Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

That a large percentage of individuals in the US do not paying income tax is a matter of concern, and not just to conservatives.  There is an underlying  sense that the paying of taxes is a duty, an act of solidarity with the collective goals of a democratically constituted nation.  While fairness requires that those best able to do so provide more of the financial support for those collective goals, fairness also requires everyone provide a share, even if that share is small.

In fact, this decline in tax-paying is partly connected with one of the programs often argued to be the most effective at reduction of poverty–the earned income credit.  Under this program, recipients’ credits are often greater than the total taxes they would have paid.

Many of the features of the earned income credit are desirable from the point of view of economic theory. The program entails virtually no overhead costs for its running. Its relatively low marginal rates distort decisions less than many alternatives (such as a minimum wage or food stamps). It can be targeted fairly accurately to those it is intended for (the working poor with children).

From the point of view of the economist, there is no difference between having a program in which an individual receives $5,000 from the government and pays $500 in taxes, or a program which just nets it all out and pays the individual $4,500.  From the point of view of the voters, and possibly from the point of view of the recipient, there is a big difference between the two. 

Beside the moral, even quasi-religious, sense to this–that paying taxes imparts a dignity to the payer (like the “widow’s mite”; also compare the rabinnic teaching that the poor are also required to give charity), there is of course also an astute political sense to this: if government coffers are filled by “others,” there is no limit to what we demand of government; if they are filled by “us” then we weigh the costs versus the benefits.

We probably need a name for the psychological quirk that causes us to regard such two-way passage of moneys as different from a one-way passage of a net amount. I recommend the term “budgeting illusion” — the sense that when sums are arbitrarily divided into different accounts, the separate pots take on a reality of their own.

Budgeting illusion also lies behind some of the difficulties we have in dealing sensibly with social security. Ultimately the money goes into the government in whatever form–payroll tax, income tax, gasoline tax–and the money comes out in national defense, social security, highways.  There is no economic sense in which the dollars collected “for” one purpose are separable from the dollars collected “for” another. For social security recipients the fungibility is fortunate, since, in particular, the present value of most people’s social security contributions is not sufficient to pay for their benefits.  Nonetheless,  most taxpayers feel that the social security payments are “their” money and the benefits are “their” compensation for it.

Even if there is no economic distinction between different dollars, there is a political distinction: Having the social security’s trust fund in a separate pot allows the social security administration some political autonomy.  It enables SSA to pay benefits without resort to the Congress even in years when they are not bringing in enough revenue to cover their costs.  The system was intentionally set up this way, of course, to ensure that changes would be close to politically impossible.  But the problem that arises is just the flip side of the earned income credit problem: in each case our awareness of the magnitudes of the payments are altered when we separate or combine the different pots of funding. 

So now Congress is trying to get the European Central Bank to tighten up its restrictions on Euros that go indirectly to Iran through its Target payment system. (See for example this article in the Financial Times). The whole thing begins to sound a little like high school drama: The angry junior refuses to talk to her enemy, and also to anyone disloyal enough to talk to her enemy. Soon that’s not good enough; anyone who talks to someone who talks to her enemy is also on the hit list.  In the end, of course, her standards become so high that she ends up talking to no one but herself.

To be fair, the sanctions against Iran have been much more effective than a skeptical economist would have believed:  trade is much reduced–and what does get through is much more expensive, which, from the point of view of the economist was the real point anyway.  But over time, sanctions are of diminishing effectiveness, as the target learns to devise evasions, and as the countermeasures to the evasions begin to disrupt the lives of more and more third parties.

In their DC bubble, congressmen are likely to believe that the regulatory power of the US is absolute: To their way of thinking the European Central Bank should tighten its requirements because it is the right thing to do, but there is always the implicit threat of restrictions to Europeans’ use of the dollar payments system and resources. The only catch with the logic is that the dollar payment system is not the only one in town.  The Euro is already an important alternative, and the Chinese, while still waiting in the wings, are seriously considering the advantages they can reap from opening their payment and currency systems to the world.  Certainly, there is a way to go before the typical commercial transaction can be carried out as safely, cheaply and reliably through renminbi as through dollars, but American restrictions that hit non-combatants in the economic warfare with Iran can bring that day a lot closer.

The e coli scare in Europe right now has thrown governments and their health services into crisis, devastated Spanish agriculture and changed a continent’s eating habits overnight. And yet, the risks, viewed in any objective sense, of eating a cucumber in Germany are minuscule: there are, in that country at this moment, thousands of intrepid cigarette smokers who are shying away from the salad course in the name of health safety. Not that I would behave any differently: the slight chance of a devastating outcome is enough to make me boil my vegetables as well.

But it is noteworthy how news of such a low probability event can cause such enormous economic dislocation. There are millions and millions of cucumbers out there; the odds of any particular cucumber being toxic are vanishingly small, and yet since we can’t know which is the lethal cucumber, we avoid them all. Result: localized disaster leading to economy wide disruption. The situation is familiar to all the souvenir salesmen in Cairo–reports of a dramatic incident of tourists’ deaths in a terrorist incident lead to decline in foreign visitors for months or years.

In both of these cases the fundamental problem is contamination: the inability to sort out the good apples from the bad apples means all must be regarded as tainted. The same situation arose in the recent financial crisis. Somewhere out there lurked toxic assets–mortgage backed securities where the underlying loans were badly supervised or fraudulently arranged or insufficiently diversified. While the pile of toxic assets was enormous, it was still a very small part of the entire financial sector. But for the average investor–even for the expert investor–the problem was that there was no way to tell which financial institution was actually contaminated–so all are tainted. (This phenomenon is not particular to the recent crisis: observers of earlier banking crises in the U.S., back into the nineteenth century, also noted similar problems.)

In the case of the financial crisis, there is a potential strategy, for those of strong constitution. After all you can tell the magnitude of the problem at the outside–calculate the number of troubled mortgages. The total fall in the value of the financial assets at the height of the crisis is much greater than this underlying amount of damage. So there are profits to be had if you can just figure out which financial assets to buy. But you don’t know which. The solution: you just buy a little of every one of them, hold on to them all, and hope your stomach is up to the challenge.

One of the worst things about being a journalist (or a blogger) is that you have to come up with articles even when there’s not much to say.  So that’s why I can’t be too harsh about the Christmas article by columnist Al Lewis of Dow Jones newswires  http://online.wsj.com/article/BT-CO-20101227-701597.html
In the version I saw in my newspaper it was entitled “Merry ….”  (the dots being a substitute for Chinese ideograms which I assume stand for “Christmas”). The article is a diatribe or lament about all the Christmas gifts and transactions actually coming from China. And it ends with

“Maybe one cold Christmas morning Americans will wake up from their yuletide dreams and there may not be so many wonderful things below the festooned boghs of their fake Chinese trees.

“Because in reality there is no Santa Claus.”

But darn it, the whole point of economics is that there *is* a Santa Claus–its name is “Gains From Trade.” We make stuff the Chinese and others want; they make stuff we want.  Some of the stuff we export is “invisibles”–financial and insurance services and the like, but no less valuable for all that.

And we can have a grand old intellectual discussion about whether the savings rate in the US should be higher (very likely) and whether a targeted refocusing of the US economy away from financial and services towards manufacturing would be desirable (doubtful).  Or we can have another Jeremiad about the irresponsibility of individual Americans over their own budgets–followed by an equally questionable article about how the entirety of American households have suddenly become thrift-conscious savers, post-recession. Evidence either way is dubious, given the difficulties of extrapolating from aggregate numbers to individual behavioral trends and of distinguishing between individual moral failings and misaligned incentives from tax policies. 

But confusing all of this with the fact that we import lots of goods from China does a disservice:  trade and imports are not a problem, and writing an article which equates volume of imports with economic decline is intellectually lazy and politically harmful: an uninformed reader of the article would reasonably conclude that the solution would be to forbid trade with China or at least insist that all Christmas purchases have x% local content.  In fact either idea would be lousy economics and a lousy Christmas gift.

Still another article which equates an educational institution’s success with its graduation rate. (This time: “Black Colleges Need a New Mission” by Jason L. Riley, Wall Street Journal September 28, 2010, p A21).  President Obama didn’t make the same mistake in his interview a couple of days ago, but he certainly used graduation rates as a metric for estimating school quality, and other politicians have been more naïve about making the link. And, sad to say, our own university uses graduation rate as an indicator of the success of its component colleges, driven along in this, no doubt, by the rules and opinions of accreditation boards.

There’s always a danger in using any single metric, of course, and graduation rate is a particularly simple and tempting one to collect.  But there are two important dangers with respect to its use. First, it gives the wrong answer when comparing disparate populations. (Which hospital is better? One with a mortality rate of 20 in 100 or one with a mortality rate of 1 in 1000? Well, suppose the first is treating patients with advanced cancers and the second is treating nosebleeds…) Second, it gives the wrong incentives. Sticking with the hospital analogy, it encourages institutions to reject cancer patients; if you want to show your charter school is good, make sure to screen for students likely to succeed anyway.  But in the case of schools the problem is worse:  if schools are rewarded for high pass rates, they have the incentive to lower standards and graduate everyone regardless of achievement.  In the hospital case, it’s as if we encouraged the doctors to stick a “cured” sign around the patient’s neck and quickly shove him out the door.  Unlike the hospital case, however, it’s a lot easier to hide the fact that the awarded degree is meaningless:   harder to go back and check whether the graduate is succeeding in his work than whether the cancer has returned.

I suspect that most careful analyses actually take these difficulties into account: use multiple metrics, adjust suitably, watch out for incentives.  I just wish columnists would.

A week when the price of gold is at record highs would hardly seem to be the time to argue against gold as an individual investment or as a currency backing. So that’s just what I’ll do.

A year when other countries have been talking up the possibility of replacing the dollar as the world’s reserve currency with something else–another currency, maybe, or a basket of currencies–would hardly seem the time to be complacent about the perceived weakness of the dollar. And again, that’s just what I’ll be.

Actually my argument against gold as an individual investment is simply that there’s no reason to include gold in an investment portfolio in any greater proportions than any other commodity, and no reason to include commodities in any greater amount than warranted by the basic arguments for diversification. Commodities, including gold, are useful as a component of a portfolio as a hedge against financial crises; so are US Treasuries. Commodities, including gold, are useful as a hedge against inflation; so are common stocks. Is gold useful as a hedge against meltdown of the world economic order?–Certainly not if held as financial claims, and probably not if held as bars under the bed: hardtack and distilled water will end up more valuable. As for speculation on future directions of the price of gold–your guess is as good as mine, and I wish you the best of luck.

Largely the same people who would rather hold gold than cash would also rather make cash more gold-like. Partly the belief is that re-tying the dollar to gold is the only effective way to make it “stronger” and that making it stronger is a good thing.

But had the dollar been tied to gold over the recent run-up, that would have been a very bad thing. During the past past year, the run up in gold prices has nearly 20%, and inflation has been minuscule. If dollars had been priced by gold, then there would either have been a massive deflation, or there would have been serious dislocations, as prices of goods and services in the US economy became way-too-high, and businesses struggled to adjust.

I’ve heard it argued that the US should strengthen the dollar to protect its position as the world’s reserve currency. The Chinese, for example, would like to be able to use some other currency than the dollar as a basis for world trading, and have been attempting to make their own currency more acceptable as a reserve for their trading partners. Imagine the effect if they were to peg the yuan to gold–wouldn’t everybody flock to this stronger currency, to the detriment of the US economy?

Well, probably not. I don’t claim to understand the psychology of international currency dealers and speculators, but I do know that they’ll be concerned by the stability of the promise: a country that goes on the gold standard can go off it as well–and the same people that flock to the currency at the initial announcement will run away from it whenever there is a sign that the government cannot commit to continue the peg. We’ve seen such swings in sentiment for currencies pegged to the dollar; they’d be even more dramatic when pegged to a fluctuating commodity price. As a result it seems to me that smart money will still hedge with a basket of currencies, just as they do now.

What about the more moderate version of this argument, that the US should strengthen the dollar in less drastic ways to keep its reserve currency status secure? It’s probably true that prospects of further depreciation of the dollar discourage some holders of dollars, and tightening US monetary policy would make the dollar more attractive as a reserve (although the mechanism through which this happens is actually pretty murky).

But why would the US want to continue to be the reserve currency country in the first place? There are two reasons why the dollar’s ceasing to be the reserve currency would be bad:

1. Loss of seignorage. Because payment assets are useful, others are willing to hold them even if they don’t generate as high a return. That’s how kings made money minting money. It would be expensive for the US to lose this seignorage, but by no means devastating for the US economy.

2. Loss of status as unit of account. Lots of transactions are denominated in dollars even if the payment is actually accomplished in yen or euros. In ancient times when it was expensive to hire scribes to multiply and divide for you, there would be lots benefit from having other people make their pricing decisions based on the unit of account you used for your own day-to-day operations. With electronic calculators, this is now trivial. There is still a little bit of risk reduction provided by the decision by others to use the unit of account most convenient for you. But again, the disappearance of this advantage wouldn’t be devastating.

So the reserve currency role is a nice perk. But if the only way to keep it is to use monetary policy to keep the currency strong, even when the domestic economic situation demands loose monetary policy then that it way too high a price to pay. When inflation is low and unemployment is high, monetary policy should be easy, even if it’s detrimental to our reserve currency status.

Recently the US and Swiss governments settled a dispute
about disclosures to the IRS of information on Americans’ bank accounts with Swiss bank UBS (see for example this WSJ article). The controversy reopens the question of the public policy behind financial privacy.

From an economist’s point of view the whole idea of the value of “privacy” seems somewhat mysterious: economic agents care about consuming, but why should they care about whether the engage in that consumption in public or in private? (This of course may say more about economists than it does about privacy).

In the case of financial assets, the role of privacy is clearer, although its social value is more questionable. One of the most important characteristics of cash is that it’s difficult to trace. Pecunia non olet , “money has no odor”: by paying in cash a person can keep transactions private.

Well and good, if we want to engage in illegal or immoral transactions, but why should the government encourage such a thing? Wouldn’t we be better off as a society if we tried to eliminate the use of cash and so to eliminate these transactions? In a paper a few years ago (See “Money is Privacy”) Will Roberds and I concluded that it wasn’t just about drugs and prostitution. Instead, there were circumstances in which maintaining privacy of transactions could have a benefit to society: for example, if public knowledge that someone has purchased something expensive makes it more likely that the purchaser become a victim of theft; or if the linking of the purchase to information about the individual makes identity theft easier. (See also our paper “Credit and Identity Theft”)

Still, this isn’t the same as disclosing the information to the government itself. What is the social benefit in keeping the government (as opposed to criminals) in the dark? One possibility is the fear of incompetence: as the government keeps tabs on transactions or assets, we may worry that others will break into the databases, or suborn government employees into disclosing the information.

But I suspect that in the eyes of the typical American holder of a Swiss bank account, the fear is of the government itself as the thief. One version of this belief—one which I do not agree with—is that taxation itself is theft. A second version is that these accounts are a kind of catastrophe insurance: protection against the (remote) possibility that tyranny take hold.

A third version, one with which I have greater sympathy, is that governments cannot be trusted to keep their promises. This issue needs to be considered in some detail:

The successful functioning of a society rests on individuals’ ability to keep their promises in general. And the laws and mores of a society are designed in part to encourage individuals to do so: promise-breakers are sued in courts and shunned in society. However, it is much more difficult to figure out a way to bind the institution that designs and enforces the laws to stick to its own promises.

In a sense this is inevitable: Part of the difficulty is that we don’t always want it to. Circumstances change, unforeseen contingencies arise, and we don’t want the “dead hand of the past” to prevent us, collectively, from adjusting to new events. But the agreements reached collectively were compromises in the first place, and so there will certainly be disagreements about whether a new situation merits tearing up or continuing to honor the old promise. And there will be circumstances where we’d all agree up front that it would be better to reach a binding commitment but we know that after the fact collectively we’ll end up changing our minds (the jargon in economics is “time consistency”).

Nowhere is this more likely to happen than with respect to tax and investment policy. We design a tax system to encourage certain behaviors—specifically, work and investment— but then once the work is done or the investment committed (and once the society has reaped the rewards), it seems in retrospect inequitable to leave the wealth holders with special privileges; indeed why shouldn’t the wealthy be taxed more? After all, now that times are tough, they are certainly best able to afford it.
And so one group, focusing on current inequality, advocates emergency capital levies, and the other, focusing on past sacrifices, focuses on the justice of keeping promises. (And if you think one side or the other is clearly right in this debate, then I suggest you try changing the period of time in which the wealth accumulation has occurred and see if you don’t change your view: should accumulations over three generations not be taxed more highly? Is it really fair to change the tax rate on savings accumulated over the last three weeks?)

So our inability to commit in satisfactory ways not to impose higher taxes after the wealth has been accumulated has the unfortunate side effect of discourages savings. If we want to encourage savings, then perhaps we’d like to find ways to send the wealth outside of the taxing jurisdiction. Of course, after the fact, we’ll always want to change our minds, tighten the taxes and find ways to track down the wealth we initially let hide from us…

It’s nice to see something you have been arguing is important for years finally make it to the newspaper. The Financial Times did a couple of long pieces Friday (August 21) on the CLS Bank, an institution I’ve been doing research on since before it was founded (see, Carnegie-Rochester Conference Series on Public Policy, Volume 54, Issue 1, June 2001, Pages 191-226 or http://papers.ssrn.com/sol3/papers.cfm?abstract_id=248058 ).

The CLS bank takes counterparty risk (so-called “Herrstatt risk”) out of currency trading. I’ll quote one of the FT articles:

“Since 2002, an increasing number of trades have been settled through CLS Bank. Owned by a group of the largest financial institutions, it runs a daily system for netting payments between it members that dramatically reduces settlement risk. Currencies accounting for about 95 percent of daily trading can be settled through CLS and all big banks use the system.”

In fact the volume going through the CLS bank on a daily basis is mind-boggling. A conservative estimate says that every couple of weeks, the system turns over value equal to annual world GDP, making it—during the day time at least—by far the largest financial institution in the world. (That “during the day time” caveat reminds me of the boast by Memphis International Airport that it is the busiest airport in the world at night—because it’s the hub for FedEx). During the night, once all trades are settled, CLS bank shrinks down to practically non-existent.

The second article in the FT then goes on to argue that CLS bank’s solution for counterparty risk in FX trading should be the basis for reform of settlement systems of all sorts. That’s a little simplistic: FX trading is special is several important ways, and CLS is designed to take advantage of those special circumstances. Moreover, CLS is fundamentally dependent on the support and cooperation of central banks, and it’s doubtful that those central banks would be willing to give the same arrangements to other settlement systems. Still, the design of new settlement systems is one important potential remedy for the fragility we have endured in new financial markets over the past couple of years, and it’s useful to use CLS as at least a partial model for those new systems.

For more on innovations in payment and settlement systems see “Why Pay? An Introduction to Payment Economics” by Charles Kahn and William Roberds Journal of Financial Intermediation
Volume 18, Issue 1, January 2009, Pages 1-23

http://econpapers.repec.org/article/eeejfinin/v_3a18_3ay_3a2009_3ai_3a1_3ap_3a1-23.htm

The law of unintended consequences is a mainstay of economic thinking. Someone with power establishes a rule or regulation of some sort and assumes that people will simply follow it. But people don’t just do what they’re told. Instead, they have desires, objectives, goals. And when the rules change, people respond according to their goals. And sometimes the rule maker doesn’t like the result.

The university makes you change your internet password once a year—and of course their rules about what constitutes an acceptable password are different from those of the bank, the shopping site, and the newspaper site. For these sites, this inconvenience is good: they don’t want me using the same password for fear of cross contamination—as someone snooping at the newspaper gets into my bank account.

But it can be counterproductive: one place where I worked demanded we change passwords once a month, with the result that what the rulemakers thought was a seven character password was effectively a four character password, with everyone using variants of xxxxjan, xxxxfeb, xxxxmar… Bottom line: lots of inconvenience for users; unintended consequence: less protection, not more.

Of course, in the case of Homeland Security, everybody has his or her favorite version of this story: body searches of grandmothers and the like. And of course, some of that criticism is unfair: if a search pattern is established, terrorists will recruit to foil it. And also of course, sometimes the goal of the rulemakers is simply to be seen to be doing something: effectiveness is beside the point.

Probably the greatest example of ineffectiveness of security rules arises in the case of anti-money laundering regulation as applied to drug enforcement. The regulatory burden the rules place on banks is stupendous: the costs and difficulties of opening new accounts has multiplied out of all recognition; the burden of serving foreign customers has become so prohibitive that many American banks avoid the business. And the effect on the market for illegal drugs has been nil. While the compliance costs for the regulation are onerous for the law-abiding, the costs for evaders are negligible.

In this arena, a classic example of unintended consequences arises: the anti-money laundering regulations require banks to report “suspicious account activity” to the authorities. But what constitutes suspicious activities is undefined—it is, to be fair, inherently undefinable. There are penalties on the banks for non-reporting. Result: banks report everything, the system is overwhelmed, and less useful information gets through than would have happened without the rule.

The anti-money laundering programs can point to some notable successes in other fields, in particular in confronting political corruption. This probably says something about the relative profit opportunities of corrupt politicians and drug bosses.

The good news is that the average individual in the U.S. (and in particular the typical newspaper reporter) understands the law of unintended consequences at gut level. The bad news is that when columnists attempt to predict the public responses to new legislation, the analysis is subject to pop psychologizing and all sorts of wishful thinking. I admit that my preferred form of armchair theorizing—economic modeling—is not without its faults. But I would put it up as a superior explanation, particularly for large numbers and for periods of time longer than a particular newspaper article can be remembered.