259; share of 115; world’s 200, 204n79 Geithner, Timothy 148, 157, 240, 252, 255 gender 37, 89, 98, 114, 116, 140, 171; roles 86–87 General Electric 141 General Motors 119–20 generations, grandchildren’s 191; next 90–91, 271; prior 118, 196, 206; unborn 87 genes 39, 50, 60, 65, 77, 79–80, 89–91, 133 genoeconomics 77, 79 Georgescu-Roegen, Nicholas 202 Germany 15, 20–21, 25, 29–30, 135–36, 166–67, 175, 187, 192, 202, 205, 223, 227–28, 235; union representatives in 135 GI Bill 271 Gilded Age 269 Gini coefficient 23–24, 36 Glass-Steagall Act 242–43, 247, 258 GlaxoSmithKline 146, 150, 156–57 globalization 112, 115, 225, 228, 231, 250, 270; anti 135 Global Warming 203 GNP (gross national product) 84, 86, 122, 172–73, 175–76, 178, 183–84, 195–96, 198, 207, 211, 242; growth of 184, 270; per capita 179 Goldman Sachs 50, 82–83, 93, 119–20, 139, 235, 249–50, 253 Goldschmid, Harvey (SEC Commissioner) 249 goods, coveting 46; durable 176; generic 7, 58, 99, 101; luxury 85; manufactured 219; positional 45, 84–85; ration 105; unskilledlabor-intensive 219 Google 53, 120, 197–98, 259 government 15–16; aid 27; bailouts 103; big 53; bonds 259; budgets 205, 207; conservatorship 103; control 145; debt 129, 205, 207–09;

Index  281 effective 182, 205; expenditures 175, 205, 211; federal 24, 205, 208, 271; government agencies 100, 148, 228; guidance 109; haters of 252; inspection 51; institutions 28, 116; intervention 27, 96; investments 209, 214, 228; IOUs 225; local 135; oversight 30, 58, 242, 247; Payment-Sharing Plan 263–64; policy 92; protection 92; regulation 147; revenues 210–11, 214; role 192, 205; services 28, 148, 209; subsidies 103, 257; support 209, 250; taxation 209 Government National Mortgage Association (GNMA) 234 governors 108, 188, 218, 229, 240, 257, 261, 263 Gramm, Phil 157; Wendy 157 gratification 52–53, 213; delayed 88, 213; instant 49, 87, 183, 214 Great Depression 172–75, 231, 241, 250, 253, 260 Great Moderation 232, 251, 259 Great Recession 44, 92, 118, 121, 173, 253, 259 greed is good 200 Greensboro Sit-Ins 171 Greenspan, Alan 33, 36, 58, 75, 100–01, 103, 107, 134, 141, 144, 231, 232, 234, 236–42, 244–45, 247, 250, 257, 259–61, 269, 272; bubbles of 236; ideology of 243; trust in 259 Greenspan put 232, 233, 250 gross domestic product see GDP gross national product see GNP group dynamics 32; dysfunctional 244 groups 46–47; disadvantaged 22; ethnic 192; ideology 107; interests 90, 103; morality of 91; privileged 211; reference 132, 168; social 52 groupthink 100, 107, 244 growth 15, 18, 26, 110–11, 132–34, 164, 184, 194, 196, 202, 206–07, 214, 227, 234, 254, 269, 271–72; anaemic 209; effects of 223; housing 240; income 130–31; industrial 224; long-term 183, 223; protected 232; rapid 210, 261; stable inclusive 70; trend 266; uneconomic 200; wage 111–12, 268 gullibility 145; of consumers 151; of people 75 Gupta, Rajat 146; convicted 96 habits 19, 46, 52, 58, 81, 84, 86, 144, 169, 266 Haldane, Andrew 259

happiness 16, 18, 26, 54–55, 69, 71, 78, 96, 133, 136, 157, 188, 195–96, 201, 208 Hayek, Friedrich 206 health 15, 17, 26, 28, 30, 37, 49, 63, 68, 78, 85, 107, 121, 144, 148, 157, 166, 168, 183, 249, 271; ill 49; insurance 22, 28, 62, 107, 269; maternal 49; mental 16, 22, 45; public 207; statistics 35 health care 15, 26, 29–30, 37, 39, 46, 89, 95, 105, 161, 183; as basic need 105; best 134; expenditures 29; industry 185; system 28; universal 183, 212 hedonic treadmill 195 herding behavior 74, 84, 86, 149, 173, 236, 240, 248 heuristics 17, 34, 65–66, 74, 110, 116; as information-processing shortcut 65 hierarchy 84, 156; evolved 59 higher education 34, 55, 78, 139, 202 high school diploma 115, 155, 268 Hispanics 22–23, 124–25, 164, 190–91, 216 Hollywood 53, 214 homeless 23, 106; children 36 homicides 20, 37, 186 homo oeconomicus 33, 44, 57–80, 173, 179, 181 hours 97; working 85 household income 123, 126, 128, 130, 132, 164, 247, 256, 263, 267; median 164, 247, 255, 261; real 239 households 21; female headed 22; rich 140; single-parent 22; size of 130; wealth of 140, 272 houses 36, 49; equity 268; prices of 74–75, 237, 239, 240–41, 247, 252 human, biology 45; capital 22, 90, 109, 121, 138, 150; mind 57, 62; nature 53, 77, 88, 90–92, 97, 186 hunger 22, 28, 44–45, 64, 169, 175; people 106 Huxley, Aldous 45, 53–55, 198, 202 hyperglobalization 215 Iceland 166, 195, 208 ideologues 214, 252 ideology 16, 26, 33–34, 81, 166, 182, 216, 247; dominant 48–49, 101; free-market 81; schism 181 illegal activities 146, 150 illusions 43, 101, 198, 212, 232, 247 IMF 232, 247 imperfections, market 94, 142, 158

282 Index import 219–20, 224, 227; certificates 229; cheap 219; minus exports 175 incarceration 34, 217 incentives 53, 100, 113, 116, 132, 142–44, 164, 200, 211–12, 214, 235, 240, 242; irresistible 81; perverse 246; strong 251; structures 30, 121, 265; supposed 119; unbalanced 148 income 18–20; after-tax 130–31, 209, 211, 271; aggregate 79, 125, 128; annual 26, 128, 130, 217; average 129; distribution 24–26, 117, 122–23, 125, 128–29, 136, 210, 269; expected 68; full-time 160; high 211; household income 85, 125, 163, 256, 261, 269; inequality 16, 34, 49, 129, 134, 141, 251, 272; lifetime 77; lower-middle-class 222; median 114, 124, 138, 163; national 79, 90, 198; per capita 195; personal 125; pyramid 125; real disposable 130; redistribute 169, 212, 220; relative 84, 132–33, 194; retirement 65; share 26, 128, 210, 214; taxes 210–11; total 23–24, 124–29, 136, 169, 269; women’s 114, 196 individualism 27, 45, 53, 86, 107; methodological 181; pretence of 41; rugged 208 industrial, dictatorship 83; countries 28, 212 Industrial Revolution 19, 122, 194, 200 industries 37; advertising 67; automobile 198; carbon 27; fashion 84, 184, 196; fast food 112; financial 138, 248, 260; firearms 44; green 255; groups 31; pharmaceutical 82, 156, 161; privileged 117; protected domestic 228; R&D intensive 203n53; subsidizing infant 224 IndyMac 103 inefficiencies 28–29, 51, 74, 95, 106, 109, 143, 145–46, 152, 159, 212, 266–67; hidden 212; large 75 inequality 21, 23–24, 35, 55, 84, 87–88, 131, 134, 136–37, 140, 182–84, 214, 254, 271; ameliorate 168; increasing 20; level of 269; political 165; rampant 26; taxes counterbalance 212 INET (Institute for New Economic Thinking) 108, 140, 217 infallibility 250 infant industries 224, 228 infection 183–84; parasitic 88 inflation 114, 125, 176, 178–80, 193, 214–15, 218, 259, 268; accelerating 193–94; asset 215, 246; deflation 214; double-digit 111;

low 215; rapid 180; and rate of 176, 193, 214–15; target 214–15 influence, commercial banks 176; consumers 46; corporate world 41; political 82, 165; undue 118; unwarranted 17, 82 information 27, 50, 55, 59–66, 68, 78, 89, 93–95, 98, 104, 106, 109–10, 112, 118, 142–45, 152, 156, 236, 240, 250, 263; age 24; asymmetric 93, 107, 142–43, 145, 215; complete 61; economics 93–94, 98, 182, 265; finagle 235; identical 144; imperfect 49, 55, 58, 81, 93–95, 101, 120, 144, 150, 152, 187, 265; incomplete 60, 65, 93, 144; limited 34, 60, 64–65, 78; overload 59, 61; perfect 63; pertinent 93; reliable 93, 151; technology 19, 110; uncertain 93; unobservable 94; unsavory 105 infrastructure 25, 109, 175, 194, 205, 207, 209, 254–55, 271; bridges 25, 27, 209; dams 209; I-35W Mississippi River Bridge 36; Oroville Dam 25, 217; projects, large 152; report card 217; waste facilities 25 innovation 27, 117, 194, 196–98, 206, 214, 227, 234–35, 242–43, 246–47, 267; automated teller machine 197; bite-backs 197–98; financial 197, 234, 240, 243; Schumpeterian 197; veneration of 197 insider trading 83, 96, 146 instability 186, 242, 251, 265; financial 236, 242–43; inherent 260; political 175 instincts 45, 57, 60, 65, 77, 91 institutions 19, 27–28, 54, 82–83, 85–86, 105, 109, 118, 147, 152, 165, 185, 191, 196, 202, 209, 228, 235, 242–44, 248, 258, 260, 272; bureaucratic 100; change 155; as constraints 185–86; democratic 83; dominant 17; financial 252; government-sponsored 119, 121; impatient 30; inefficient 185; new 193–94; nonmarket 27; optimal 152; political 198; powerful 53; as structures 26, 116–17, 122; well-designed 139, 265 insurance 18, 22, 58, 240; companies 62, 105, 107, 144, 235; contracts 144, 235; entrap 28; Gap 63; government-mandated 107; health 145; identity theft 25, 156; insurance 25; markets 68, 107; pricing life 262; refunds 150, 158 intangibles 48, 122, 143, 147 integration 79–80, 215 intellectual, malfeasance 31; property theft 230

Index  283 intelligence 61–62, 89, 94, 119, 144; emotional 86; natural 116; quotient (IQ) 59, 76–77, 151 interaction effects 83, 181 interest rate 119–20; accelerator 176; excessive 151; higher 235; low 176–77, 207, 235, 245–46, 269; manipulating 82; moderate 237; near-zero 103, 257; nominal 176–77; payments 207, 270; real 120, 176; rigging 146; risks 151; teaser 105; usurious 90; zero 177, 257 interests 15; common 148; connected 239; corporate 148; firm’s 105; parochial 148; public 87, 147–48; social 147; special 162; vested 27, 82, 88, 105, 211, 254–55 internet 27, 46, 53, 78, 93, 106, 110, 112, 117–18, 209; companies 233 Interstate, Highway System 216; roads 26 intuition 34, 57–60, 64–66, 132 inventory cycles 107 investment banks 243–45, 249; behemoth 253; big 244 investment, decision 153–54, 210–11; managers 240; optimal 155 investments 15, 58, 87, 95, 117, 152–53, 155, 157, 175, 178, 205, 207–10, 233–34, 237, 242, 253, 271; large 102; new business 248; personal 149; safe 225, 235; strategies 155; total 250 investors 50, 72, 74–75, 93, 103, 135, 143, 173, 233–36, 240, 242–43, 248, 250–52; defrauding 161; private 271; protection 249; rational 153 invisible hand 49–50, 55, 83, 94, 96, 100–01, 103, 147, 265 iPhones 39, 41, 72, 102–03, 132, 196, 215, 218 iPod 102–03, 108 Iraq 231 Ireland 20–21, 25, 30, 166 irrational 78, 260; motives 84 IRS 24, 36, 124, 217 Israel 29–30, 37, 80, 157, 166, 195, 208, 240 Italy 20–21, 25, 29–30, 35, 136, 157, 166, 175, 235 jail 55, 146, 169, 201, 224, 269; sentence 103 Japan 15, 21, 25, 29–30, 135, 205, 223, 227 jobs 15–16; auto industry jobs 203; better 26; current 65; decent 40, 155, 270; export 112, 270; full-time 138, 192, 201, 267; guaranteed 202; high-paying 148; major 149; part-time 138, 201; switching 112 Johnson, Lyndon B. (LBJ) 258

Johnson, Simon 37, 96, 157, 187, 253, 259, 263 Joneses 54, 84–85, 201, 254; keep up with the 46, 191 judgment 17, 33, 58–60, 89–90, 110, 214, 242; bad 143; human 62; intuitive 65, 144; moral 86; plausible 65 justice 33, 138, 140, 146; ethical 129; moral 89; social 79, 97 Kahneman, Daniel 16–17, 37, 64–65, 68, 70–72, 78–79, 110, 251, 262, 265; experiments 74 Kaldor-Hicks criterion 97 Keynesian 183, 205, 233; economics 178, 180; equation 219; models 179, 215; new 182; policies 180, 182, 216; standard 214 Keynes, John Maynard 16, 37, 106, 172–73, 175, 177, 186, 189, 191, 201, 205, 231, 248, 259; innovation 176 Kindleberger, Charles 260 knowledge 58, 78, 89, 94, 100, 112, 121, 142, 145, 224; common 84, 123, 228; complete 95; current 152; economy 109; new 122; partial 59; perfect 57 Kodak 197, 203 Komlos, John 16, 18, 34, 36, 130, 140, 157, 202, 272 Korea 21, 25, 223 Krugman, Paul 36, 141, 156, 187, 202, 204, 210–11, 216–18, 227–28, 230, 256–57, 260–63, 265, 268, 270, 272 Kwak, James 98, 263 labor 54, 109, 112–13, 119–20, 122–23, 140, 179, 184–85, 188, 192–94, 201, 220; compensation of 113, 115, 137; contracts 62; costs 120; big 112, 165; economics 138; effort 217; female 138, 185; income 113, 115; inferior bargaining position 115; marginally attached 189; marginal product of 109; organized 165; power 137, 161; productivity 110–12, 137; robot 197; services 210; share of GNP 115, 121; statistics of 54, 113, 137–38, 156, 170, 190, 195, 201, 260, 272; supply 215; time 191; turnover 156; underutilization 190–91, 195 labor force 85, 97, 100, 112, 114–15, 125, 130, 142, 159, 165, 167, 185, 189–92, 194–95, 201, 248, 263, 267; augmented 201; official 201; participation rate 114, 184; total 110, 140

284 Index labor market 107, 110, 112, 138, 160–62, 165, 185, 189, 191–93, 201, 209, 267; binary 191; legal 20; new institutions of 194; stability 192 Laffer Curve 217 laissez-faire 16, 94, 253, 260 Lasch, Christopher 87, 97, 272 law 16, 26–28, 42, 83, 87, 101, 117, 121–22, 149–52, 185, 217, 238; antiquated 247; antitrust 117; balanced-budget 206; copyright 102; economic 194; enforced 237; immutable 106; inadequate 145; lawyers 117, 167; schools 167; system 27, 109, 121 Layard, Richard 195, 202 Lazonick, William 108, 138, 140 learning-by-doing 104, 122, 228 LeBron James 89, 212 Lehman Brothers 90, 103, 178, 235–36, 244, 249–51, 253, 256, 261–63; bankrupt 50, 143, 244, 250; defaulting 248; e-mails of 156; probability of bankruptcy 249; ratings of 246; share prices of 251 leisure, activity 85; class 54, 96; leisure time 39, 192 lenders 28, 35, 158, 176, 192, 242, 246–47, 257, 260–61; imprudent 268; irresponsible 145; predatory 151, 158, 243, 246–47, 269; subprime mortgage 151; troubled 244 Lending Act 97n60 liberal 97; economists 216 libertarian paternalism 147 liberty 16–17, 170 Libor interest rate 108; fixing scandal 103, 150 life, anxious 52; dignified 45–46, 49, 183; economic 91, 213, 260; emotional 52; everyday 63; expectancy 19–20, 22, 26, 28–30, 37, 269; fulfilled 48; good 43–44, 46, 87; happier 54; miserable 160; quality of 20, 26, 31, 34, 81, 93, 107, 192, 211–12, 267, 269, 271–72; satisfaction 20, 133, 183–84, 194–96, 269; stress-free 81; virtuous 19 lifestyle 44, 90, 95, 207; extravagant 50 liquidity 244, 250, 263 liquidity trap 177–78 living standards 51, 225, 228, 254 loans 151, 176, 234, 242, 247, 254, 257; foreign 207; NINJA 246; no documentation 246; predatory 237, 243 lobbies 83, 96, 105, 148–49, 165, 254

logic, deductive 32; fallacies of 66; inductive 3 London Whale, the 74, 100, 107n5 Long-Term Capital Management 232–33, 259 Lorenz curve 24 loss 70–74; alleged social 222; annual 266; aversion 71, 79; avoiding 71; biodiversity 122; dead-weight 221; financial 231; largest single trading 79; risk seeking in 73–74 Lucas, Robert E. 259, 261 luck 89, 104, 116–17, 133 luxuries 15, 45–46, 84 Lynch, Merrill 103, 118, 139, 142–43, 249–51, 253, 262 macroeconomic 174, 181–82, 187, 219, 242, 259; circular flow 200; conventional 241; Keynesian 179, 206; models 79, 169; policymaking 255; policy void 181 macroeconomics 79, 172–88, 202, 221, 255, 270; mainstream 180; neoclassical 180; stalemate 271 Madison Avenue 41, 43, 45–46, 52–53, 66, 68, 84, 196, 214 Madrick, Jeffrey 17, 37 mainstream 31, 35, 40, 49, 51, 102–03, 106, 109, 160–61, 165, 208, 272; canon of 81, 196; economics 39, 44, 64, 86, 88, 92, 106, 120, 178, 180, 219; economists 17, 26, 37, 68, 120, 161, 168, 196, 232, 242, 266, 270; models 236; textbooks 33, 65, 159, 184, 221, 265 Main Street 26, 82–83, 101, 149, 215, 251, 253, 256–58, 267 management 47, 100, 112–13, 122–23, 135, 143, 253; demand 232 managers 100, 109–10, 135, 143, 201, 240; decent 102; dissuade 144; greedy 134; hedge fund 168; money 51 manias 260 manipulation 17, 42, 54, 66–67, 76, 78, 83, 145, 148, 203, 261; corporate 44; exchange rate 219 manufacturing 129, 137, 215, 224, 229, 248 marginal, cost 102, 109–10, 162; product 109–10, 112, 116, 118–19, 122, 163–64; revenue 109; utility 109–10, 169; worker 110 Marglin, Stephen A. 16, 55 market 15–17; asset 75; captive 160; component 181; credit 89, 107, 187; decentralized 106, 155; desegregated 32; efficient 94, 101, 146,

Index  285 236, 249; eighteenth-century 50; electricity 148; failure 94, 150; financial 122, 234, 238, 240, 243, 258; forces 75, 117, 216; global 215, 250; housing 236–37, 240, 243; ideal 142; idealized 242; imperfect 49, 101; impersonal 147; incomplete 55, 187; job 227; missing 150, 198; nonexistent 265; off-guard 250; open 209; organization 102; outcomes 31, 51, 88, 99, 142, 150, 161; participants 19, 26; perfect 32–33, 142; place 40, 76, 87, 146, 151, 166; playing field 83; power 99, 101, 103–04, 150, 160–61, 163; prices 99, 198; principles 29; processes 31; product 179; real 39, 58, 113, 150, 152, 156, 265; secondary 120; segment 101; share 47, 101–02, 197; shoe 15; stock 178, 242; structure 99, 230; subprime 244, 252; successes 49; system 19, 83, 141; unregulated 27, 148; value 119–20, 236; work 265 marketing 54, 105, 150; off-label 146; strategies 43, 47; techniques 58 Marlboro cigarettes 47–48, 54 marshmallow experiment 213, 218n39 Maslow, Abraham 48, 54 masses 97, 258; underemployed 193 mass murder 20; shootings 16, 34 mathematical models 182, 233 maximize 59, 61, 63–64, 89, 91, 143, 180; output 90; utility 58–59 Mayer, Marissa 118, 139 MBS see mortgage-backed security McCloskey, Deirdre 16–17, 37 mechanism, amplification 244; feedback 172; market 134; self-correcting 172; self-regulating 49, 243 media 15, 41–42, 50, 101, 252; major financial 240; social 44, 87 medical care 18, 37, 45, 49, 166; of infants 184; system 171; universal 195 medical, conditions 77; costs 105, 166; schools 166–67, 171; system 28–29, 186 Medicare 214; contributions of employers 109; overcharging 146 Medicare Part D 62–63, 83 medicine 19, 27, 55, 161–62, 171, 183, 271 Meltdown 58, 83, 93, 100, 103, 146, 175–76, 180, 182, 202, 222, 231, 238, 241–44, 252, 254, 266; catastrophic 240; great 144–45, 254, 272 memory 199, 231, 257; working 76

mental constructs 86 meritocracy 89 Mexico 31, 195, 200, 229, 232 MF Global 103 Michigan 25, 173 microeconomics 172, 203, 221 microfoundations 79, 180, 182 Microsoft 104, 112, 120, 197, 207 middle class 22, 84, 112, 125, 127–29, 132, 140–41, 165, 183, 214, 251, 253; hollowing out 125, 128; lower 127; vanishing 140; wages 197 military 82, 110, 201, 207; expenditures 211, 270; -industrial complex 17, 82, 95 Millennium Development Goals 49 millionaires 36, 82, 118, 210–11, 252, 271; patriotic 217 mind 26, 57, 64–67, 79, 85–86, 207, 225, 255; conscious 42; intemperate 17; rational 41; subconscious 41; unconscious 41–42, 58–59 minimum wage 14, 159–62, 170n1-4; federal 159; laws 160; in San Francisco 170n3 minorities 28, 116, 123, 167, 190, 192, 267 Minsky, Hyman 157, 241–43, 247, 260–61; model of bubbles 246 misery 24, 91, 175, 192 mispricing 134, 240, 243 mobility, downward 23; intergenerational 168; social 26 model 16; building 32; conventional 70, 73, 75; credit-scoring 247; default 31, 61, 81, 93, 101, 103, 110; good 75; neoclassical 179; optimizing 81; rational-agent 33, 68; real-business-cycle 236; satisficing 63 Mokyr, Joel 198, 203 monetarist backlash 180 Monetary Economics 187n17, 217n20; school of 176 monetary policy 176–78, 187, 194, 201, 205, 232; accommodating 187, 269; expansionary 177–78; reform 186 money 204, 250; base 176, 215; big 37, 255; expansion 178; idolizing 85; illusion 179–80; laundering 103, 150, 157; lending 176; lending officer 246; managers 51, 100, 233, 242, 248, 250; market 244; policy 176; and power 271; quantity of money 176, 178, 215; stock 177; supply 176, 178, 187; velocity of 176–77

286 Index monopoly 31, 81, 99, 101–04, 122, 150, 161–62, 228, 265; drugs 170; profits 102, 228; rents 117–18, 197; rights 101, 118; spatial 102 monopsonists 161 Moody’s Analytics 216, 246, 261 moral 31, 88–89, 133, 134, 204; anchors 87; beliefs 59; goals 31; precepts 86; restraint 150 moral hazard 144, 156, 243, 250, 253, 257 mortality 23, 36; midlife 23; rates 23 mortgage 51, 58, 62, 150, 172, 174, 214–15, 234–35, 239, 245, 251, 256, 261; adjustable-rate 247; brokers 68, 143; down payments 155; fixed-rate 247; fraudulent 237; lenders 234, 244; market 246; no-money-down 52; payments 214, 235, 258; predatory 251; refinanced 257; securitize 93, 234, 246–47, 252; sign 68; subprime 261–62; toxic 252; underwater 257; variable-rate 145 mortgage-backed securities 50, 178, 234–35, 239, 243, 245, 257, 259; sellers 58; triple-Arated 246 mothers 25, 49, 106, 108, 116–17; poverty 171n39; single 35, 160, 168 Mozilo, Angelo 103, 108, 119, 150, 157, 251 multinationals 120, 148 multiplier 175, 186; effects 207, 222; fiscal 187 NAACP 35 NAFTA (North American Free Trade Agreement) 112, 224, 229 narcissism 87, 97, 272 Nasdaq 170 national debt 183, 205–07, 212, 216, 248, 270, 272; growing 198 nationalize 257, 263 natural lottery 133, 140 natural rate of unemployment 193–94, 202 Nazareth, Annette L. (SEC) 249 Nazis 172, 192 NBA (National Basketball Association) 117, 138 necessities 15, 45–46; basic 106, 161, 173; social 45 negative feedback loop 75, 107 neighborhoods, dysfunctional 22, 155; safe 40; underprivileged 252; upscale 123 neoclassical 34, 172; microeconomics 179; synthesis 178 Neo-Keynesian 34

neoliberal gospel 37 nervous system 52, 60 Netherlands 20–21, 25, 29–30, 135–36, 166, 195, 208 networks, communications 117; neural 12, 60; social 61, 98n80, 122 Neuromarketers 66, 78 neurons, firing 60; mirror 91 NFL 139 nonemployment 114, 189, 191, 253, 271; endemic 258, 267 nonpositional goods 84, 96 nonprice competition 101 norms 26, 85–86, 92, 118, 146, 168; moral 145 North American Free Trade Agreement (NAFTA) 112, 224, 229 Norway 20–21, 25, 29–30, 135–36, 166, 171, 195, 208, 250, 262 Nouriel Roubini 240, 253, 260, 262 nudge 78, 147, 157 Obama, Barack 34, 206, 240–41, 252, 254–55, 257–58, 264, 268 Obamacare see Affordable Care Act Obama’s stimulus 215 obesity 155, 213 obligations, collateralized debt 50; defaulted 236; moral 168; mutual 94 obsolescence, planned 197 occupations 110, 116–18, 125, 138; low-skilled 222; mid-skilled 115 Occupy Wall Street movement 10 OECD (Organization for Economic Cooperation and Development) 29, 35, 136, 171, 201, 216 Offer, Avner 98 oil 101, 119, 122, 200, 229; companies 102; embargo 161; industry 103; price of 88, 232 oligarchy 83, 134, 271 oligopolies 31, 81–83, 99, 101–03, 109, 120, 122, 150, 162, 220, 227; finance 116; industries 159; market 104 O’Neal, Stanley 142, 156 OPEC (Organization of the Petroleum Exporting Countries) 88, 105, 170n23 open-market operations 176 opinion leaders 84 opioid, epidemic 20; overdose 22–23; producers 165

Index  287 opportunistic behavior 31, 50, 93, 145–46, 149–51, 156, 265 optimism, spontaneous 186 optimization 58, 61, 64, 100 optimum 62, 153; outcomes 152–53; output 161; social 150, 155 option 32, 64, 72–74, 147, 258, 262; default 147; prices 262 organization, anti-consumerist 54; authoritarian 100; industrial 102–03 Organization of the Petroleum Exporting Countries (OPEC) see OPEC organs, selling of 148 Orwell, George 198; dystopian vision of 53 OSHA 108 output 41, 89, 109–10, 118, 123, 149, 161–64, 196, 210; aggregate 180; domestic 220; firm’s 110; motor vehicle 54; potential 175, 208, 266; total 125, 180 overconfidence 74 overconsumption 53 overpaid 135; financiers 116 overweight 44, 47, 60, 269 pain, inflicting 196 paint, lead-based 198 Paradox of Choice 158n64 Pareto, efficient 196; optimal 208, 219, 222, 225 Parks, Rosa 168 part-time workers 116, 189, 201, 266–67; involuntary 189; women 116 patent, infringement 230; new 197; protection strategies 203 path dependence 152–53; Lock-In 158n63 Paulson, Hank 253 Pavlovian conditioning 41, 43–45, 47, 58, 149; with frequent-flyer miles 43 payments 98, 109, 116, 172, 215, 224, 234–35; monthly 235, 256; rental 237 peer pressure 86, 118, 167; overt 85 pensions 103, 209, 231 perception 66, 68, 87, 250 perfect, competition 15, 33, 101–02, 120, 152, 180; foresight 64, 152–55 personal, relationships 51, 196; satisfaction 195 persons, incarcerated 191; insured 144; legal 82; poor 169, 221; rich 169; risk-seeking 68; second-richest 217; single 180

perspectives, behavioral 39; historical 229, 250; new macroeconomic 183; psychological 192 peso crisis 232 Peter Lindert 218 pharmaceuticals 83, 146, 186, 197 Phelps, Edmund 16 Phillips curve 179–80 physicians 166 Piketty, Thomas 34, 140 plutocracy 27, 83, 123, 139, 166 policies, accommodating 270; basic income 192; easy-money 246; fiscal 175, 177, 193, 205–06; homeowner-eviction 257; income redistribution 161; industrial 228; macroeconomic 194; misplaced macroeconomic 255; starve-the-beast 211; trade-enhancing 228; welfare-enhancing 219 politburo 260; free-market 238 politics 26, 28, 32, 253, 270; campaign contribution 37, 82–83, 206; democratic 83; discontent 225; dysfunction 123, 182; gridlock 271; lobbying 155 pollution 31, 58, 150, 183, 198, 200; air quality 122; carbon dioxide 122, 183, 200; carbon fuels 198; chlorofluorocarbons 198; Deepwater Horizon Oil Spill 31, 204; diesel emissions 156; Flint, Michigan 25, 209; fossil fuels 204; Fukushima 200; gas leak, deadly 31; Gulf oil spill 183; trade CO2 pollutants 200; Union Carbide 31; unsafe water 209–10 Ponzi finance 241; scheme 146 poor 26, 131; and destitute 175 Pope John Paul II 17 pornography 54n7 Post-Keynesian Economics 34, 260 poverty 19, 21–23, 25, 35, 87, 123, 139, 160, 168, 171, 218, 251, 269; culture of 22, 155; rate 21–22, 136; thresholds 54, 170; total 136; trap 76 power 17, asymmetric 44; bargaining 112, 171, 209; begets power 165; corporate 81, 165; economic 81–83; imbalances 31, 83, 265; monopoly 27, 118, 161; monopsony 161; political 82, 209, 271; redistribute 163; social 82 predatory lending 58, 68, 243 predictions, biased 28; economic 33; valid 92 preference 57–58, 67, 71, 79–80, 87, 98, 166; reversals 66; social 88 prefrontal cortex 41, 59, 77

288 Index prejudice 78, 140 pre-tax, profits 121; income 123 price 74; ceilings 161–62; competition 15, 28, 30, 104; controls 161; discovery 106; discrimination 106; to earnings ratio 233, 259; gouging 88, 161; index 140, 179; level 172, 174, 176, 179–80, 215; mechanism 106, 172; wars 105 prices drug 108; excessive 144; exorbitant 102, 161; garbling of 105; gasoline 105; home 98, 245, 247–48, 260; market-clearing 106; monopoly 102; optimal 104; relative 96, 214, 219 principal-agent problem 113, 142–44, 243, 251 principles, economic 265; free-market 28–29; textbooks 227 private debt 270 privileges 82, 89, 117–18, 133–34, 148 process, complex 106; conscious cognitive 77; cultural 121; democratic 17, 148; economic 20, 122; evolutionary 91, 152; political 82, 99, 148, 258; rational 42; speculative 236 producers 30–31, 41, 49, 94, 105, 107, 110, 149, 152, 162, 172, 214, 220–21, 224, 229; higher-cost 224; low-cost 104 product, branded 227; complex 30, 58; foreign 222, 226; generic 99; gross national 84, 172, 195; homogenous 99; joint 110, 118, 123, 164; manufacture 101; multifaceted 62; natural 34; quality of 67, 161; toxic 150; undifferentiated 101 product differentiation 16, 55, 99, 101, 230 production 88, 93, 99, 107, 109–10, 112, 120–22, 162, 179, 183, 185, 214, 219–20, 223, 228; costs 104, 155; factors of 109–25, 128–41; optimal 150; process 121–22 Production Possibilities Frontier (PPF) 184–86 productivity growth 111, 210; slowdown 267; -wage gap 111–13 Professional Air Traffic Controllers Organization (PATCO) 112; strike of 137 profit 60, 81–82, 84, 87–88, 100–05, 109–10, 112–13, 116, 118, 120–23, 138–39, 144–45, 150–51, 158–63, 168, 170, 179–80, 207, 211, 213–15, 220, 223, 227–28, 233, 241–42, 246, 250–51, 258, 262, 270; big 102; businesses 48; domestic 139; excessive 171; extra 146; extraordinary 122, 243; goals 246; high 102, 160; long-term 143; margins 120; maximization 100, 144; near-monopoly

83; potential 211; share of 165, 242; super 233; surge 83; tax 29; zero 101 properties, common 150; private 17, 86, 172 property rights 28, 134, 175; guaranteed 121 prospect theory 68, 70–74, 79; gains and losses 70–71, 221 Protestant work ethic 87, 97 psychological dependence 46; rewards 52; weakness 47, 53, 93 psychologists 57–58, 91 psychology 17, 19, 32, 39, 53–55, 61, 78, 192, 236; cognitive 42, 53; social 32, 86 public, goods 24, 27, 40, 109–10, 117–18, 121, 157, 198, 200, 205–06, 209; sectors 162, 175; squalor 25 quality-of-life 20 quantitative easing 178 Quasi-Monopolist 160 QWERTY 158 race 51, 123, 201, 203, 248; arms 84; underemployment by 201 railroads 81, 152 Rajan, Raghuram 240, 260; lecture of 244 rate of return 120, 233, 259 rating agencies 234, 246, 252 rational agent model 44, 57, 60, 74, 242 rational decision 43, 62, 66, 74 rationality 17, 57, 60–61, 66, 78, 86; assumption of 33, 60, 78; bounded 31, 37, 61–62, 64, 78, 100 rationing 106, 161 Rawls, John 1, 89, 97, 116–18, 133–34, 138, 140, 165 raw materials 101, 120; homogeneous 99 R&D 203 Reaganomics 34, 258; tax cuts 15, 212, 214 Reagan, Ronald 18, 28, 112, 206, 208, 211, 247–48, 262; administration of 36, 112, 206, 234, 242, 247 real business cycle, model 187; school of 180, 183, 215 Real-World Economics 15–18, 159, 265 recession 75, 177, 187, 205–06, 210, 224, 232, 234, 240, 242, 244–45, 247–48, 257–58, 262, 266–67; short 269 reciprocity 88, 98

Index  289 recovery 156, 187, 256; real inclusive 271 redistribution 87, 90, 125, 129, 159, 168–69, 196, 212, 219 reforms 175, 254–55, 272; fundamental structural 258; labor law 96 regulation 37, 51, 58, 74, 78, 94, 121, 139, 142–53, 155–58, 234–35, 242–43, 247; effective 258 regulators 96, 100, 148, 234, 242–43; stability deceives 242 Regulatory Capture 148 Reich, Robert 34 relative income hypothesis 84 rents 94, 109, 114, 116, 119, 168, 171, 174, 197, 210, 237, 242, 247; economic 134; extracting economic 197; house prices to 237 representative agent models 79, 182 Republican, administration 22, 217; agenda 211; politicians 36; tax cuts 187, 272 repugnance 37n62, 157n32 research 61, 77, 91, 93, 102, 144, 187; scientific 91 reserves 177, 235; requirements of 176 resources 46, 62, 88–89, 100, 102, 119, 122, 152, 155, 182, 184–85, 194, 220; educational 90; endowments 228; exhaustible 15; human 150, 169, 183; natural 109, 122; unemployed 185 responsibility, collective 28 retirement 147, 208, 214, 240, 270 return 35, 64, 116–17, 120–21, 139, 172, 193, 209, 233, 251, 259, 262, 271 revenue 24, 99, 120, 161–62, 192, 207, 210–11; sufficient government 211; tariff 220; tax 226; total 210 revolution 26, 53, 94, 98, 112, 115, 117, 172, 197, 271; information technology 194; technological 209 revolving door 148 rights 28, 32, 82, 168; civil 28, 54; granted 117; human 17; minority 27; ownership 227; patent 227; political 82 risk 22, 61, 79, 87, 97, 103, 105, 121, 143, 148, 182, 194, 197, 235, 239, 246–53, 261n67; accrued 144; aversion 68–69, 72–73, 77, 89, 192; diversifying 243; excessive 51, 74, 100, 242–43, 248; experience pricing 242; framework 249; intangible 248; management 250; markets, incomplete 94; mispricing of 74, 240, 243, 248; seeking 69; systemic 196, 242, 244, 257; taking 80 Robber Barons 81, 142, 269

Robinson, Joan 78, 108, 141 robots 65, 141; taxing 197 Rodrik, Dani 17 Romney, Mitt 15, 18 Roosevelt, Franklin D. 27, 28, 83, 96, 170, 231, 258; stabilizers 242 Roubini, Nouriel 248, 257; warning of 244 Rubin, Robert 238 rules of thumb 34, 61–62, 65, 78, 100, 110, 224 Russian government 232; infiltrators 198 Sachs, Jeffrey 195, 202, 255, 263 safety 26, 30, 85, 146, 148, 198, 212, 265; financial 252; net 89, 195, 205, 243, 269; standards 50; state-provided 20 salaries 102, 109, 112–14, 116–19, 136, 142, 144, 164–68, 170–71; after-tax 212; capping 119; executive 135; large 102, 117–18, 168 satisficing 62–64, 81, 100, 104, 110, 144, 265; firms 116 saving rate 213–14; high 207; low 213, 270; personal 84, 96 savings 84–85, 87, 96, 205, 207, 210, 213–14, 227, 247, 268; deposits 46, 187; global 207; glut 207, 246, 250; potential 113 scale, economies of 100, 209, 227–28, 230 scandal 83, 108, 156, 158 Scandinavia 136, 183, 196, 205; welfare states of 195 Schiff, Peter 261 school 24, 34, 38, 117, 180, 201, 209, 212, 223; better 150; dysfunctional 155; good 40; high 35, 89, 94, 155, 223, 268; mediocre 150; systems 22; underfunded 24; underprivileged 90 school-to-prison pipeline 168, 212 Schumpeter, Joseph 196, 202, 234, 253 securities 22, 49, 85, 134, 176, 195, 235, 250, 260, 270; financial 196, 214, 239; foreign 227; mortgaged-backed 234; mortgage-related 246; packaged 93; social 26, 49, 214 securitization 234 selection, adverse 28; device 104; natural 60 self: -actualizing 48; -control 19, 44, 62, 65, 87, 147, 213; -esteem 92; -interest 34, 49, 59, 90, 94; -made man 134; -regulation 52, 260; -respect 46, 48; -restraint 44; -sacrifice 90 selfie 197

290 Index selfish 16, 33, 52, 77, 86, 88, 90, 143; excessive 251; individuals 49, 106 sellers, short 90, 251 Senate 83, 218 Sequential Decision 152, 154 services, financial 211, 249; medical 105; mental health 20; social 49, 212; world’s ecosystem 200 servitude 54; technological 198 sex 41, 65, 67, 114, 138, 190, 195, 201 shareholders 47, 83, 100, 102, 113, 122, 135–36, 138, 142–44, 233, 239, 251 Shiller, Robert 17, 54, 187, 203, 233, 236, 259, 261, 263, 265; warnings 244 Shkreli, Martin 88, 96n17, 161, 170n14 shocks 23, 243, 245; major oil 111 shopping 51–52, 88 signals 84, 94–95, 105, 116–17; electrochemical 60; job market 98 Silicon Valley 53, 97, 214 Simon, Herbert 17, 61–62, 78, 265, 272 Sims, Christopher 181, 187 Skidelsky, Robert 203 skills 65, 116, 155, 266, 271; depreciation of 192 Skinner, B.F. 17 slavery 88, 123, 148; freed 82 slump 250, 256; economic 231 slums 22, 123, 212 Smith, Adam 16, 49, 50, 81, 96, 98–99, 143, 156, 158–59, 170, 205; intuition 91 social: cohesion 122; dislocation 196; fabric 134, 225, 269; fortune 133, 140; interactions 31, 86; media 198; moron 59; norms 64, 84–88, 91, 118, 132, 152; order 85, 89, 168, 175, 209; outcomes 80; position 84, 95, 175; problems 19, 22, 26, 183; pyramid 89; realignments 220; relationships 81; role 251; safety nets 183, 214; security contributions 109; security disability 224; spending 212; status 45–46, 84, 95, 195; structures 86; tensions 200; upheaval 168; welfare 49, 84–85, 101, 117, 161–62, 169 socialism 34, 83, 175, 202, 253 socialization 22, 41 society 17; attributes 79; benefit 49, 208, 222; black-swan-robust 270; democratic 27; equitable 34; homogeneous 169; instant-gratification 214; the narcissist 97;

non-Western 86; thriving 195; unequal 136; winner-take-all 16, 106 Society of Civil engineers 209 socioeconomic: status 89; system 46, 86, 134 sociology 32, 171 software 86, 104, 230 sophisticated mathematicians 246 sophistication 233, 251; mathematical 250 speculate 74–75, 186, 233, 236, 242–43, 248, 250–51 speech, free 82 Spence, Michael 98, 182, 232, 265 spillovers 244 sports franchises 122 S&P stock-price index 236 Sraffa, Piero 139 stability 28, 134, 148, 157, 175, 178, 192, 213, 237, 241–42, 249, 271; economic 183; social 28, 53 stagflation 157, 180 stagnation 163, 165, 247, 267; secular 256, 263, 268–69, 272 standards, educational 90; prudent mortgage-lending 252 starve the beast 24, 36, 211, 258 status goods 46 Stiglitz, Joseph 15–18, 37, 49–50, 55, 83, 93–94, 96, 98, 134, 140–41, 156, 158, 182, 187, 202, 204, 217, 232, 263–65, 270 stimulus 43, 216, 225, 227 stocks 74, 158, 172, 248, 259; internet 236, 245 strategy, framing 105; profit-sharing 194; starve-the-beast 212 stress 19, 44, 146–47 St. Thomas Aquinas 32, 37n76 student debt 212, 270; growing 254 subprime mortgage 103, 234, 245–46, 252; crisis 68, 76, 93, 119, 231, 232, 235, 245–46, 250, 252, 261 subsidies 117, 177, 194, 224, 226, 228, 264 subsistence 194; bare 160 suicides 22–23, 224, 251, 262 Summers, Lawrence 34, 108, 187, 216–17, 229, 232, 238, 245, 255–56, 263, 268–69, 272 Superman 59–60, 62 superrich 95, 129, 131, 124–25 supply 39, 75–76, 104–06, 116, 122, 138, 159, 161, 167, 176, 179, 205, 207; aggregate 99, 181;

Index  291 constraint 167; curves 103–04; and demand 117; elastic 207; excess 75, 246 sustainable 81, 89, 92, 265; development 204 Sweden 20–21, 25, 29–30, 135–36, 141, 166, 195, 208 Switzerland 15, 20–22, 25, 29–30, 135–36, 150, 166, 195, 205–06, 208; capitalism in 183 systemic effects 101, 243, 245; see also risk, systemic tail 125; fat 248; left 26, 123 Taleb, Nassim 16, 247, 253, 261–62 talent 89 tariffs 220–22, 224–28; protection 222; reduction 223 tastes 40–41, 44, 84, 86, 149; acquired 45; endogenous 39–41, 86, 96n21, 149, 241; exogenous 39–40 taxes 15, 24, 26, 36–37, 96, 108, 121, 124–25, 131–32, 139–40, 182, 183, 205, 207–12, 217, 227, 229, 258, 269, 271; decreasing 24–25, 206; high 212; progressive 85; in textbooks 209 taxi drivers 197 taxpayers 24, 117–18, 121, 125, 143, 211, 227, 236, 251, 253, 256–57 Taylor, John 261 teachers 117, 209 Tea Party 258 teaser rates 68, 105, 243 technological, change 117, 152, 155, 181, 194–96, 198; companies 102; progress 195 technologies 37, 117, 152–53, 155, 181, 184, 196, 198, 247; disruptive 100; financial 196; inferior 152–53; initial 152; new 152, 197–98; optimal 152–53; outdated railroad 209; stealing proprietary 230 teen childbearing 35 Temin, Peter 140 textbooks 15, 61–64, 76, 78, 89, 91–93, 100–01, 106, 108, 180, 208, 219, 265, 272; conventional 81, 99; introductory 16, 31, 142 textbook no-brainers 93 theorem, factor-price equalization 222 theory: classical 37; contract 144; conventional 68, 85, 122; deductive 272; efficient market 236; macroeconomic 181; microeconomic 99; neoclassical 81, 83; utility maximization 92 thrift 34, 183, 214; institutions 244

time: constraint 64; limited 64, 105, 144, 148; pressure 61, 65, 93 too-big-to-fail 265; see also banks, too-big-to-fail totalitarianism 45 trade 17, 79, 100, 106, 144, 158, 219–20, 222–23, 226–30; balanced 225, 227; deficit 112, 219, 225–27, 229, 246, 250, 254, 270; import certificates 226–28; liberalization 222; policy 225, 228; theory 222; theory, new 227–28, 265 tranches 234–35; bottom 235 transaction costs 27, 31, 62, 64, 100–01, 104, 106, 144, 146–47, 149–50, 152, 156, 265; excessive 51 transitivity 57–58 transportation 160; public 45 treadmill existence 45 trickle-down economics see economics, trickle-down Trolls 203 Troubled Asset Relief Program 256 Trump, Donald, 20, 34, 119, 134, 183, 229; administration 77, 82; election of 193, 202; tax law 187, 217 Trumpism 175, 220, 225, 231, 258 trust 40, 51, 65, 77, 87, 122, 139, 146, 149, 212, 249; excessive 247; social 195 truth 87, 146, 165, 219; inconvenient 31, 114, 182, 266, 269; in Lending Act 97; in packaging 94 turbocapitalism 150, 258; twenty-first-century 50 Tversky, Amos 17, 64–65, 68, 70–72, 79, 110; experiments of 74 Twitter 198 Uber 197, 203 ultra-right-wing commentators 252 uncertainty 15, 17–18, 28, 37, 58–60, 64–65, 100, 107, 142, 177, 182, 195, 207, 211–12, 265; intractable 34 underclass 20 underemployment 164, 183, 185, 189, 191–92, 194, 202, 206, 220, 224–25, 254, 263, 267, 271; endemic 165; rate 190, 267; technological 270 underwriting standards 237, 243, 246–47; lower 269; stringent 234 unemployment 44, 49, 159, 162–63, 172–76, 179–81, 189, 191–94, 201–02, 208, 214, 216, 219, 221–24, 237, 268; benefits 129, 175; chronic 185; frictional 194; hidden 190; insurance 209;

292 Index involuntary 179; large-scale 110; natural rate of 193–94; real 190; technological 112, 197 unemployment rate 163, 180, 189, 191, 193, 202, 216; official 189–90, 194, 216, 267; real 189–90, 216 unions 17, 112–13, 115–16, 137, 162–63, 165; and countervailing power 162; power 112, 137, 163, 165; trade 170 United Nations 49, 55, 195, 202, 208, 217 utility 57–59, 68–73, 79, 84, 90, 92, 96, 110, 144, 169, 209, 221–22; expected 68, 73; forecasting 92; maximize 33, 57, 60, 68, 78, 84, 86, 169, 179; negative 71, 73; realized 92 utility function 44, 57, 61, 68, 70–71, 79, 91, 180; concave 69; conventional 70; convex 69; expected 68; interdependent 83–84, 132; reference-dependent 132; of representative agent 187; risk-seeking 70 value, asset 242, 244, 259; discounted 233; function 70–71, 79; fundamental 233, 236–37, 247; house 235; intrinsic 146; judgment 19, 81, 89, 91–92; present 119; system 85–86, 88, 91–92, 121 Veblen, Thorstein 54, 84, 95–96; goods 45 veil of ignorance 89, 192 velocity of circulation of M1 176–77 Volcker, Paul 197 wage 83, 99, 109–16, 120, 137–38, 158–59, 161–65, 190, 192, 210, 214–15, 222–24, 268; declining 174, 225, 267; dispersion 88; fair 118; gap 116; high 160; lower 115–16; low-wage sectors 159; nominal 174, 179–80, 215; profit-sharing 192; real 110–12, 174, 179–80, 215; stagnating 254; sticky 175, 180; subsistence 165; unskilled 219, 222; Walmart 222; warehouse workers 198 Wall Street 27, 44, 53, 118, 157–58, 197, 214–15, 232, 236–37, 246, 248, 250–51, 253–54, 257–58; Lords of 118; resuscitated 253 Walmart 100, 108, 120, 161–62; doorbuster sales 106; worker killed in stampede 97 Warren, Elizabeth 77, 79, 140 Washington 16, 96, 140–41, 170, 202, 204, 259–63; captured 96 Washington Mutual 103, 246, 252, 261

waste 29, 150, 169, 183, 231; costly 182; hazardous 25, 209 wasted crisis of 2008 255, 258 wealth 19–20, 26–27, 46, 68–70, 72–73, 77–79, 81, 83–84, 89–91, 93, 96–97, 99, 107, 117, 133–34, 141, 148, 156–58, 170, 191, 196, 216, 218, 231, 246, 253, 265, 271–72; corporate 165; gap 141, 248; housing 98; inherited 89 wealthy 15, 90, 117, 132, 148, 161, 165, 169, 209, 211, 268; banker 117; countries 28, 168 Weber, Max 87, 97 welfare 18, 22, 25, 36, 51, 57–58, 68, 71, 81, 85, 87, 89–92, 119, 129–30, 132–33, 140, 142, 144, 146, 155, 161, 169, 196, 198, 200, 220, 223, 228, 232; aggregating 90; children’s 20, 26, 136; consumer 223; economics 18, 37, 265; and efficiency 146; function 132; index 183; lower-middle class 132; measure of 90, 183–84; system 208; total 219 Wells Fargo Bank 120, 157–58; fake-accounts scandal 150, 157 West, Cornel 34 whites 124–25, 168, 190, 267; lower-class 23 Whybrow, Peter 45, 52, 54–55, 59, 60, 80, 195 winner-take-all 117 women 26, 29, 37, 42–43, 47, 54, 83, 86, 98, 114–16, 138, 163, 185, 195–96, 239, 266, 268; black 168; educated 268; liberation of 195; married 86; unemployed 108; wages of 165 Wonderwoman 59–60, 62 work 15, dehumanize 119; effortful 87; experience 116, 146; full-time 191, 260; hours 51, 192 workers 85, 87, 110, 112, 114–15, 119–20, 123, 125, 135, 138, 158–61, 163, 165, 174, 179–80, 191–92, 197, 214–15, 221–22, 224, 229, 248, 271; domestic 222; ethic of 87; foreign 222; highincome 217; high-productivity 212; local 161; low-skilled 270; low-wage 159; nonunionized 165; part-time 160; salary 137, 140 working-age population 22 world corporate 45, 52, 87, 135, 146, 163; developed 39, 46, 135–36, 197, 200; hyperglobalized 215; industrialized 172 World Trade Organization (WTO) 112, 224, 230 Zuckerberg, Mark 138