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October 2012

10/28/2012

Is Banking Unusually Prone to Risky Practices? Posner

I think the answer is y es, and that this becomes apparent if we understand the Darwinian character of

competition, though this is not to suggest that competition invariably , or even ty pically , leads to corrupt

behavior.

There are many analogies between biological evolution and commercial markets, and as a result words like

competition and equilibrium are important both in evolutionary biology and in economics. In an article

published in 1950 the economist Armen Alchian argued that standard economic results could be predicted

as products of a struggle for surv ival among competitors, without need to assume conscious profit

maximization by any of them. But the explicit analogizing of economic behavior to Darwinian theory is far

older than 1950, and in fact reached its

apogee in the decades following the publication in 1859 of The Origin of Speciesin the movement that came

to be known as Social Darwinism. In its extreme form Social Darwinism advocated eugenic

breeding, to improve the human race, and the elimination of poor relief and other redistributive policies,

v iewed as interfering with the struggle for surv ival and hence with the surv ival of the fittest.

But the Social Darwinists had committed a big, though common, error, which is to confuse fitness with

goodness. The fitness in Darwinian theory is adaptation to the environment, not improvementwhich

brings me at last to banking, and economic competition more generally . A competitive environment favors

firms that adapt to that env ironment; and so to determine whether a market is working well from an overall

social standpoint, one has to understand the environment, and the business behavior that best enables a firm

to surv ive and thrive in it. An analy sis so motivated is a fruitful application of Darwinian theory to

competitive markets.

Banking traditionally meant borrowing from persons who want by investing to defer production or

consumption (in other words, to save but be compensated for sav ing, rather than just stuffing their sav ings

under their mattress) and lending the borrowed money to persons who want to save less and produce or

consume more. Increasingly the word banking is defined more broadly , as v irtually any form of financial

intermediation, in recognition of the greater variety of investments made by

what are still called banks in our still lightly regulated financial sy stem. But the traditional form of financial

intermediation is all I need to discuss in order to make my point.

The obvious problem for a bank is how to earn a spreadthat is, how to lend at a higher interest rate than it

borrows, as otherwise it will not cover its costs. The standard answer is to borrow short and lend long. Short-

term interest rates are lower than long-term rates because the risk of default is lower (there is no need to

predict the borrowers long-term health) and because the borrower retains liquidity , which is valuedin the

traditional demand deposit the borrower can withdraw at a

moments notice the money that hes lent the bank (a deposit is a loan). Because a long-term loan is riskier

and the lender surrenders liquidity , long-term interest rates are higher, so by borrowing short and lending

long the bank earns the spread it needs to surv ive and thrive.

The shorter the term of the banks borrowed money , and the longer the term at which it lends, the bigger the

spread but the greater the risk of default. If the lenders to the bank decide that the bank is making risky loans,

they , or some of them, may decide to withdraw their money . The more who do, the riskier the position of the



other short-term lenders to the bank is, and so they will follow suit--hence bank runs. Because the banks

lending is long term, the bank can quickly find itself with

no liquid capital and with long-term assets consisting of loans that are risky (which is what precipitated the

depositors to flee the bank) and hence may be likely to default.

One might think that, cognizant of such risks, banks would be cautious borrowers and lenders; they would not

borrow so short (and thus risk a run) or make such long-term (and therefore risky ) loans. But that need not

be true. Maximizing spread may be very risky in the long run, but in the short run it may generate very high

profits that shareholders and managers may be able to pocket and may compensate them for the risk of a

future disaster, the costs of which will be borne by others. Banks that follow a more cautious strategy and

therefore have lower profits may have trouble attracting and retaining talented employ ees and may not be

able to hold on to short-term capital (the demand deposits) against the competition of more profitable banks

(profitable because less risk averse) for short-term capital.

As we know from the global financial collapse of 2008 and the ensuing global economic depression (and

there are numerous historical precursors), the collapse of a banking industry can create

large external costs. For, to repeat, Darwinian evolution is toward fitness rather than goodness. A high-risk

industry with frequent bankruptcies may be optimally adapted to its economic environment, but its risks

may create serious danger for the economy as a whole. That is the argument for federal deposit insurance

and other traditional, though now largely dismantled, regulations of bank solvency . Other high-risk

industries with frequent bankruptcies, such as the airline industry , do not pose macroeconomic risk because

they are small and because the firms can continue operating in bankruptcy ; they do not experience runs that

leave them assetless. For such industries, deregulation may be optimal. But for banking it is not.

In recent decades some influential conservative economists, notably Alan Greenspan, the long-term

chairman of the Federal Reserve, committed a variant of the Social Darwinist fallacy . They deemed

markets, including financial markets, as self-regulating, in the sense of achiev ing socially optimal results

without need for traditional regulatory controls. At the urging of these economists and under pressure from

the financial industry itself, some regulatory controls were rescinded and others ceased

to be v igorously administered. The underly ing assumption was that markets work. They do work, but in

much the same way that biological evolution works. Biological evolution has produced a marvelous variety

of life forms, and economic evolution has produced a marvelous variety of products and serv ices that have

greatly increased human well-being. But both ty pes of evolution produce good results only as by -products

to the struggle for surv ival. Unregulated all they can achieve is fitness in the sense of adaptation to the

environment. That may be good enough in most industries, but it is not good enough, for the overall health of

the economy , in banking.

Lax regulation, particularly of nonbank banks like Bear Sterns, Lehman Brothers, and Merrill Ly nch,

encouraged sharp banking practices. Firms in a competitive market cannot afford to be very ethical, any

more than a tiger or other predator can afford to be gentle or kind. The firms will be under heavy pressure to

engage in any highly profitable practice they can get away with, even if the profits that the practice promises

are short term, prov ided those profits are great enough to dispel or at least

greatly lessen the concern of managers and other key employ ees and investors with the long term. The

short-term orientation will influence the business decisions of the managers and other employ ees (loan

officers, traders, etc.) who exercise discretion; they will try to make as much money for themselves and their

firms as they can, as quickly as they can, to avoid economic extinction.

The Darwinian analogy of markets to nature is aptand it is a warning against a certain ty pe of economic

complacency that appears to have contributed decisively to the economic doldrums in which much of the

world is languishing, as well as to the frauds and other corrupt practices in banking that have surfaced. When

an industry s structure and centrality to the economy pushes it toward assuming macroeconomic risk, the

need for careful regulation is acute.

Posted at 09:17 PM | Permalink | Comments (14)

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Government Regulation, Competition, and Corruption-Becker

A widely accepted definition of corruption by businessmen is that their behavior v iolates laws or widely

accepted ethical norms. Using this definition I would claim that the banking industry is more corrupt than

the ty pical industry not because it is reasonably competitive, but partly because it is a highly regulated

industry , and partly because it is an industry trusted with large amounts of money of customers. I will

consider in turn the effects of competition, regulation, and trust.

Many believe that competition leads to a race to the bottom, where cheating of customers and other forms of

corrupt behavior prevail because of competitive pressures. However, if repeat business is important for a

company s profitability , and if customers are aware of when they are cheated or are the v ictims of other

unethical behavior by companies, competition tends to eliminate corrupt companies and promotes

companies that behave honestly toward consumers. The reason is that corrupt companies will have little

repeat business, and by assumption that would crush their profit prospects.

When repeat business is of little importance, as in many tourist centers, corrupt businessmen have much

better chances of surv iv ing and even thriv ing. It is in these cases that honest businessmen have trouble

doing well because they are outcompeted by corrupt businessmen. Tourists do not have sufficient incentives

to invest in knowledge of the reputations of local businessmen since they usually do not return to the same

locality . In that case, their unhappy experience with cheaters would not affect their future behavior very

much.

Unfortunately , the empirical ev idence is limited on the relation between the degree of competition in an

industry and its degree of corruption. Part of the reason for the scarcity of reliable information is that

empirical studies of competitiveness do not tend to account for how important repeat business is, and the

interaction between regulation and competitiveness.

One widely cited study on international corruption is Transparency Internationals annual ranking of

countries by the degree of corruption among government officials (its Corruption Perception Index). New

Zealand, Denmark, Finland, Sweden, and Singapore head the list, while Sudan, Turkestan, North Korea, and

Somalia are at the bottom. Some countries at the top have large governments, such as Norway and Sweden,

but all the top countries have rather competitive economies, certainly much more competitive than

countries at the bottom. These international comparisons do not indicate that competition leads to greater

corruption, when corruption is measured by corruption of government officials.

While these indexes show that government officials are more corrupted in some countries than in others

countries, greater regulation and government control in an industry often induces more corrupt practices in

that industry . Companies that are successful at bribing or otherwise influencing officials to gain extra

business or other advantages clearly are more likely to surv ive such competition. Of course, the advantage

to corrupt business behavior would be eliminated if all officials and lawmakers were completely honest, but

that is far from alway s the case.

Numerous examples are available of the advantages to businesses from corrupting regulators and other

government officials. Fannie Mae and Freddie Mac, quesi-private companies, engaged in various corrupt

practices during the housing boom in order to gain added business (see the expose of these companies in

Reckless Endangerment by Morgenson and Rossner). Chinese government officials are accused of

widespread corrupt practices as they allocate valuableland and capital to different companies.

From this perspective, the banking industry may well be more corrupt than the average industry not because

it is reasonably competitive, but partly because it is highly regulated. Banks gain financially if they can

induce regulators and others officials to give them advantages in the enforcement of the many complicated

regulations that govern modern banking.

Corruption in the banking industry is also induced by the large quantities of money that that they receive in

trust from depositors and others. Some regulations have undoubtedly protected lenders to banks from

corrupt practices by bankers, although not sufficiently to prevent various highly suspect banking practices

during the run up to the financial crisis. Still, an expansion of certain rules-based regulations of the banking



industry has been warranted, such as greater capital requirements relative to bank assets.

In any case, my discussion indicates that the corruption of businessmen depends mainly on the importance

of repeat business in a competitive environment, the ability of companies to influence the decisions of

lawmakers and regulators, and the magnitude of the liquid assets of customers that are entrusted to

companies.


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10/21/2012

What Limits to Using Money Prices to Buy and Sell? Becker

Perhaps partly due to the severity of the Great Recession, in recent y ears more books, articles, and blog

postings than usual have argued against the use of markets to organize different parts of the economy . A

subset of this ty pe of literature is opposed not to markets in general, but to the purchase and sale of

particular goods and serv ices. One example is the 2012 book by the well-known philosopher Michael Sandel,

What Money Cant Buy : The Moral Limits of Markets. Another example is the opposition to a market in

kidney s and other organs to be used in transplantation surgeries. Alv in Roth, the latest and highly merited

winner of the Nobel Prize in economics, has argued that v irtually no country allows such a market because

most people feel repugnant toward allowing organs to be bought and sold in an open market.

A general criterion that should be used in determining when money prices should be allowed to help bring

demand into balance with supply is whether the private and social gains of using prices exceed the private

and social costs. One major advantage of allowing money prices is that the cost to buy ers equals the revenue

to sellers, so that no resources are lost in the process of equating supply and demand. By contrast, when

markets are cleared by queues, the waiting time is a cost or price to consumers, but sellers do not receive

revenue from this cost imposed on consumers.

Another advantage of prices is that the limited supply of goods will be allocated to consumers who are willing

to pay the most for the goods. This is an attractive result when dealing with indiv iduals of similar incomes,

but rationing by money price may be a disadvantage if richer persons get most of the medical care or other

goods considered necessary for a decent life. However, the way to meet this problem is not by eliminating

money prices as a way of rationing supply , but instead by redistributing income to poorer indiv iduals, and

sometimes perhaps by directly subsidizing the consumption of goods by the poor, as with Medicaid.

To show how these and other principles work out in practice I will discuss a few examples where the use of

markets and prices has been criticized. I start with transplanting of organs since not only Roth and Sandel,

but many doctors and others have expressed their opposition to allowing organs to be bought and sold. I

concentrate on kidney s since kidney transplants are the most common, and indiv iduals can donate one

kidney while they are liv ing as well as allowing their kidney s to be used after they die. The reasons given for

opposing buy ing and selling kidney s are varied, but include Roths discussion of repugnance, and a claim

that many poor persons would either be tricked into giv ing organs or would give because they were

desperate for money .

These and other reasons for opposing using money prices to increase the supply of organs for transplant are

not completely without merit, although the vast majority of indiv iduals who need a kidney transplant or

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have relatives who need transplants want to increase organ supply by buy ing them and other means.

Moreover, there are great costs to the present sy stem that forbids the purchase and sale of organs. In the

United States, about 90,000 indiv iduals are waiting for a kidney transplant, and the average wait is about 6

y ears. The great majority of those waiting are on dialy sis, and life expectancy while on dialy sis is short. For

this reason, about 4,000 indiv iduals die each y ear while in the queue to get a kidney . Kidney exchanges,

introduced in 2005, and other efforts to greatly reduce the waiting time have produced little overall benefit.

In fact, the average waiting time rose from 4 y ears in 2005 to the 6 y ears wait at present.

Allowing kidney s to be purchased for transplant use would reduce the ty pical wait for a kidney to no more

than a few months, and would eliminate all the deaths because of the time consuming queue to get a kidney .

Since in the US and many other countries, governments largely finance transplants, access to transplants

under a sy stem when they can be purchased would not greatly depend on a persons income. In light of these

considerations, I do not understand how any one who is knowledgeable of the great cost imposed by the

present sy stem on the many indiv iduals who need kidney s could oppose allowing kidney s to be purchased

and sold, even after taking full account of repugnance and the other alleged costs of allowing a market in

kidney s (for a more detailed discussion of allowing a market in organs, see Becker and Elias, The Journal of

Economic Perspectives, Summer 2007 , pp 3-24, and my blog post on organ transplants on 1/01/06) .

I briefly discuss two other controversial examples. Traffic congestion is a big problem in most cities in the

world, such as Beijing, Los Angeles, and Mexico City . Traffic congestion imposes major costs on drivers since

it often greatly increases the time to go from one destination to another. Again, as with the transplant

market, time spent in traffic is an inefficient price since it wastes the time of drivers without prov iding

benefits to any one else. Indeed, it harms others because the driv ing time of other drivers is increased when

someone decides to drive during congested times.

One alternative to traffic jams is to place a charge on using roads and highway s during congested time

periods, as the city of London does by pricing admission to the central business district during prime week

day times. This "congestion price" would reduce driv ing times by encouraging some people to shift their

driv ing to less congested times, to use carpools, to take slower and more indirect routes to their destinations,

or to reduce their driv ing.

Of course, people who place higher values on their time would be more likely to pay congestion fees and

continue to use the main roads. Since richer indiv iduals tend to have high values of time, poorer persons

would be more likely to shift their driv ing patterns. However, a better way to help lower income drivers than

by using congestion is to use the revenue collected from congestion tolls to help poorer indiv iduals, such as

by improving roads in poorer neighborhoods. Congestion is too inefficient a method to ration road use and

help drivers who place less value on their time.

My final example deals with the voluntary army that uses pay instead of a forcible draft to get a sufficient

number of men and women to serve in the armed forces. Most readers are too y oung to remember the

opposition to eliminating the draft in the US prior to converting to a fully voluntary armed force in 197 3. It

was then claimed, among other things, that a voluntary army would be mercenary and reduce patriotism,

that only the poor and minorities would enlist, that a voluntary army would not fight well in difficult wars,

and so on.

The ev idence from the past almost 30 y ears in the US and from other countries that use a voluntary army is

just the opposite; namely that a voluntary army is very professional and fights hard under difficult



circumstances (think of Afghanistan and Iraq), that many y oung men and women from middle class families,

and even upper class families, do volunteer, and that instead of exploiting minorities it prov ides some of the

best opportunities for their advancement (Colin Powell is just one prominent example).

I have not attempted to draw a sharp line between where prices and markets should be used and where they

should not be. Nor do I deny that for some activ ities the cost of using money prices would exceed the gains. I

do believe, however, that in the US and other economies, the bigger problem is not excessive use of prices

and markets but insufficient use. The examples I discuss illustrate the reasoning behind this conclusion.

Posted at 07 :26 PM | Permalink | Comments (3)


Sale of Body PartsPosner

I agree with Becker that a market in kidney s should be permitted. The repugnance that the idea of selling

body parts engenders in many people seems to me to have no rational basis; it would be otherwise if one

were talking about the sale of ones ey es, heart, etc.

The only function of a second kidney is as a spare. A person who loses a kidney does not experience a loss of

health as a result. What is true is that if y ou sell a kidney , y ou have no back up. It is sometimes suggested that

the problem be solved by a rule prov iding that a donor seller of

a kidney goes to the head of the queue for a kidney transplant if his remaining kidney starts to fail and if

necessary he is given the new kidney free of charge. But such a rule would be unnecessary , as Ill point out.

The present sy stem, much like the ban (frequently evaded though it is) on buy ing a baby for adoption (that

is, of compensating the mother for giv ing up her birth child for adoption), has created a serious shortage of

kidney s for transplantation. As a result of this shortgage, the

average waiting time for a kidney transplant is six y ears in the United States,

during which time the prospective recipient of the transplant is likely to be

on dialy sis. Dialy sis usually takes at least 12 hours a week, and the death

rate of dialy sis patients is high. If kidney s were salable, the waiting time

for a transplant would drop precipitately , probably to zero (which is why its

unnecessary to guarantee a donor that hell go to the head of the queue if his

remaining kidney failsthere will be no queue), because demand is fixed at the

number of people who have advanced kidney disease, while the supply would be

highly elastic since many of the worlds poor, who are in the billions, would

regard giv ing up a spare kidney as a low-cost way of earning some badly

needed money . The market would be worldwide because the cost of shipping

kidney s long distances is negligible. (Kidney s from cadavers would have to be

harvested quickly , but I dont think cadavers would continue to be a major

source of kidney s for transplanation, as they are now.) The U.S. demand would be small; there are fewer than

20,000 kidney transplants per y ear in the United States, although there would

be more if there were a market in them, because there would be fewer deaths of

people awaiting transplants and hence more transplant candidates.

I imagine that the equilibrium price of a kidney would be low, and the overall cost of treating kidney disease

lower than today because there be so much less dialy sis. Hence moving to a market would not increase

overall U.S. health costs, and would in fact reduce them. Moreover, there would be attractive income-

redistributive effects. The market solution would cause a modest shift

of income from phy sicians and other personnel of dialy sis centers to poor people, assuming realistically that

the poor would be the principal sellers of kidney s.

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The financial collapse of 2008 and the ensuing economic depression that the United States is slowly crawling

out of have created some second thoughts about the nations commitment to free markets. But there is an

important distinction between the fallacy (associated particularly with

Alan Greenspan) that markets are self-regulating and a general skepticism about

the efficiency of markets. Markets are self-regulating only in the Darwinian

sense; competition weeds out losers, but the winners may be imposing heavy

costs on society that they do not bear (pollution, for example, or the kind of

macroeconomic damage that the highly competitive financial sector has caused

because of its competition-driven risk taking). A market in kidney s would have

to be regulated, but the regulatory challenge would be slight, given all the

experience we have in the regulation of phy sicians, hospitals, drugs, medical

dev ices, and surgical and other medical procedures.



10/14/2012

Luck, Wealth, and Implications for Policy--Posner

Liberals and conservatives tend to disagree about the role of luck in financial success, the

former thinking it play s a very big role, the latter thinking it play s a small

role: that instead financial success is largely attributable to talent and hard

work. Taken to its extreme, the second position is the one that was espoused by

the radical libertarian Ay n Rand.

The economic significance of the disagreement has mainly to do with taxation. Taxing success

that is attributable to pure luck does not have disincentive effects, and so is

a cheap away of financing government. Taxing success that is attributable to

hard work may induce a substitution toward leisure, reducing money incomes, and

taxing financial success attributable to talent may induce some talented people

to substitute activ ities that generate substantial nonpecuniary income (apart

from leisure), which may not be socially as productive as business. Bey ond the

economic concern, however, is an ethical one that is particularly acute in a

society , such as ours has become, in which there is great inequality of income

and wealth.

I dont find any merit to the celebration of the ty coon by Ay n Rand and her followers. I think

that ultimately every thing is attributable to luck, good or bad. Not just the

obvious things, like IQ, genes that predipose to health or sickliness, the historical

era and the country in which one is born, the wealth of ones parents, whom one

happens to meet at critical stages of ones life and career, ones height and

looks and temperament, to the extent genetic, and ones innate propensity to

risk or caution (that is an exceptionally important factor); but also the

characteristics that cause a person to make critical decisions that may turn

out well or badly , characteristics that really are derivative from some of the

prev iously noted luck characteristics. The decision-determining

characteristics include intelligence, imagination, attitude toward risk, and

personality characteristics such as aggressiveness, maladjustment, indolence,

and hav ing a low or high personal discount rate (how future-regarding one is or

is not). Talent is luck but so is the propensity for working hard (often the

consequence of a compulsive personality ) or not working hard.

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In short, I do not believe in free will. I think that every thing that a person does is

caused by something. It is true, and is the basis of belief in free will, that

often we are conscious of considering pros and cons in deciding on a course of

action; we are deciding, rather than hav ing the decision made by something

outside us. But calculation and decisionmaking are different. Deciding may

just mean calculating the balance of utility and disutility ; the result of the

balance determines the decision. No doubt when a cat pounces on a mouse, it has

decided to do so; but the decision was compelled by circumstancesthe feline

diet, the presence of the mouse, etc. A complete description of the incident

would not require positing free will.

If this is right, a brilliant wealthy person like Bill Gates is not entitled to his

wealth in some moral, Ay n Randian sense. But it would be ridiculous to infer

from this that the government should take his wealth away from him and scatter

it among the poor, on the theory that the only difference between Gates and a

poor person is that one is lucky and the other is not. But the reason that it

would be ridiculous is that it would have terrible incentive effects, not that

it would v iolate some deep sense of human freedom.

The effects of heavy taxation of wealth may depend in part on the kind of luck that generated the wealth that

is now to be taken away and given to someone else. There may be different effects from taxing wealth that

results primarily from personal qualities, such as IQ and ambition, and taxing

wealth that is unrelated to such qualitiesinherited wealth, for example, or

wealth obtained by winning a lottery , or, a subtler and more important example,

wealth resulting from financial risk taking unguided by real insight (or, it

hardly needs noting, from antisocial activ ities such as crime). Heavy taxation

of earned wealth is likely to induce many able and energetic people to increase

their leisure activ ities relative to productive workbut to induce other such

people to increase their work effort relative to leisure in order to preserve

or augment their wealth in the face of the heavy taxation. Heavy taxation of

unearned wealth is more likely to have the second than the first effect,

because, lacking talent, such people will have to work hard (to work, periodmay be they were liv ing off their

inherited or otherwise bestowed wealth and not working at all) in order to maintain a decent

standard of liv ing, lacking as they do the talent of the wealthy people who

earned their wealth rather than hav ing it fall into their laps.

I mentioned financial risk taking. Because of the uncertainty (in the Knight-Key nes

sensethat is, a probability that cannot be quantified) of speculation,

speculative profits, as by trading stocks and bonds, are mainly the result of

dumb luck rather than of skill or hard work. In fact many speculators work

hard, but the number who are consistently successful seems little if any

greater than one would expect as a result of mere luck. Speculative profits

tend to soar in rapidly rising markets and collapse when markets sour. Market

turns are hard to spot and fluctuations in the prices of particular stocks are

difficult to predict because, as Key nes famously pointed out, when y ou are

speculating on stock prices y ou are speculating not merely about the fortunes

of the company that issued the stock but about how other speculators assess

those fortunes and indeed how they assess y our assessments. Although

speculation tends to generate information about underly ing values and to that

extent is socially productive, the benefits of that information bear no

relation to the profits and losses that speculation generates. Those are

gamblers profits and losses and taxing the profits heav ily would probably have

only a small negative effect on the generation of socially valuable



information.

So there is in my v iew nothing unfair about heavy taxation of wealth, but there are

practical objections. One is that the wealthy have sufficient political

influence to pepper any new tax law with loopholes that will enable wealthy

persons to minimize their tax liability . Another is that the additional tax

money raised will be squandered on unproductive governmental activ ities,

including handouts that reduce recipients work incentives. This objection

would disappear, however, if the proceeds of additional taxes on the wealthy

were earmarked for reducing the federal deficit.

There are complaints that already , though the maximum federal income rate is low (the top

marginal rate is 35 percent, and for capital gains, div idends, and interest is

only 15 percent), the very wealthy pay a very high proportion of total federal

income tax, and almost half the adult population pay s no federal income tax at

all, though it pay s federal pay roll taxes and state taxes. I cant see why

any one should care that the wealthy pay a disproportionate share of federal

income tax, unless there is ev idence (of which Im unaware) that taxing the

wealthy at even lower rates than they are being taxed would elicit greater

productive effort. Indeed, I dont even know what disproportionate should

mean in this context. Would it be disproportionate to require the

highest-earning 1 percent of the population to pay 1 .5 percent of total federal

income tax?

Federal tax law is riddled with deductions and exemptions that are loopholes in the sense

that they have no social product. An example is the mortgage-interest

deduction, which incentiv izes people to own rather than rent their homesand

why encourage home ownership? Another example is the exemption of employ er-paid

employ ee health benefits from federal income tax, which encourages excessive

expenditures on health care. Some taxes, such as the corporate income tax,

cause distortions, as does treating div idends and interest differently by

allowing interest but not div idends to be deductible by corporations. Reform of

the tax code would be preferable to raising taxes on any one, but the major

loopholes and deductions and exemptions are sacred cows, leav ing changes in tax

rates and spending levels as the only feasible methods of achiev ing fiscal

discipline.



Luck and Taxation-Becker

I do not believe that differences in value judgments are the main source of the disagreement among

economists over how much to tax indiv idual with different levels of wealth and income. These value

judgments include beliefs about how much of high incomes are due to good luck, whether high-income

indiv iduals deserve their incomes, or whether there is free will. Such considerations, however, may be

more important among the general public since, for example, they may not want to tax heav ily a Steve Jobs

or Brad Pitt because they admire these (and some other) successful indiv iduals and their accomplishments.

For economists, differences in v iews on what the tax structure should be and on other policies mainly come

down to different beliefs about how taxes and other policies affect behavior. For example, economists who

support much greater taxes on higher income indiv iduals believe that higher taxes will not much affect how

hard these indiv iduals work, their propensity to start businesses, or other kinds of behavior. On the other

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hand, other economists, including me, believe that high marginal tax rates not only discourage effort and

other choices by those being taxed, but also affect the form in which they take their incomes. These

adjustments include increases in non-taxable perquisites, such as greater use of a company s plane, hiring

expensive accountants and lawy ers to search for loopholes in the tax code, converting income into capital

gains when these gains are taxed at lower rates, and investing abroad if the income earned there is taxed at

lower rates.

Unfortunately , the empirical ev idence accumulated so far does not conclusively support either approach.

That is, it is unclear how large is the effect of higher income taxes on the behavior of richer indiv iduals. The

relevant ev idence is growing, but so far different perceptions of these effects prevent the resolution of the

sharp differences in opinions among even a-political economists on the damage done by high marginal

income tax rates.

The important point for our discussion is that beliefs about the importance of good or bad luck in

determining high or low incomes is not usually the decisive source of differences in attitudes about tax rates

and other public policies. For example, one may correctly believe that luck has a major role in determining

the genes, education, and other opportunities of highly successful indiv iduals, and y et believe as well that

high tax rates on their income and wealth would induce major changes in their behavior. Conversely , one can

believe that luck is unimportant in determining success, and at the same time believe that high tax rates on

rich indiv iduals would little affect their behavior. And, of course, various other combinations are possible

about the relation between the role of luck in achievement and induced responses to taxes and other policies.

A well-known illustration of the link between luck and behavior is the advocacy of a single tax on

unimproved land proposed in the 19th century by the American economist Henry George. His argument was

that the intrinsic quality of land was entirely due to the luck of its location with respect to soil, rainfall,

sunshine, and other relevant determinants of land productiv ity . This led George to argue that taxing heav ily

the higher value of unimproved better land would raise considerable revenue, and y et cause no harm since

the value of unimproved land is determined entirely by its good luck in location. Critics of this single tax

proposal responded that while George deid not want to tax the value due to heavy use of fertilizers,

machinery , and other agricultural investments, in practice it is impossible to separate accurately the

unimproved value from the total value. As a result, some of the investments in land would also be taxed.

These agricultural investments would surely be affected by taxes on land, even though the location of land

with regard to sunshine, soil, etc. is entirely a matter of luck.

My conclusion is that even though luck play s a huge role in determining genes, family , education, and other

determinants of success or failure, this does not imply very much about the desirable tax rates and other

public policies.



10/07 /2012

Will Long-Term Growth Slow Down? Becker

Sustained long-term economic growth beginning in the near future would help greatly toward overcoming

two major problems confronting the United States (and Europe and Japan). One is the high ratio of

government debt to GDP that resulted from budget deficits due to the rapid increase in government spending

during the past several y ears. GDP that continues to grow faster than outstanding debt is the surest way to

reduce the burden of the debt. Sustained long-term growth would also allay the fears of many parents that

their children would not be any better off than they are.

Improvements in productiv ity due in large measure to new technologies have been the major source of long-

term economic growth in per capita incomes. From 1880 or so to the beginning of the financial crisis,

American productiv ity advanced on average at a rate of a little less than 2% per y ear. This helped, along with

capital accumulation, to produce a long-term growth in American per capita incomes of about 2% per y ear.

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Since growth continued at such a steady rate for such a long time, one might reasonably expect that the US

would resume growing at a similar rate once it gets bey ond the effects of the financial crisis and the Great

Recession.

However, a recent study by Robert Gordon of Northwestern, one of the leading experts on productiv ity , puts

a damper on these expectations (see his Is U.S. Economic Growth Over? Faltering Innovation Confronts the

Six Headwinds, NBER working paper 18315, August 2012). Gordon argues that advances in productiv ity

were slowing even before the financial crisis hit because the innovations of the past several decades,

including computers and the Internet, were less important than those at the end of the 19th century and

beginning of the 20th century . He also argues that future growth in the U.S. is likely to be even slower than in

recent decades because of six headwinds that he believes will reduce growth. If Gordon is right, Americans

face an unprecedented and dismal future of basically stagnating incomes.

It is common during a long and deep recession or depression for economists and others to become

pessimistic about the economic future. For example, at the end of the Great Depression in 1939, a leading

American economist of that time, Alv in Hansen of Harvard University , argued that the U.S. and Europe were

in for long-term (secular) stagnation, partly because he believed that technological progress would be much

slower in the future. Of course, he turned out to be completely wrong. However, Gordons forecasts abstract

from the financial crisis and resulting recession, and he bases his pessimism on how the situation looked to

him prior to the crisis.

Gordon follows an established approach by div iding the past 200 y ears into periods of three Industrial

Revolutions. The initial one occurred during the last half of the 18th century and the first several decades of

the 19th century , with the steam engine and railroad being examples of the major new technologies from that

revolution. The second, and what he considers the most important, industrial revolution occurred between

187 0 and 1900. This revolution gave us, among other inventions, electricity , the automobile, the airplane,

and the small engine. The third revolution started around 1960, and encompasses computers, the Internet,

and genomics and biotech.

Gordons main reason for pessimism about future growth is the ev idence he presents that American labor

productiv ity (measured by output per unit of labor input) advanced much more slowly after 197 0 than it did

between 1890 and 197 0. He also points out that throughout most of history - that is, until the first industrial

revolution- annual growth in world per capita income was close to zero. Perhaps, according to Gordon, we

should think of the 3 industrial revolutions not as the norm for the future, but as temporary exceptions

that will not be repeated in the future.

Gordon makes a thoughtful case for his conclusion that future long-term growth for the U.S. will be much

slower than past growth. Still, I do not find the case convincing. While growth during the past two centuries

was radically different from the slight annual growth during the prior two thousand y ears, the reason is not

luck or accident, but in good part was due to the development of science, and especially to the application of

science to industrial progress. Knowledge builds on knowledge, and the available ev idence does not indicate

that the accumulation of knowledge is subject to diminishing returns. This suggests that future knowledge

could very well grow at a rate comparable to its growth during the past century and a half.

Another difference between the past two centuries and prev ious history is the emergence of economies that

relied on competition and private enterprise. This was the economic sy stem in Great Britain when it led the

world in productiv ity advances, and it describes the U.S. economy after it took over leadership from Britain.

Advances in technology and productiv ity are likely to continue at a good rate if the U.S. and other leading

countries continue to emphasize competition and the private sector, and do not use governments to try to

determine future technology winners.

I also believe that Gordon underestimates the full impact of the third revolution based on computers and

other modern technologies. As he shows, the effects on productiv ity of the 2nd revolution lasted for close to

100 y ears, while the 3rd revolution has been going on for no more than about 50 y ears. It is extremely

difficult even for the most informed indiv iduals to predict the long-run effects on productiv ity of new

technologies. Gordon quotes someone working in 187 6 for Western Union, the major telegraph company ,



who claimed, The telephone has too many shortcomings to be considered as a serious means of

communication and Bill Gates who stated, 640 kiloby tes ought to be enough for any one.

I will say little about the six headwinds that Gordon believes will also slow down future growth since his

arguments are not convincing. To take a few of his headwinds, I believe globalization will add to, not subtract

from, U.S. growth and real per capita incomes, that the effects of hav ing fewer y oung persons working

relative to the number of retired older persons will be partially overcome by considerable extensions of the

ages at which workers ty pically retire, and that inequality will likely begin to decrease. Along with Gordon I

am concerned about the effects of global warming on the economy , but I expect new technologies to go a

long way toward solv ing that considerable problem, just as technological discoveries overcame many

challenges in the past.

I agree with Gordon that sizable future growth in per capita incomes in a leading economy like the American

one will not come automatically just because past growth was considerable. However, I do believe that the

div idends from the 3rd industrial revolution are far from exhausted, and that future growth can be robust

given the right economic environment. What I mean by the right env ironment has several components,

but number 1 would be a continued reliance on competition and the private sector as the principal way to

organize the economy , and number 2 would be to improve investments in education and other human

capital.



Will U.S. Economic Growth Slow? Posner

It is good to be reminded that the rate of economic growth

is not constant, that it has varied a good deal in the past, and that it may

decline over the indefinite future, as feared by Robert Gordon in the study

discussed critically by Becker. I agree with the criticisms, of which the

central one is that the future is unpredictable, including not only the

technological future but also the political future and the future of personal

tastes and preferences. Moreover, almost all prediction is extrapolation from

current conditions, so pessimism is characteristic of economic predictions made

during a period of economic depression, such as the United States remains in.

The material standard of liv ing of many Americans is very high; roughly 20 percent of American households

have an annual income in excess of $100,000. At that level, desire for leisure (including early retirement),

or for goods and serv ices that are labor-intensive, making productiv ity gains (from capital substitution)

difficult to achieve, may retard economic growth y et increase economic welfare. At the same time, growing

inequality of income may reduce the demand for goods and serv ices in lower household-income quintiles,

with negative effects on economic growth. Although it seems unlikely , one can at least imagine a situation in

which growing inequality of income produces a rich upper crust satiated with material possessions and a vast

underclass unable to afford many such possessions, and this would be a pattern inimical to economic

growth.

For reasons explained by Key nes, consumption drives the economy (by stimulating supply and hence

employ ment, which in turn prov ides income for further consumption), and so if the desire for consumption

flags, the economy would grow very slowly , or not at all, or would decline, unless government picked up the

slack. Y et if the flagging of desire for consumption represented simply a satiation with material possessions

and a resulting preference for leisure, economic welfare might actually increase rather than decrease.

Europeans, judging from the average length of the work week in Europe relative to the United States, place a

higher value on leisure than Americans, and may be we will grow more like Europeans, once our economy

recovers from its present doldrums.

Of course we mustnt press the idea of material satiation too faras Key nes did in his 1930 essay Economic

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Possibilities for Our Grandchildren. It predicts that barring another world war or some comparable tragedy ,

a century hence per capita income would be four to eight times greater because of continued capital

investment. So far, so good; despite another world war, GDP per capita in the United States has increased

almost six-fold since 1930 (and Britains per capita income about the same), and we still have 18 y ears to go

before the century is up. Key nes thought the increase in per capita production would lead to a dramatic fall

in the hours of work; by 2030 a person would have to work only 15 hours a week to maintain his standard of

liv ing. The economic problem would have been solved and the challenge would be to fill up peoples leisure

time with rewarding leisure activ ities. Unlikely ! People in wealthy countries like the United States

and Britain are working fewer hours per week on average than in 1930: roughly 40 rather than 50. But

Key nes thought that by 2010 the average would be 20. Material

satiation is not in the offing, but there is no iron law of economics that the

work week shall not fall below 40 hours; increased substitution of leisure for

work may continue as incomes continue to rise.

Probably economic growth is not something to worry about,

but rather concern should focus on correcting inefficient practices, such as

reluctance to allow the immigration of highly qualified scientists and

engineers because of the competition they would offer to our citizens in

technical careers; or nepotism in higher education; or neglect of

infrastructure; or excessive criminalization; or our screwed-up tax sy stemthe

list goes on and on. Correcting inefficiencies will enable more rapid economic

growthor less, if peoples preferences are for goods, serv ices, or activ ities

(or inactiv ity ) in which productiv ity is difficult or impossible to increase.

Economic growth should be thought of not as a goal, but as a by product of an

efficient economy ; the focus of policy should be on means rather than ends.



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