1 Managing Resources

Analysis of firm behavior and the management of resources begins with the firm’s production function, which describes how resources are turned into output. There are three broad categories of resources, which are also sometimes called inputs or factors of production.

The first category is labor, by which we mean the physical human effort that goes into production. The second category is capital, which can be subdivided into two components, physical capital and human capital. Physical capital refers to things like factories, machines, and equipment that are part of the production process. Human capital refers to know-how and managerial skills that go into production -- more the thinking side of human production, compared to the sheer labor effort. Finally, the third category is thought of as land, particularly when referring to agricultural production.

Capital needs a special note. First, in the context of production, economists do not mean money when they refer to capital. In common parlance, people may refer to money as capital, specifically financial capital, when they talk about starting a business, for example. However, money itself does not produce anything therefore is not part of the production function; instead it buys the resources that produce things. Second, both physical the human capital share some characteristics: both are produced themselves (human capital being produced by education), and neither is “used up” in production.

Sometimes economist refer to the production function as the “technology” used to produce something. Production functions take on different characteristics in the short run and in the long run. The short run refers to the period of time in which some resources -- especially capital -- are fixed. For example, we often may only be able to alter our employment of labor in the short run. In the long run, all inputs are variable and nothing is fixed.

The marginal product of an input is a measure on how output changes as more of that input is added, holding everything else constant. The law of diminishing marginal product says that although output may go up as an input is added, ceteris paribus, the rate at which output goes up will decline. In other words, marginal product will be positive, but declining, as the input increases. This makes sense: picture a firm with a given factory size (capital) adding workers. As it does so, output should go up -- but not at a constant rate, because eventually the limited size of the factory becomes a “bottleneck” inhibiting increased production.

In the long run, production functions can be characterized by returns to scale. Increasing returns to scale means that scaling up all inputs by x percent leads to an increase in output of more than x percent. Similarly, decreasing returns to scale means that increasing all inputs by x percent leads to an increase in output of less than x percent. Many real-world production functions are characterized by constant returns to scale: increasing inputs by a certain percent leads to the same percentage rise in output. It is important to keep in mind the distinctions between marginal product and returns to scale.

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The cost functions of a firm are derived directly from its production function. In the short run, firms have fixed costs associated with their fixed inputs. Likewise, variable costs are associated with variable inputs. The sum of fixed and variable costs are total costs. The marginal cost of production is the extra cost associated with producing another unit of output. Marginal cost is directly related to marginal product for the short run. For example, if labor is the only variable input in the short run, then the law of diminishing product implies that the marginal cost of production will have to rise eventually.

Average costs are also used frequently. In the short run, firms have average fixed costs and average variable costs, which sum to average total cost. Typically the average variable and average total cost curves are “U-shaped” meaning that they initially decline but eventually rise as output increases, at lest in the short run. In the long run, all costs are variable. The average total cost curve for the long run is the “lower envelope” of all the different possible short run averages total costs curves, each typically associated with a differing amount of capital.

If the average cost of production declines initially as output increases, the firm enjoys economies of scale in the long run -- a phenomenon associated with increasing returns to scale in production. Economies of scale are exhausted at minimum efficient scale. Constant returns to scale imply constant average total costs in the long run, and decreasing returns to scale imply rising average total costs in the ling run, or diseconomies of scale.

Managers need to employ marginal analysis to maximize profits for the firm. In terms of output, this means comparing marginal revenue to marginal cost. Marginal revenue is the additional revenue generated by producing and selling another unit of output. Marginal cost, as noted above, refers to the additional cost of producing that output. If marginal revenue is greater than marginal cost, producing another unit of output is profitable and production should be increased. If marginal revenue is less than marginal cost, producing another unit of output is not profitable and in fact output should be decreased.

If initially marginal revenue is greater than marginal cost and the firm increases production, marginal revenue will fall (except in perfect competition, where it remains constant for the price-taking firm), because the firm will have to lower its price to sell more units. At the same time, increasing output means facing higher marginal costs, especially in the short run due to the law of diminishing marginal product. Thus as output increases, marginal revenue falls and marginal cost rises until the two are equal. At this point the firm will have maximized it profits, leading to a very important principle in managerial economics: a necessary condition for profit maximization is marginal revenue must equal marginal cost.

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Similarly, marginal analysis can be employed in thinking about the optimal employment of resources. Once again, the manager weighs the benefits of employing one more unit of a resource with the costs. Hiring one more unit of a resource resulting in more output, by the amount of the marginal product of that resource. If that output is then sold in the marketplace, the firm earns the value of the marginal product for that resource as income. On the other hand, the firm has to pay for the resource; this is the marginal resource cost of the input

The effective manager must compare the value of the marginal product with the marginal resource cost. Suppose for example that a firm was considering hiring one more worker for a day, and the worker could produce an extra 20 widgets. If widgets sell for $5 each, then the value of the marginal product of that worker would be $100 (20 x 5 = 100). If the marginal resource cost of the worker is, say $80 per day in wages, then the firm will find it profitable to hire the worker, since $100 of revenue coming in more than the $80 of wages expended. On the other hand, if the worker costs $120 per day, it is not worth it to the firm to hire the worker.

Suppose the firm pays the worker $80 and there fore hires him. The firm then considers hiring another worker. But perhaps the marginal product of labor is declining, and that worker’s marginal product is less than 20 widgets. The firm must go through the same computations, looking at this set of rules: if the value of the marginal product is greater than the marginal resource cost, hire more workers. If the value of the marginal product is less than the marginal resource cost, hire fewer workers. As with output, the optimum is achieved only when the marginal values are the same. A necessary condition for profit-maximizing resource employment is the value of the marginal product must equal marginal resource cost.

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2 Human Capital

To most people capital means a bank account, a hundred shares of IBM stock, assembly lines, or steel plants in the Chicago area. These are all forms of capital in the sense that they are assets that yield income and other useful outputs over long periods of time.

But these tangible forms of capital are not the only ones. Schooling, a computer training course, expenditures of medical care, and lectures on the virtues of punctuality and honesty also are capital. That is because they raise earnings, improve health, or add to a person’s good habits over much of his lifetime. Therefore, economists regard expenditures on education, training, medical care, and so on as investments in human capital. They are called human capital because people cannot be separated from their knowledge, skills, health, or values in the way they can be separated from their financial and physical assets.

Education and training are the most important investments in human capital. Many studies have shown that high school and college education in the United States greatly raise a person’s income, even after netting out direct and indirect costs of schooling, and even after adjusting for the fact that people with more education tend to have higher Iqs and better-educated and richer parents. Similar evidence is now available for many years from over a hundred countries with different cultures and economic systems. The earnings of more educated people are almost always well above average, although the gains are generally larger in less developed countries.

Consider the differences in average earnings between college and high school graduates in the United States during the past fifty years. Until the early sixties college graduates earned about 45 percent more than high school graduates. In the sixties this premium from college education shot up to almost 60 percent, but it fell back in the seventies to under 50 percent. The fall during the seventies led some economists and the media to worry about “overeducated Americans.” Indeed, in 1976 Harvard economist Richard Freeman wrote a book titled The Overeducated American. This sharp fall in the return to investments in human capital put the concept of human capital itself into some disrepute. Among other things it caused doubt about whether education and training really do raise productivity or simply provide signals (“credentials”) about talents and abilities.

But the monetary gains from a college education rose sharply again during the eighties, to the highest level in the past fifty years. Economists Kevin M Murphy and Finis Welch have shown that the premium on getting a college education in the eighties was over 65 percent. Lawyers, accountants, engineers, and many other professionals experienced especially rapid advances in earnings. The earnings advantage of high school graduates over high school dropouts has also greatly increased. Talk about overeducated Americans has vanished, and it has been replaced by concern once more about whether the United States provides adequate quality and quantity of education and other training.

This concern is justified. Real wage rates of young high school dropouts have fallen by ore than 25 percent since the early seventies, a truly remarkable decline. Whether because

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of school problems, family instability, or other factors, young people without a college or a full high school education are not being adequately prepared for work in modern economies.

Thinking about higher education as an investment in human capital helps us understand why the fraction of high school graduates who go to college increases and decreases from time to time. When the benefits of a college degree fell in the seventies, for example, the fraction of white high school graduates who started college fell, from 51 percent in 1970 to 46 percent in 1975. many educators expected enrollments to continue declining in the eighties, partly because the number of eighteen-year-olds was declining, but also because college tuition was rising rapidly. They were wrong about whites. The fraction of white high school graduates who enter college rose steadily in the eighties, reaching 60 percent in 1988, and caused an absolute increase in the number of whites enrolling despite the smaller number of college-age people.

This makes sense. The benefits of a college education, as noted, increased in the eighties. And tuition and fees, although they rose about 39 percent from 1980 to 1986 in real, inflation-adjusted terms, are not the only cost of going to college. Indeed, for most college students they are not even the major cost. On average, three-fourths of the private cost—the cost borne by the student and by the student’s family—of a college education is the income that college students give up by not working. A good measure of this “opportunity cost” is the income that a newly minted high school graduate could earn by working full-time. And during the eighties this forgone income, unlike tuition, did not ri8se in real terms. Therefore, even a 39percent increase in real tuition costs translated into an increase of just 10percent in the total cost to students of a college education.

The economics of human capital also account for the fall in the fraction of black high school graduates who went on to college in the early eighties. As Harvard economist Thomas J. Kane has pointed out, costs rose more for black college students than for whites. That is because a higher percentage of blacks are from low-income families and, therefore, had been heavily subsidized by the federal government. Cuts in federal grants to them in the early eighties substantially raised their cost of a college education.

According to the 1982 “Report of the Commission on Graduate Education” at the University of Chicago, demographic-based college enrollment forecasts had been wide of the mark during the twenty years prior to that time. This is not surprising to a “human capitalist.” Such forecasts ignored the changing incentives—on the cost side and on the benefit side—to enroll in college.

The economics of human capital have brought about a particularly dramatic change in the incentives for women to invest in college education in recent decades. Prior to the sixties American women were more likely than men to graduate from high school but less likely to continue on to college. Women who did go to college shunned or were excluded from math, sciences, economics, and law, and gravitated toward teaching, home economics, foreign languages, and literature. Because relatively few married women continued to work for pay, they rationally chose an education that helped in “household

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production”—and no doubt also in the marriage market—by improving their social skills and cultural interests.

All this has changed radically. The enormous increase in the labor participation of married women is the most important labor force change during the past twenty-five years. Many women now take little time off from their jobs even to have children. As a result the value to women of market skills has increased enormously, and they are bypassing traditional “women’s” fields to enter accounting, law, medicine, engineering, and other subjects that pay well. Indeed, women now comprise one-third or so of enrollments in law, business, and medical schools, and many home economics departments have either shut down or are emphasizing the “new home economics.” Improvements in the economic position of black women have been especially rapid, and they now earn just about as much as white women.

Of course, formal education is not the only way to invest in human capital. Workers also learn and are trained outside of schools, especially on jobs. Even college graduates are not fully prepared for the labor market when they leave school, and are fitted into their jobs through formal and informal training programs. The amount of on-the-job training ranges from an hour or so at simple jobs like dishwashing to several years at complicated tasks like engineering in an auto plant. The limited data available indicates that on-the-job training is an important source of the very large increase in earnings that workers get as they gain greater experience at work. Recent bold estimates by Columbia University economist Jacob Mincer suggest that the total investment in on-the-job training may be well over $100 billion a year, or almost 2 percent of GNP.

No discussion of human capital can omit the influence of families on the knowledge, skills, values, and habits of their children. Parents affect educational attainment, marital stability, propensities to smoke and to get to work on time, as well as many other dimensions of their children’s lives.

The enormous influence of the family would seem to imply a very close relation between the earnings, education, and occupations of parents and children. Therefore, it is rather surprising that the positive relation between the earnings of parents and children is not strong, although the relation between the years of schooling of parents and children is stronger. For example, if fathers earn 20 percent above the mean of their generation, sons at similar ages tend to earn about 8 percent above the mean of theirs. Similar relations hold in Western European countries, Japan, Taiwan, and many other places.

The old adage of “from shirtsleeves to shirtsleeves in three generations” is no myth; the earnings of grandsons and grandparents are hardly related. Apparently, the opportunities provided by a modern economy, along with extensive public support of education, enable the majority of those who come from lower-income backgrounds to do reasonably well in the labor market. The same opportunities that foster upward mobility for the poor create an equal amount of downward mobility for those higher up on the income ladder.

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The continuing growth in per capita incomes of many countries during the nineteenth and twentieth centuries is partly due to the expansion of scientific and technical knowledge that raises the productivity of labor and other inputs in production. And the increasing reliance of industry on sophisticated knowledge greatly enhances the value of education, technical schooling, on-the-job training, and other human capital.

New technological advances clearly are of little value to countries that have very few skilled workers who know how to use them economic growth closely depends on the synergies between new knowledge and human capital, which is why large increases in education and training have accompanied major advances in technological knowledge in all countries that have achieved significant economic growth.

The outstanding economic records of Japan, Taiwan, and other Asian economies in recent decades dramatically illustrate the importance of human capital to growth. Lacking natural resources—they import almost all their energy, for example—and facing discrimination against their exports by the West, these so-called Asian tigers grew rapidly by relying on a well-trained, educated, hardworking, and conscientious labor force that makes excellent use of modern technologies.

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3 More about “Free” Resources

The problem when resources are “free” is that wrong mix of goods and services will be produced. This is a common result when decision-makers do not take into account some by-product of their actions that burdens or benefits others. A polluter, for example, considers air or water free. For him, dumping pollutants into their air or water is a cheap way to dispose of wastes. Yet, his actions do involve costs because he affects the alternatives that others face. The polluter may make others forego clean water. One could say that the polluter imposes some costs of production on others, although this use of the word “cost” differs from the normal meaning of cost. Those who bear this cost are not involved in the choice, and in its pure meaning cost is an alternative foregone in a choice.

It is easy to show that when a decision-maker ignores some costs of his decision, his decision may be economically inefficient. The demand curve represents the marginal benefit to consumers (and to firms because they are price takers). The supply curve represents the marginal cost to sellers, and because producing the product requires resources that could be used elsewhere, it also represents a cost to buyers. But the production of the product also generates and unwanted by-product that sellers ignore. The marginal cost from the point of view of society as a whole includes this by-product and is thus higher than it seems to the firm.

If negative externalities cause too much of a product to be produced, positive externalities should cause too little to be produced. When a person improves his house, his neighbors benefit. Because the decision-maker will not generally consider these spillover advantages to others, less than the efficient amount of the activity will take place.

When scarce resources are perceived as “free”, there will be potential value that a market will not capture. Is it possible for a society to capture this value, and if so, how?

A common “solution” to this problem has been to assume it away. This solution is especially common in plans for utopias, and writers in the Marxian tradition frequently illustrate it. In some of these arguments, pollution exists because capitalistic man is greedy, but when the new socialist man comes into existence, the problem will cease. Solution by assumption has at times crept into mainstream economic thinking as well.

A more practical solution is to increase private ownership in the system of property rights. This is an ironic solution in a way, because many environmentalists and ecologists have argued that the existence of externalities proves that a market system is seriously flawed and should be scrapped for an alternative, generally with greater state ownership and control. Economic analysis, however, shows that externalities exist when property rights are incomplete. Reducing the role of private property would make the externality problem worse. When no one owns the air or water, there is no incentive to avoid an overuse of the resource.

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In a classic example of the problem of the commons, buffalo were hunted almost to extinction in the 19th century. If an individual hunter limited his kills, he was unlikely to benefit from his restraint. A buffalo that he did not kill would probably be killed by someone else. Yet, from the point of view of buffalo hunters as a group, the optimal strategy would have been to limit killing so that the industry could maintain itself indefinitely.

In contrast with the buffalo, the number of cattle in the American West increased during the 19th century. The key difference between the different fates of buffalo and cattle was not that buffalo hunters were greedy and cattle raisers were not. It was that cattle were privately owned and buffalo were “free”. Private-property rights force people to take into account all costs and benefits of their actions. A cattleman’s decision to kill or not kill his cattle did not affect other cattlemen in the ay that a buffalo hunter’s decision to kill or not kill buffalo affected other buffalo hunters. When a resource is owned by all, when it is “free,” there is a strong tendency for individuals to misuse that resource.

The existence of private property rights allows the law to deal with externality problems. A person who is harmed by someone’s actions can ask the courts to decide about compensation. The court’s decision will depend on whether or not he has a right to some good or service. Courts have established property rights for clean air, clean water, scenic views, sunshine, and quiet. If a person is not due compensation, then he does not have the property rights but the other party may have them. In this case he can pay the party harming him to stop the offending activity.

Victims of pollution seldom band together and sue the polluter, nor do they band together and pay him not to pollute. The difficulty with legal action is that there are serious problems (and thus large costs) in contracting and organizing large groups for legal action. One of these problems is the free-rider problem. Ronald Coase pointed out that pollution problems would not exist if there were no difficulties and expenses in making contracts between polluter and victim. The implication of Coase’s work is that externalities should not be a small-group problem because legal remedies will exist if only a very few people are involved. It will only be a large-group problem.

Coase shows that private-property rights are not always a feasible way to solve the externality problem of “free” resources. Another solution is for the government to act as if it were the owner of these resources. The government does this when it regulates the number of ducks that hunters can kill. It says in effect that the government does this when it regulates the number of ducks that hungers can kill. It says in effect that the government owns the ducks, and people cannot kill them without the permission of the government.

Government can charge for the use of its resources. It could, for example, charge polluters for the use of clean water and air. This charge would make polluters take into account the side effects of their activities (or in the jargon of economists, they would internalize the externalities), and would move marginal cost curve in the graph upward. There is some user fee (pollution tax) that would make the decision-makers’ marginal

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cost curves coincide with the marginal-cost-to-society curve, and thus correct the efficiency problem.

Government policy dealing with pollution and negative externalities has largely been one of regulation. Most economists believe that this is a less-desirable (efficient) method of dealing with the problem than a policy of a pollution tax.

Finally, there may not be a good solution to the problem of “free” resources for two reasons. First, the cost of a solution may be greater than the benefits of the solution. Most economists believe that there is some “optimal level: of pollution. Many productive processes produce waste products. These waste products, when considered damaging to people, are pollution. To remove them or to transform them into a form that no one considers damaging requires resources, and the use of those resources means that fewer other products can be produced. Thus the reduction of pollution involves the weighting of costs and benefits as does virtually all other activity that economists discuss. The optimal level of pollution becomes that level at which the marginal benefit of any more reduction just equals the marginal cost of any more reduction If removing pollution that causes $1.00 worth of harm costs $10.00, it is economically inefficient to remove it. It is extremely unlikely that the optimal (economic efficient) level will ever be zero.

Second, there may be externality problems within the government just as there can be externality problems in the market. When there are externality problems in the market, we can call on the government as an outside agent to solve them. But if there problems exist in the government, there is no one to turn to. For example, suppose that the citizens of a country are split into fifty special interest groups, and each group gets special benefits from the government. To pay for those benefits, the government must tax the citizens. The citizens end up paying a dollar in taxes to get eighty cents of special benefits. (Bureaucracy eats up the other 20%). Though all would be better off getting rid of all special benefits, no one group will want to give up its special benefits, and the costs of organizing the fifty different groups to come up with an agreement may be very large. There may be no solution to this problem of the commons.

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4 Comparative Advantage

The reasons why free trade is desirable can be developed by extending the discussion of the Crusoe economy that is commonly used to illustrate production-possibilities frontiers. Suppose that Robinson Crusoe, living on an almost deserted desert isle, can either catch four fish a day or find eight coconuts. One day, he discovers that Friday also lives on the island. If Friday can either catch six fish a day or find seven coconuts, can Crusoe and Friday profit by specialization and trade? The answer is clearly “yes”. Crusoe is the better coconut gatherer, and Friday the better fisherman.

However, suppose that Friday can either catch ten fish or find then coconuts. Friday is now better than Crusoe in both activities. Can there be mutual benefit from trade in this case? Or should Friday do all the work and Crusoe none? Or should Friday refuse to trade since he is better in both? It was a major achievement of David Ricardo early in the 19th century to show that in this second Crusoe-Friday story both parties could benefit from trade. His results contributed to the long reign of relatively free trade in 19th century England, and thus to the prosperity that England enjoyed in this period.

To see that mutually beneficial trade is possible even though Friday is better in all activities, one must look to opportunity costs. Individually, both Friday and Crusoe trade with nature in the production process. Crusoe can get another fish only by giving up time in which he could find two coconuts, and in getting another coconut he sacrifices one-half of a fish. Thus, a fish costs Crusoe two coconuts and a coconut costs one-half of a fish. Friday can get another fish by giving up the time during which he can find another coconut, or one-tenth of the day. During this time, he could find one coconut. For Friday, trading with nature means that one fish costs one coconut and vice versa. Looking at these opportunity costs tells us that Crusoe finds coconuts cheaper and Friday finds fish cheaper. The table below summarizes these results.

Opportunity Cost of Fish and CoconutsFor Friday: 1 fish costs 1 coconut --- 1 Coconut Costs 1 FishFor Crusoe 1 Fish Costs 2 Coconuts --- 1 Coconut Costs ½ Fish

We still have not discovered whether Friday and Crusoe could do better trading with each other rather than with nature. A way to answer this question is to try a few prices. Suppose that one fish was worth one-half a coconut, or one coconut was worth two fish. With this trading ratio both would find fish cheap and coconuts expensive. Therefore, both would want to sell coconuts and buy fish. Hence at this price no trading would take place.

Suppose that the trading ratio were one fish for 1.8 coconuts (and thus one coconut cost 5/9 fish). With this ratio, Crusoe would find fish cheap—rather than spend two coconuts to catch one, he could spend 1.8 coconuts and buy one. Hence, Crusoe would be willing to sell coconuts. Friday would find coconuts cheap—rather than give up one fish by gathering his own coconuts, he could sell 5/9th of a fish and get one. Hence, Friday

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would be willing to sell fish. Trade will take place because both individuals find that it improves their well-being.

In the above example, trade occurs because of comparative advantage. Friday is better in everything than Crusoe, but he is “more better” in catching fish and “less better” in finding coconuts. Crusoe is worse than Friday in everything, but he is “less worse” in finding coconuts. Though they both benefit from trade, Friday will maintain a higher standard of living.

The example of Crusoe and Friday also illustrates that exchange is not a zero-sum game, but a positive sum game. In a zero-sum game, whatever anyone wins comes at someone else’s expense. In poker, for example, if one person wins $100, some other person(s) must have lost $100. If the amount of winnings is added up and the amount of losings is subtracted away, the result will be zero. The term “Zero-sum game” reflects this total. In contrast, both parties in a voluntary exchange can benefit. Because total winnings exceed any losses, the name “positive-sum” game is appropriate. A negative-sum game, in which winnings will be less than losses, is also possible. War is one example and a bad marriage is another.

A possible reason that few people prior to Adam Smith seem to have recognized this mutually beneficial aspect of exchange may be that in his day much exchange involved bargaining. In bargaining, the seller tries to get as high a price as he can and the buyer as low a price as possible. If the seller can get $2.50 for a product rather than $2.00, he benefits from the higher price at the expense of the buyer. People do discuss who got the “better of the bargain.” This feature of exchange, which is of vital importance to those involved in a market, can obscure the fact that no exchange will take place unless both parties believe that they benefit from it. Bargaining determines how big the producer’s surplus will be relative to the size of the consumer’s surplus, but unless both buyer and seller each have some surplus, no trade will take place.

Crusoe and Friday could be replaced by two nations. The principle of comparative advantage continues to hold, and it implies that the world as a whole will not be operating on its production-possibilities curve—that it will be production inefficient—if each nation is self-sufficient.

The inefficiency can be illustrated by putting the numbers of the second Crusoe-Friday into production possibilities tables. Suppose that in self sufficiency Crusoe chooses three fish and two coconuts, and Friday chooses five fish and five coconuts. The total island production is then eight fish and seven coconuts. But with total specialization, with Crusoe producing only coconuts and Friday producing only fish, island production would be ten fish and eight coconuts, which means that under self-sufficiency island resources were used inefficiently. Or, suppose that originally Crusoe was self-sufficient at one fish and six coconuts, and Friday was self-sufficient at five fish and five coconuts. Island production is six fish and eleven coconuts. In this case, only partial specialization might be desirable. If Friday produces three coconuts and Crusoe produces eight, island

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production could be eleven coconuts and seven fish, which is a gain of one fish compared to production with no specialization.

Production Possibilities:

Crusoe FridayFish coconuts fish coconuts 4 0 10 0 3 2 9 1 2 4 7 3 1 6 5 5 0 8 0 10

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5 Law of Diminishing Returns

The law of diminishing returns says that adding more of one input while holding other inputs constant results eventually in smaller and smaller increases in added output.. If capital is held constant at two, the marginal output of labor (which economists usually call marginal product of labor) is shown in the table below. The first unit of labor increases production by 13, and as more labor is added, the increases in production gradually fall.

The Marginal Product of Labor Labor Marginal Output First 13Second 7Third 5Fourth 5Fifth 4

The law of diminishing returns does not take effect immediately in all production functions. It is possible for the first unit of labor to add only four units of output,the second to add six, and the third to add seven. If a production function had this pattern, it would have increasing returns between the first and third worker. What the law of diminishing returns says is that as one continues to add workers, eventually one will reach a point where increasing returns stop and decreasing returns set in.

The law of diminishing returns is not caused because the first worker has more ability than the second worker, and the second is more able than the third. By assumption, all workers are the same. It is not ability that changes, but rather the environment into which workers (or any other variable input) are placed. As additional workers are added to a firm with a fixed amount of equipment, the equipment must be stretched over more and more workers. Eventually, the environment becomes less and less favorable to the additional worker. People’s productivity depends not only on their skills and abilities, but also on the work environment they are in.

The law of diminishing returns was a central piece of economic theory in the 19th century and accounted for economists’ gloomy expectations of the future. They saw the amount of land as fixed, and the number of people who could work the land as variable. If the number of people expended, eventually adding one more person would result in very little additional food production. And if population had a tendency to expand rapidly, as economists thought it did, one would predict that (in equilibrium) there would always be some people almost starving. Though history has shown the gloomy expectations wrong, the idea had an influence on the work of Charles Darwin and traces of it still float around today among environmentalists.

If one increases all inputs in equal proportions, one travels out from the origin on a ray. There is no law to predict what will happen to output in this case. If a 10% increase in all

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inputs yields more than a 10% increase in output, the production function has increasing returns to scale. If it yields less than a 10% increase in output, the production function has decreasing returns to scale. And if it yields exactly a 10% increase in output, to has constant returns to scale.

Returns to scale are important for determining how many firms will populate an industry. When increasing returns to scale exist, one large firm will produce more cheaply than two small firms. Small firms will thus have a tendency to merge to increase profits, and those that do not merge will eventually fail. On the other hand, if an industry has decreasing returns to scale, a merger of two small firms to create a large firm will cut output, raise average costs, and lower profits. In such industries, many small firms should exist rather than a few large firms.

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6 Socialism

Socialism—defined as a centrally planned economy in which the government controls all means of production—was the tragic failure of the twentieth century. Born of a commitment to remedy the economic and moral defects of capitalism, it has far surpassed capitalism in both economic malfunction and moral cruelty. Yet the idea and the ideal of socialism linger on. Whether socialism in some form will eventually return as a major organizing force in human affairs is unknown, but no one can accurately appraise its prospects who has not taken into account the dramatic story of its rise and fall.

The Birth of Socialist Planning

It is often thought that the idea of socialism derives from the work of Karl Marx. In fact, Marx wrote only a few pages about socialism, as either a moral or a practical blueprint for society the true architect of a socialist order was Lenin, who first faced the practical difficulties of organizing an economic system without the driving incentives of profit seeking or the self-generating constraints of competition. Lenin began from the long-standing delusion that economic organization would become less complex once the profit drive and the market mechanism had been dispensed with—“as self-evident,” he wrote, as “the extraordinarily simple operations of watching, recording, and issuing receipts, within the reach of anybody who can read and write and knows the first four rules of arithmetic.” In fact, economic life pursued under these first four rules rapidly became so disorganized that within four years of the 1917 revolution, Soviet production had fallen to 14 percent of its prerevolutionary level. By 1921 Lenin was forced to institute the New Economic Policy (NEP), a partial return to the market incentives of capitalism. This brief mixture of socialism and capitalism cam to an end in 1927 after Stalin instituted the process of forced collectivization that was to mobilize Russian resources for its leap into industrial power.

The system that evolved under Stalin and his successors took the form of a pyramid of command. At its apex was Gosplan, the highest state planning agency, which established such general directives for the economy as the target rate of growth, the allocation of effort between military and civilian outputs, between heavy and light industry, or among various regions. Gosplan transmitted the general directives to successive ministries of industrial and regional planning, whose technical advisers broke down the overall national plan into directives assigned to particular factories, industrial power centers, collective farms, or whatever. These thousands of individual subplans were finally scrutinized by the factory managers and engineers who would eventually have to implement them. Thereafter, the blueprint for production reascended the pyramid, together with the suggestions, emendations, and pleas of those who had seen it. Ultimately, a completed plan would be reached by negotiation, voted on by the Supreme Soviet, and passed into law.

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Thus, the final plan resembled an immense order book, specifying the nuts and bolts, steel girders, grain outputs, tractors, cotton, cardboard, and coal that, in their entirety, constituted the national output. In theory such an order book should enable planners to reconstitute a working economy each year—provided, of course, that the nuts fitted the bolts, the girders were of the right dimensions, the grain output was properly stored, the tractors operable, and the cotton, cardboard, and coal of the kinds needed for their manifold uses. But there was a vast and widening gap between theory and practice.

Problems Emerge

The gap did not appear immediately. In retrospect, we can see that the task facing Lenin and Stalin in the early years was not so much economic as quasimilitary--mobilizing a peasantry into a work force to build roads and rail lines, dams and electric grids, steel complexes and tractor factories. This was a formidable assignment, but far less formidable than what would confront socialism fifty years later, when the task was not so much to create enormous undertakings, but relatively self-contained ones, and to fit all the outputs into a dovetailing whole.

Through the sixties the Soviet economy continued to report strong overall growth—roughly twice that of the United States—but observers began to spot signs of impending trouble. One was the difficulty of specifying outputs in terms that would maximize the well-being of everyone in the economy, not merely the bonuses earned by individual factory managers for “over fulfilling” their assigned objectives. The problem was that the plan specified outputs in physical terms. One consequence was the managers maximized yardages or tonnages of output, not its quality. A famous cartoon in the satirical magazine Krokodil showed a factory manager proudly displaying his record output, a single gigantic nail suspended from a crane.

At the economic flow became increasingly clogged and clotted, production took the form of “stormings” at the end of each quarter or year, when every resource was pressed into use to meet preassigned targets. The same rigid system soon produced expeditors, or tolkachi, to arrange shipments to harassed managers who needed unplanned—and therefore unobtainable—inputs to achieve their production goals. Worse, in the absence of the right to buy their own supplies or to hire or fire their own workers, factories set up fabricating shops, then commissaries, and finally their own worker housing to maintain control over their own small bailiwicks.

It is not surprising that this increasingly Byzantine system began to create serious dysfunctions beneath the overall statistics of growth. During the sixties the Soviet Union became he first industrial country in history to suffer a prolonged peacetime fall in average life expectancy, a symptom of its disastrous misallocation of resources. Military research facilities could get whatever they needed, but hospitals were low on the priority list. By the seventies the figures clearly indicated a slowing of overall production. By the eighties the Soviet Union officially acknowledged a near end to growth that was, in reality, an unofficial decline. In 1987 the first official law embodying Mikhail Gorbachev announced his intention to revamp the economy from top to bottom by introducing the

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market, reestablishing private ownership, and opening the system to free economic interchange with the West. Seventy years of socialist rise had come to an end.

Socialist Planning in Western Eyes

Understanding of the difficulties of central planning was slow to emerge. In the midthirties, while the Russian industrialization drive was at full tilt, few voices were raised about its problems. Among those few were Ludwig von Mises, and articulate and exceedingly argumentative free-market economist, and Friedrick Hayek, of much more contemplative temperament, later to be awarded a Nobel Prize for his work in monetary theory. Together, Mises and Hayek launched an attack on the feasibility of socialism that seemed at the time unconvincing in its argument as to the functional problems of a planned economy. Mises in particular contended that a socialist system was “impossible” because there was no way for the planners to acquire the information—“produce his, not that”—needed for a coherent economy. This information, Hayek emphasized, emerged spontaneously in a market system from the rise and fall of prices. A planning system was bound to fail precisely because it lacked such a signaling mechanism.

The Mises-Hayek argument met its most formidable counterargument in two brilliant articles by Oskar Lange, a young economist who would become the first polish ambassador to the United States after World War II. Lange set out to show that the planners would, in fact, have precisely the same information as that which guided a market economy. The information would be revealed as inventories of goods rose and fell, signaling either that supply was greater than demand or demand greater than supply. Thus, as planners watched inventory levels, they were also learning which of their administered (i.e., state-dictated) prices were too high and which too low. It only remained, therefore, to adjust prices so that supply and demand balanced, exactly as in the marketplace.

Lange’s answer was so simple and clear that many believed the Mises-Hayek argument had been demolished. In fact, we now know that their argument was all too prescient. Ironically, though, Mises and Hayek were right for a reason that they did not foresee as clearly as Lange himself. “The real danger of socialism,” Lange wrote, in italics, “is that of a bureaucratization of economic life.” But he took away the force of the remark by adding, without italics, “Unfortunately, we do not see how the same or even greater danger can be averted under monopolistic capitalism.”

The effects of the “bureaucratization of economic life” are dramatically related in The Turning Point, a scathing attack on the realities of socialist economic planning by two Soviet economist, Nikolai Smelev and Vladimir Popov, that gives examples of the planning process in actual operation. In 1982, to stimulate the production of gloves from moleskins, the Soviet government raised the price it was willing to pay for moleskins from twenty to fifty kopecks per pelt. Smelev and Popov noted:

State purchases increased, and now all the distribution centers are filled with these pelts. Industry is unable to use them all, and they often rot in warehouses before

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they can be processed. The Ministry of Light Industry has already requested Goskomtsen [the State Committee on prices] twice to lower prices, but “the question has not been decided” yet. This is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices. And how can they possibly know how much to lower the price today, so they won’t have to raise it tomorrow?

This story speaks volumes about the problem of a centrally planned system. The crucial missing element is not so much “information,” as Mises and Hayek argued, as it is the motivation to act on information. After all, the inventories of moleskins did tell the planners that their production was at first too low and then too high. What was missing was the willingness—better yet, the necessity—to respond to the signals of changing inventories. A capitalist firm responds to changing prices because failure to do so will cause it to lose money. A socialist ministry ignores changing inventories because bureaucrats learn that doing something is more likely to get them in trouble than doing noting, unless doing nothing results in absolute disaster.

Absolute economic disaster has now been reached in the Soviet Union and its Eastern former satellites, and we are watching efforts to construct some form of economic structure that will no longer display the deadly symptoms of inertia and indifference that have come to be the hallmarks of socialism. It is too early to predict whether these efforts will succeed. The main obstacle to real perestroika is the impossibility of creating a working market system without a firm basis of private ownership, and it is clear that the creation of such a basis encounters the opposition of the former state bureaucracy and the hostility of ordinary people who have long been trained to be suspicious of the pursuit of wealth. In the face of such uncertainties, all predictions are foolhardy save one: no quick or easy transition from socialism to some form of nonsocialism is possible. Transformations of such magnitude are historic convulsions, not mere changes in policy. Their completion must be measured in decades or generations, not years.

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7 Reaganomics

“Reaganomics” was the most serious attempt to change the course of U. S. economic policy of any administration since the new Deal. “Only by reducing the growth of government,” said Ronald Reagan, “can we increase the growth of the economy.” Reagan’s 1981 Program for Economic Recovery had four major policy objectives: (1) reduce the growth of government spending, (2) reduce the marginal tax rates on income from both labor and capital, (3) reduce regulation, and (4) reduce inflation by controlling the growth of the money supply. These major policy changes, in turn, were expected to increase saving and investment, increase economic growth, balance the budget, restore healthy financial markets, and reduce inflation and interest rates.

Any evaluation of the Reagan economic program should thus address two general questions: How much of the proposed policy changes were approved? And how much of the expected economic effects were realized: Reagonomics continues to be a controversial issue. For those who do not view Reagonomics through an idealogical lens, however, one’s evaluation of this major change in economic policy will depend on the balance of the realized economic effects.

President Reagan delivered on each of his four major policy objectives, although not to the extent that he and his supporters had hoped. The annual increase in real (inflation-adjusted) federal spending declined from 4.0 percent during the Carter administration to 2.5 percent during the Reagan administration, despite a record peacetime increase in real defense spending. This part of Reagan’s fiscal record, however, reflected only a moderation, not a reversal, of prior fiscal trends. Reagan made no significant changes to the major transfer payment programs (such as Social Security and Medicare), and he proposed no substantial reductions in other domestic programs after his first budget.

Moreover, the growth of defense spending during his first term was higher than Reagan had proposed during the 1980 campaign, and since economic growth was somewhat slower than expected, Reagan did not achieve a significant reduction in federal spending as a percent of national output. Federal spending was 22.9 percent of gross domestic product (GDP) in fiscal 1981, increased somewhat during the middle years of his administration, and declined to 22.1 percent of GDP in fiscal 1989. This part of the Reagan record was probably the greatest disappointment to his supporters.

The changes to the federal tax code were much more substantial. The top marginal tax rate on individual income was reduced from 70 percent to 28 percent. The corporate income tax rate was reduced from 48 percent to 34 percent. The individual tax brackets were indexed for inflation. And most of the poor were exempted from the individual income tax. These measures were somewhat offset by several tax increases. An increase in Social Security tax rates legislated in 1977 but scheduled for the eighties was accelerated slightly. Some excise tax rates were increased, and some deductions were reduced or eliminated.

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More important, there was a major reversal in the tax treatment of business income. A complex package of investment incentives was approved in 1981 only to be gradually reduced in each subsequent year through 1985. And in 1986 the base for the taxation of business income was substantially broadened, reducing the tax bias among types of investment but increasing the average effective tax rate on new investment. It is not clear whether this measure was a net improvement in the tax code. Overall, the combination of lower tax rates and a broader tax base for both individuals and business reduced the federal revenue share of GDP from 20.2 percent in fiscal 1981 to 19.2 percent in fiscal 1989.

The reduction in economic regulation that started in the Carter administration continued, but at a slower rate. Reagan eased or eliminated price controls on oil and natural gas, cable TV, long-distance telephone service, interstate bus service, and ocean shipping. Banks were allowed to invest in a somewhat broader set of assets, and the scope of the antitrust laws was reduced. The major exception to this pattern was a substantial increase in import barriers. The Reagan administration did not propose changes in the legislation affecting health, safety, and the environment, but it reduced the number of new regulations under the existing laws. Deregulation was clearly the lowest priority among the major elements of the Reagan economic program.

Monetary policy was somewhat erratic but, on net, quite successful. Reagan endorsed the reduction in money growth initiated by the Federal Reserve in late 1979, a policy that led to both the severe 1982 recession and a large reduction in inflation and interest rates. The administration reversed its position on one dimension of monetary policy: during the first term, the administration did not intervene in the markets for foreign exchange but, beginning in 1985, occasionally intervened with the objective to reduce and then stabilize the foreign-exchange value of the dollar.

Most of the effects of these policies were favorable, even if somewhat disappointing compared to what the administration predicted. Economic growth increased from a 2.8 percent annual rate in the Carter administration, but this is misleading because the growth of the working-age population was much slower in the Reagan years. Real GDP per working-age adult, which had increased at only a 0.8 annual rate during the Carter administration, increased at a 1.8 percent rate during the Reagan administration. The increase in productivity growth was even higher: output per hour in the business sector, which had been roughly constant in the Carter years, increased at a 1.4 percent rate in the Reagan years. Productivity in the manufacturing sector increased at a 3.8 percent annual rate, a record for peacetime.

Most other economic conditions also improved. The unemployment rate declined from 7.0 percent in 1980 to 5.4 percent in 1988. The inflation rate declined from 10.4 percent in 1980 to 4.2 percent in 1988. The combination of conditions proved that there is no long-run trade-off between the unemployment rate and the inflation rate (see Phillips Curve). Other conditions were more mixed. The rate of new business formation increased sharply, but the rate of bank failures was the highest since the thirties. Real interest rates increased sharply, but inflation-adjusted prices of common stocks more than doubled.

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The U. S. economy experienced substantial turbulence during the Reagan years despite favorable general economic conditions. This was the “creative destruction” that is characteristic of a healthy economy. At the end of the Reagan administration, the U. S. economy had experienced the longest peacetime expansion ever. The “stagflation” and “malaise” that plagued the U. S. economy from 1973 through 1980 were transformed by the Reagan economic program into a sustained period of higher growth and lower inflation.

In retrospect the major achievements of Reaganomics were the sharp reductions in marginal tax rates and in inflation. Moreover, these changes were achieved at a much lower cost than was previously expected. Despite the large decline in marginal tax rates, for example, the federal revenue share of GDP declined only slightly. Similarly, the large reduction in the inflation rate was achieved without any long-term effect on the unemployment rate. One reason for these achievements was the broad bipartisan support for these measures beginning in the later years of the Carter administration. Reagan’s first tax proposal, for example, had previously been endorsed by the Democratic Congress beginning in 1978, and the general structure of the Tax Reform Act of 1986 was first proposed by two junior Democratic members of Congress in 1982. Similarly, the “monetarist experiment” to control inflation was initiated in October 1979, following Carter’s appointment of Paul Volcher as chairman of the Federal Reserve Board. The bipartisan support of these policies permitted Reagan to implement more radical changes than in other areas of economic policy.

Reagan failed to achieve some of the initial goals of his initial program. The federal budget was substantially reallocated—from discretionary domestic spending to defense, entitlements, and interest payments—but the federal budget share of national output declined only slightly. Both the administration and Congress were responsible for this outcome. Reagan supported the large increase in defense spending and was unwilling to reform the basic entitlement programs. Similarly, neither the administration nor Congress was willing to sustain the momentum for deregulation or to reform the regulation of health, safety, and the environment.

Reagan left three major adverse legacies at the end of his second term. First, the privately held federal debt increased from 22.3 percent of GDP to 38.1 percent and, despite the record peacetime expansion, the federal deficit in Reagan’s last budget was still 2.9 percent of GDP. Second, the failure to address the savings and loan problem early led to an additional debt of about $125 billion. Third, the administration added more trade barriers than any administration since Hoover. The share of U. S. imports subject to some form of trade restraint increased from 12 percent in 1980 to 23 percent in 1988.

There was more than enough blame to go around for each of these problems. Reagan resisted tax increases, and Congress resisted cuts in domestic spending. The administration was slow to acknowledge the savings and loan problem, and Congress urged forbearance on closing the failing banks. Reagan’s rhetoric strongly supported free trade, but pressure from threatened industries and Congress led to a substantial increase in new trade restraints. The future of Reaganomics will depend largely on how each of

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these three adverse legacies is resolved. Restraints on spending and regulation would sustain Reagonomics. But increased taxes and a reregulation of domestic and foreign trade would limit Reaganomics to an interesting but temporary experiment in economic policy.

The Regan economic program led to a substantial improvement in economic conditions, but there was no “Reagan revolution.” No major federal programs (other than revenue sharing) and no agencies were abolished. The political process continues to generate demands for new or expanded programs, but American voters continue to resist higher taxes to pay for these programs. A broader popular consensus on the appropriate roles of the federal government, one or more constitutional amendments, and a new generation of political leaders many be necessary to resolve this inherent conflict in contemporary American politics.

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8 Canadian and American Economics Compared

The comparison between the economies of Canada and the United States is generally far more of a concern to Canadian than to American.

Canada is under constant pressure to remain competitive with the United States. IF it dows not then forces such as the brain drain will occur, where the top Canadians emigrate to the U.S. If Canada falls behind corporations will also leave for the United States. The U.S. has far less to fear as any losses to Canada can be easily managed.

Despite the contrasts listed below Canada and the United States are extremely similar economically. They are both developed countries and are thus vastly closer to each other than to the majority of the world’s countries. Canada also is by almost all economic indices closer to the United States than it is to Europe.

Boom and bust cycles in Canada and the United States are closely linked as are many indices such as inflation and interest rates. Demographic patterns are also similar, with a slightly higher birth rate in the U.S. and a higher immigration rate in Canada.

Geography

In its quest to remain competitive Canada starts at an immediate disadvantage. Canada’s harsh climate lead to high costs for such things as heating. Workers are less likely to immigrate to Canada and the wealthy are more likely to leave for tropical climates.

The climate of Canada also contributes to higher transportation costs as planes, trains, and automobiles are all more expensive to operate than in much of the United States. Canada’s low population density also makes transportation costs higher. More of a historical concern was that much of the country lacks natural river systems that could be easily used for transportation. Canada’s terrain is also somewhat more rugged than the United States. The Rocky Mountains are more of an obstacle, and the mass of the Canadian Shield provides a formidable barrier to any links between Ontario and Manitoba.

Canada does have some distinct geographic advantages. The large river systems in the north are sources of cheap hydro-electric power. The main advantage is Canada’s vast supplies of natural resources. While the United States has large supplies of resources, these are not enough to meet domestic demands and they are forced to import many raw materials, a great deal of which come from Canada. By contrast Canada is a net exporter of resources. This leads to an important difference as increases in the price of resources boosts the Canadian economy while hurting the American. For example a rise in oil prices generally causes a fall in the Dow Jones but an increase in the TSX.

Government

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Differences between government intervention in the economies of the two countries is most closely examined in Canada, because some feel that policies that more closely emulate the U.S. are preferable, while others disagree.

Taxation

The average tax rate in Canada is higher than in the United States. In Canada total tax revenue for every level of government equals about 36.8% of GDP, in the U.S. this is closer to 30%. There is some regional variation, however. A resident of oil rich Alberta pays less in taxes than a resident of high tax Massachusetts.

The taxes are applied differently as well. Canada’s tax system is more heavily biased against the highest income earners, thus while Canada’s tax rate is higher on average, the bottom fifty percent of the population is more lightly taxed than in the United States.

Canada also has a national sales tax of 7% on all purchases, while the U.S. federal government relies almost entirely on income taxes.

Canada has no inheritance tax while the United States still does, but the U.S. tax is currently scheduled to be abolished.

Social Programs

For its higher taxes Canada has a more complete system of social programs than the United States. These differences include having all major universities receive government funding, having a national broadcaster in the CBC and, most notably, having a fully government-funded health care system. The United States, however, spends far more on military than Canada.

The greatest difference in social programs is in health care. The United States spends far more of its per capita GDP on health care than does Canada. Canadians, however, receive comparable care and most figures such as life expectancy and infant mortality are better in Canada. Another advantage is that the Canadian health care system is also very attractive to employers, as in Canada health care is mostly paid through income taxes, while in the United States most companies have to extend health benefits to full-time employees, something they do not have to do in Canada. The main disadvantage of the Canadian system is the long lines and waiting periods, especially for procedures of less importance.

See also: Canadian and American health care systems compared

Anti-trust

The United States has since the Sherman Anti-Trust Act been strongly opposed to monopolies. In Canada this has been far less of an issue and Canada has never had rigorously enforced rules against monopolization.

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Fiscal and Monetary Policy

Canada is generally forced to follow American monetary policy quite closely; any large difference in interest rates could quickly lead to large problems for the Canadian economy. The U.S. Federal Reserve and the Bank of Canada both staunchly believe in fighting inflation while neither aggressively pursue policies of full employment. One difference that has emerged recently is that while Canada is still hewing closely to the balanced budgets policies of the 1990s the United States has moved into a heavy deficit, a policy both countries followed in the 1970s and 1980s.

Political Turbulence

Over the last few decades the Canadian economy may have been hurt by the threat of Quebec separatism, and Quebec’s economy was almost certainly damaged. In the earlier era turbulence in the United States from the civil rights movement and Vietnam War may have hurt that country’s economy. This also sometimes benefited Canadians as draft dodgers during the Vietnam War created a reverse brain drain that lasted for many years.

Market Size

One of the most important differences historically between Canada and the United States was the size of the two markets. When both nations had high tariffs the two countries did not have a unified market. Canada’s smaller market led to higher prices and greater inefficiency.

A good example of this is the automobile industry, which can be clearly demarcated into two periods: before and after the free trade creating Auto Pact of 1969. Before Canada had its own production lines creating each of the models that would be sold in Canada. These branch plant factories would only make small production runs of each vehicle, requiring frequent and expensive retooling. The factories would also generally be smaller. Fewer varieties were available to Canadian consumers and prices were generally higher. However, these cars were almost all still made by American companies. After the Auto Pact, the industry was transformed as a unified North American market was created. The Canadian factories were rebuilt to be much larger, but to make only one model that would be sold in both countries creating large economies of scale. The prices of cars fell in Canada as wages and total employment in the automobile sector increased.

After the Second World War tariffs between the two countries gradually fell, with full free trade being established by the 1988 Canada-United States Free Trade Agreement. Some industries are still protected, however. These are mostly sensitive areas such cultural industries including publishing, television, and newspapers, which all of have stringent foreign ownership rules. Other areas such as the transport industry are also protected with Canadian control of the airlines and trains being viewed as in the national interest.

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This tends to create far more monopolies in Canada. For instance the air travel industry in Canada is dominated by a single airline, Air Canada. Canada has long had to make a trade-off between monopolization and efficiency, which the United States has not. The United States can support a number of airlines that are big enough to operate efficiently, and still have a competitive market. Canadians are forced to choose between small inefficient airlines that would be competitive, or one monopolistic airline that will generate its own inefficiency.

Another example of this trade off is the book industry, which has recently switched models. Until the 1990s Canada had many small and fairly inefficient bookstores. Then Chapters entered the market and quickly created a near monopoly, eliminating the inefficiencies of smaller stores but potentially leading to a monopolistically set price and limited choice of books.

The larger market of the United States also contributes to the brain drain. Top Canadians will often find greater opportunities in the United States. An example of this is the entertainment industry. If Jim Carrey had remained in the Canadian entertainment industry, he would have made far less money and would not be world famous. The Canadian film industry will never be able to match the American one because Canada’s thirty million people cannot buy enough tickets to allow hundred million-dollar budgets and stars that earn twenty million dollars per film.

Banking

Canada and the United States have long had very different banking systems. The United States’ was copied from England while Canada’s was taken from Scotland. The United States traditionally has had a plethora of banks, all with very few branches. This has lead to a competitive but unstable system, with many thousands of banks having collapsed during U.S. history. Canada has always had far fewer banks per capita, but the banks have been larger and quickly became nationwide. Canadian banks have many branches and distributed assets and Canada has only had one major bank, the Homestead Bank, collapse in its history. This disbursement has continued to this day. In 2002 in Canada the six largest banks controlled 90 percent of Canadian domestic assets, while the five largest U.S. banks controlled only 9.7 percent of their domestic assets.

In real terms Canadian banks are much smaller. In 2003 the three largest banks in America had assets equal to the entire 67 banks (only 14 domestic) operating in Canada. In relative size Canadian banks are more competitive. The largest Canadian bank has 1300 branches while in the U.S. the four largest banks have just over 2000 branches each.

Canada’s banks have traditionally been much fiercer competitors internationally. In part this is rooted in Canada’s smaller market. For Canadian banks international exchange was always a central concern. For American banks domestic banking was paramount. In the 1920s in the American economic center of New York Canadian banks dominated the international banking sector due to greater expertise and focus. Thus Canadian banks came to have far wider spread networks. Much of the banking system in the West Indies

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is controlled by the Canadian banks. Canadian banks also have far more of a presence in the United States than American firms do in Canada. In part this is because American firms cannot buy Canadian banks, but Canadian banks have, at times, been able to buy American ones. Since the large Canadian banks already operated nationwide chains of a thousand or more branches, they find it relatively easy to integrate smaller chains of American banks into their systems. In recent years this advantage has disappeared as American banks have also grown substantially in size and today have many branches.

Despite these foreign ownership rules, Canadian banks have been far less strictly regulated than their American counterparts. Canadian banks are far freer to participate in the financial planning and insurance industries than their American counterparts. Canadian banks have not faced laws against usury, or interest guarantees on deposits. Profits for Canadian banks are generally higher.

However, service charges are also lower in Canada, and Canada’s banking system also provides better service by most measures. Canada has more branches and more ATMs per capita than the United States. Cheques take less time to clear, as do most other transactions. Canadian banks have been far more active in promoting debit cards and internet banking, and both services are used far more often by Canadians.

Prices

In Canada prices have long tended to be higher. This is partly because of structural issues in Canada such as low population density and harsher weather, and partly due to Canada’s tax system, which depends more heavily on sales taxes relative to income taxes than the U.S. This has contributed to problems such as cross-border shopping and a reduced standard of living. Since the early 1990s this has not been the case, as the Canadian dollar had fallen low enough that it more than made up for price differences. Today prices are somewhat lower in Canada; the Big Mac Index shows that in 2003 a Big Mac cost $2.65 in the States and only $2.41 in Canada (both figures in USD).

Fuel prices have always been higher in Canada, even though Canada is a net exporter of energy. This is partly for the same reasons as above and partly because of environmental taxes levied specifically on fuel. Unlike many oil producers, particularly those in the developing world, Canada does not heavily subsidize fuel, so prices are based on the world market price.

Productivity

By most measures Canadian workers are less productive, although some of this difference is caused by Americans tending to work longer hours. Canadian level of mechanization are also not always as high.

For the last thirty years the productivity gap has been closing, in large part because of the elimination of the smaller market problem through free trade. From 1961 to 1973 labor

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productivity rose annually by 3.3 percent in Canada and 1.7 percent in the United States. From 1973 to 1995 it was 1.1 percent in Canada and 0.8 percent in the States.

Unemployment

Canada has a higher unemployment rate than the United States with the Canadian number being around 7 to 8% while the U.S. tends to be around 5%. During the 1980s when this gap first emerged it was a controversial issue. Canada’s higher income taxes and more generous benefit programs were blamed. It has recently been noted that about half of the difference is caused by the two countries measuring the unemployment rate differently. Carig Riddel, a UBC economist, found that the unemployment gap had averaged about 2% over the last several years. His numbers show that 0.9% of the difference was caused by differing measurement systems. Other factors explaining the remaining difference are the large number of seasonal workers in trades such as fishing and logging who are employed for a portion of the year. Canada’s more restrictive labor laws, increased role of unions, and greater unemployment benefits have also all been blamed for creating some or the difference. However, when unemployment insurance and welfare were sharply cut in many parts of Canada during the 1990s there was little gain relative to the Americans.

Balance of trade

While the United States has in recent years had a large trade deficit Canada has recently maintained a trade surplus. The Canadian surplus is almost entirely due to trade with the United States. Canada has trade deficits with the countries of Europe and Asia, just as the Americans do. In 2002 Canada exported about 100 billion dollars worth of goods more than they imported to the U.S. With the rest of the world it had a trade of $83 billion creating an overall surplus of some $17 billion.

Income

Canadian GDP per capita is lower than that in the United States, but median income is very similar in the two countries. Wealth in the United States is more highly concentrated and the higher per capita GDP is almost entirely a difference among the wealthiest 1% of the two countries.

The GDP gap has also been shrinking. From 1961 to 1973, real GDP grew at an average annual rate of 5.5 percent in Canada and 4.0 percent in the United States. From 1973 to 1995 it was 2.6% in Canada and 2.3% in the States.

Standard of Living

Standard of living is perhaps the hardest measurement to make since a wide array of factors have to be taken into account. The United Nations Human Development Index has traditionally listed Canada higher than the United States, with only a few exceptions.

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Other independent groups, such as the Economist rank Canadian cities as better places to live than American ones.

Canada ranks higher than the U.S. in statistics such as life expectancy, infant mortality, and literacy. The United States has more major consumer goods per capita than Canada. For instance, while Canada had only 714 televisions per 1000 people in 1996, the United States had 805.

The income gap in the United States is larger. There is sometimes a racial element to poverty in the United States. African-Americans and Hispanics, on average, have a lower standard of living than the rest of the population. Canada’s French-Canadians also used to be a much poorer group, but since the Quiet Revolution in the 1960s this has mostly been remedied. Canada’s First Peoples, a comparatively smaller percentage of the population, have a far lower standard of living than the majority

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9 The Lion, the Dragon, and the Future

In the 1980s, a select group of economies in Asia came to be known as the “Asian tigers” because of their aggressive approach to economic growth. Among the tigers were Singapore, Malaysia, Thailand, and Indonesia. All took the view that a combination of low wages and high export sales represented the fast track to economic growth and prosperity. Now these tigers are being overtaken by the “dragon” of Asia—China –which is following the same path, with perhaps even more success.

For decades after the Communists’ rise to power in 1949, China was best known for poverty and repression, and its aggression came mostly on the military front. But in recent years, economic aggression has become the byword. Although both poverty and repression are still the norm, both are changing for the better. China, it seems, is trying to learn from capitalism, even if not converting to it.

China’s economic offensive began almost thirty years ago in its southeastern province of Guangdong. The Chinese leadership decided to use this province as a test case, to see if capitalist direct foreign investment could stimulate economic growth in a way that could be politically controlled. The experience was deemed a success—economic growth soared amid political stability. What the government learned from the experience helped it smooth the 1997 transition of Hong Kong from British to Chinese control. Most important in terms of China’s long-term economic aspirations, many foreign investors came to view the Guangdong experiment as solid evidence that they could invest in China without fear that the Communist government would confiscate their capital. Beginning about 1992, foreign investment in China began to soar. The annual rate of such investment is more than ten times greater than it was at the beginning of the 1990s.

There are two powerful forces that are attracting economic investment to China: demand and supply. On the demand side, 1.3 billion people live there, some 20 percent of the world’s population. Although per capita income is still low by world standards, it has been increasing by more than 6 percent per year, after adjusting for inflation. At that rate, the standard of living for the Chinese people—and hence their purchasing power in world markets—is doubling every decade or so. China is already the world’s largest cell-phone market, with 200 million customers. Within a few years, it is estimated, China will account for 25 percent of the world’s purchases of personal computers. Indeed, China now spends over $60 billion per year on information technology and services, and this amount is growing at a rate of nearly 30 percent per year. By 2030, the Chinese economy will likely have replaced the economy of the United States as the world’s largest.

With its population of 1.3 billion, china also offers attractions on the supply side. Highly skilled workers have been plentiful in the Chinese labor market. China’s universities produce more 450,000 engineering graduates each year, including 50,000 in computer science. (By comparison, there are about 30,000 new computer science graduates each year in the United States.) In many cities, the fact that the Chinese workforce is generally well educated and often English-speaking has helped make the country attractive to foreign employers. Collaborative scientific ventures between Chinese researchers and U. S. firms are becoming increasingly common. A research team at Beijing University played a role in deciphering the genetic makeup of rice, for example. American computer hardware and software firms Intel, IBM, Oracle, and

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Microsoft have shifted some key components of their research to China in recent years. American firms are even setting up customer-service call centers in China. Microsoft customers from the United States who call for help may well find themselves talking with one of that company’s four hundred engineers who are located in Shanghai.

Malaysia, Thailand, and Singapore are increasingly concerned by the growing competition they face from their neighbor to the north. Chinese medium- and high-tech industries are starting to cut into the market share of the very sectors that have helped fuel the growth of the Asian tigers in recent decades. The situation is even more critical in Japan, where wages are much higher than in China but whose technological lead over China is gradually eroding. “Are we to become a vassal of the Chinese dynasty again?” asked one Japanese official, clearly concerned that his nation’s manufacturing firms were having trouble competing with Chinese firms. Eventually, Japan and China’s other neighbors will adjust to the growing economic presence of China, but the transition may be unpleasant.

Most Americans, however, are more concerned about the likely impact on the U. S. economy of China’s capitalist ambitions. Will the dragon consume American firms and jobs as it grows? The short answer is no. The long answer has two elements. To this point, a key element of China’s competitiveness has been the low wages there. Even though American and European firms operating in China choose to pay their workers more than state-owned enterprises pay, this has still yielded considerable savings. As recently as five years ago, unskilled and semiskilled labor in China cost only 25 percent as much as in Europe. Moreover, foreign firms have been able to hire engineers for salaries that are only 10 to 20 percent of the cost of hiring engineers in the West.

Labor markets in China are changing rapidly, however. Average wages are rising at 6 to 8 percent per year, with bigger increases among higher-skilled workers, and migration into the cities has slowed due to a sharp cut in agricultural taxes. Many firms have been unable to hire as many workers as they would like, and most firms have had to upgrade their fringe benefits and other on-the-job amenities just to retain existing workers. Even so, turnover has soared as firms compete for a pool of talent that is no longer growing. Wages are still well below American and European levels, but the gap is closing steadily, thereby cutting the competitive advantage of many Chinese firms.

Rising wages in China will also translate into higher demand for goods produced by American and European firms. China, like all nations, must in the long run import goods equal in value to those it exports (unless China intends to give its exports away, which so far no one is claiming). This means that just as China has become a potent supplier of many goods and services, it is at the same time becoming a potent demander of still other goods and services.

Thus far, the Chinese demand for goods has not been as visible in American markets because American firms tend to produce goods and services designed for higher-income consumers, and China has, as yet, relatively few of those. In the meantime, the demand-side influence of the Chinese economy is already showing up, albeit in odd places. To take one example, right now China’s most important import from the United States is trash. Ranging from used newspapers to scrap steel, Chinese companies buy billions of dollars’ worth of the stuff every year to use as raw materials in the goods they produce. In addition to yielding profits (and employment) in these U. S. export industries,

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this exportation of U. S. trash reduces the burden on U. S. landfills and, by pushing up the prices of recyclable scrap, encourages more recycling in the United States.

Eventually, of course, we’d like to be sending China more than our rubbish, and that time is coming. As China’s economy grows, so will the number of affluent Chinese, and with 1.3 billion potential candidates, that ultimately means plenty of consumers for America’s high-end goods. Thus the long-run effects of China’s growth will mean a different American economy—we’ll be producing and consuming different mixes of goods and services—but America will also be a richer nation. Voluntary exchange, after all, creates wealth, and the Chinese dragon is big enough to create a lot of wealth.

Just to China’s southwest, another giant is stirring. Around 1990, the lion of India began to throw off the self-imposed shackles of nearly a half-century of markets largely closed to international competition. The central government, for example, began opening many of its state-owned companies to competition from private-sector rivals. FedEx and United Parcel Service (UPS) have made huge inroads on the Indian postal service, and numerous foreign firms are now competing with the state-owned telephone service, which had long been a complete monopoly.

Entry into the Indian market brought familiarity with its workforce, many of whose members are fluent in English. The technical capabilities of graduates of top Indian universities, combined with their English skills are low wages, made them perfect staffers for a proliferation of call centers that have opened throughout India. Tens of thousands of technical and customer-relations jobs that used to go to Middle America are now held by the growing middle class in India. As we discussed in Chapter 14, “A Farewell to Jobs,” it was in many respects this very movement that brought outsourcing to the forefront of the American consciousness.

But India, too, is struggling with growth. The talent pool at the top is thin: Only a dozen or so of India’s seventeen thousand universities and colleges can compete with America’s best, and the wages of graduates of these top schools are soaring. Moreover, India suffers from overwhelming infrastructure problems: Much of its road system is either overcrowded or in disrepair, and its port facilities are in desperate need of modernization. For the time being, such transportation problems are likely to keep India from becoming a major manufacturing powerhouse. India has also been hampered by its huge and seemingly permanent government bureaucracy. For example, despite the fact that the postal service there has lost more than half of its business to newcomers such as FedEx and UPS, none of the 550,000 postal service employees can be fired.

At least India is a democracy, and its legal system, inherited from the British, who ruled there for so long, is in close conformity with the legal systems of most developed nations. Matters are rather different in China. As noted in Chapter 4, “The Mystery of Wealth,” political and legal institutions are crucial foundations for sustained economic growth. Despite the advances China has made over the past thirty years, its wealth-creating future may be clouded unless it can successfully deal with two crucial institutional issues.

First, there is the matter of resolving the tension inherent when a Communist dictatorship tries to use capitalism as the engine of economic growth. Capitalism thrives best in an environment of freedom and itself creates an awareness of and appreciation for the benefits of that freedom. Yet freedom is antithetical to the ideological and political tenets of the Communist government of China. Will the government be tempted to

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confiscate the fruits of capitalist success to support itself? Or will growing pressure for more political freedom force the government to repress the capitalist system to protect itself? Either route would likely bring economic growth in China to a swift half.

The second potential long-run problem faced by China lies in that nation’s cultural attitude toward intellectual property. In a land in which imitation is viewed as the sincerest form of flattery, it is routine to use the ideas of others in one’s own pursuits. As a result, patent and copyright laws in China are far weaker than in Western nations. Moreover, actions elsewhere considered to be commercial theft (such as software piracy) are largely tolerated in China. If foreign firms find that they cannot protect their economic assets in the Chinese market, foreign investment will suffer accordingly, and so will the growing dragon that depends on it so heavily.

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10 Supply-Side Economics

Supply-side economics provided the political and theoretical foundation for a remarkable number of tax cuts in the United States and other countries during the eighties. Supply-side economics stresses the impact of tax rates on the incentives for people to produce and to use resources efficiently. A person’s marginal tax rate—the tax rate she pays on an additional dollar of income—determines the breakdown between taxes, on the one hand, and income available for personal use, on the other. Since they directly affect the incentive of people to work, to save and invest, and to avoid and evade taxes, marginal tax rates are central to supply-side analysis.

An increase in marginal tax rates reduces the share of additional income that earners are permitted to keep. This adversely affects output for two major reasons. First, the higher marginal rates reduce the payoff that people derive from work and from other taxable productive activities. When people are prohibited from reaping much of what they sow, they will sow more sparingly. Thus, when marginal tax rates rise, some people, those with working spouses for example, will opt out of the labor force. Others will decide to take more vacation time, retire earlier, or forgo overtime opportunities. Still others will decide to forgo promising but risky business opportunities. These reductions in productive effort shrink the effective supply of resources and thereby retard output.

Second, high marginal tax rates also encourage tax shelter investments and other forms of tax avoidance. As marginal tax rates rise, investments that generate paper losses from depreciable assets become more attractive. So, too, do business activities that present opportunities to deduct expenditures on hobbies (for example, collecting antiques, raising horses, or traveling) and personal amenities (luxury automobiles, plush offices, and various fringe benefits). Thus, people are directed into activities because of tax advantages rather than profitability. Similarly, they are encouraged to substitute less desired tax-deductible goods for more desired nondeductible goods. Waste and inefficient use of valuable resources are a by-product of this incentive structure.

It is important to distinguish between a change in tax rates and a change in tax revenues. Because higher tax rates discourage work effort and encourage tax avoidance and even tax evasion, the tax base will shrink as the rates increase. When something is taxed more heavily, you will get less of it. Therefore, an increase in a tax rate causes a less than proportional increase in tax revenue. Indeed, economist Arthur Laffer (of” Laffer curve” fame) popularized the notion that higher tax rates may actually cause the tax base to shrink so much that tax revenues will decline.

This inverse relationship between a change in tax rates and the accompanying change in tax revenues is quite likely when marginal tax rates are high, but unlikely when rates are low. An analysis of the incentive effects for different tax brackets illustrates why this is true. Suppose that a government with progressive income tax rates ranging from a low of 15 percent to a high of 75 percent cuts tax rates by one-third. The top tax rate would then fall from 75 percent to 50 percent. After the tax cut, taxpayers in the highest tax bracket who earn an additional $100 would get to keep $50 rather than $25, a 100 percent

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increase in the incentive to earn. Predictably, these taxpayers will earn more taxable income after the rate reduction, and the revenues collected from them will decline by substantially less than a third. In fact, given the huge increase in their incentive to earn, the revenues collected from taxpayers confronting such high marginal rates may actually increase.

The same 33 percent rate reduction will cut the bottom tax rate from 15 percent to 10 percent. Here, take-home pay per $100 of additional earnings will rise from $85 to $90, only a 5.9 percent increase in the incentive to earn (compared to the 100 percent increase in the top bracket). Because cutting the 15 percent rate to 10 percent exerts only a small effect on the incentive to earn, the rate reduction has little impact on the tax base. Therefore, in contrast with the revenue effects in high tax brackets, tax revenue will decline by almost the same percent as tax rates in the lowest tax brackets. The bottom line is that cutting all rates by a third will lead to small revenue losses (or even revenue gains) in high tax brackets and large revenue losses in the lowest brackets. The share of the income tax paid by high-income taxpayers will rise.

During the great tax debate of 1975 to 1986, the opponents of the supply-side view argued that it was unrealistic to expect lower tax rates to lead to increased tax revenues. According to the critics an increase in the tax base that was large enough to increase revenues would require an unrealistically large elasticity of labor supply (increase in hours worked due to higher after-tax wages). In response the supply-side proponents stressed that reductions in tax avoidance activities, as well as labor-supply effects, would enlarge the tax base when the rates were reduced. According to the supply-side view the combination of a decline in tax avoidance and increase in business activities would permit lower rates with little or no loss of revenues in the top tax brackets. At the same time, most supply-side economists, though perhaps not all, noted that reductions in low tax rates would lead to revenue losses.

Empirical studies of tax cuts that happened during the twenties and sixties buttressed the supply-side position. Prodded by Secretary of the Treasury Andrew Mellon, three major tax cuts reduced the top marginal tax rate from 73 percent in 1921 to 25 percent in 1926. in addition, the tax cuts eliminated or virtually eliminated the personal income tax liability of low-income recipients. The results were quite impressive. The economy grew rapidly from 1921 through 1926. After the rates were lowered, the real tax revenue (in 1929 dollars) collected from taxpayers with incomes above $50,000 of income declined by 45 percent. Thus, as the tax rates were cut, the revenues collected from high-income taxpayers rose, while those collected from lower-income taxpayers declined. The tax cuts of the twenties substantially increased the percent of taxes paid by the wealthy.

The results of the Kennedy-Johnson tax cuts of the midsixties were similar. Between 1963 and 1965, tax rates were reduced by approximately 25 percent. The top marginal tax rate was cut from 91 percent to 70 percent. Simultaneously, the bottom rate was reduced from 20 percent to 14 percent. For most taxpayers the lower rates reduced tax revenues. In real 1963 dollars the tax revenues collected from the bottom 95 percent of taxpayers fell from $31.0 billion in 1963 to $29.6 billion in 1965, a 4.5 percent reduction. In

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contrast, the real tax revenues collected from the top 5 percent of taxpayers rose from $17.2 billion in 1963 to $18.5 billion in 1965, a 7.6 percent increase. As in thecase of the tax cuts of the twenties, the rate reductions of the sixties reduced the tax revenue collected from low-income taxpayers while increasing the revenues collected from high-income taxpayers.

Major tax legislation passed in 1981 and 1986 reduced the top U. S. federal income tax rate from 70 percent to approximately 33 percent. The performance of the U. S. economy during the eighties was impressive. The growth rate of real GNP accelerated from the sluggish rates of the seventies. U. S. economic growth exceeded that of all other major industrial nations except Japan.

The critics of the eighties tax policy argue that the top rate reductions were a bonanza for the rich. The taxable income in the upper tax brackets did increase sharply during the eighties. But the taxes collected in these brackets also rose sharply. Measured in 1982-84 dollars, the income tax revenue collected from the top 10 percent of earners rose from $150.6 billion in 1981 to $199.8 billion in 1988, an increase of 32.7 percent. The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger. In contrast, the real tax liability of other taxpayers (the bottom 90 percent) declined from $161.8 billion to $149.1 billion, a reduction of 7.8 percent. These findings confirm what the supply-siders predicted: the low rates, by increasing the tax base substantially in the upper tax brackets, caused high-income taxpayers to pay more taxes. In effect, the lower rates soaked the rich.

Probably the most detailed study of the tax changes in the eighties was conducted by Lawrence Lindsey of Harvard University. Lindsey used a computer simulation model to estimate the impact of the eighties’ tax-rate changes on the various components of income. He found that after the tax rates were lowered, the wages and salaries of high-income taxpayers were approximately 30 percent larger than projected. Similarly, after the rate cuts capital gains were approximately 100 percent higher than projected, and high-income taxpayers’ business income was a whopping 200 percent higher than expected. Lindsey concluded that the main supply-side effects resulted from (a) people paying themselves more in the form of money income rather than fringe benefits and amenities, (b) increases in business activity, and (c) a reduction in tax shelter activities. His findings undercut the position of those supply-side critics who had assumed that substantial supply-side effects were dependent on a large increase in labor supply.

Studies liking rate changes with changes in tax revenue measure the short-term effects of tax policy. But because taxpayers take time to adjust, revenues are even more responsive to rate changes in the long run. James Long and I conducted a study that found that taxpayers in states with lower marginal tax rates had much lower deductions and much lower expenditures on tax shelters than taxpayers in states with higher marginal rates. We found that when the combined federal-state marginal tax rate rises above 50 percent, the government’s tax revenues decline. Lindsey estimates that the government’s revenue begins declining at even lower tax rates, approximately 35 percent.

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Supply-side economics influenced tax policy throughout the world in the late eighties. Of eighty-six countries with a personal income tax, fifty-five reduced their top marginal tax rate during the 1985-90 period, while only two (Luxembourg and Lebanon) increased their top rate. Countries that substantially reduced their top marginal tax rates include Australia, Brazil, France, Italy, Japan, New Zealand, Sweden, and the United Kingdom.

Reflecting the dominant Keynesian view at the beginning of the eighties, most economists thought that tax changes influenced output and revenue primarily by changing the demand for goods and services. Both research and the tax policy changes of the eighties, however, indicate that supply-side incentive effects are quite important. While controversy continues about the precise magnitude of the supply-side effects, the view that marginal tax rates in excess of 40 percent exert a destructive influence on the incentive of people to work and use resources wisely is now widely accepted among economists. This was not true prior to the eighties. An important piece of evidence for the shift in thinking is a 1987 statement by the Congressional Budget office (CBO), which had been critical of the supply-side claims and had always assumed in its revenue projections that taxpayers did not respond at all to changes in tax rates. The CBO wrote: “The data show considerable evidence of a very significant revenue response among taxpayers at the highest income levels.” This change in thinking is the major legacy of supply-side economics.

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11 The Production Possibilities Frontier

Scarcity, Choice and the Production Possibilities Frontier

The Economic Problem of Scarcity `

Scarcity occurs because human wants exceed the limits of available resources.

Economics deals with the basic fact that scarcity exists in our everyday lives and in our economy. Imagine for a minute that a messenger suddenly knocks on your door. He greets you with the delightful information that a previously unknown distant relative has carefully monitored your progress through life. The relative is pleased with your progress and as a test has decided to give you $5 million. There is one stipulation, however; you must spend this money within three months.

Would you have any trouble spending the money? Unless you are already smothered in wealth, you should have no trouble coming up with a list of expenditures. A car, a beachfront apartment, a ski chalet, a boat, a vacation in paradise, a new computer, TV, and stereo. GSM Cellular phone, PCS wireless, satellite uplink, personal messaging system, ADSL, cable modem and ISDN Internet access, your list suddenly grows longer than you expected. The money would be exhausted in no time. Wake up; a survey of the worn bills in your wallet reveals the basic fact that you face a scarcity of money in relation to the list that we just constructed.

The same idea applies to the economy as a whole. Resources such as raw materials are in finite supply and must be allocated to their best use. For example, in the western United States, water is a relatively scarce resource. The water that originates in Colorado flows westward into the Colorado River, eventually providing cities in Southern California with drinking water. In years when rainfall is below normal, regional water restrictions come into effect and users may be prevented from certain activities such as washing their cars. Virtually all resources are scare, meaning that more of them are desired than is available.

Choice

Given the presence of scarcity, choices must be made as to how resources are allocated.

Our lives are filled with wide range of choices regarding the use of limited personal funds. Advertisers constantly inform consumers of their consumption possibilities and the choices available. The same principle applies for the economy as a whole. We elect politicians who work with policy makers to allocate government expenditures. Together they make difficult choices concerning how taxes will be spent. Or if a tax reduction is desired, a decrease in government expenditures should accompany the tax cut.

Problems arise when government try simultaneously to reduce taxes and maintain a high level of expenditures. As pointed out, the U.S. government must take the choice between

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reduced expenditures today or run the risk of jeopardizing future economic growth and prosperity.

The tradeoff between consumption today and consumption tomorrow deals with the concept of opportunity cost.

Opportunity Cost

The relevant cost of any decision is its opportunity cost – the value of the next-best alternative that is given up.

By making choices in how we use our time and spend our money we give something up. Instead of reading this material, what else could you be doing? Your best alternative may involve sports, leisure, work entertainment, and more. If you choose to go to a restaurant this evening, the money that you spend on dinner will not be available for other uses, even saving.

Businesses and government also deal with opportunity costs. As noted, by choosing to maintain large deficits today, the federal government may reduce future economic growth. Or laws that protect wilderness areas and endangered species will ensure a better environment tomorrow at the opportunity cost of reduced access to resources today.

Businesses must choose what type of goods to produce and the quantity. Given limited funds, the opportunity cost of producing one type of good will arise from not being able to produce another.

The Production Possibilities Frontier (PPF)

Introduction to the Production Possibilities Frontier (PPF)

The production possibilities frontier is used to illustrate the economic circumstances of scarcity, choice, and opportunity cost.

To describe the concept of the production possibilities frontier, assume that we live on an island that has only two cities (Seattle and Detroit), and two industries (automobiles and airplanes). Given the resources available on our island economy, the table below shows how labor and capital can be allocated to the production of autos and airplanes.

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The Production Possibilitiesfor a Single Country

Option Automobiles AirplanesA 150 0B 125 4C 80 9D 30 16E 0 25

The table fives five production possibilities, option Q through E. Each option shows what alternative mixes of automobiles and airplanes that society can choose to produce. Option A is one where our island dedicates all or its resources to the production of automobiles, entirely forsaking production. Option B shows a preference for the production of a few airplanes, but giving up some automobiles in the process. The tradeoff of airplanes for autos continues to point E, where our country dedicates itself to the production of airplanes (25), producing zero automobiles.

The table presented here can be used to describe the economic problems of scarcity, choice and opportunity cost. Scarcity is present because finite amounts of each good can be produced. We may want a combination of 150 autos and 25 airplanes, but given the limited labor and capital inputs available, this is not a feasible combination. To produce 150 autos requires that all labor and capital available be used in the assembly of automobiles, leaving nothing for the production of airplanes.

Only by giving up some autos (moving from Option A to Option B) do we gain airplanes. In a practical sense, labor and capital is switched from producing automobiles to airplanes. This presents opportunity cost – the best alternative that we give up (autos) to increase airplane output.

Finally, choice is demonstrated by the five options of the table. How are choices made? Perhaps the firm or the market will determine the combination of autos and airplanes that are produced. There can be a central planning agency that makes this determination or the democratic process will let citizens vote for their preferences.

Automobiles150

25

Airplan

es

Figure 1-1 The Production Possibilities Frontier

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Figure 1-1 is a graphical representation of the information presented in the table above. The boundary presented in the graph represents the different possibilities that society has in the allocation of resources. The frontier boundary and its interior represent what is achievable given our island’s currently available resources. In contrast, points outside the frontier are not attainable given the resources and technology present.

Note two characteristics of the production possibilities frontier. First, it slopes downward to the right. This represents the tradeoff present in production. By producing more automobiles, workers and capital must migrate from Seattle to Detroit. An increase in auto production necessitates a reduction in the output of airplanes.

In addition, the production possibilities frontier is “bowed outward.” The curvature of the production possibilities frontier reflects the increasing opportunity cost when substituting one type of production for another. This situation is caused by the specialization of workers. If society initially favors auto production over airplanes so that we are located in the southeast portion of the frontier, workers become skilled in auto production. But as we move to the left along the curve, increasing airplane output and decreasing auto production, some workers switch to building airplanes. For many workers, the skills used in producing autos are not perfectly transferable. In addition, the machinery used for auto production may not be well suited to making airplanes. As a result, the output per worker falls as they are relocated to making goods in which they are less skilled.

Just as the previous table described the economic problems of scarcity, choice and opportunity cost, the PPF does the same. Points outside the frontier may be desirable, but are not obtainable given the inputs of labor and capital available to society. As we change out preferences and move to the North West along the frontier, airplane manufacturing increases at the opportunity cost of automobile assembly.

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12 Canada’s “Free” Health Care has Hidden Costs

Proponents of the Canadian model praise its universal coverage and its apparent low cost. Total (private and public) health expenditures are only 10% of gross domestic product in Canada, compared to 14% in the U. S. A study published last August in the New England Journal of Medicine claimed that a third of this difference is explained by lower administrative costs in the Canadian system. But, among its other faults, this accounting ignores the hidden economic costs of Canadian health care.

The Canadian system is built around a compulsory public-insurance regime that provides most medical and hospital services free. Of course, it is not free for the taxpayer, who finances the system at a rate of 22% of all taxes raised in Canada. The Canadian government pays about 71% of total Canadian health care expenditures, compared to 44% paid by the government in the U. S. This translates into public health expenditures of 7% of GDP in Canada and 6% in the U. S.—a rather small difference. The difference in total expenditures is due to higher private expenditures in the U. S. Why are private health expenditures so low in Canada? The main reason is that they are illegal, which gets us to the heart of the system’s hidden costs.

Canadian public health insurance is not only compulsory, it is also monopolistic. The system is administered by provincial governments under strict guidelines imposed by federal law and federal subsidies. Private insurance covering publicly insured services is illegal. Physicians are forbidden to accept private payments above the fees billed to the government. Hospitals are public or non-profit, and tightly regulated. Physicians’ fees are determined—or “negotiated”—by provincial agencies. Prices of drugs are controlled. In short, the public supply of medical services is rationed, and there is little private alternative. Hence the apparent low cost of the system.

The hidden costs include the poor quality of services, and the costs imposed on customers (aptly called “patients” in this case) who have to wait in queues.

Quality is subjective and can only be evaluated through consumer choices, but the government won’t let consumers make choices and vote with their feet if they are not satisfied. Anecdotal evidence of questionable quality is everywhere. In a recent piece in Montreal’s Gazette, a Canadian related her own experience, and contrasted the “kindness, discretion and professionalism” of staffing U. S. hospitals, with the frequent rudeness of unionized personnel in the Canadian system.

Long waiting lines are a fixture of the system. The Fraser Institute, a Vancouver think tank, has calculated that in 2003, the average waiting time from referral by a general practitioner to actual treatment was more than four months. Waiting times vary among specialties (and, less wildly, among provinces), but remain high even for critical diseases: The shortest median wait is 6.1 weeks for oncology treatment; excluding radiation, which is longer. Extreme cases include more than a year’s median wait for neurosurgery in New Brunswick. The median wait for an MRI is three months. Since 1993, waiting times have increased by 90%

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Waiting lines impose a real cost, which is approximated by what individuals would be willing to pay to avoid them. Waiting costs include health risk, lost time (especially for individuals whose time is most valuable), pain and anguish. Socialist systems are notoriously oblivious to anguish, discomfort, humiliation and other subjective factors which bureaucrats cannot measure or don’t value the same way as the patient does.

A Quebec physician, Dr. Jacques Chaoulli, is suing the government for not allowing patients to pay for better care. The Supreme Court of Canada will hear his appeal of lower-court rebuttals in June. Last month, a class-action case was launched against Quebec hospitals on behalf of 10,000 breast cancer patients who, since October 1997, have had to wait more than eight weeks each for post-surgery radiation therapy.

Liberalization proposals are met by the “two-tier system” bogey man—that if choice is allowed an unequal system will develop. But if directly paying a doctor is illegal, there are legal ways to jump the queues. As pointed out by Professor Livio Di Matteo of Lakehead University in Ontario, what now exists is a three-tier system. The very rich (like Robert Bourassa, the Late Premier of Quebec) go to the U. S. for rapid, personalized, high-tech treatments. The second tier is made of “the well informed and aggressive, who can push their way to the front of the treatment line.” The poor and those with no connections get stuck in the queue.

At least two Indian groups are now considering building private clinics or hospitals on their land—just as other sorts of illegal-elsewhere trade thrive on Indian reserves. Yet, Canadians who patronized such clinics would still be prohibited from purchasing private insurance to cover the service, leaving the opportunity only to the wealthiest.

As noted by Wharton professor Patricia Danzon, another hidden cost of the Canadian system comes “from forcing everyone to have the same level and type of insurance,” whatever their individual preferences are.

One last cost should not be ignored: the loss of personal responsibility and the habit of dependence on the state. Opinion polls show that Canadians are generally proud of their public health insurance. Indeed, for most people, any basis for comparison has been made illegal. Auberon Herbert, a libertarian Member of Parliament in late 19th century England wrote, “If government half a century ago had provided us all with dinners and breakfasts, it would be the practice of our orators today to assume the impossibility of our providing for ourselves.”

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13 Baseball Players and Opportunity Costs

On December 21, 2002, the Toronto Blue Jays decided not to offer salary arbitration to outfielder Jose Cruz, one of there more popular players. By not offering arbitration, Cruz became a free agent and could sign a contract with any of the other 29 teams in major league baseball. Under the rules of arbitration, any team signing Cruz would not have to give the Blue Jays any players, money, or draft picks in return.

The reaction in Toronto by many in the media was rather predictable. Caller after caller on local sports talk shows asked, “How could we get rid of one of our best players and get nothing in return?” The hosts of these shows seem to do little to try and answer these questions. If radio talk show hosts were required to take an introductory course in economics, they would understand the concept of opportunity cost and would be better able to answer these questions posed by their callers.

MoneyWe need to examine two important resources which major league baseball teams have in order to understand the personnel decisions they make. The first resource at their disposal is the money that they use to sign players. Teams generally do not have enough money to sign every player they want to a contract, although the New York Yankees are trying to prove otherwise. Had the Blue Jays offered salary arbitration to Jose Cruz, his salary for 2003 would have been decided by an arbitrator. The best estimates available suggest that Cruz would have received $5 million for 2003 if his salary was determined by an arbitrator. If we believe this estimate and if the Jays had offered Cruz arbitration, the Jays would be required to retain Cruz and pay him $5 million for the season. This would be 5 million dollars that the Jays could not use for other purposes.

If we look at the moves the Blue Jays have made over the winter, it seems that they used this $5 million to sign other players. The Blue jays have signed 6 players to contracts who played elsewhere in 2002. the players and the salaries they will be paid in 2003 are as follows:

FormerPlayer Position Salary TeamBordick,Mike Shortstop $1,000,000 Baltimore Catalanotto,Frank Outfielder $2,200,000 Texas Creek,Doug Pitcher $ 700,000 Seattle MyersGreg Catcher $1,000,000 Oakland Sturtze,Tanyon Pitcher $1,000,000 Tampa Tam,Jeff Pitcher $ 600,000 Oakland Total 6 players $6,500,000

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So the Jays have spent $6.5 million on players during this off-season. It is likely that, if the Jays were paying Jose Cruz $5 million for 2003, they would not have spent this $6.5 million on these six players.

The Major league Roster

The second important resource a team has is the 25 spots on their major league roster. By Major League Baseball rules a team can only carry 25 players at one time. If a team is at this limit (which teams almost always are) and they with to add a player to the roster, they must first take a player off. So the cost to the Blue Jays of signing these 6 players is not simply the money they have to pay for there services, but it is also in the roster spots the players take up.

If the Jays had not signed these 6 players, they would have had to find other players to tae up these six roster spots. One of those players probably would have been Jose Cruz. The other 5 would have probably been players from the minor leagues with little or no major league experience. First year players typically make the major league minimum salary of $300,000. if the Jays had kept Cruz and called up 5 minor league players, the six roster spots would look as follows.

Player Salary Cruz,Jose $5,000,000 MinorLeaguer 1 $ 300,000 Minor Leaguer 2 $ 300,000 MinorLeaguer 3 $ 300,000 Minor Leaguer 4 $ 300,000 MinorLeaguer 5 $6,500,000

This option is now directly comparable to what the Jays did over the winter, as both take up 6 roster spots and cost $6.5 million:

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Option A Option B Player Salary Player Salary Bordick, Cruz,Mike $1,000,000 Jose $5,000,000 Catalanotto, MinorFrank $2,200,000 Leaguer 1 $ 300,000 Creek, MinorDoug $ 700,000 Leaguer 2 $ 300,000 Myers, MinorGreg $1,000,000 Leaguer 3 $ 300,000 Sturtze, MinorTanyon $1,000,000 Leaguer4 $ 300,000 Tam, MinorJeff $ 600,000 Leaguer 4 $ 300,000 Total $6,500,000 Total $6,500,000

One of the most commonly used principles in economics is opportunity cost. The opportunity cost of something is simply the highest valued alternative that must be foregone when a choice is made. Here I’ve presented two choices the Jays could have make. Of course the Blue Jays had other alternatives: they could have signed 6 minor leaguers and kept the leftover money, or signed a different set of players. But it is likely the Jays felt that these two options were their best choices. So the opportunity cost of choosing the A set of players is the foregone opportunity to sign the B set of players. Similarly, the opportunity cost of the set of players B is simply the set of A players.

So we wee that the Jays did not give up Jose Cruz for “nothing”. Instead they gave up Jose Cruz and the opportunity to play 5 minor league players and received the opportunity to play Bordic, Catalanotto, Creek, Myers, Sturtze, and Tam instead. So when a team decides not to retain the services of the player, they always receive two things in return: the money it would have taken to retain the player, and the spot on the 25 man roster that the player would have taken.

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14 Rationing Health Care

Americans spend a larger share of national income on health care- more than 14 percent – than any other people of the world. Moreover, for almost every one of the last twenty-five years, the price index for medical care has increased more rapidly than the price index for all goods and services in general. With spending on health care at record high levels, it is little wonder that some political leaders have labeled health care in the United States a “crisis,” arguing we should implement government-mandated universal health care coverage. It is thus instructive to look at what has happened in other countries that have adopted some form of a national health care system.

We obviously cannot cover every aspect of health care here, nor can we demonstrate that one system of health care delivery is better than another one. What we can do, however , is to note the consequences of this critical point: In a world of scarcity, some form of rationing is inevitable. In the market system, that rationing is done by prices. Under the systems of government-mandated universal health care that now exist (or are likely to exist in the future), prices are not permitted to ration demands. Instead , these systems rely on another system of rationing: It is called rationing by waiting, because people are forced to wait – for weeks or months – for whatever level of medical care is offered them.

The most common form of government-mandated universal health care coverage found in the world today is the single-payer health care system that in essence offers universal health care to consumers at a money price of zero. (The term single-payer is used because the government writes the checks for the medical bills.)

Britain offers a typical example. The British National Health Service (NHS) has been in existence since 1948. Once touted as one of the world’s best national health care examples, the NHS has deteriorated dramatically. Consider hospital beds: In 1948 there were ten hospital beds per thousand people. Today there are about five per thousand people, since 1948 about 50 percent of Britain’s hospitals have been closed for “efficiency” reasons – meaning that the British government cannot or will not afford to keep them open. Britain now has fewer hospital beds per capita than every Western European country except Portugal and Spain.

Because patients in Britain do not pay directly for the services they receive, some other means of rationing must be used. In Britain, the rationing device is waiting, and as the number of hospital beds and other medical facilities have been cut relative to the population, it is little surprise that waiting times have increased. Currently more than a million British patients are waiting for hospital admission. Many others do not show up on waiting lists because they simply do not apply, knowing that the wait is so long. In some London hospitals, individuals routinely spend more than 12 hours waiting to see a physician.

The total staff in the NHS has, in contrast, skyrocketed. Whereas in 1948 the staff-to-bed ratio was .73 to 1 for each hospital bed, today it is 3.1 to 1 for each hospital bed; even with the drop in beds per capita, there are now twice as many staff members for each

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patient as thee were in 1948. one would expect this would enhance medical care. Unfortunately, however, the staff, for the most part, do not deal directly with the treatment of patients. Rather, they have become part of the NHS bureaucracy. This is because the government-run NHS adds a new department or committee for every new aspect of medicine that develops. The NHS consists of a bureaucratic network unknown in the decentralized medical system in the United States.

In fairness to the NHS, some of the changes in the system over the last fifty years have been mirrored in health care systems elsewhere. For example, improvements in surgical techniques and pharmaceuticals have shortened hospital stays in most nations, resulting in a reduced demand for hospital beds. This surely helps explain at least some of the sharp cuts in NHS beds per capita. Nevertheless, horror stories of bungled operations and patients left untended in hospital hallways have become a regular feature in British newspapers. Things got so bad by 2002, that Britain’s Labor Party – the initial creator and steadfast supporter of the NHS – proposed that the poorest-performing NHS hospitals be handed over to the private sector.

The national health care system in Canada offers another example of the effects of non price rationing. In essence, under the Canadian system the government picks up the entire tab for all covered medical procedures. Currently, only 11 percent of Canada’s national health care spending goes to administration, compared to 24 percent in the United States. Canada devotes 9.5 percent of its national income to health care, about a third less than in the United States. Perhaps because of the seemingly low cost of the Canadian system, many supporters of health care reform in the United States often point to Canada’s system as one that the United States should emulate.

One impact of the lower level of spending in Canada is that their system does not provide the latest in medical technology. Although Canada ranks fifth highest among developed nations in health care spending as a share of income, it ranks in the bottom third of those countries in availability of technology. For example, compared to the United States, on a per capita basis Canada has far fewer CAT scan and magnetic resonance imaging (MRI) machines, critical in performing sophisticated, difficult diagnostics. Similarly, Canadian medical facilities have almost none of the medical devices needed to remove kidney stones without painful and dangerous surgery. Moreover, operating rooms in Canada operate on strict financial budgets and are allowed to continue operating only if they are within those monthly budgets. What happens if an operating room exhausts its budget on, say, the 20th of the month? It shuts down until the beginning of the next monthly budget cycle.

The costs to the users of the Canadian system show up in other ways as well. Two Canadian economists, Cynthia Ramsay and Michael Walker of The Fraser Institute in British Columbia, have studied the waiting times across a variety of medical specialties. They discovered that many Canadians each year were not permitted to enter the hospital when they or their physician deemed best; instead they had to wait until facilities became available. Moreover, Canadians typically were not even able to get in to see their doctors when they wanted. Ramsay and Walker measured the delay from

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Table 11-1 Average waiting time for treatment by a Specialist in Canada

(In weeks)Specialty Shortest wait Longest wait Canada AverageOrthopedics 10.3 39.7 25Plastic Surgery 9.1 40.5 19.8Ophthalmology 8.1 39 22.3Gynecology 5.5 27.2 13.1Otolaryngology 8.3 26 14.4Urology 8.2 29.2 12.6Neurosurgery 10 31 17General Surgery 6.2 22.3 9.2Internal Medicine 4.6 7.2 6.4Cardivascular 12.5 31.5 17.9

the time that a primary care physician referred a patient until a specialist actually treated the patient; they found that the demand for health care was rationed by waiting. Listed in Table 11-1 are the average waiting times in weeks for the serviced of various medical specialists. The tree columns show the waiting times for Canada as a whole and the waiting times in individual Canadian provinces that had, respectively, the shortest and longest waiting times.

Two facts are apparent from Table 11-1. First, it is common place for Canadians to have to wait three or four months to receive health care that is anything beyond that offered by a nurse of primary care physician. Second, the Canadian system produces huge inequalities in the way people are treated, not only across illnesses, but also across provinces for the same illness. These long waits, and the extent of unequal treatment, have produced a regular stream of Canadians who come to the United States and spend their own money for medical care here, rather than await their fate at home. The waiting in Canada has gotten so bad that some provincial governments ship heart bypass patients and cancer patients needing radiation over the US border to receive treatment. Although this is politically unpopular with the Canadian federal government, the alternative, it seems, is to let the patients die at home waiting.

Another example of government-controlled health care involves the Netherlands. The government there decides on global budgets to control hospital expenditures. It also limits the number of doctors who may specialize in a give area and caps the number of patients they may see. In addition, the government controls physician fees. To help the government meet its budgets, many medical specialists have simply stopped working as much as they used to work. It is commonplace for highly trained surgeons to work only half days or to take weeks off at the end of the year. The result is that typically there is about a three-month waiting list for coronary bypass surgery. Over 15 percent of the patients on the waiting list die before the operation can be performed. Diabetics wait a average of three months to obtain laser treatment for retinal hemorrhaging-and risk blindness in the process. The average wait for removal of gallbladder stones and repairs

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of hernias is from four to eight weeks. Some forms of reconstructive surgery require waits of up to four years.

Under Dutch law, companies must pay employees’ salaries for the first two to six weeks of an illness, depending on the size of the company. This has generated an interesting incentive: The companies have discovered that they can reduce their costs by renting hospital rooms that they keep open for their employees. The companies thus do not have to pay employee salaries while they wait –disabled- for treatment. Although the Dutch system is supposed to provide equal treatment for all, treatment in fact has come to depend on the size and influence of the company for which a person works.

Although our analyses have involved three foreign countries, we need go no further than our own Veterans Administration (VA) to find similar examples. The Veterans Administration operated a 100 percent government-owned and financed health care system. It is the largest health care system in our country and one of the largest in the world. It has 163 medical centers with over 80,000 beds. It operates 362 outpatient and community clinics that receive 43 million patient visits a year. In addition, it has 137 nursing homes with over 87,000 patients. All of the states, plus the District of Columbia and Puerto Rico, have at least one VA medical center, and the VA boasts almost 250,000 employees nationwide.

The General Accounting Office (GAF) did a study of the VA a few years ago, concluding that the VA system faces a growing demand for “free” medical services. Herein lies the rub-the quantity demanded of most services at a zero price will almost always exceed the quantity supplied. Consequently, because price is not used as a rationing device, some other method must be used to ration the scarce resources. Fifty-five percent of the patients who use the VA for routing medical problems wait three hours or longer and sometimes an entire day in order to be seen for a few minutes by a VA general physician. Even among patients requiring urgent medical care, one in nine must wait at least three hours. Patients in need of specialized care cannot even be seen by a specialist for 60 to 90 days. They wait months more if surgery or other special procedures are required.

Whether the location is Britain, Canada, Holland, or even the US Veterans Administration, when prices are prevented from clearing the market for medical care, waiting time is the most commonly used means of rationing demand. As one unidentified US veteran told the GAO, “I pack a lunch and take a book.” Another veteran, retired 69 year old Army Major Elmer Erickson, stated, “Be prepared to spend the day there. You will eventually see a doctor.

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15 Foreign Investment in the United States

Introduction

In the short run, foreign capital invested in the United States raises U. S. gross domestic product (GDP). This means that U. S. residents are better off than they would be without foreign capital. Still, long-run scenarios of foreign ownership trouble many critics: What payment will foreigners exact for our use of their capital? Will sustained inflows of foreign capital give foreigners control of the U. S. capital stock, reduce job quality, or distort U. S. investment and research? Fortunately, these concerns can be dispelled by reviewing the extent of foreign investment in the U. S. economy vs. U. S. investment abroad, considering the motivations for foreign investment, and computing the negligible potential for foreign control.

Foreign Investment in the United States—how Much? Or What? By Whom?

Between 1982 and 1990 U. S. current account deficits—the amount by which imports of goods and services plus foreign aid exceeded U. S. exports of goods and services—totaled over $900 billion. The deficits were financed by net capital inflows—foreign investment in the United States less U. S. investment abroad. Although U. S. holdings of foreign assets rose, foreign holdings of U. S. assets rose by $900 billion more. U. S. assets abroad minus foreign assets in the United States went negative in 1985 for the first time since 1914.

These data, however, are based on historic cost, the cost at the time the investment was made. The proper measure of any investment is its current market value, not its historic cost. Recognizing this, the U. S. Commerce Department switched to market valuation in its June 1991 report. Measured by market values, the net foreign investment position of the United States remained positive until 1987, and reached minus $360.6 billion in 1990, about 40 percent smaller than the number computed on an historic cost basis.

At the end of 1990, about 16 percent of foreign assets in the United States were owned by foreign governments, while 84 percent were privately owned. (Similarly, 14 percent of foreign assets owned by the United States were official, and 86 percent were private.)

In contrast, as a share of total investment, U. S. direct investment abroad (comprising equity holdings of 10 percent or more of any firm) is substantially larger than foreign direct investment abroad still exceeded 1990, and by a wider margin than in 1985--$184 billion versus $152 billion.

Despite the notoriety of Japanese investors, the British have the largest U. S. direct investment holding—with the Dutch not far behind—as has been the case since colonial times. In 1990 the United Kingdom held about 27 percent of foreign direct investment in the United States, significantly greater than Japan’s 21 percent. The European Economic Community (EC) collectively holds about 57 percent. Moreover, according to research by Eric Rosengren, between 1978 and 1987, Japanese investors acquired only 94 U. S.

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companies, putting them fifth behind the British (640), Canadians (435), Germans (150), and French (113).

Why Do foreigners Invest in the United States?

With no restrictions on movements of labor or capital, each tends to flow to any host country where wages or returns are higher than at home. During the eighties laborers migrated to western Europe from eastern Europe, southern Europe, and Turkey, and to the Arab Gulf states from Africa and southern Asia because of higher wages. Capital migrated to the United States because of higher returns. The U. S. stock market’s annual appreciation of over 15 (not counting dividends) was exceeded among the major Western industrial countries only by the Japanese stock market’s rise of nearly 20 percent. In comparison, average stock market increases were 5 percent in Canada, about 11 percent in France 12 percent in Germany, 14 percent in Italy, and 12 percent in the United Kingdom.

Tax differences also influence international capital flows. Both defenders and critics of the Reagan administration’s 1981 tax cuts agree that they caused increased capital inflows during the eighties. Defenders argue that U. S. investments became more profitable after tax than non-U. S. investments, both to U. S. investors and to foreign investors, while critics argue that large federal deficits drew the capital inflows.

Consistent with the defenders’ view, U. S. investors were selling off foreign assets in the early eighties to finance domestic investment. U. S. direct investment abroad, valued at historic cost, declined from 1981 to 1984; in market value it declined during 1983 and 1984. Correspondingly, U. S. nonresidential fixed investment rose substantially in 1983 and 1984 and peaked in 1985, following publication of the U. S. Treasury’s tax reform proposals in the fall of 1984. In 1985 U. S. direct investment abroad began to rise again. Meanwhile, foreign investment in the United States grew somewhat faster in the early eighties than in the late eighties. Higher tax rates on capital gains became effective in 1986, and from the end of 1985, the rise in U. S. foreign direct investment has exceeded that of foreign direct investment in the United States. Moreover, the pattern of the rise and fall of the U. S. dollar—appreciating between 1980 and 1985 and depreciating from 1985 to 1987—i8s also consistent with the defenders’ view.

The United States attracts capital not only because of lower taxes, but also because of greater U. S. consumer wealth and labor productivity. At purchasing power parity—GDP adjusted for differences in exchange rates and prices—U. S. wealth (per capita GDP) was one-fourth greater than Japan’s in 1990 and one-third greater than Germany’s. Moreover, except for Japan the other main industrial countries did not narrow this margin between 1980 and 1990. On a production-per-employee basis, the message is the same: U. S. labor is the most productive in the world.

Is Foreign Investment Good or Bad?

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Foreign investment increases the amount of capital—equipment, buildings, land, patents, copyrights, trademarks, and goodwill—in the host economy. The increase in the quantity and quality of tools for labor’s use in converting one set of goods (labor and other inputs) into another (finished output) raises labor productivity and GDP. Because about two-thirds of GDP goes to labor as wages, salaries, and fringe benefits, rising output means higher wages or more employment. Thus, foreign investment raises labor productivity, income, and employment. Workers are better off with more capital than with less and are usually indifferent to the nationality of the investor.

Politicians generally overlook labor’s benign attitude toward foreign capital, sometimes at their peril. In the 1988 presidential campaign the Democratic candidate, Michael Dukakis, told a group of workers at a St. Louis automotive parts plant: “Maybe the Republican ticket wants our children to work for foreign owners…but that’s not the kind of a future Lloyd Bentsen and I and Dick Gephardt and you want for American.” Dukakis’s advance staff failed to tell him that the workers Dukakis was addressing had been employed by an Italian corporation for eleven years.

What Are the Long-Term Consequences of Foreign Investment in the United States?

The availability of foreign capital lowers the cost of capital to corporations. This makes additions to plant and equipment cheaper, permits some investment projects that otherwise would not be profitable, and raises the value of firms. Thus, even though most foreign capital inflows do not substantively alter the ownership of U. S. firms, they benefit asset owners as well as labor by lowering interest rates and the cost of capital.

Yet some critics, such as Martin and Susan Tolchin, warn of desperate long-run consequences from foreign capital even while conceding its short-run benefits. They worry about loss of skilled employment opportunities, loss of technological advantage, slower growth, and a declining standard of living. All of these worries are based on two implicit assumptions. First, they assume that foreigners will obtain control of the U. S. economy. Second, they assume that, unlike U. S. investors abroad, foreigners will use this control to systematically reduce the efficiency of the host economy. Both assumptions are false.

The probability of foreign investors obtaining control of the U. S. economy is negligible. Between 1982 and 1989, according to estimates by the U. S. Commerce Department, the U. S. stock of nonresidential capital rose from $5.9 trillion to $8.4 trillion. At the end of 1989, the U. S. net international investment position was estimated to be - $267.7 billion, or only 3.2 percent of this capital stock.

Even sustained net capital inflows of $100 billion per year, as happened during the mideighties, would not shift control of the U. S. capital stock to foreigners. At that rate foreign investors’ share of the fixed U. S. capital stock would rise to about 8.4 percent in the year 2000, but decline to 7.8 percent in 2010 and to 2.8 percent in 2020.

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The second concern is finessed by competitive forces in a market-based capitalist economy. If foreign owners of a U. S. firm reduced its efficiency by not using employees in the most advantageous way, the owners would lose wealth. They also would lose employees and, eventually, the firm. Labor, management, and technology would be hired away by other existing firms or by new firms eager to use them in the most profitable way feasible. The firm’s decline in market value—due to the inefficiency of its incumbent management—also would make it an attractive takeover target, as its price would be lower than its value under efficient resources utilization. Either way, foreign owners could not subjugate an industry through perverse management, even if they were willing to sacrifice profits to do so.

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15 Foreign Exchange Markets

Each country in the world has its own currency. When individuals or firms import a good or service they need to purchase the currency of the exporting country. Equally exporting firms generally expect to be paid in their own currency. In some cases exporting firms would prefer to be paid in a hard currency i.e. one that is generally acceptable world- wide. However, in most cases importing and exporting can only operate effectively if there is a system whereby countries can exchange currencies. The foreign exchange market enables this to happen. The foreign exchange market is made up of all the institutions that buy and sell foreign currencies. Indeed when you buy foreign currency prior to going on holiday at the bank you are involved in transactions on the foreign exchange market. Your bank must buy the currency of the country you are intending to visit at the relevant exchange rate. A currency’s exchange rate represents the value of a country’s currency expressed in terms of another country’s currency.

The rate at which a country’s currency can be exchanged for that of another country’s is a very important factor when considering the trading position of a country. There are two systems that can determine the value of a country’s currency:

A fixed exchange rate system where a country’s government determines the value.

A floating exchange rate regime where the value of the currency is determined by supply and demand for the foreign currency.

In addition there are a number of intermediate systems. For example, the exchange rates were allowed to float or be market determined between a ceiling and a floor.

Fixed Exchange Rates

With a fixed exchange rate system the government, often acting through its agent the Central Bank, fixes or pegs the value of the currency to another currency such as the US dollar. Official exchange rates are then usually quoted in terms of US dollars. It shows the value of US dollars in terms of another country’s currency and vice versa.

If the pegged value coincides with the equilibrium price for foreign exchange there is no need for the government to act. The problem arises when the foreign exchange market go into disequilibrium.

Where excess demand for foreign currency exists the central banks have three options open to them if the official exchange rate is to be maintained:

They can accommodate the shortage by using up reserves of foreign currency or borrowing foreign currency from overseas incurring foreign debt.

They can deal with the balance of payments deficit through reducing the demand for imports such as operating protectionist measures such as tariffs, quotas and licences.

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They can attempt to ration the amount of foreign exchange made available to those people they consider should have it through exchange controls.

Floating Exchange Rates

With a floating system the exchange rate between the local currency and a foreign currency is determined when the demand for and available supply of foreign currency is the same. When the economy is experiencing a balance of payments deficit and there is excess demand for the foreign currency the exchange rate of the local currency falls or depreciates. This may have the effect of automatically restoring equilibrium. In this case the foreign currency value of exports falls making them less attractive locally. Both could lead to an improvement in the balance of payments situation.

If however there is a balance of payments surplus and an excess supply of foreign currency the value of the local currency will rise, again restoring a balance in the foreign exchange market and the balance of payments.

Any changes in the conditions of demand and supply of foreign currency such as a change in the demand for imports and exports or change in capital flows, such as foreign direct investment from multinationals, will bring about a change in the market exchange rate.

If the demand for foreign currency increases, the demand curve for foreign currency shifts to the right from D1 to D2. The effect of this will be for the value of the foreign currency to appreciate.

Balance of payments deficits caused by increases in the demand for foreign currency or reductions in the available supply of it will always lead to a depreciation of the value.

Effects of a Floating Exchange Rate System

Arguments in favor of floating exchange rates

1. Balance of Payments on current account disequilibrium will automatically be restored to equilibrium.

Thus, in theory, governments need not worry about having to manage their balance of payments situation. If the exchange rate is allowed to fluctuate freely any disequilibrium will automatically be restored to equilibrium. The need to resort to overseas borrowing to finance balance of payments deficits is therefore less. The attention of government can then be focused on achieving other government objectives such as inflation, unemployment, economic growth and poverty reduction.

2. Reduces inflationary pressures and international uncompetitiveness

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One argument is that a floating exchange rate will reduce the level of inflation. Allowing the exchange rate to float freely should ensure that exports do not become uncompetitive. This is embodied in the Purchasing Power parity theory. A high rate of inflation would tend to make exports uncompetitive. Their demand would fall and the foreign exchange flowing into the country would also fall. The supply curve of available foreign currency would in turn shift to the left causing its value to increase. This would lower the price of exports making them more competitive.

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17 Equilibrium Analysis

In many aspects of economic analysis, we tend to assume that a condition of equilibrium exists with respect to key economic variables. Common examples include different models of market behavior known as Supply and Demand analysis.

In these models of the market, we define the behavior or sellers based on the goal of profit maximization in the production and/or sale of a particular good. Higher selling prices allow a trader/seller to reap a gain over and above the price initially paid for a final good or asset. In the case of business firms, the production of additional units of a particular good involve increasing opportunity costs in drawing resource inputs away from other productive uses. Higher prices are necessary to cover these increasing costs of production. Thus, these types of behaviors on the selling side of the market typically lead to a positive relationship between market price (the dependent variable) and quantity supplied (the independent variable).

Separately, we define the behavior of buyers based on the goal of maximizing the utility gained from the purchase and consumption of this same good. As prices fall, holding income constant, the buyer finds that his/her purchasing power has increased allowing for buying greater quantities of a particular good. It is also the case that, for the consumer, additional quantities of a good consumed provide less additional satisfaction relative to previous units consumed. This notion known as diminishing marginal utility implies that the consumer is willing to pay less for these additional units as it becomes more efficient to use his/her income for the purchase of other goods. For the buyer, these types of behaviors typically lead to a negative relationship between the market price (dependent variable) and quantity demanded (another independent variable).

These relationships are demonstrated numerically in the table and graphically in the diagram in Figure 1. Press any of the ‘Plot’ buttons.

Figure 1 – Supply and Demand

Market Quantity Quantity Surplus/Price Demanded Supplied Shortage

$8.00 6.0 16.0 - 10.0$7.00 9.0 14.0 - 5.0$6.00 12.0 12.0 0.0$5.00 15.0 10.0 5.0$4.00 18.0 8.0 10.0

In these models, we assume that one unique price exists such that the Quantity Supplied by sellers is exactly equal to the Quantity Demanded by buyers. This unique price P* is defined to be the equilibrium price.

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Figure 2 – A Simple Market Model

PriceSupply

AP*

DemandO Q* Q/time

The Supply and Demand framework represents an analytic tool that assists in the understanding of how markets operate. Each curve represents the separate behavior of the sellers (Supply) and the behavior of buyers (Demand) in a particular market.

This notion of Equilibrium tends to be a rather strong assumption in these economic models.

In the physical world we often observe equilibrium conditions or situations resulting from the influence of physical laws. For example: a piece of chalk resting on a table is in equilibrium. This situation is the result of the effects of gravity and the existence of a flat and level surface. Gravity helps to maintain and even restore this equilibrium condition if this position of rest is disturbed. In our market models, we need to ask is: where does the gravity come from to establish and maintain an equilibrium price? The answer is in the reaction of sellers and buyers to disturbances in the market.

For example, it could be the case that the market price has been forced above equilibrium such that supply decisions by Producers with respect to output exceed the amount demanded by consumers. In this case a surplus is the result. This surplus is often first recognized by the sellers through the accumulation of inventories.

These sellers would react by cutting the price of their product relative to competing sellers (price-cutting is how sellers compete) and by reducing the rate of production. [Press Price Adjustment] Buyers would react to the presence of lower prices by increasing their rate of consumption. This process would be expected to continue until the excess inventories have been eliminated.

If the market price differed from the equilibrium price such that the quantity demanded exceeded the quantity supplied, a different disequilibrium condition known as a shortage would result. Often, but not always, shortages are first recognized by buyers in the form of empty shelves, queuing, and general difficulty in making a desired purchase.

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These consumers react by bidding prices up in competition with other buyers (bidding is how buyers compete) much like an auction for a single piece of art. As these prices are bid upwards, some buyers drop out of the market reducing the overall rate of consumption. [Press Price Adjustment] Sellers react to the presence of higher prices by allocating resource inputs from other uses towards production of this particular good.

Thus in our models of the market place. Competition provides the gravity to maintain or restore the equilibrium price. if surpluses exist, competition among sellers force prices downwards. If shortages exist, competition among buyers force prices upwards.

In typical market models surpluses are the result of market prices exceeding the equilibrium prices such that price-cutting behavior helps restore this equilibrium price. shortages are the result of market prices taking values below the equilibrium price such that bidding restores the equilibrium price.

In reality, surpluses and shortages are caused by changes or shifts in either the demand or supply functions. These shifts are the result of shocks to other (exogenous) variables that affect supply decisions by producers or demand decisions by consumers. Typically, outward shifts in demand will lead to an increase n both the equilibrium price and quantity due to movement along an upward sloping supply curve. Inward shifts of demand will have the opposite effect (a decrease in equilibrium quantity and price). outward shifts in supply (along a downward sloping demand curve)will lead to an increase in equilibrium quantity and a reduction in equilibrium price.

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18 How Tariffs Effect The Economy

The upcoming book Advanced International Trade: Theory and Evidence by Robert Feenstra gives three situations in which governments often impose tariffs:

To protect fledgling domestic industries from foreign competition. To protect aging and inefficient domestic industries from foreign competition. To protect domestic producers from dumping by foreign companies or

governments.Dumping occurs when a foreign company charges a price in the domestic market which is “too low”. In most instances “too low” is generally understood to be a price which is lower in a foreign market than the price in the domestic market. In other instances “too low” means a price which is below cost, so the producer is losing money.

The cost of tariffs to the economy is not trivial. The World Bank estimates that if all barriers to trade such as tariffs were eliminated, the global economy would expand by 830 billion dollars by 2015. The economic effect of tariffs can be broken down into two components:

The impact to the country which has a tariff imposed on it. The impact to the country imposing the tariff.

In almost all instances the tariff causes a net loss to the economi8es of both the country imposing the tariff and the country the tariff is imposed on.

Impact to the economy of a country with the tariff imposed on it.

It is easy to see why a foreign tariff hurts the economy of a country. A foreign tariff raises the costs of domestic producers, which causes them to sell less in those foreign markets. Producers cut production due to this reduction in demand, which causes jobs to be lost. These job losses impact other industries as the demand for consumer products decreases because of the reduced employment level. Foreign tariffs, along with other forms of market restrictions, cause a decline in the economic health of a nation.

The Effect of Tariffs on the Country Imposing Them

Except in all but the rarest of instances, tariffs hurt the country that imposes them, as their costs outweigh their benefits. Tariffs are a boon to domestic producers who now face reduced competition in their home market. The reduced competition causes prices to rise. The sales of domestic producers should also rise, all else being equal. The increased production and price causes domestic producers to hire more workers which causes consumer spending to rise. The tariffs also increase government revenues that can be used to the benefit of the economy.

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There are costs to tariffs, however. Now the price of the good with the tariff has increased, the consumer is forced to either buy less of this good or less of some other good. The price increase can be thought of as a reduction in consumer income.

Generally the benefit caused by the increased domestic production in the tariff protected industry plus the increased government revenues does not offset the losses the increased prices cause consumers and the costs of imposing and collecting the tariff. We haven’t even considered the possibility that other countries might put tariffs on our goods in retaliation, which we know would be costly to us. Even if they do not, the tariff is still costly to the economy. Tariffs cause consumers to alter their behavior which in turn causes the economy to be less efficient. Adam smith’s The Wealth of Nations showed how international trade increases the wealth of an economy. Any mechanism designed to slow international trade will have the effect of reducing economic growth. For these reasons economic theory teaches us that tariffs will be harmful to the country imposing them.

That’s how it should work in theory. How does it work in practice?

Empirical Evidence on the Effect of Tariffs on the Country Imposing Them

Study after study has shown that tariffs cause reduced economic growth to the country imposing them. A few of examples:

1. The essay on Free Trade at The Concise Encyclopedia of Economics looks at the issue of international trade policy. In the essay, Alan Blinder states that “one study estimated that in 1984 U. S. consumers paid $42,000 annually for each textile job that was preserved by import quotas, a sum that greatly exceeded the average earnings of a textile worker. That same study estimated that restricting foreign imports cost $105,000 annually for each automobile worker’s job that was saved, $420,000 for each job in TV manufacturing, and $750,000 for every job saved in the steel industry.”

2. In the year 2000 president Bush raised tariffs on imported steel goods between 8 and 30 percent. The Machinac Center for Public Policy cities a study which indicates that the tariff will reduce U. S. national income by between 0.5 to 1.4 billion dollars. The study estimates that less than 10,000 jobs in the steel industry will be saved by the measure at a cost of over $400,000 per job saved. For every job saved by this measure, 8 will be lost.

3. The cost of protecting these jobs is not unique to the steel industry or to the United States. The National Center For Policy Analysi8s estimates that in 1994 tariffs cost the U. S. economy 32.3 billion dollars or $170,000 for every job saved. Tariffs in Europe cost European consumers $70,000 per job saved while Japanese consumers lost $600,000 per job saved through Japanese tariffs.

These studies, like many others, indicate that tariffs do more harm than good. If these tariffs are so bad for the economy, why do governments keep enacting them?

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If Tariffs Are Bad For The Economy, Who Do We Have Them?

Study after study has shown that tariffs, whether they be one tariff or hundreds, are bad for the economy. If tariffs do not help the economy, why would a politician enact one. After all politicians are reelected at a greater rate when the economy is doing well, so you would think it would be in their self interest to prevent tariffs.

Recall that tariffs are not harmful for everyone, and they have a distributive effect. Some people and industries gain when the tariff is enacted and others lose. The way gains and losses are distributed is absolutely crucial in understanding why tariffs along with many other policies are enacted. To understand the logic behind the policies we need to understand The Logic of Collective Action. My article titled The Logic of Collective Action discusses the ideas of a book by the same name, written by Mancur Olson in 1965.

Olson explains why economic policies are often to the benefit of smaller groups at the expense of larger ones. Take the example of tariffs placed on imported Canadian softwood lumber. We’ll suppose the measure saves 5,000 jobs, at the cost of $200,000 per job, or a cost of 1 billion dollars to the economy. This cost is distributed through the economy and represents just a few dollars to every person living in America. It is obvious to see that it’s not worth the time and effort for any American to educate himself about the issue, solicit donations for the cause and lobby congress to gain a few dollars. However, the benefit to the American softwood lumber industry is quite large. The ten-thousand lumber workers will lobby congress to protect their jobs along with the lumber companies that will gain hundreds of thousands of dollars by having the measure enacted. Since the people who gain from the measure have an incentive to lobby for the measure, while the people who lose have no incentive to spend the time and money to lobby against the issue, the tariff will be passed although it may, in total, have negative consequences for the economy.

The gains from tariff policies are a lot more visible than the losses. You can see the sawmills which would be closed down if the industry is not protected by tariffs. You can meet the workers whose jobs will be lost if tariffs are not enacted by the government. Since the costs of the policies are distributed far and wide, you cannot put a face on the cost of a poor economic policy. Although 8 workers might lose their job for every job saved by a softwood lumber tariff, you will never meet one of these workers, because it is impossible to pinpoint exactly which workers would have been able to keep their jobs if the tariff was not enacted. If a worker loses his job because the performance of the economy is poor, you cannot say if a reduction in lumber tariffs would have saved his job. The nightly news would show a picture of a California farm worker and state that he lost his job because of tariffs designed to help the lumber industry in Maine. The link between the two is impossible to see. The link between lumber workers and lumber tariffs is much more visible and thus will garner much more attention.

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The gains from a tariff are clearly visible but the costs are hidden, it will often appear that tariffs do not have a cost. By understanding this we can understand why so many government policies are enacted which harm the economy.

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19 Protectionism

The fact that trade protections hurts the economy of the country that imposes it is one of the oldest but still most startling insights economics has to offer. The idea dates back to the origin of economic science itself. Adam Smith’s The Wealth of Nations, which gave birth to economics, already contained the argument for free trade: by specializing in production instead of producing everything, each nation would profit from free trade. In international economics it is the direct counterpart to the proposition that people within a national economy will all be better off if all people specialize at what they do best instead of trying to be self-sufficient.

It is important to distinguish between the case for free trade for oneself and the case for free trade to improve one nation’s own welfare (the so-called “national-efficiency” argument). The latter is an argument for free trade to improve every trading country’s welfare (the so-called “cosmopolitan efficiency” argument). Underlying both cases is the assumption that price are determined by free markets. But government may distort market prices by, for example, subsidizing production, as European governments have done in aerospace, electronics, and steel in recent years, and as all industrial countries do in agriculture. Or governments may protect intellectual property inadequately, causing underproduction of new knowledge. In such cases production and trade, guided by distorted prices, will not be efficient.

The cosmopolitan-efficiency case for free trade is relevant to questions such as the design of international trade regimes. For example, the General Agreement on Tariffs and Trade oversees world trade among member nations, just as the International Monetary Fund oversees international macroeconomics and exchange rates. The national efficiency case for fee trade concerns national trade policies; it is, in fact, Adam Smith’s case for free trade. Economists typically have the national efficiency case in mind when they talk of the advantage of free trade and of the folly of protectionism.

This case, as refined greatly by economists in the postwar period, admits two theoretical possibilities in which protection could improve a nation’s economic wellbeing. First, as Adam Smith himself noted, a country might be able to use the threat of protection to get other countries to reduce their protection against its exports. Thus, threatened protection could be a tool to pry open foreign markets, like oysters, with a “strong clasp knife,” as Lord Randolph Churchill put it in the late nineteenth century. If the protectionist threat worked, then the country using it would gain doubly: from its own free trade and from its trading partners’ free trade as well. However, both Smith and later economists in Britain feared that such threats would not work. They feared that the protection imposed as a threat would be permanent and that the threat would not lower the other countries’ trade barriers.

The trade policy of the US today is premised on a different assessment: that indeed US markets can, and should, be closed as a means of opening new markets abroad. This premise underlies sections 301 through 310 of the 1988 Omnibus Trade and

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Competitiveness Act. These provisions permit, and sometimes even require, the US government to force other countries into accepting new trade obligations by threatening tariff retaliation if they do not. But those “trade obligations: do not always entail freer trade. They can, for instance, take the form of voluntary quotas on exports of certain goods to the US. Thus, they may simply force weak nations to redirect their trade in ways that strong nations desire, cutting away at the principle that trade should be guided by market prices.

The second exception in which protection could improve a nation’s economic well-being is when a country has monopoly power over a good. Since the time of John Stuart Mill, economists have argued that a country that produces a large percentage of the world’s output of a good can use an “optimum” tariff to take advantage of its latent monopoly power and, thus, gain more from trade. This is, of course, the same as saying that a monopolist will maximize his profits by raising his price and reducing his output.

Two objections to this second argument immediately come to mine. First, with rare exceptions such as OPEC, few countries seem to have significant monopoly power in enough goods to make this an important, practical exception to the rule of free trade. Second, other countries might retaliate against the optimum tariff. Therefore, the likelihood of successful (i.e., welfare-increasing) exploitation of monopoly power becomes quite dubious. Several economists have recently made their academic reputations by finding theoretical cases in which oligopolistic markets enable governments to use import tariffs to improve national welfare, but even these researchers have advised strongly against protectionist policies.

One may well think that any market failure could be a reason for protection. Economist did fall into this trap until the fifties. Economists now argue, instead, that protection would be an inappropriate way to correct for most market failures. For example, if wages do not adjust quickly enough when demand for an industry’s product falls, as was the case with US autoworkers losing out to foreign competition, the appropriate government intervention, if any, should be in the labor market, directly aimed at the source of the problem. Protection would be, at best, an inefficient way of correcting for the market failure.

Many economists also believe that even if protection were appropriate in theory, it would be “captured” in practice by special interests who would misuse it to pursue their special interests who would misuse it to pursue their own interests instead of letting it be used for the national interest. One clear cost of protection is that the country imposing it forces its consumers to forgo cheap imports. But another important cost of protection may well be the lobbying costs incurred by those seeking protection. These lobbying activities, now extensively studied by economist, are variously described as rent-seeking or directly unproductive profit-seeking activities. They are unproductive because they produce profit or income for those who lobby without creating valuable output for the rest of society.

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Protectionism arises in ingenious ways. As free trade advocates squelch it in one place, it ops up in another. Protectionist seem to always be one step ahead of free traders in creating new ways to protect against foreign competitors.

One way is by replacing restrictions on imports with what are euphemistically called “voluntary” export restrictions (VERs) or “orderly” market arrangements (OMAs). Instead of the importing country restricting imports with quotas or tariffs, the exporting country restricts exports. The protectionist effect is still the same. The real difference, which makes exporting nations prefer restrictions on exports to restrictions on imports, is that the VERs enable the exporters to charge higher prices and thus collect for themselves the higher prices caused by protection.

That has been the case with Japan’s voluntary quotas on exports of cars to the US. The US could have kept Japanese car imports in check by slapping a tariff on them. That would raise the price, so that consumers would buy fewer. Instead, Japan limits the number of cars shipped to the US. Since supply is lower than it would be in the absence of the quotas, Japanese auto producers to find the funds to make investments that made them yet more competitive!

The growth of VERs in the eighties is a disturbing development for a second reason as well. They selectively target suppliers (in this case Japan) instead of letting the market decide who will lose when trade must be restricted. As an alternative, the US could have provided just as much protection for domestic automakers by putting a quota or tariff on all foreign cars, letting consumers decide whether they wanted to buy fewer Japanese cars or fewer European ones. With VERs, in other words, politics replaces economic efficiency as the criterion determining who trades what.

Protectionism recently has come in another, more insidious form than VERs. Economists call the new form “administered protection.” Nearly all industrialized countries today have what are called “fair trade” laws. The stated purpose of these laws is twofold: to ensure that foreign nations do not subsidize exports (which would distort market incentives and hence destroy efficient allocation of activity among the world’s nations) and to guarantee predatory fashion. Nations, therefore, provide for procedures under which, when subsidization or dumping is found to occur, a countervailing duty (CVD) against foreign subsidy or an antidumping (AD) duty can be levied. These two “fair trade” mechanisms are meant to complement free trade.

In practice, however, when protectionist pressures rise, “fair trade” is misused to work against free trade. Thus, CVD and AD actions often are started against successful foreign firms simply to harass them and coerce them into accepting VERs. Practices which are thoroughly normal at home are proscribed as predatory when foreign firms engage in them. As one trade analyst put it, “If the same anti-dumping laws applied to US companies, every after Christmas sale in the country would be banned.”

Much economic analysis shows that in the eighties “fair trade” mechanisms turned increasingly into protectionist instruments used unfairly against foreign competition. US

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rice producers got a countervailing duty imposed on rice from Thailand, for example, by establishing that the Thai government was subsidizing rice exports by less than 1 percent-and ignoring the fact that Thailand also slapped a 5 percent tax on exports. We usually think a foreign firm is dumping when it sells at a lower price in our market than in its own. But the US government took an antidumping action against Poland’s exports of golf carts even though no golf carts were sold in Poland.

Therefore, economists have thought increasingly about how these “fair trade” mechanisms can be redesigned so as to insulate them from being “captured” and misused by special interest. Ideas include the creation of binational, as against purely national, adjudication procedures that would ensure greater impartiality, as in the US-Canada Free Trade Agreement. Also, greater use of GATT dispute settlement procedures, and readier acceptance of their outcomes, has been recommended.

Increasingly, domestic producers have labeled as “unfair trade” a variety of foreign policies and institutions. Thus, those who find Japanese commercial success hard to take have objected to its retail distribution system, its spending on infrastructure, and even its work habits. Opponents of the US-Mexico Free Trade Agreement have claimed that free trade between the two nations cannot be undertaken because of differences in Mexico’s environmental and labor standards. The litany of objections to gainful, free trade from these alleged sources of “unfair trade” (or its evocative synonym, “the absence of level playing fields”) is endless. Here lies a new and powerful source of attack on the principles of free trade.

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20 The $750,000 Steelworker

In even-numbered years, particularly years evenly divisible by 4, politicians are apt to give speeches about the need to protect U. S. jobs from the evils of foreign competition. We are thus encouraged to buy American. If further encouragement is needed, we are told that if we do not voluntarily reduce the amount of imported goods we purchase, the government will impose (or make more onerous) either tariffs (taxes) or imported goods or quotas (quantity restrictions) that physically limit imports. The objective is to save U. S. jobs.

Unlike black rhinos or blue whales, U. S. jobs are in no danger of becoming extinct. There are an infinite number of potential jobs in the American economy, and there always will be. Some of these jobs are not very pleasant, and many others do not pay very well, but there will always be employment of some sort as long as there is scarcity. Thus when a steelworker making $72,000 per year says that imports of foreign steel should be reduced to save his job, what he really means is this: He wants to be protected from competition so he can continue his present employment at the same or higher salary rather than move to a different employment that has less desirable working conditions or pays a lower salary. There is nothing wrong with the steelworker’s goal (better working conditions and higher pay), but it has nothing to do with saving jobs.

In any discussion of the consequences of restrictions on international trade, it is essential to remember two facts. First, we pay for imports with exports. It is true that in the short run, we can sell off assets or borrow from abroad if we happen to import more goods and services than we export. But we have only a finite amount of assets to sell, and foreigners do not want to wait forever before we pay our bills. Ultimately, our accounts can be settled only if we provide (export) goods and services to the trading partners from whom we purchase (import) goods and services. Trade, after all, involves quid pro quo (literally, something for something). The second point to remember is that voluntary trade is mutually beneficial to the trading partners. If we restrict international trade, we reduce those benefits, both for our trading partners and for ourselves. One way these reduced benefits are manifested is in the form of curtailed employment opportunities for workers. In a nutshell, even though tariffs and quotas enhance job opportunities in import-competing industries, they also cost us jobs in export industries; the net effect seems to be reduced employment overall.

What is true for the United States is also true for other countries: They will buy our goods only if they can market theirs, because they too have to export goods to payfor their imports. Thus any U. S. restrictions on imports—via tariffs, quotas, or other means—ultimately cause a reduction in our exports, because other countries will be unable to pay for our goods. Hence import restrictions must inevitably decrease the size of our export sector. So imposing trade restrictions to save jobs in import-competing industries has the effect of costing jobs in export industries.

Import restrictions also impose costs on U. S. consumers. By reducing competition from abroad, quotas, tariffs, and other trade restraints push up the prices of foreign goods and enable U. S. producers to hike their own prices. Perhaps the best-documented example of this is the automobile industry.

Due in part to the enhanced quality of imported cars, sales of domestically produced automobiles fell from 9 million units in 1978 to an average of 6 million units

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per year between 1980 and 1982. Profits for U. S. automobile manufacturers plummeted as well, turning into substantial losses for some of them .U. S. automakers and autoworkers’ unions demanded protection from import competition. They were joined in their cries by politicians from automobile-producing states. The result was a voluntary agreement by Japanese car companies (the most important competitors of U. S. firms) that restricted U. S. sales of Japanese cars to 1.68 million units per year. This agreement—which amounted to a quota even though it never officially bore that name—began in April 1981 and continued into the 1990s in various forms.

Robert W. Crandall, an economist with the Brookings Institution, has estimated how much this voluntary trade restriction has cost U. S. consumers in terms of higher care prices. According to his estimates, the reduced supply of Japanese cars pushed their prices up by $1,600 apiece, measured in 2005 dollars. The higher price of Japanese imports in turn enabled domestic producers to hike their prices an average of $640 per car. The total tab in the first full year of the program was about $7 billion. Crandall also estimated the number of jobs in automobile-related industries that were saved by the voluntary import restrictions at about 26,000. Dividing $7 billion by 26,000 jobs yields a cost to consumers of about $275,0000 per year for every jot saved in the automobile industry. U. S. consumers could have saved over $2 billion on their car purchases each year if instead of implicitly agreeing to import restrictions, they had simply given $75,000 to every autoworker whose job was preserved by the voluntary import restraints.

The same types of calculations have been made for other industries. Tariffs in the apparel industry were increased between 1977 and 1981, saving the jobs of about 116,000 U. S. apparel workers at a cost of $45,000 per job each year. At about the same time, the producers of citizens ban radios also managed to get tariffs raised. Approximately six hundred workers in the industry kept their jobs as a result, at an annual cost to consumers of over $85,000 per job.

The cost of protectionism has been even higher in other industries. Jobs preserved in the glassware industry due to trade restrictions cost $200,000 apiece each year. In the maritime industry, the yearly cost of trade protection is $270,000 per job. In the steel industry, the cost of preserving a job has been estimated at an astounding $750,000 per year. If free trade were permitted, each worker losing a job could be given a cash payment of half that amount each year, and consumers would still save a lot of money.

Even so, this is not the full story. None of these studies estimating the cost to consumers of saving jobs in import-competing industries have attempted to estimate the ultimate impact of import restrictions on the flow of exports, the number of jobs lost in the export sector, and thus the total number of jobs gained or lost.

When imports to the United States are restricted, our trading partners can afford to buy less of what we produce. The resulting decline in export sales means fewer jobs in exporting industries. And the total reduction in trade leads to fewer jobs in exporting industries. And the total reduction in trade leads to fewer jobs for workers such as stevedores (who unload ships) and truck drivers (who carry goods to and from ports). On both counts—the overall cut in trade and the accompanying decline in exports—protectionism leads to job losses that might not be obvious immediately.

Several years ago, Congress tried to pass a domestic content bill for automobiles. In effect, the legislation would have required that cars sold in the United States have a minimum percentage of their components manufactured and assembled in this country.

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Proponents of the legislation argued that it would have protected three hundred thousand jobs in the U. S. automobile manufacturing and auto parts supply industries. Yet the legislation’s supporters failed to recognize the negative impact of the bill on trade in general and its ultimate impact on U. S. export industries. A U. S. Department of Labor study did recognize these impacts, estimating that the domestic content legislation would actually cost more jobs in trade-related and export industries than it protected in import-competing businesses. Congress ultimately decided not to impose a domestic content requirement for cars sold in the United States.

More recently, when President Bush decided in 2002 to impose tariffs of up to 30 percent on steel imports, the adverse effects on the economy were substantial and soon apparent. To take but one example, prior to the tariffs, the Port of New Orleans relied on steel imports for more than 40 percent of its revenues, in part because once steel coming into the port is offloaded, the ships are cleaned and refilled with U. S. grain for export. By reducing imports, the tariffs slashed economic activity at the port and cut U. S. grain exports. Businesses and farms all up and down the Mississippi River were adversely affected. More broadly, the higher costs of imported steel produced a decline in employment in U. S. industries that use steel as an input. Indeed, one study estimated that due to the tariffs, some two hundred thousand people lost their jobs in 2002 in these industries alone—a number that exceeded the total number of people actually employed by the steel manufacturing firms protected by the tariff.

In principle, trade restrictions are imposed to provide economic help to specific industries and to increase employment in those industries. Ironically, the long-term effects may be just the opposite. Researchers at the World Trade Organization (WTO) examined employment in three industries that have been heavily protected throughout the world: textiles, clothing, and iron and steel. Despite stringent trade protection for these industries, employment declined during the period of protection, in some cases dramatically. In textiles, employment fell 22 percent in the United States and 46 percent in the European Union. The clothing industry had employment losses ranging form 18 percent in the United States to 56 percent in Sweden. Declines in employment in the iron and steel industry ranged anywhere from 10 percent in Canada to 54 percent in the United States. In short, restrictions on free trade are no guarantee against job losses, even in the industries supposedly being protected.

The evidence seems clear: The cost of protecting jobs in the short run is huge. And in the long run, it appears that jobs cannot be protected, especially if one considers all aspects of protectionism. Free trade is a tough platform on which to run for office. But it is the one that yields the most general benefits if implemented. Of course, this does not mean that politicians will embrace it, and so we end up “saving” jobs at a cost of $750,000 each.

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21 Economic Indicators

An economic indicator is simply any economic statistic, such as the unemployment rate, GDP, or the inflation rate, which indicate how well the economy is doing and how well the economy is going to do in the future. Investors use all the information at their disposal to make decisions. If a set of economic indicators suggest that the economy is going to do better or worse in the future than they had previously expected, they may decide to change their investing strategy.

To understand economic indicators, we must understand the ways in which economic indicators differ.

Relation to the Business Cycle/Economy

Economic Indicators can have one of three different relationships to the economy:

Procyclic: A procyclic (or procyclical) economic indicator is one that moves in the same direction as the economy. So if the economy is doing well, this number is usually increasing, whereas if we’re in a recession this indicator is decreasing. The Gross Domestic Product (GDP) is an example of a procyclic economic indicator.

Countercyclic: a countercyclic (or countercyclical) economic indicator is one that moves in the opposite direction as the economy. The unemployment rate gets larger as the economy gets worse so it is a countercyclic economic indicator

Acyclic: An acyclic economic indicator is one that has no relation to the health of the economy and is generally of little use. The number of home runs the Montreal Expos hit in a year generally has no relationship to the health of the economy, so we could say it is an acyclic economic indicator.

Frequency of the DataIn most countries GDP figures are released quarterly (every three months) while the unemployment rate is released monthly. Some economic indicators, such as the Dow Jones Index, are available immediately and change every minute.

Timing

Economic Indicators can be leading, lagging, or coincident which indicates the timing of their changes relative to how the economy as a whole changes.

Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

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Lagged: a lagged economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

In the next section we will look at some economic indicators distributed by the U. S. Government

Many different groups collect and publish economic indicators, but the most important American collection of economic indicators is published by The United States Congress. Their Economic Indicators are published monthly and are available for download in PDF and TEXT formats. The indicators fall into seven broad categories:

Total Output, Income, and SpendingEmployment, Unemployment, and WagesProduction and Business ActivityPricesMoney, Credit, and Security MarketsFederal FinanceInternational Statistics

Each of the statistics in these categories helps create a picture of the performance of the economy and how the economy is likely to do in the future

Total Output, Income and Spending

These tend to be the most broad measures of economic performance and include such statistics as:

Gross Domestic Product (GDP) [quarterly]Real GDP [quarterly]Implicit Price Deflator for GDP [quarterly]Business output [ quarterly]National Income [quarterly]Consumption Expenditure [quarterly]Corporate Profits [quarterly]Real Gross Private Domestic Investment [quarterly]

The Gross Domestic Product is used to measure economic activity and thus is both procyclical and a coincident economic indicator.

The Implicit Price Deflator is a measure of inflation. Inflation is procyclical as it tends to rise during booms and falls during periods of economic weakness. Measures of inflation

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are also coincident indicators. Consumption and consumer spending are also procyclical and coincident.

Employment, Unemployment, and WagesThese statistics cover how strong the labor market is and they include the following:

The Unemployment Rate [monthly]Level of Civilian Employment [monthly]Average Weekly Hours, Hourly Earnings, and Weekly Earnings [monthly]Labor Productivity [quarterly]

The unemployment rate is a lagged, countercyclical statistic. The level of civilian employment measures how many people are working so it is procyclic. Unlike the unemployment rate is a coincident economic indicator.

Production and Business Activity

These statistics cover how much businesses are producing and the level of new construction in the economy:

Industrial Production and Capacity Utilization [monthly]New Construction [monthly]New Private Housing and Vacancy Rates [monthly]Business Sales and Inventories [monthly]Manufacturers’ Shipments, Inventories, and Orders [monthly]

Changes in business inventories is an important leading economic indicator as they indicate changes in consumer demand. New construction including new home construction is another procyclical leading indicator which is watched closely by investors. A slowdown in the housing market during a boom often indicates that a recession is coming, whereas a rise in the new housing market during a recession usually means that there are better times ahead.

Prices

This category includes both the prices consumers pay as well as the prices businesses pay for raw materials and include:

Producer Prices [monthly]Consumer Prices [monthly]Prices Received and Paid By Farmers [monthly]

These measures are all measures of changes in the price level and thus measure inflation. Inflation is procycli8cal and a coincident economic indicator.

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22 Price as a Rationer

There have been many cases throughout history in which governments have been unwilling to let markets adjust to market-clearing prices. Instead, they have established either price ceilings, which are prices above which it is illegal to buy or sell, or price floors, which are prices below which it is illegal to buy or sell.

If a price ceiling is placed below the market-clearing equilibrium price becomes illegal. At the ceiling price, buyers want to buy more than sellers will make available. Because they cannot buy as much as they would like at the legal price, buyers will be out of equilibrium. The normal adjustment that this disequilibrium would set into motion in a free market, an increase in price, is illegal; and buyers or sellers or both will be penalized if transactions take place above the ceiling. Buyers are faced with the problem that they want to buy more than is available. This is a rationing problem.

Price ceilings are not the only sort of price controls governments have imposed. There have also been many laws that establish minimum prices, or price floors. At the price floor, buyers are in equilibrium, but sellers are not. They would like to sell a higher quantity, but buyers are only willing to take a lesser price. To prevent the adjustment process from causing prices to fall, government may buy the surplus, as the US government has done in agriculture and in precious metals. If it does not buy the surplus, government must penalize either buyers or sellers or both who transact below the price floor, or else price will fall. Because there is no one else to absorb the surplus, sellers will.

Rationing is necessary to deal with scarcity. When an item is scarce, people must sacrifice something in order to get as much of the item as they would like to have. There are some goods that are not scarce. Air is an example—it is free to all who want to breathe it. Ice is not scarce in Greenland. But almost all other goods are scarce. Price is a way to ration goods. It deprives those who do not have enough income or desire for a product. The function of price as a rationer is most clearly seen when price is prohibited from acting as a rationer, so that some other method of rationing (such as queuing or coupon rationing) must emerge or be developed.

Non-Price Rationing

Queuing is a commonly-used way to solve the rationing problem caused by price ceilings. A queue is a waiting line that solves the rationing problem by a “first com, first served” solution. Though price ceilings fix the monetary cost that buyers can pay so that buyer equilibrium cannot be restored by higher prices, they do not limit the monmonetary cost of waiting.

Under a system of queuing, waiting time changes to restore buyer equilibrium. A person who is willing to buy five items for $1.00 each with no waiting time may be unwilling to buy any if the price is $1.00 with a two-hour wait. Waiting time rises until enough

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buyers drop out of the market to restore the match between the amount available and the amount people are willing to buy.

Although queuing is a rarity in the US, it was part of daily life in Eastern Europe and the Soviet Union before 1990. Hedrick Smith explained:

“The only real taste of social shopping vigils in recent American history were the pre-dawn lines at service stations during the gasoline crisis in the winter of 1973-4… But it was temporary and only for one item. Imagine it across the board, all the time, and you realize that Soviet shopping is like a year round Christmas rush. The accepted norm is that the Soviet woman daily spends two hours in line, seven days a week…I noted in the Soviet press that Russians spend 30 billion man-hours in line annually to make purchases…30 billion man-hours alone is enough to keep 15 million workers busy year-round on a 40-hour week.

Smith noted that coping with shortages and queuing required a different approach to shopping than that with which Americans were familiar. People tended to carry large amounts of cash and a bag or briefcase whenever they went out, just in case they found some desirable good. When they saw a line, they joined it because there usually was something worthwhile at the front. People shopped not just for themselves but for friends and kin, and as a result “know by heart the shoe, bra, pant and dress size, waist and length measurements, color preferences and other vital particulars for a whole stable of their nearest and dearest…:

In another reading selection we noted that it was possible to explain the gasoline shortage and the resulting queuing in the early 1970s in terms of a good-versus-bad model, but that economists did not use this model. Rather, economists consider the shortages the direct result of price controls in existence at the time. A move by certain oil-producing nations caused the supply curve for gasoline to shift to the left. When US government price restrictions kept pump prices from rising to equilibrium, shortages resulted. These shortages were predictable because price is a rationing device in this model. In contrast, the only function of price in a good-versus-bad model is to take money from one group and give it to another.

A second system of non-price rationing is with coupons. In this system, the government distributes coupons that must be presented along with money in order to buy a product. Coupons restore buyer equilibrium because they change the cost of a product, though in a different way than queuing does. Under the system of queuing, the cost of a product is its price plus waiting time; under a system of coupon-rationing, the cost of a product is its price in money plus its price in coupons.

The existence of price ceilings is often accompanied by illegal transactions, or a black market. Black markets exist when people try to “beat the system,’ either the system of coupons or queuing. In an economy of free markets, there can be no black markets.

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23 Immigrants and Economic Growth

Nobody can deny that the United States is a land of immigrants. Should anyone try, simply point them in the direction of the Statue of Liberty, a gift from the citizens of France in recognition of America’s role as a haven for “tired…..poor….huddled masses yearning to breathe free.” Yet both before and after the statue’s 1886 dedication, the immigration that it celebrates has had a darker side, for not everyone who comes to the US does so legally. This nation has always had a flow of illegal undocumented aliens. Many of these individuals are tourists who overstay their visas and take jobs. Many are from Mexico and other Latin American countries. The US Census Bureau estimates that about 9 million illegal aliens now live in the US permanently, with another 500,000 arriving each year. But no one, not even the Census Bureau, knows for sure how many there are. Some observers argue that as many as 15 to 20 million illegal aliens may reside in the US, with a million or more coming in each year.

The Legislation of Immigration

Periodically, the federal government has attempted to reduce illegal immigration. The Immigration Reform and Control Act of 1986, for example, imposed severe penalties on employers who willfully hire illegal aliens (with fines ranging from $250 to $10,000 for each offense). Employers who repeatedly violate this law can be jailed for up to six months.The 1986 law also included an amnesty program. From the summer of 1987 to the summer of 1988, illegal aliens who could prove that they had been in this country continuously for at least five years could apply to obtain temporary legal residency status. Eighteen months later, they could apply for permanent residency. Eventually, they could apply for citizenship.The most recent legislation attempting to stem illegal immigration was the 1996 Immigration Reform Act, but immigration policy remains the focus of a continuing debate in the US, and there may be more legislation by the time you read this. Many Americans strongly believe that immigrants, especially illegal immigrants, take jobs that US citizens would other wise have and thereby lower Americans’ wages. These critics also fear that new waves of immigrants will have difficulty fitting in with present day society.Supporters of immigration point out the obvious: At one time or another, all of us were immigrants (even Native Americans, whose ancestors are believed to have come in over the Siberian land bridge many thousands of years ago). Immigration has made the US what it is today. Therefore, ask immigration advocates, how can we arbitrarily decide that immigration today is “bad for America”? Today, just as in 1886 and before, many new immigrants start on the first rung of the economic ladder by taking the low-paying jobs deemed least attractive by existing Americans. Moreover, now as before, most immigrants pay taxes and adjust rapidly to the requirements of life in their new country.

The Economics of Immigration

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From the point of view of a potential immigrant (or emigrant, as viewed from his or her country of origin), there is an implicit economic equation: Anyone who seeks to come to the US presumably believes that the economic benefits outweigh the economic costs. These costs are significant. They include the cost of travel, the cost of learning a new language if one does not already speak English, and the cost of giving up whatever degree of social and economic certainty in a new country. Many persons who attempt legal immigration encounter substantial bureaucratic hurdles and high legal costs. The expenses involved can loom particularly large when considered relative to income levels in the country of origin. Finally, of course, there is the often considerable noneconomic cost of leaving one’s family and friends for a faraway land.On the positive side, the expected economic benefits of immigration equal the net lifetime expected increasing income compared to what one could make in one’s country of origin. In addition, of course, there is the little matter of freedom, which we Americans take for granted but is often the beacon that burns brightest for the potential newcomer to our shores. Clearly, the continuing flow of immigration informs us that the benefits of emigrating to the US have outweighed the costs for literally millions of people from other countries. Whether the motive is economic or not for any given immigrant, the package offered by America has been sufficiently attractive that our reputation as the land of immigrants is amply justified.

The Link between Immigration and US economic Growth

Imagine you are doing a survey. You stop typical men and women in the street and ask the following question: If we admit more immigrants, will the US be better off, worse off, or about the same? Similar questions have been asked in numerous opinion polls. As you might expect, the majority of US residents today often answer that more immigration will make the US worse off. Their reasoning is simple: Most often, they argue that immigrants take jobs away from US residents. Moreover, they say, immigrants are a “drain on the system: in that they use government services without paying their fare share.The reality has been largely the opposite, though, even in recent decades when the debate over immigration has been so heated. From 1990 to 2006, some 16 million immigrants entered the US. Of those 16 million, about 11 million joined the labor force. Indeed, the Center for Labor Market Studies at Northeastern University discovered that during this time, over 50 percent of new wage earners who joined the labor force were immigrants. Even more striking, eight of ten new male workers during the 1990s were newly arrived immigrants. In contrast, during the 1980s, immigrants accounted for 25 percent of labor force growth, and during the 1970s they accounted for only 10 percent.Despite what the opponents of immigration would have you believe, this influx of newcomers was associated with more, not less, economic vitality. When we look at economic growth during the 1990s, we find that it averaged 3.2 percent per year, higher than in typical decade and higher than in the 1970s and 1980s, when growth averaged between 2.8 and 2.9 percent per year. Just as important, during the 1990s, immigrants prevented population loss in many cities and rural areas and reduced what would have been far greater losses in other areas of the country.

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Then there is the matter of innovation, one of the key drivers of economic growth over time. Recent studies have found that since the mid 1990s, some 25 percent of all technology and engineering startup companies in the US have been founded by immigrants. These companies employed 450,000 workers and generated over $50 billion in sales in 2005. Immigrants were also responsible for almost one of every four patent applications in the US. Newcomers from India were most likely to be involved in innovative activity, but immigrants from the United Kingdom, china, Taiwan, and Japan also played key roles. Had these individuals not come here, this innovation either wouldn’t have happened or would have happened elsewhere, and American firms and workers would be competing with it instead of using it.

The Advantages of Having So Many Immigrants

According to the Center for Labor Market Studies, the rate of US economic growth would have been lower in the 1990s and early 2000s had there not been so many immigrants. Moreover the authors of the study discovered the immigrants contribute more in taxes than they use in services. This pattern is particularly true for illegal immigrants, who are unable to avail themselves of any social services offered by local, state, or federal governments. Consequently, when they work, they typically pay taxes and receive few, if any, government services in return. Moreover, illegal immigrants are ineligible for Social Security and other benefits if they stay in the US.It is true that immigrants are more likely to collect cash and noncash welfare benefits than native residents of the US. Much of the difference in welfare receipt rates is attributable to two groups of immigrants: political refugees (as from the former Soviet Union) and immigrants who are very young or elderly. Receipt of Medicaid assistance and enrollment in subsidized school lunch programs, for example, are significantly higher among immigrants than among native residents. But as suggested by the employment figures noted earlier, most working age immigrants generally find employment quickly and contribute substantially to the nation’s economic well being. We also know from prior studies that immigrants lower the wages of existing workers only modestly, perhaps by 4 to 8 percent. They chiefly take unskilled, low paying jobs that existing Americans refuse to take at existing wages. This is precisely the pattern that has been observed at least since the early nineteenth century in America. This year’s wave of immigrants steps into the shoes of last year’s wave, who in turn move up to fill the shoes of those who came in the year before. It is a process that fuels economic growth and prosperity throughout the country.

Immigration after 9/11

Numerous press accounts have reported that US Immigration and Customs Enforcements has cracked down on both legal and illegal immigration into the Us since the terrorist attacks on September 11,2001. Nevertheless, according to the Center for Immigration Studies in Washington, D.D., the pace of immigration into the US has barely slowed. Indeed, the Census Bureau notes that since the census was taken in 2000, more than 3 million additional immigrants have arrived in the US.

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So it would appear that immigration, as always, is here to stay. As long as labor markets are free to adjust to changing conditions, this country can continue to absorb immigrants with few negative consequences. In fact, if what has happened since 1990 is any indication, more immigration will make the US better off, not worse off which is surely good news for current and prospective Americans alike.

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24 The Pseudo Economic Problems of Immigration

During the past five years more new immigrants came to the United States than ever before in our history—nearly 8 million, according to a new study by the Center for Immigration Studies. This influx has stirred much public debate. But before we adopt new policies, politicians need to distinguish clearly between the real problems caused by immigration and non-problems based on popular myths.

Probably the number one misconception about immigration is that it harms our economy. In reality, conservative estimates put the net gain to the U. S. economy from current immigration at about $20 billion. Instead of recognizing this overall gain, immigration critics typically claim that immigrants take away American jobs, depress wages and drain our tax dollars by consuming social services.

A fundamental truth about our economy is that as long as we desire more goods and services than we have, the number of jobs is practically unlimited. In fact, when we have more workers, we create more jobs. Total employment and the size of the labor force have tracked each other fairly closely over the past 50 years despite dramatic changes in immigration flows.

It’s a well-known fact that many of the jobs immigrants come here to fill are jobs Americans are not taking. And when we prevent immigrants from taking those jobs, American producers and consumers suffer the consequences. For example, due to labor shortages caused in part by increased border controls, only 30 percent of last fall’s lettuce crop in Arizona was harvested. Losses were nearly one billion dollars. There simply were not enough U. S. workers willing to pick the crops at prices that would have made it profitable.

Less well known is that many jobs immigrants take are jobs that would have otherwise been outsourced. Nearly one-third of U. S. garment workers are immigrants. Increasingly, we are turning to international trade to secure our clothing. If it were not for immigration we’d likely be importing even more clothing. Similarly, in high-skill occupations, such as software engineering, when companies are not allowed to bring immigrants to America, they send the job to the worker. Microsoft’s Bill Gates has said that eliminating caps on H1-B visas would encourage his company to outsource fewer jobs.

What about wages? Immigration increases the supply of domestic labor. Basic economic reasoning shows that when you increase the supply of any good, holding other things constant, its price should go down. However, immigration brings many secondary effects that offset the increased supply. Most immediately, when immigrants earn money, they demand goods and services. This increases the demand for labor, which in turn creates more jobs and pushes wages back up.

A less obvious, but no less important, consequence of immigration is that with a greater supply of labor, more goods and services are produced. This leads to lower prices, and an increase in the purchasing power of existing American wages. Finally, a larger labor

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force can raise the profitability of capital investment. If increased capital flows match the increased labor force, wages are not pushed down. Even Harvard economist George Borjas, a prominent critic of immigration, admits that if the capital stock increased enough to keep returns constant, immigration would not lower the earnings of natives on average.

The secondary consequences of immigration are born out in the professional economics literature. A comprehensive survey of the immigration literature, published in the Journal of Economi8c Perspectives reached the following conclusion: “Despite the popular belief that immigrants have a large adverse impact on the wages and employment opportunities of the native-born population, the literature on this question does not provide much support for the conclusion.”

The economic case for open immigration is not fundamentally different than the case for free trade or free capital mobility. Allowing goods and services, capital, and labor to flow freely allows them to be channeled to their most efficient uses and brings overall benefits to the domestic and world economies.

The objection that immigration costs tax dollars has some merit. Since many of the tax-funded services immigrants consume are funded at the local level and much of the taxes that immigrants pay goes to the federal government, immigration is a tax burden on some communities. This is fundamentally a problem of public policy, not economics. Policy reforms could fix this by decreasing the social services that immigrants and their children are eligible to consume.

We need not fear that immigrants will burden our economy, take more jobs than they create, or depress our wages. Quite the contrary, immigration brings economic benefits, so it should not be artificially limited. Current guest worker proposals by president Bush and the Senate do not go far enough. A truly beneficial reform would concentrate on creating an open immigration policy while dealing with real problems that increased immigration could bring. This would involve limiting entitlement spending and may require more restrictions on immigrants’ ability to eventually vote.

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25 Productivity and Economic Growth

Economists have estimated that over half of the increase in labor productivity growth in the US economy during the past decade can be attributed to the massive investment in the proliferation of information technology. But it was the globalization of IT hardware production that drove down price and enabled IT utilization to spread.

The Institute for International Economics’ Catherine Mann calculates that globalized production and trade reduced the cost of IT hardware by upwards of 30 percent. The result was higher productivity growth and an extra $230 billion in GDP. With IT software and services spending now twice that of IT hardware, analysts conclude that a “second wave” of productivity growth is underway in the US. Like IT hardware in the last decade, globalization of IT software and services will fuel this trend by making IT more affordable and consequently more widespread.

For much of the 1990s economist fretted that a heated economy could spark inflation. However, it is now generally recognized that the US was able to enjoy strong, sustained economic growth in the ‘90s without serious inflation because productivity kept a lid on it Global Insight, Inc. estimates that increasing IT offshoring during the 1990s resulted in a 0.6 percent reduction in the overall price level by 2003. GII expects the price level to be 2.3 percent lower by 2008 due to IT offshoring than it otherwise would be.

For example, upward spiraling health care costs continue to place mounting stress on employee and employer alike (as well as the taxpayer). Further diffusion of IT into the health sector-where it has lagged in comparison to other sectors-would help put downward pressure on prices. Direct importation of health care services would help keep costs in check. Pharmaceuticals could offshore portions of their R&D to more economical locations abroad or X-rays could be simply transmitted via broadband to well-trained radiologists in India to read.

Increasing labor productivity, falling inflation, rising spending, and growing exports induced by the continued globalization of services add up to a stronger, more vibrant economy. As this globalization of services gains steam the economic benefits will grow and multiply. Global Insight forecasts an additional $124.2 billion in US GDP by 2008 from IT software and services offshoring alone. Incremental wage gains adjusted for inflation would reach 0.44 percent.

Deloitte Research’s Carl Steidtmann accurately sums it all up:

The benefit of importing services is the same benefit that comes from importing goods. The most important benefit is an improvement in productivity. The buyer is able to get more for less. Increased trade also forces domestic producers to be more productive in order to remain competitive. Improving productivity raises the standard of living, puts downward pressure on prices and gives a boost to profitability and wages.

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Jobs

The media have been erroneously fixated on the projected gross loss of jobs due to services importation. Yet, it is simply impossible to obtain an accurate picture of the situation without examining the net effect of offshoring. Global Insight, Inc. estimates that because of IT software and services offshoring, 193,000 new jobs were created by 2003-for a net increase of over 90,000 jobs. Going forward, GII estimates that 589,000 jobs will be created, for a net gain of 317,000 by 2008.

There has been quite a fuss over the prospect of America “losing” white-collar IT jobs. However, Catherine Mann’s review of the Bureau of Labor Statistics’ prognostication for future job trends shows that this hand wringing is unfounded. BLS forecasts that 10 of the 20 top occupations in terms of future growth require IT skills. Of the 10 job categories projected to realize the largest growth, three are computer-related occupations (computer support specialists, computer software applications engineers, and computer software systems engineers). Mann writes, “Considering all occupations projected to 2010 by BLS, 13 percent of the total number of jobs created in the economy will be IT-related, and the growth in these occupations will be 43 percent, compared with an economy-wide job growth rate of 13 percent.” It is certainly worth mentioning that many of the jobs not projected to see expansion-bank tellers, switchboard operators, and telephone operators-will be casualties of technology and automation rather than offshoring. And, these are not exactly high-paying, high-skill jobs to begin with.

But the benefits of services importation also accrue to occupations not commonly thought of as IT-intensive. Further diffusion of IT is the economy (spurred on by offshoring0 will propagate job growth in other sectors not commonly associated with IT, such as the previously discussed health care field. Traditionally non-IT sectors such as education, transportation, construction, utilities, financial services, and retail and wholesale trade are all expected to realize net job growth. And, many of the jobs in these sectors will demand IT skills. As companies across all sectors of the economy integrated IT into their businesses during the 1990s, jobs requiring IT skill increased at a rate of 200 percent-twice that of the economy as a whole. This trend will continue.

Indeed, there will be those that suffer the loss of their jobs. However, the United States has the highest rate of reemployment in the developed world—nearly twice that of the next highest country—despite having the least stringent job protection laws. It is in fact this flexibility in the labor market, combined with our more entrepreneurial economy, that makes such reemployment possible.

Using BLS data from 1979-1999, the McKinsey Global Institute calculated that almost 70 percent of US workers who lost jobs due to trade were reemployed. Of these reemployed workers, the average wage recapture was 96.2 percent. Given that service workers tend to be reemployed faster than manufacturing workers, rising service importations should not disturb these trends.

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Moreover, trade-induced redeployment of labor creates a sizeable amount of extra value for the economy. MGI reports that, “Far from being bad for the US, offshoring creates net additional value for the US economy that did not exist before, a full 12-14 cents on every dollar offshored. Indeed, of the full $1.45 to $1.47 of value created globally from offshoring $1.00 of US labor cost, the US captures $1.12 to $1.14, while the receiving country captures, on average, just 33 cents.”

During a recent online chat set up by The Washington Post, Marc Andreessen, co-founder of Netscape Communications and now Chairman of the Silicon Valle-based software company Opsware, offered insight into how this value recapture works to our benefit. Andreessen acknowledged that it has become common for companies to relocate portions of their tech operation offshore to save on costs. However, he notes that these companies “are taking many of the dollars that (offshoring) frees up and spending them on new development projects, including hiring new developer, often in the US.

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26 Outsourcing and Economic Growth

One Prominent business commentator keeps a “hit list” of corporations that send jobs overseas. Such actions are decidedly un-American, he opines, whenever he gets a chance to express his views against outsourcing. The 2004 Democratic presidential nominee had a name for heads of companies that outsourced telemarketing projects, customer services, and other white-collar jobs to foreign countries: He called them “Benedict Arnold CEO’s”.

Congress recently tried to pass a bill to prevent any type of outsourcing by the Department of State and the Department of Defense. Republican representative Don Manzullo of Illinois said, “You can’t just continue to outsource overseas time after time after time, lose your strategic military base, and then expect this Congress to sit back and see the jobs lost and do nothing.” When an adviser to President George W. Bush publicly stated that the foreign outsourcing of service jobs was not such a bad idea, numerous politicians lambasted him for even the suggestion that outsourcing could be viewed in a positive light.

What Is This “Outsourcing”?

The concept of outsourcing is straightforward: Instead of hiring American workers at home, American corporations hire foreign workers to do the same jobs. As just one example, some these foreign workers are in India and they do call center work, answering technical questions for computer purchasers. Another job such workers do well (and cheaply) is software development and debugging. Because of low cost communication, especially over the Internet, software programmers can be just about anywhere in the world and still work for US corporations.Besides the fear that outsourcing “robs Americans of jobs,” there is also a claim that outsourcing reduces economic growth in the US. (Presumably, that must mean that it increases economic growth in, say, India.) Because outsourcing is part and parcel of international trade in goods and services, the real question becomes, can the US have higher growth rates if it restricts American corporations from “sending jobs abroad”?As we set out to answer this question, we must keep on simple fact in mind: Outsourcing is nothing more or less than the purchase of labor services from the residents of a foreign nation. When the Detroit Red Wings host the Vancouver Canucks, fans at the game are outsourcing. They are purchasing labor services from Canadians. In this sense, Canadian hockey players are no different from Indian Software engineers; they are citizens of foreign nations who are competing with citizens of the US in the supply of labor services. Just as important, outsourcing is no different from any other form of international trade.

The Link between Economic Growth and Outsourcing

International trade has been around for thousands of years. The means that the concept of outsourcing is certainly not new, even though the term seems to be. After all, the exchange of services between countries is a part of international trade. In any event, if we decide to restrict this type of international trade in services, we will be restricting

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international trade in general. Experts who study economic growth today have found that the openness of an economy is a key determinant of its rate of economic growth. Any restriction on outsourcing is a type of trade barrier, one that will reduce the benefits we obtain from international trade.There is a clear historical link between economic growth and trade barriers. Figure 5-1 shows the relationship between the openness of an economy fewer or more trade barriers and the rate of economic growth. At the bottom of the graph is a trade barrier index, which for the US is equal to 100. On the vertical axis, you see the average annual growth of per capita income in percentage terms.It is evident from this graph that countries that have fewer international trade barriers have also had higher rates of economic growth. The lesson of history is quite clear: International trade increases economic growth, and this in turn boosts economic well being. Government efforts to restrict outsourcing will restrict international trade, and this will make Americans poorer, not richer.

Will the United States Become a Third World Country?

In spite of the evidence just shown, Paul Craig Roberts, a former Reagan administration treasury official, declared at a Brooking Institution conference that “the United States will be a Third World country in twenty years.” His prediction was based on the idea the entire classes of high wage service sector employees will eventually find themselves in competition with highly skilled workers abroad who earn much less than their US counterparts. He contended that US software programmers and radiologists, for example, will not be able to compete in the global economy. Thus, he argued, the US will lose millions of white collar jobs due to outsourcing of service sector employment to India and China.Jeffrey E. Garten, former dean of the Yale School of Management, reiterated and expanded on this prediction. He believes that the transfer of jobs abroad will accelerate for generations to come. He argues that in countries from China to the Czech Republic, there is a “virtually unlimited supply of industrious and educated labor working at a fraction of US wages.” Similarly, according to Craig Barrett, chief executive of the chip marker Intel, American workers today face the prospect of 300 million well educated people in India, China, and Russia who can do effectively any job that can be done” in the US. Still other commentators have claimed that India alone will soak up 3 to 4 million jobs from the US labor market by 2015. Some even believe that this number may exceed 10 million. If true, one might expect American software developers and call center technicians to start moving to India!

Some Overlooked Facts

Much of the outsourcing discussion has ignored two simple facts that turn out to be important if we really want to understand what the future will bring

1. Outsourcing is the result of trade liberalization in foreign nations. After decades of isolation, the markets in China, India, and eastern Europe have begun to open

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up to international trade. As is often the case when governments finally allow their people to trade internationally, these governments have pushed hard to stimulate exports of labor services as well as goods. But this cannot be a long term equilibrium strategy because the workers producing those goods and supplying those services are doing it because they want to become consumers. Soon enough, and this is already happening, they want to spend their hard earned money on goods and supplying those services are doing it because they want to become consumers. Soon enough, and this is already happening, they want to spend their hard earned money on goods and services, many of which are produced abroad. Thus today’s outsourcing of jobs to those nations must eventually turn into exports of goods and services to those same nations.

2. Prices adjust to keep markets in balance. The supply curve of labor is upward sloping. Thus as US corporations hire foreign workers (either directly by outsourcing or indirectly by importing goods), market wages in foreign lands must rise. Between 2003 and 2006, for example, Indian labor outsourcing companies saw wages rise almost 40 percent. Over a longer span, real wages in southern China (which has been open to trade far longer than India) are now six times higher than they were just twenty years ago. Such wage adjustments obviously reduce the attractiveness of foreign suppliers. Moreover, it is not just wages that adjust: The relative values of national currencies move, too. Between 2003 and 2004, the value of the dollar fell more than 20 percent, and by 2007 it had dropped another 5 percent, making foreign goods (and workers) more expensive here and making US goods and workers more attractive in foreign markets.

None of these adjustments are instantaneous. Moreover, they are occurring because some American firms are moving output and employment abroad: hence at least some US workers are having to move to lower paying jobs, often with a spell of unemployment along the way. How big is the impact in the short run, before all of the price adjustments take place? According to the Bureau of Labor Statistics, in a typical recent year, the number of jobs lost to outsourcing is measured in the thousands out of a workforce of over 150 million. So if you are currently a US software developer, you don’t have to worry about packing your bags for Mumbai, at least not soon.

Insourcing by Foreign Firms

US firms are not the only ones that engage in outsourcing. Many foreign firms do the same. When a foreign firm out sources to the US, we can call it insourcing. For example, Mexican firms routinely send data to US accounting businesses for calculation of payrolls and for maintaining financial records. Many foreign hospitals pay our radiologists to read X-rays and MRI images. Foreign firms use American firms to provide a host of other services, many of which involve consulting. Also, when a foreign automobile manufacturer builds an assembly plant in the US, it is in effect outsourcing automobile assembly to American workers. Thus American workers in the South Carolina BMW plant, the Alabama Mercedes Benz plant, or the Toyota or Honda plants in Tennessee and Ohio are all beneficiaries of the fact that those foreign companies have

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outsourced jobs to the US. Indeed, all across the country and around the world, hundreds of millions of workers are employed by “foreign” corporations although it’s getting difficult to tell the nationality of any company, given the far flung nature of today’s global enterprises.

What Really Matters: The Long Run

If you own the only grocery store in your small town, you are clearly harmed if a competing store opens across the street. If you work in a small telephone equipment store and a large company starts taking away business via Internet sales, you will obviously be worse off. If you used to be employed at Wal-Mart and have just lost your job because Wal-Mart outsourced to a cheaper Indian firm, you will have to look for a new job.These kinds of “losses” of income or jobs have occurred since the beginning of commerce. They will always exist in any dynamic economy. Indeed, if we look over the American economy as a whole, roughly one million workers lose their jobs every week. But slightly more than one million people find a new job every week. So on balance, employment in the US keeps growing, even though the average person will change jobs every three years, some of them, no doubt, because of international competition. But job turnover like this is an essential component of a labor market that is continually adjusting to economic change. It is a sign of health, not sickness, in the economy. If you find this hard to believe, you can look west or east. In Japan, efforts to “protect” workers from international trade resulted in economic stagnation and depressed real income growth from 1989 to 2006. In Europe, similar efforts to “preserve” the jobs of existing workers have resulted in higher, not lower unemployment, because firms are unwilling to hire people that they cannot fire later.If you are still wondering, simply look back at Figure 5-1. The lessons of history and of economics are clear: Trade creates wealth and that is true whether the trade is interpersonal, interstate, or international. The reality is that labor outsourcing is simply part of a worldwide trend toward increased international trade in both goods and services. As international trade expands assuming that politicians and bureaucrats allow it to expand the result will be higher rates of growth and higher levels of income in America and elsewhere. American workers will continue to enjoy the fruits of that growth, just as they always have.

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27 The Effect of Income Taxes on Economic Growth

Income Taxes – Looking at Extreme Cases

One of the most commonly discussed issues in economics is how tax rates relate to economic growth. Advocates of tax cuts claim that a reduction in the tax rate will lead to increased economic growth and prosperity. Others claim that if we reduce taxes, almost all of the benefits will go to the rich, as those are the ones who pay the most taxes. What does economic theory suggest about the relationship between economic growth and taxation?

In studying economic policies, it is always useful to study extreme cases. Extreme cases are situations such as “What if we had a 100% income tax rate?”, or “What if we raised the minimum wage to $50.00 an hour?” While wholly unrealistic, they do give very stark examples of what direction key economic variables will move when we change a government policy.

First suppose that we lived in a society without taxation. We’ll worry about how the government finances its programs later on, but for now we’ll assume that they have enough money to finance all the programs we have today. If there are no taxes, then the government does not earn any income from taxation and citizens do not spend any time worrying about how to evade taxes. If someone has a wage of $10.00 an hour, then they get to keep that $10.00. if such a society were possible, we can see that people would be quite productive as any income they earn, they keep.

Now consider the opposing case. Taxes are now set to be 100% of income. Any cent you earn goes to the government. It may seem that the government would earn a lot of money this way, but that’s not likely to happen. If I don’t get to keep anything out of what I earn, why would I go to work? I’d rather spend my time reading or playing baseball. In fact, going to work would risk my ability to survive. I’d be much better off spending my time trying to come up with ways to get the things I need without giving them to the government. I’d spend a lot of my time trying to grow food in a hidden garden and bartering with others for the things I need to survive. I wouldn’t spend any time working for a company if I didn’t get anything from it. Society as a whole would not be very productive if everybody spent a large portion of their time trying to evade taxes. The government would earn very little income from taxation, as very few people would go to work if they did not earn an income from it.

While these are extreme cases, they do illustrate the effect of taxes and they are useful guides of what happens at other tax rates. A 99% tax rate is awfully like a 100% tax rate, and if you ignore collection costs, having a 2% tax rate is not much different from having no taxes at all. Go back to the person earning $10.00 an hour. Do you think he’ll spend more time at work or less if his take home pay is $8.00 rather than $2.00? I’d bet you that at $2.00 he’s not going to spend a lot of time at work and he is going to spend a lot of time trying to earn a living away from the prying eyes of government.

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In the case where government can finance spending outside of taxation, we see the following:

Productivity declines as the tax rate increases, as people choose to work less. The higher the tax rate, the more time people spend evading taxes and the less time they spend on more productive activity. So the lower the tax rate, the higher the value of all; the goods and services produced.

Government tax revenue does not necessarily increase as the tax rate increases. The government will earn more tax income at 1% rate than at 0%, but they will not earn more at 100% than they will at 10%, due to the disincentives high tax rates cause. Thus there is a peak tax rate where government revenue is highest. The relationship between income tax rates and government revenue can be graphed on something called a Laffer Curve.

Of course, government programs are not self-financing. We’ll examine the effect of government in the next section.

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28 Education

In considering the elementary and secondary level, we look at how much money is spent on education and attempt to determine whether taxpayers are getting what they pay for. To that end we plot measures of cost, and we look at the ratio of the numbers of students to teachers. Next we examine measures of success such as students’ performances on standardized tests and the numbers of degrees that are granted. Finally, we ask why college costs so much and whether it is worth it to get a degree.

External Benefits

Of course, K-12 education is public and it has been for so long that we may not even think of asking why. There are social as well as economic reasons for having free public education. Societally, benefits accrue to us all from having children become educated, whether or not they are our own children. Economically, benefits accrue to us because people who are educated are less likely to be on welfare or commit crimes against us and are more likely to be productive citizens who pay more in taxes than they cost in government benefits. An additional benefit that we derive from public school education is that having children of all races, ethnic groups, religions, and income classes in the same schools may foster social stability. Thus the external benefits of K-12 education justify having a considerable subsidy to that education.

SHOULD WE SPEND MORE?

The Basic Data

As of 1999 the US was spending more than $389 billion to educate 47 million elementary and secondary students. In exploring whether this amount of money is justified, we can look at how inflation-adjusted spending per pupil has tracked over time and compare the amounts that have been spent with outcomes such as test scores and graduation rates. It is important that we look at things in this way because as the number of students rises, the number of classrooms needed rises too. This not only raises construction and maintenance costs; it also increases the number of teachers that are needed. Thus, whether or not spending increases, it is spending per pupil that matters. In addition, because inflation makes a 1960 dollar more valuable than a 1999 dollar, we need to adjust the spending figures for inflation. Though a flawed measure, the CPI is what we typically use to perform that adjustment.

. Although it leveled off in the 1990s, there is, nonetheless, a marked increase from $2600 per student in 1960 to $7,855 in 1999 in inflation adjusted spending per child . While that spending went for many other things as well, it served to decrease average class size dramatically. In 1960 there were more than 26 students per class; there are currently 16. If the demands on what needs to be taught have remained constant, such a significant reduction in the number of students in a class would be expected to have a

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similarly significant impact on the success of students. By some measures it has, and by others, it has not.

Students’ scores on the SATs over the same period did not respond in proportion to the reductions in class sizes, and there is no clear evidence that reducing class size led to an improvement in SAT scores for college-bound students. If anything, the opposite happened. While average math SATs rebounded after 1980, they remained more than 10 points below where they had been in 1960. The decline in verbal SATs bottomed out later and the rebound was less dramatic. These scores are more than 30 points below where they had been 40 years earlier.

On the other hand, high school graduation rates have been rising dramatically. This is especially true for African Americans and Hispanics. High school graduation rates showed marked increases over the last 40 years, doubling for whites and Hispanics and more than tripling for blacks.

Literature on whether More Money Will Improve Educational Outcomes

Eric Hanushek, a leading economist on the issue of education, summarized 377 studies where one or more measure of input like student-to-teacher ratio (the quantity of teachers), teacher education, and teacher experience (the quality of teachers) was used to explain test scores. He reported that most of these studies found no relationship between test scores and these inputs and that nearly as many found a negative one as a positive one. This stunning conclusion, however-that money does not matter and that spending more is a waste of taxpayer resources-is in some dispute by other economists. These economists contend that test scores are less important than the earnings of the graduates. They state that over the last century graduates of schools in states that spent more had more earning power than those who graduated in states that spent less. All economists who study the issue have found, moreover, that educational outcomes are determined mostly by factors that are largely beyond the control of schools, such as family income and family structure.

These results are not as contradictory as they might seem. It might very well be that the structure of public schools has been such that more money had a significant impact in the 1940s through the 1960s because we were spending so little and were on the steep, upward-sloping part of the curve. The argument that Hanushek and others make is that it appears that we are now “on the flat of the curve,” meaning that we have done all we can do with more teachers. Now we need to look at something else.

The Public School Monopoly

We e saw that in industries dominated by monopolies prices are higher and output is less than it would be under perfect competition. Public schools operate in most communities as a monopoly. Though there are private schools and home schooling, these are not real options to most parents. Even more interesting is that this monopoly charges you, in the form of state and local taxes, whether or not you use the schools. It would be as if your

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electric company could continue sending you a bill even after you decided to buy your own electric generator.

There are reasons for this. If you believe that the external benefits of K-12 education are so great that they justify being subsidized, then parents who choose to send their children to private schools should have to continue paying school-related taxes because they are getting those external benefits.

Ultimately, the problem that seems to come to the fore with a monopoly is that it becomes unresponsive to the needs and desires of its customers. In the case of public schools, there is no compelling monetary incentive for the school to help a child with a particular need or to foster excellence in another child. Consider the following problem that exists at the beginning of every school year in nearly every school in the country. Every school has teachers of varying quality and many parents know who the better ones are. Parents want the teachers they consider to be better, and the principal must disappoint some of these parents. Under competition, a disappointed parent could threaten to move to another school. Under competition, the principal would have at least a budgetary incentive to make bad teachers better. Under the current system in most school districts, the parents are simply told, “That’s the way it is.”

Merit Pay and Tenure

One of the areas that distinguish teachers from other professionals is the lack of economic performance incentives and lifetime job security. The reason is that most teachers in the US are represented by a union that is an independent union, an affiliate of the National Education Association, or the American Federation of Teachers. Unions in general and teachers’ unions in particular, prefer that pay be based solely on education and seniority.

This means that a poor teacher with more experience earns more than a good teacher with fewer years in the classroom. This is a problem because energetic teachers can become discouraged by the lack of monetary recognition for their efforts. Any time pay is based strictly on who you are rather than what you do, there is an incentive to do as little as possible.

The other serious obstacle to rewarding good teachers and getting rid of bad ones is teacher tenure. Much like the institution of tenure in colleges and universities, K-12 educators are often granted tenure after they have successfully met certain criteria and taught for a set number of years. This means that, short of some abusive behavior, they cannot be fired. This further adds to the lack of performance incentives in older teachers.

Many teachers and their union representatives argue several points in defense of this system. First, they argue that as professionals they are above economic considerations and teach to the best of their ability all the time. Second, they argue that granting a principal the power to fire senior teachers and hand out merit pay would foster cronyism. Only those that did the principal’s bidding would keep their jobs or get large pay

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increases. Last, they argue that pay in general is low relative to other professionals and that any additional money should raise all teachers’ pay to a higher level.

Private versus Public Education

In the presence of failed or failing public schools, many have come to ask whether private schools should be allowed to receive public funds. In general, students from private schools perform dramatically better and have far fewer discipline problems than students in public schools. This happens even though most private schools exist with funding that is far less than that of public schools.

When private schools outperform public schools it can be attributed to a variety of factors. Because the parents, we can surmise that the students come from homes where education matters, they are wealthier on average than their counterparts in public schools, and it is unlikely they possess academic or physical disabilities.

The question is whether, after separating out these factors, private schools do outperform. The answer is an equivocal “yes”. If you look at public school students who fit a profile similar to private school students, private schools do a little more with a little less. The difference is not as dramatic as it is without this filter, but it still exists. The primary reason is that parent involvement is higher and administrative costs are lower in private schools.

School Vouchers

The question raised by the preceding analysis is whether parents should be allowed to take their children out of a public school and have them placed in another public school or a private school that is then given the taxpayer money that would have gone to educate the child in the first public school. This would amount to about $2500 per year for an “able” student. With cost savings and a general dislike of teachers’ unions in mind, this option is popular among Republicans. Democrats, strict believers in the “public” part of public education, generally oppose attempts at privatization.

There are, however, ongoing experiments with school vouchers. The school system in Milwaukee, Wisconsin, for example, has been operating a school choice program since 1990. In this system low-income parents can obtain vouchers to send their children to secular (i.e., nonreligious) private schools. The degree of parental disgust with public schools can be seen in the fact that there was space for only a third of those who applied for the vouchers.

The results of this experiment and others like it are mixed. Until recently, only a research team at the University of Wisconsin had access to the data and they concluded that, compared to all other Milwaukee public school students, children did no better. Research that ensued after the data were released to the general academic community suggest that those in the program for three or more years did better (3 to 5 percentile points on reading and 5 to 12 on math)

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29 Gross Domestic Product

In economics, the gross domestic product (DGP) is a measure of the amount of the economic production of a particular territory in financial capital terms during a specific time period. It is one of the measures of national income and output. It is often seen as an indicator of the standard of living in a country, but there are some problems with this view.

Definition

GDP is defined as the total value of all goods and services produced within that territory during a specified period (or, if not specified, annually, so that “the UK GDP” is the UK’s annual product). GDP differs from, gross national product (GNP) in excluding inter-country income transfers, in effect attributing to a territory the product generated within it rather than the income received in it.

Whereas nominal GDP refers to the total amount of money spent on GDP, real GDP refers to an effort to correct this number for the effects of inflation in order to estimate the sum of the actual quantity of goods and services making up GDP. The former is sometimes called “money GDP,” while the latter is termed “constant-price” or “inflation-corrected” GDP – or “GDP in base-year prices” (where the base year is the reference year of the index used). See real vs. nominal in economics:

A common equation for GDP is:

GDP – consumption + investment + exports – imports

Economists (since Keynes) have preferred to split the general consumption term into two parts; private consumption, and public sector spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:

a. Private consumption is a central concern of welfare economics. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.

b. If separated from endogenous private consumption, Government Consumption can be treated as exogenous, so that different government spending levels can be considered within a meaningful macroeconomic framework.

Therefore the standard GDP formula is expressed as:

GDP = private consumption + government + investment + net exports (or simply GDP = C + G + I + NX)

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Definition of the components of GDP

The breakdown of GDP into the variables C, I, G, and NX helps economists define each part more exactly:

C is private consumption (or Consumer expenditures) in the economy. This is sometimes clarified as: consumer expenditures on final goods and services. All the variables in the GDP equation measure final goods and services expenditures rather than total expenditures; the distinction removes from total expenditure those items which are primarily assets. For instance, buying a Renoir doesn’t boost GDP by $20m. (If it did, buying and selling the same painting repeatedly to a gallery would imply great wealth rather than penury.) Note that the Renoir purchase would effect the GDP figure, but not as a $20m receipt, the auctioneer’s fees would appear in GEP under Consumer expenditure, because this is a final service.

* I is defined as business investments in infrastructure, or any other spending intended to generate a subsequent return through business activities. Examples of investment are: training , R&D, marketing, and recruitment. The work ‘investment’ here is meant very specifically as non-financial product purchases. Buying financial products is classed as saving in macroeconomics, as opposed to investment (which, in the GDP formula is a form of spending). The distinction is (in theory)( clear; if money is converted into goods or services, without a repayment liability it is investment. For example, if you buy a bond or share the ownership of the money has only nominally changed hands, and this transfer payment is excluded from the GDP sum. Although such purchases would be called investments in normal speech, from the total-economy point of view, this is simply swapping of deeds, and not part of the real economy or the GDP formula.

*G is the sum of all government expenditures. The ratio of this to GDP as a whole is critical in the theory of crowding out, and the Keynesian cross.

NX are “net exports” in the economy (gross exports – gross imports). GDP captures he amount a country produces, including goods and services produced for overseas consumption, therefore exports are added. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic. This is the concept of Gross value added.

It is important to understand the meaning of each variable precisely in order to:

Read national accounts Understand Keynesian or neo-classical macroeconomics.

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Examples of GDP component variables

Examples of C, I, G, & NX: If you spend money to renovate your hotel so that occupancy rates increase, that is private investment, but if you buy shares in a consortium to do the same thing it is saving. The former is included when measuring GDP (in I), the latter is not.

If the hotel is your private home your renovation spending would be measured as Consumption, but if a government agency is converting the hotel into an office for civil servants the renovation spending would be measured as part of public sector spending (G).

If the renovation involves the purchase of a chandelier from abroad, that spending would also be counted as an increase in imports, so that NX drops and the total GDP is unaffected by the purchase. (This highlights the fact the GDP is intended to measure domestic production rather than total consumption or spending. Spending is really a convenient means of estimating production.

If you are paid to manufacture the chandelier to hand in a foreign hotel the situation would be reversed, and the payment you receive would be counted in NX (positively, as an export). Again, we see that GEP is attempting to measure production through the lense of expenditure; if the chandelier you produced had been bought domestically it would have been included in the GDP figures (in C or I) when the spending receipts of the purchaser was sampled, but because it was exported it is necessary to ‘correct’ the amount consumed domestically to give the amount produced domestically. (As in Gross Domestic Product).

CALCULATION

The GDP is calculated by the Bureau of Economic Analysis (BEA).

Cross-border comparison

GDPs of different countries may be compared by converting their value in national currency according to either

Current currency exchange rate: GDP calculated by exchange rates prevailing on international currency markets

Purchasing power parity exchange rate: GDP calculated by purchasing power parity (PPP) of each currency relative to a selected standard (usually the United States dollar).

The relative ranking of countries may differ dramatically between the two approaches.

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The current exchange rate method converts the value of goods and services using global currency exchange rates. This can offer better indications of a country’s international purchasing power and relative economic strength. For instance, if 10% of GDP is being spent o buying hi-tech foreign arms, the number of weapons purchased is entirely governed by current exchange rates, since arms are a traded product bought on the international market (there is no meaningful ‘local’ price distinct from the international price for high technology goods).

The purchasing power parity method accounts for the relative effective domestic purchasing power of the average producer or consumer within an economy. This can be a better indicator of the living standards of less developed countries because it compensated for the weakness of local currencies in world markets. The PPP method of GDP conversion is most relevant to non-trade goods’ and services.

There is a clear pattern of the purchasing power parity method decreasing the disparity in GDP between high and low income (GDP) countries, as compared to the current exchange rate method. This finding is called the Penn effect.

For more information see measures of national income.

PROBLEMS

Although GDP is widely used by economist, its value as an indicator has also been the subject of controversy. Criticism of GDP include:

Very often different calculations of the GDP are confused among each other. For cross-border comparisons one should especially regard whether it is calculated by purchasing power parity method or current exchange rate method.

GDP doesn’t take into account the black economy, where the money isn’t registered, and the non-monetary economy, where no money comes into plan at all, resulting in inaccurate or abnormally low GDP figures. For example, in countries with major business transactions occurring informally, portions of local economy are not easily registered. Also, bartering may be more prominent than the use of money, even extending to services (I helped you build your house ten years ago, so now you help me). In Cuba this even goes so far that everyone owns the house they live in, but people are only allowed to swap houses, not sell them.

In ‘poor’ countries, it may just be that everything is cheap, except for a few western goodies. So one may have little money, but if everything is cheap that evens out nicely. Thus, the standard of living may be quite reasonable, it’s just that there are, say, fewer tv-sets, meaning people have to share them (which may actually increase the quality of life in a social sense).

The quality of life is determined by many other things than physical goods (economic or not). (The best thing in life are free, if they’re things at all.)

If many products are of low quality in terms of durability then people will have to (unnecessarily) buy them again and again, thus boosting the GDP without

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increasing their satisfaction. (On the other hand, if products were very durable then that would hamper innovation because people would be less inclined to buy new products, giving producers less of an incentive to develop them.) Similarly, if many products are of low quality in terms of usability and people don’t know beforehand which products are the best choice for them, then they will either have to make do with an inferior product or buy again and again until they find something more satisfying. Furthermore, if products have a short lifespan in the market (eg because of fast innovation of fashion) then this process starts all over again when people need a replacement. Note that in a capitalist society these factors working together can easily cause a very high GDP combined with low customer satisfaction.

GDP doesn’t measure the sustainability of growth. A country may achieve a temporary high GDP by overexploiting natural resources. Oil rich states can sustain high GDPs without industrializing, but this high level will not be sustainable past the point that the oil runs out.

GDP counts work that produces no net change. For example, if a factory pollutes a river, that boosts GDP, and when the taxpayers pay to have it cleaned up, that boosts GDP again. See parable of the broken window,

Negative externalities aren’t subtracted from the GDP figure. As a measure of actual sale prices, GDP does not capture the economic surplus

between the price paid and subjective value received. The annual grow of GDP is corrected by using the “GDP deflator”, which tends to

under-estimate the objective differences in the quality of manufactured output over time. (The deflator is explicitly based on subjective experience when measuring such things as the consumer benefit received from computer-power improvements since the early 1980s). therefore the GDP figure may underestimate the degree to which improving technology and quality-level are increasing the real standard of living.

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30 Using National Income Data to MeasurePoverty and Living Standards

Economic growth is measured by an increase in the real GDP per capita. Can the same measure be satisfactory used to indicate poverty?

The World Bank’s uses a GDP per capita benchmark of US$370 as an indicator of absolute poverty. How reliable is this measure? Can we conclude that people living in countries with a GDP per capita of less than $370 live in poverty? Indeed, should measures of national income such as GDP per capita be used to measure poverty levels at all? Are there alternative measures that provide better indicators of poverty?

There are a number of problems that should be considered if national income statistics such as GDP per capita are used as indicators of poverty and living standards.

Failure to consider the distribution of IncomeAs with all mathematical averages, per capita income data does not take into account how the GDP is distributed amongst the population. If the income is unevenly distributed, then increases in the GDP per capita may disproportionately benefit a small group of high income earners and have little impact on reducing poverty. If GDP per capita data is to be used then its distribution must also be taken into account.

Failure to consider the effect of inflation Using any monetary data, such as GDP per capita over time, must recognize that output and incomes measures can increase for many reasons other than the country producing more goods. It is an increase in goods and services that is necessary if poverty is to be alleviated or peoples’ livings standards raised.

Output and incomes measures may increase because the rate of inflation has simply increased the money value of goods and service produced rather than their real value. Real GDP per capita would be a better indicator as this is a measure of the physical value of goods and service produced. Although the measure is expressed in money terms, it has been adjusted to take into account only the actual increase in goods and services produced and to disregard the effect on inflation increasing the money value of output.

Failure to include non marketed outputIt should be remembered that GSP only included output that involves a financial transaction i.e. is marketable. A considerable amount of Zambia’s agricultural output is produced on small-scale communal farms for subsistence purposes. It is currently estimated that only 25% of production on communally owned land involves monetary transactions. The rest is not included in any national income calculations. Likewise the output of the informal sector will not be included.

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Failure to include environmental degradationIncreasing national income and growth may occur at the expense of the environment. Rapidly growing economies may result in negative externalities. An agricultural sector that increases productivity by intensive use of pesticides and fertilisers or deforestation may reduce future fertility and worsen the level of poverty for future generations.

Failure to consider the types of goods producedGDP includes all goods and services produced. Much production is not concerned with producing goods and services that reduce poverty or raise current living standards. Increases in the production of capital goods and military goods will raise GDP per capita however may well reduce living standards as the opportunity cost of such production is the consumer goods foregone.

Alternative Indicators of PovertyEconomists use a wide range of variables as indicators if the level of poverty. Some of the more common are given below. Thos listed fall into two categories. The first is Health and Education Indicators and the second measures of access to and the impact of education.

1. Measures of Good Health Infant mortality

The number of live born babies who do not survive to their first birthday out of each thousand babies born in total.

Life expectancy (at birth) The average number of years a new born baby can expect to live if conditions remain the same.

Calorie per dayThe main cause of malnutrition, which means the body has insufficient energy to maintain good health. Many countries have improved over the last 30 years however many in African countries have deteriorated.

Protein per dayLack of protein causes malnutrition and lack of mental development as protein deficiency when the mother is pregnant has an effect on the intellectual development of the foetus.

Number of doctors per 100,000 of the populationThis is an indicator if the level of health care available. The higher the number of doctors per 100,000, the better the level of health care should be.

Number of hospital beds per 1000,000This also is an indicator of the standard of health care. The more beds available per 100,000 of the population, the better the access to health care for the people.

2. Measures of Access to and Impact of Education Literacy rates

The percentage of the population over the age of 15 whom can read and write a simple sentence about their lives.

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Primary school enrolment rateThe number of children of primary school age who are enrolled at school as % of age group.

Secondary school enrolment rateThe higher the enrolment rate, the more children have access to secondary education and therefore the higher the overall educational standards are likely to be.

Individual indicators invariably fail to consider all the characteristics of poverty. Economists have consequently attempted to construct measures of indices that combine several of the individual indicators together. These are called composite indicators.

Composite Indicators of Poverty and Living Standards

Development is more than simply increasing economic output i.e. GDP per capita. It is a wider concept than economic growth. Even is a country’s economy experiences real growth of GDP it does not mean that economic development is taking place. Nevertheless, wider more meaningful indicators of development are often correlated with GDP per capita.

There are a number of single indicators that can be used to measure the extent to which the inhabitants of a country are experiencing poverty. These all focus on one area; either health, education, or income. A number of composite indicators have been developed that allow several indicators to be aggregated together to give a more general measure of poverty and living standards.

The Physical Quality of Life Index (PQLI)In this index three single indicators were combined together; life expectancy at birth, infant mortality and literacy rates. For each indicator the performance of individual countries were rated on a scale of 1 to 100 where 1 represents the worst and 100 the best. There was a correlation with the GDP per capita however it was not as close as might be expected.

The Human Development Index (HDI)This index, produced by the United Nations Development Programme (UNDP), includes indicators of longevity, knowledge and income. It combines life expectancy (at birth), an average of literacy rates and number of years of education and GDP expressed in terms of its purchasing power in the domestic economy. Some countries have shown rapid economic growth but have not shown correspondingly high HDI index.

Years Human Development Index Real GDP per capita (1987 prices)

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1975 1997 1975 1997

Japan 0.851 0.924 13825 25084

Switzerland 0.914 22043 26441

Netherlands 0.856 0.921 12599 18369

United Kingdom 0.84 0.918 9310 14096

France 0.848 0.918 12763 18554

United States 0.865 0.927 16756 21541

Zambia 0.453 0.431 438 300

Kenya 0.453 0.544 322 372

India 0.545 251 465

The Human Suffering Index (HIS)

The index ranks people according to the level of human suffering based on 10 measures

Life expectancy Daily calorie supply Access to clean water Infant immunization Secondary school enrolment Per capita GDP Rate of inflation Communications Technology Political freedom Civil rights

Human Poverty Index

The United Nations defines poverty as the “denial of choices and opportunities most basic to human development-to lead a long healthy, creative life and enjoy a decent standard of living, freedom, self esteem and the respect of others.”

Whilst the Human Development Index measures the progress of the country in achieving development the human Poverty Index is more aimed at reflecting on how the progress is distributed and the level of deprivation and poverty being experienced I the country. There are two HPI indices most commonly used. HPI-1 is a measure of absolute poverty used in Less Developed Countries and HPI-2 is a measure of relative poverty used in More Developed Countries.

HPI-1 measures poverty in Less Developed Countries. The variables used are: The percentage of people expected to die before age 40 The percentage of adults who are illiterate

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Deprivation in overall economic provisioning-public and private-reflected by the percentage of people without access to health services and safe water and the percentage of underweight children under five.

HPI-2 measures human poverty in industrial countries. Because human deprivation varies with the social and economic conditions of a community, this separate index has been devised for industrial countries. It focuses on deprivation in the same three dimensions as HPI-1 although with an adjusted set of criteria and one additional one, social exclusion measures by low incomes and long term unemployment.

The variables are the percentage of people likely t die before age 60, the percentage of people whose ability to read and write is far from adequate, the proportion of people with disposable incomes of less than 50% of the median and the proportion of long-term unemployed (12 months or more).

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31 Hyperinflation

In economics, hyperinflation is a condition in which prices increase extremely rapidly as a currency loses it value. It is inflation out of control. Formally, it is “an inflationary cycle without any tendency towards equilibrium.”

Characteristics of hyperinflation

In 1956, Phillip Cagan wrote “Monetary Dynamics of Hyperinflation”, generally regarded as the first serious study of hyperinflation and its effects. In it he defined hyperinflation as a monthly inflation rate of at least 50%.

International Accounting Standard 29 describes four signs that an economy may be in hyperinflation:

1. the general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power;

2. the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that currency;

3. sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short;

4. interest rates, wages and prices are linked to a price index; and the cumulative inflation rate over three years approaches, or exceeds, 100%.

Rates of inflation of several hundred percent per month are often seen. Extreme examples include Germany in the early 1920s when the rate of inflation hit 3.25 million percent per month; Greece during its occupation by German troops (1941-1944) with 8.55 billion percent per month; and Hungary after the end of the W. W. ii. At 41.9 quadrillion percent per month (4.19 x 1016%). Other more moderate examples include Eastern European countries such as Ukraine in the period of economic transition in the early 1990s, in Latin American countries such as Bolivia and Peru in 1985 and 1988-1990, and Brazil in the early 1990s.

Hyperinflation did not directly bring about the Nazi takeover of Germany; the inflation ended with the introduction of the Rentenmark and the Weimar Republic continued for a decade afterward. The inflation did, however, call into question the competence of liberal institutions. It also produced resentment of Germany’s bankers and speculators (many of them Jewish) who were blamed for the inflation.

Hyperinflation is generally associated with paper money because the means to increasing the money supply with paper money is the simplest: add more zeroes to the plates and

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print, or even stamp old notes with new numbers. It also it the most dramatic. The history of paper money is replete with episodes of hyperinflation, followed by a return to “hard money”. Older economies would revert to hard currency and barter when the circulating medium became excessively devalued, generally following a “run” on the store of value.

Unlike inflation, which some economists feel can be a justifiable policy choice, hyperinflation is always regarded as destructive- it effectively wipes out the purchasing power of savings held as paper assets of the country afflicted with it, distorts the economy in favor in favor of extreme consumption and hoarding of real assets – causes the monetary base, whether specie or hard currency – to flee the country, and makes the afflicted area anathema to investment. Hyperinflation is met with drastic remedies, whether shock therapy of slashing government expenditures or altering the currency basis. An example of the latter is placing the nation in question under a currency board as Ecuador has now in 2005, which allows the central bank to print only as much money as it has in foreign reserves.

The aftermath of hyperinflation is equally complex, as hyperinflation has always been a traumatic experience for the area which suffers it, the next policy regime almost always enacts policies to prevent its recurrence. Often this means making the central bank very aggressive about maintaining price stability as is the case with the German Bundesbank, or the move to some hard basis of currency for example the gold standard or a currency board. Many governments have enacted extremely stiff wage and price controls in the wake of hyperinflation, which is in effect, a form of forced savings: goods become unavailable, and hence people hoard cash, as was the case in the People’s Republic of Chine under “Great Leap Forward” and Cultural Revolution”.

Root causes of hyperinflation

In general, hyperinflation is associated with fiat money and/or very rapid debasement of currency such as the 1834-1839 debasement of the akce, the standard silver coin of the Ottoman empire, which saw its value drop by five fold- increasing the nominal amount of circulating medium. Episodes of hyperinflation produce staggering increases in price – and bank notes denominated in millions, billions and trillions, coins denominated in the millions, or withdrawn from circulation all together. The vicious cycle of borrowing to meet all expenses begins and the monetary authority does not act to contain the cycle and may indeed accommodate it. Hyperinflation is often the result of governments using unbacked currency during was time to pay the expenses of the conflict, such as the United States in the 1770s and the Republic of China in the 1940s.

The root cause is a matter of more dispute. For both economists of the classical school as well as monetarists, it is always the result of the monetary authority’s irresponsibility (or stupidity), “running the printing presses.” For neo-liberal economists, hyperinflation is considered to be the result of a crisis of confidence, where the monetary base of the country flees, producing widespread fear that individuals will not be able to convert local currency to some more transportable form – for example gold, or an internationally

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recognized hard currency such as the US Dollar. See below for more discussion. These models are based on the neo-classical synthesis and chart the drop in the country’s money stock against hyperinflation.

Hyperinflation can also occur in the absence of a central monetary authority. One case is when there is “free banking” and banks are allowed to print their own notes without strong regulatory authority. These episodes are often brief, as there is then a run on banks, a panic, and a collapse in the money supply leading to a depression and deflation. An example of this is the Mississippi Company “bubble” under John Law.

Less commonly, hyperinflation may occur when there is debasement of the coinage – wherein coins are consistently shaved of some of their silver and gold, increasing the circulating medium and reducing the value of the currency. The “shaved” specie is then often restruck into coins with lower weight of gold or silver. Hyperinflation occurs in such a circumstance when “token” coins begin circulating, with no relationship to the par value of gold or silver.

One common cause of hyperinflation is warfare, civil war or intense internal conflict of other kinds: governments needing to do whatever is necessary to continue fighting, since the alternative is defeat. They cannot cut outlays because the main outlay is for armaments to fight the war itself. Further, a civil war may make it difficult to raise taxdes or to collect the existing taxes. In normal times, a deficit is financed by borrowing, that is selling government bonds. But under conditions of was or civil war, it is typically difficult and expensive to borrow, especially if the was is going poorly for the government in question. The banking authorities, whether central or not, “monetize” the deficit, printing money to pay for the government’s efforts to survive. The hyperinflation under the Chinese Nationalists from 1939-1945 is a classic example of a government printing money to pay civil war costs. By the end, currency was flown in over the Himalaya, and then old currency was flown out to be destroyed.

In the United States, hyperinflation was seen during the Revolutionary War and during the Civil War, especially on the Confederate (losing) side. Many other cases of extreme social conflict encouraging hyperinflation can be seen, as in Germany after World War I and in Yugoslavia after the death of Marshall Tito.

Hyperinflation and the currency

As noted, in countries experiencing hyperinflation, the central bank often prints money in larger and larger denominations as the smaller denomination notes become worthless. This can result in the production of some interesting banknotes, including those denominated in amounts of 1,000,000,000 or more.

By late 1923, the Weimar Republic of Germany was issuing fifty-million-mark banknotes and postage stamps with a face value of fifty billion marks. The highest value banknote issued by the Weimar government’s Reichsbank had a face value of 100 Billion marks (100,000,000,000,000 or One Hundred Trillion US/UK)

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The largest denomination banknote ever officially issued for circulation was in 1946 by the Hungarian National Bank for the amount of 100 quintilllion Pengo.

One way to avoid the use of large numbers is by declaring a new unit of currency (so, instead of 10,000,000,000 Dollars, a bank might set 1 New Dollar = 1,000,000,000 old Dollars, so the new note would read “10 New Dollars”.) While this does not lessen actual value of a currency, it is called revaluation.

Some banknotes were stamped to indicate changes of denomination. This is because it would take too long to print new notes. By time the new3 notes would be printed, they would be obsolete (that is, they would be of too low a denomination to be useful).

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32 Consumption tax

For most of the twentieth century, the principal federal tax on individuals in the United States was on income, whether it is earned from labor (wages and salaries) or capitals (interest, dividends, and capital gains). But a growing number of economists and politicians have concluded that the United States should replace the income tax-partially or entirely-with a tax on consumption.

Most of the political debate over a consumption tax has centered on whether the United States should adopt a value-added tax (VAT) similar to the ones that European countries have. While a VAT definitely is a tax on consumption, it is not the kind that most consumption-tax advocates prefer. What’s more, the debate over weather to add a VAT to the U.S. tax code has obscured the more basic issue of weather to tax income or consumption.

A consumption tax-also known as an expenditures tax, consumed-income tax, or cash-flow tax-is a tax on what people spend instead of what they earn. A VAT does that in the same way that a sales tax does. But a true consumption-tax system would entail something much different from simply layering a VAT on top of the current income tax. One way to think of a consumption-tax system is simply as an income tax that allows unlimited deductions for savings and those taxes all with drawls from savings, much like independent retirement accounts (IRAs).

Proponents of a consumption tax argue that it is superior to an income tax because it achieves what tax economists call “temporal neutrality.” A tax is “neutral” if it does not alter spending habits or behavior patterns and thus does not distort the allocation of resources. No tax is completely neutral, since taxing any activity will cause people to do less of it and more of other things. Foe instance, the income tax creates a “tax wedge” between the value of a person’s labor (what employers are willing to pay) and what person receives (after-tax income.) as a result, people work less (and choose more leisure) than they would in a world with no taxes.

The theoretical case for a consumption tax actually is a case against the income tax. Champions of a consumption tax argue that the income tax does enormous long-term damage to the economy because it penalizes thrift by taxing away part out the return to saving, less investment, less innovation, and lower living standards than we would enjoy without a tax on saving. In other words, the income tax creates a bias in favor of current consumption at the expense of saving and future consumption.

Equally important, the result is less saving than society would choose in the absence of any taxes. The “social value” of saving is the marker interest rate that borrowers are willing to pay for the use of resources now. (Economists are confident this is the value to society because it is the price society has established by bidding for savings, or offering savings to borrows, in the marketplace.) If each potential saver could collect that market interest rate, the result would be an optimal amount of saving (that is, an optimal division of resources between present and future consumption). Optimal in this sense refers to the

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amount of saving that individuals deciding freely on the basis of market prices, would choose to do on their own, rather than the amount of saving that a politician, social planner, or economist thinks they ought to do. But the income tax creates a wedge: the after-tax interest that savers receive is less than the pretax market interest that borrowers pay. So we get less than the optimal amount of saving.

In contrast, a properly constructed consumption tax can be neutral between consumption and saving. That is because taxes fall only on income that is consumed, not on income that is consumed, not on income that is saved. The results are that the tax wedge on saving is zero and that total saving in the economy is much closer to the optimal amount.

To see how this works, first consider what happens with the income tax to a person with $10,000 of pretax income. Assume for simplicity that the only tax bracket is 25 percent. That the marker (pretax) interest rate on bonds is 5 percent, and that inflation is zero. Under the income tax, the individual pays 2,500 in taxes no matter what he does, what then can consume $7,5000 of goods and services now. Or he can save $7,500, investing it in bonds paying 5 percent interest. In the first year the individual earns $375 interest (5 percent of $7,500), pays 25 percent of that ($93.75) in taxes, and is left with $281.25 of after-tax interest income. Added to his original $7,500, he now can consume $$7,781.25 of goods and services, or 3.75 percent more than a year ago. Note that the market paid the individual 5 percent to postpone consumption. But the income tax reduced what he received to 3.75 percent.

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33 Lower Capital Gains rate will gain revenue

President Bush’s proposal to reduce the capital gains tax will once again spark the debate over capital gains and tax revenues. This debate is becoming as predictable as the annual return of the seasons. We have been through the same debate year in, year out and some people continue to refuse to learn from American economic history. One year ago, 2 years ago, and even as far back as 1978, we have heard the very same argument against reducing the capital gains tax: That it would somehow lose precious tax revenues for the Federal Government.

Skeptics said about the 1978 capital gains tax cut that it would do little for investment and do much to erode tax revenues. I remember then Treasury Secretary Michael Blumenthal asserting that the proposed capital gains rate reduction from 50 to 28 percent would cost the Treasury over $2 billion in revenue. He said, “The measure would do little for capital formation and would waste revenues.”

Secretary Blumenthal objected. But in Congress, cooler economic heads prevailed and the House and Senate agreed with my distinguished Wisconsin colleague, the late Congressman Bill Steiger, that it was time to cut the capital gains tax.

That was a cut in the tax on capital gains. Well, what happened? Did revenues go down? We’ve been through this time, and time, and time again and you can go through the facts on this until everyone is blue in the face, but people just don’t listen.

The fact is, taxes paid on capital gains increased from $9.1 billion in 1978 to $11.7 billion in 1979, and $12.5 billion in 1980. In 1981, we cut the top rate on capital gains even further to 20 percent, and capital gains tax revenues rose to $12.7 billion in 1981, $12.9 billion in 1982, $18.5 billion in 1983, $21.5 billion in 1984 and $24.5 billion in 1985. Tax revenues to the Treasury were 184 percent higher in 1985 than in 1978.

These are all IRS figures. Nobody denies them. But a lot of people insist on ignoring them and persist in making statements about revenues that are contrary to facts.

Allow me to quote from last week’s Washington Post editorial on capital gains:…”revenues would certainly drop. Taken all together, over a period of several years, the effect on revenue would be zero at best and possibly a substantial loss.” Does this sound familiar? It should it’s the same old discredited nonsense we’ve been hearing year in, year out since 1978.

This blithe disregard for the facts a disregard which is no doubt ideologically motivated does nothing to expand public understanding of this issue. I would like to take this opportunity to explain to my colleagues once again why lower capital gains rates lead to higher tax revenues.

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This revenue windfall will come from three sources. First, because the tax cost of selling equities will be cut in half, lower capital gains rates will lead to greater realizations by stockholders. These greater realizations will lead to permanently higher receipts from the capital gains tax.

As the historical record shows, capital gains taxes paid continued to climb several years after the tax rate cuts of 1978 and 1981. Many econometric studies of capital gains rates and revenues have quantified this potential realization effect. Harvard Prof. Lawrence Lindsey estimates that a flat 15 percent capital gains rate would increase capital gains taxes paid by $31 billion over 3 years.

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Second, a lower capital gains tax rate increases the value of stocks. Taxing capital gains at a high rate reduces the potential return on investment and this future return translates into a lower price for the stock today. Conversely, a lower capital gains rate will increase stock prices, giving the Government more gains to tax.

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Third, and most important, a lower capital gains rate will raise GNP. Even the Congressional Budget Office admits that “lower rates on gains could increase savings and capital formation and channel more resources into venture capital.” What CBO failed to recognize, however, is that this increased capital formations means that the entire tax base will grow even faster resulting in an even greater increase in overall revenues to the Federal Government.

Because of the high capital gains rate, individuals have no incentive to assume the extra risk associated with investment in growth stocks.

As a result, entrepreneurs are finding it more difficult to secure investment funds from private sources. This shortage of startup capital today threatens to rob our economy of innovations, productivity gains, and job opportunities in the future.

Without startup capital, many of today’s dynamic, young companies such as Apple Computers, Federal Express, and Cray Research, never would have made it from the blackboard to the marketplace.

Other countries recognize the benefits of encouraging long term investment in fact; many do not tax capital gains at all. Their commitment to long term investment has created new technologies and new innovations and better products. We buy their products. They take our money. And US jobs move overseas.

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Table 1Capital Gains Rates and the Associated Revenue(in billions of dollars)

Year Revenue Tax rate (percent)1968 $ 5.9 26.91969 5.3 27.51970 3.2 32.21971 4.4 34.41972 5.7 45.51973 5.4 45.51974 4.3 45.51975 4.5 45.51976 6.6 49.1251977 8.1 49.1251978 9.1 49.125

1979 11.7 281980 12.5 281981 12.7 281982 12.9 201983 18.5 201984 21.5 201985 24.5 201986 46.4 20

Table 2

Comparison of US Taxation of Capital Gains with Some of Our European and Asian Competitors

Country Percent2 United Kingdom 40United States 33Sweden 18Canada 17.51France 16W. Germany 0Belgium 0Italy 0Netherlands 0Hong Kong 0Singapore 0S. Korea 0Taiwan 0Malaysia 0Japan (1)

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1 No Capital gains tax until Mar. 3, 1989 (except for substantial trading or substantial shareholders). After Mar. 3, 1989 shareholder has a choice of a 20 percent national and a 6 percent local tax on net gain at the time of filing, or 1 percent of sales proceeds withheld at source (this option is available only on shares listed for at least 1 year).

2 Maximum long-term capital gains tax rates.

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34 Road to Serfdom

Friedrich A. von Hayek, one the giants of classical free-market economics, warned that “The Road to Serfdom” results from the unintended consequences of market

interventions by governments, leading to economic distortions that ultimately lead to further interventions. He noted that liberty is lost - gradually, incrementally, and

inexorably - with each subsequent intervention descending down the road to serfdom.

Is the United States heading down such a path? I hope not, but I have been worrying for some time that we might be. By pursuing an ownership society through Social Security reform, tax reform and tort reform, President Bush seems determined that we do not head further down the road to serfdom but instead get on the expressway to economic freedom.

In the modern age the road to serfdom may not solely result from anti-market interventions but may also include the inability - or unwillingness - of political leader to eliminate anti-market barriers already on the books.

In his book Hayek exposed the primary fallacy of central planning: the impossibility that all knowledge can be brought together in a few genius individuals, “the best and the brightest.” Economics, markets statistics and history conclusively dispel any such assertion.

Presently the American economy, despite its resilience and our nation’s entrepreneurial acumen, is suffering from a 75-year hangover remaining from a number of failed and failing socialist projects. The most evident examples are our ailing and out-of-date entitlement programs, our confiscatory tax code and increasing regulatory burden. As such, it is not enough to maintain the status quo. We must reform these systems, remove barriers and eliminate as mush of this dead-weight loss from our economy as possible. And that is exactly what the president has set out to do.

Last week the Wall Street Journal/Heritage Foundation released their annual Index on Economic Freedom, which concluded for the first time that America no longer ranks among the top 10 freest economies in the world – this despite the fact that our score remained unchanged from the previous year. Instead we fell in the ranking because while we were trending water, Chile, Australia and Iceland further opened their economies and surpassed us.

America’s worst index category was the “fiscal burden” of government, due to Washington’s rapidly growing spending and one of the highest corporate tax rates in the world. Excessive regulation is another reason the United States failed to the make the top 10.

While not mentioned specifically by the index, Social Security is a major piece of the federal government’s budget, and due to the well-meaning but flawed pay-as-you-go structure of the program, Social Security reform looms as one of the greatest barriers to

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sound budget policy. Ironically, however, this problem also creates perhaps the greatest opportunity to expand economic freedom in our lifetimes.

On this front we cannot afford to continue to put our heads in the sand. OF we do nothing, we will fall behind. We are already behind. More than 20 nations have already reformed their retirement security programs, replacing pay-as-you-go systems with personal accounts that workers own and control. If fact, Chile - a nation that passed us on the index this year - was the first nation to create personal accounts.

That said, the ideas for reform reported in the press this week, if acted upon, would represent another missed opportunity rather than a step in the right direction. Just as we cannot afford to do nothing, we cannot afford to take one step forward, two steps back. We cannot pass just any reform proposal and call it a day. We cannot pass a reform proposal with accounts that are too small to fundamentally reform the system. On this score there can be no compromise.

Another area we are falling behind is in our tax policy, despite the positive impact the 2003 tax rate reductions have had on economic growth. This year, Romania and Georgia joined the “flat-tax club,” bringing the number of nations in Europe to adopt the flat tax to eight. So far, Georgia has the lowest flat tax of 12 percent on corporate and personal income.

Here in America, both the individual income and corporate income tax codes are in dire need of reform. We need to move further toward removing barriers to work, saving, investing and entrepreneurial risk-taking. On this front we definitely cannot afford to stand still.

At a minimum, we need to make permanent the 2001/2003 tax-rate reductions and index the alternative minimum tax for inflation. As recent data shows, tax receipts are on the rise, and if unchecked through further tax relief will continue upward to historic levels, slowly but surely dragging the economy down over the long run.

The president’s new commission on tax reform, headed by the capable leadership of Connie Mack, R-Fla., and Sen. John Breaux, D-La., should not waste time exploring “revenue enhancers” of any sort. If the commission proposes to eliminate credits, deductions and exemptions, closing these loopholes must be more than offset by reductions in the rate structure, both individual and corporate, and eliminate entirely taxes on savings and investment. And they should keep a keen eye on international tax competitiveness.

In today’s world, the road to serfdom – a road well traveled during the 20th century – is not only paved with good intentions but also seems to contain a slippery slope left over from socialist policies from previous administrations that, if left in place, will force us to run faster and faster just to stand still while other countries continue to pass us as they ride by in the flat-tax fast lane.

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35 Tax Cuts: When They Matter, When They Don’t

All modern presidents have one thing in common: They promise to cut taxes or at least not raise them. Some presidents have even succeeded in keeping their word, for we have seen numerous tax cuts over the past half-century. From a fiscal policy point of view, not all tax cuts are the same, though. That is, some tax cuts have had relatively little effect on the unemployment rate and economic growth, while others have had significant effects. What we want to know is, why aren’t all tax cuts created equal?

The Importance of the Margin

In economics, we say that choices are always made “at the margin”. What this means is that people react to whatever changes their incentive structure in terms of marginal benefits and marginal costs. If the government were to announce a one-time-only lump-sum tax cut of, say, $1,000 per family, there would be little, if any, change in the incentive structure for consumers, savers, and investors. Why? Because the one time only cut in taxes would not change the marginal benefit or the marginal cost of any of the activities of consumers, savers, or investors.

What is important to the incentives-and hence the behavior-of individuals is whether their actions can affect their income, net of taxes. As you probably know, the more taxable income you make, the higher your tax bracket and thus the higher the marginal tax rate you pay on the last dollar of income earned. So if you are a single person and your taxable income goes from, say, $25,000 to $40,000, your marginal tax rate will jump from, say, 15 percent to 25 percent.

As your taxable income goes up, you jump into higher and higher tax brackets. In general, to make sensible choices about working, people need to evaluate the marginal benefit of earning more income compared to the marginal cost, where cost is measured in terms of added effort and forgone leisure activities. The higher the marginal tax rate, the lower the marginal benefits from working because less income is kept by the person who earned it. So as marginal tax rates rise, the incentive to work is reduced because the marginal benefits of work are reduced.

The Importance of Permanence

A second issue that must be considered when thinking about tax cuts is their permanence- or lack thereof. In general, people are forward-looking creatures. They consider not just what is happening today but also what is likely to happen later in the year and even several years into the future. Thus for two reasons, a tax cut that is expected to be short-lived is much different from one that is expected to be long-lived or permanent.The first reason is that a temporary tax cut can induce people to make temporary changes in their behavior that have very little sustained effect. For example, if income taxes are cut this year but people know they will be raised again next year, people will respond

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quite simply: They’ll work more this year and work less next year. Politicians may make headlines by pointing out the extra employment and output, this year, but the reality is that over the longer haul, little will have changed. The second reason permanence is important has to do with investment. People invest when they get an education, and firms invest when they build new plants or buy new equipment. Investments yield income over long periods of time, and so people worry about the long-run taxes on that income. A permanent tax cut will raise the marginal benefits of investment far more than a short-lived tax cut because it ahs a greater impact on the total value of the tax bill.

Permanent and Marginal

The upshot of all this is quite simple. A short-lived tax cut or a one-time tax rebate is unlikely to affect incentives on the margin and hence is unlikely to affect people’s behavior. But a permanent reduction in marginal income tax rates can have substantial effects on how much people are willing to work, save, and invest. Indeed, there is considerable evidence that when marginal tax rates at the highest levels have been reduced, Americans earning those relatively high incomes have responded by working more, saving more, and investing more.Consider also that individuals who take risks in our economy entrepreneurs are sensitive to the potential net reward to such risk taking. Higher net rewards lead to more risk taking and in the long run to greater economic growth.A recent study conducted in France examined the implications of the French tax system. Researchers calculated what Bill Gates, founder and chairman of the largest software company in the world, Microsoft, would be worth today if he had started that company in France. Had Gates been a Frenchman and started Microsoft in France, he would have face much higher marginal tax rates on both his personal income and the gains to his investments. The researchers estimated that Gates’s net worth would be only about 20 percent of what it is today in the US. The average French person’s response to this information was, so what? That 20 percent of many billions of dollars is still a lot of wealth. An economist’s response is quite different. Bill Gates, or anybody else taking risks, would have taken fewer business risks (and worked fewer nights and weekends and taken more vacations) had marginal tax rates been as high as they have been (and currently are) in France.

Three Cases of Marginal Tax Cuts and Their Results

During three important periods in the twentieth century, US presidents significantly lowered marginal tax rates. The first cuts were the Coolidge-Mellon marginal tax rate cuts of the 1920s. The result was the Roaring Twenties-economic boom years. The second were the tax cuts pushed by President John F. Kennedy in the early 1960s and implemented somewhat reluctantly by Congress after Kennedy’s assassination. The result was the prosperous 1960s. The last major marginal personal income tax cut was enacted under the leadership of President Ronald Reagan in the 1980s. The result was a boom that lasted from 1983 to 1990.

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Critics of this analysis of the effects of marginal tax rate cuts point out that many other things were happening in the US and the world during these periods. Nevertheless, the fact remains that one variable was the same in each period-major cuts in federal marginal personal income tax rates.

The Problem with Backward-Looking Windfalls

Presidents have at times believed they could “jump-start” a slowly moving or stagnating economy by sending out tax rebate checks from the US Treasury. Indeed, rebates have been used several times in the past twenty years. The result of tax rebates has always been nil. Specifically, very little change in the rates of unemployment and economic growth has ever occurred after the issuance of a tax rebate.The reasons are clear. Tax rebates are backward looking-they are based on past income and work effort, both of which are out of the individual’s control. None of the marginal benefits or marginal costs associated with work, saving, or investing are affected. Moreover, such tax cuts are temporary; even if they could somehow be linked to future actions (such as by offering a tax rebate on earned over the next years), there would be no permanent effects on incentives. Most notably, any change in incentive to save or invest would be minimal, implying that the impact on economic growth would be negligible.

Tax Cuts and Phaseouts

Phaseouts for personal exemptions and itemized deductions (such as charitable contributions and mortgage interest payments) started in 1990 as a seemingly innocent way to raise federal government tax revenues without appearing to do so. Under the phaseout provisions of the current tax law, as you earn more taxable income, after a certain level, the federal government reduces (phases out) your personal exemptions and itemized deductions. The current Internal Revenue Code slowly but surely takes away certain tax breaks as taxable income goes up. In 2006, for example, taxpayers filing single or joint returns started losing their itemized deductions and personal exemptions when their adjusted gross income exceeded $150,500.The existence of phaseouts leads to higher de facto marginal tax rates, and Americans are not stupid. Those earning higher incomes understand quite clearly that their marginal tax rates are higher than those listed in the government tax tables. Why? Because the phaseouts for itemized deductions and personal exemptions effectively increase marginal tax rates by increasing taxable income by more than the person’s additional earnings. On balance, the phaseouts add an extra 1 to 2 percentage points to marginal tax rates at the upper end.The continued existence of phaseouts dampens the potential effectiveness of any cuts in federal marginal income tax rates, such as those implemented in 2003. For higher income earning individuals, any given reduction in marginal tax rates is less because of phaseouts. Higher income earning individuals react accordingly, correctly treating the supposed tax cut as less than the politicians say it is and working and investing less than one might otherwise expect.

Income versus Payroll Tax Cuts

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Most proposed and enacted tax cuts have involved federal personal income taxes. The federal government, though, likes to play a little game with its tax revenues. It labels some taxes income taxes, but it labels other taxes payroll taxes. Payroll taxes are supposedly used for Social Security, disability, and Medicare expenses. To keep the illusion going, the law says that employers and employees share payroll taxes equally.There is a saying that a rose is a rose; among economists, the corresponding saying is that a dollar is a dollar. These saying s mean one thing only: It doesn’t matter what label a government puts on a tax; what matters is tax revenues. When the government spends funds, recipients and taxpayers care not a hoot from which particular tax revenue accounts those funds are supposedly derived. Whether Medicare payments come out of a fund labeled “payroll taxes” or are paid from an account called “general fund,” there is no difference to the economy. What matters to the incentives and thus the behavior of taxpayers are the dollars left on the margin after the government collects taxes.Today, the top 40 percent of income earners in America pay over 99 percent of all federal income taxes. Almost 50 percent of income earners pay no federal personal income taxes. Not surprisingly, when President George W. Bush presented his 2003 plan to reduce federal income taxes, 50 percent of American polled did not believe that federal income taxes were too high. Why should they? Almost none of them actually pay any federal income taxes.In contrast, virtually anybody who is self-employed or works for a company pays payroll taxes. When payroll taxes were instituted in the 1930s, they represented a mere 1 percent of federal tax revenues. Today, they represent about 35 percent. Because so many people actually pay payroll taxes, some economists have called for a reduction in these taxes. University of Texas economist Daniel Hamermesh estimated that a 10 percentage point reduction in payroll taxes would lead to a short-term 3 percent increase in employment and a long term 10 percent increase in employment in the US. His analysis explicitly uses marginal thinking. The reward to working would increase permanently, and the cost of hiring would decrease permanently. The obvious result; a larger supply of workers and a greater demand for workers. Will wee see a reduction in payroll taxes soon? Almost certainly not. As long as the myth that we need to have a separate fund for Social Security and Medicare continues to dominate thinking in Congress, the payroll tax will remain sacrosanct. In fact, as we not in Chapter 14, payroll taxes will probably continue to rise in order to “fund” Social Security and Medicare benefit payments. Despite the adverse incentive effects of these taxes, no politician wants to be accused of “tampering” with Social Security or Medicare.

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36 Fair Tax – Income Taxes vs. Sales Taxes

The Fair Tax proposal

Tax time is never a pleasant experience for any American. Collectively millions and millions of hours are spent on filling out forms and trying to decipher arcane instructions and regulations. By filling out these forms we become painfully aware of how much money we put into federal coffers each year. This heightened awareness causes a flood of proposals on how to improve the way governments collect funds. A group known as Americans for Fair Taxation proposes replacing income taxes with a national sales tax. Representative John Linder of Georgia has even sponsored a bill known as the Fair Tax Act of 2003. a fellow guide, Robert Longley, has written an interesting summary of the Fair Tax proposal.

The idea to replace the income tax with a sales tax is not a new one. Federal sales taxes are widely used in other countries around the world, and given the low tax burden compared to Canada and Europe it is at least plausible that the federal government could obtain enough revenue from a sales tax in order to completely replace federal income taxes. The Fair Tax movement has come up with a scheme where income, estate, and payroll taxes could all be replace with a 23 percent national sales tax. It is not hard to see the appeal of such a system. Since all taxes would be collected by businesses, there would be no need for private citizens to fill out tax forms. We could abolish the IRS! Most states already collect sales taxes, so a federal sales tax could be collected by the states, thus reducing administrative costs. There are a lot of apparent benefits to such a change.

There are three questions we must ask in order to analyze such a change:

1. What impact will the change have on consumer spending and the economy?2. Who wins and who loses under a national sales tax?3. Is such a scheme even feasible?

Fair Tax- Effect on the Economy and consumer Spending

One of the largest effects a change to a national sales tax system such as Fair Tax would have is to change people’s working and consumption behavior. People respond to incentives, and tax policies change the incentives people have to work and to consume. It is unclear if replacing an income tax with a sales tax would cause consumption within the United States to rise or fall. There will be two opposing forces at play:

1. The Effect on Income

because income is no longer taxed, the incentives to work have changed. Many workers can choose the amount of overtime they work. Take the example of someone who would make an extra $25.00 if he worked an hour of overtime. If his marginal income tax rate

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for that extra hour of work is 40%, he would only earn $15.00 and pay $10.00 in income taxes.

If income taxes have been eliminated, he would get to keep the whole $25.00. If an hour of free time is worth $20.00, then he would work the extra hour under the sales tax plan, but not work it under the income tax plan. So a change to a sales tax plan reduces the disincentives to work, so workers as a whole will end up earning more. If workers earn more, they’ll spend more. So the effect on income suggests that the Fair Tax plan will cause consumption to increase.

2. Changes in spending patterns

It goes without saying that people don’t like paying taxes if they don’t have to. If there is a large sales tax on purchasing goods we should expect people to spend less money on those goods. This could be accomplished in several ways:

Spending less and saving more. Of course, today’s savings are likely to be used for tomorrow’s consumption, so consumers may just be delaying the inevitable. They still may wish to save more, as they may believe the sales tax will not last forever or they may plan on finding other ways to avoid the tax in the future.

Spending money outside of the United States. Currently if consumers wish to spend their money cross-border shopping in Canada or on a vacation in the Caribbean, they have already been taxed by the Federal government on that money at the income level. Under a sales tax scheme, they can spend their earnings outside the country and not be taxed on any of it, unless they bring enough goods back into the United States. So we should expect to see more money spent on vacations and outside of the United States, and less money spent within the United States.

Spending in a manner which evades taxes.

If there is an easy way to evade taxes, it is likely that a large number of people will participate in it. One easy way to evade sales taxes is to claim your spending as a “business expense”, even if it is a purchase for personal use. Goods which are used in production, known as intermediate goods, are not subject to a regular sales tax. The government could close this loophole by making the sales tax a “Value Added Tax” (VAT) such as the Canadian Goods and Services Tax (GST). VATs and GSTs are rather unpopular with the business community, as they raise the costs of production, so it is unlikely the U. S. would want to embark on this path. With a high sales tax rate, tax evasion will be prevalent, so this effect will cause a decrease in spending on “taxed” goods.

Overall it is not clear whether consumer spending will increase or decrease. But ther are still conclusions we can draw on what effect this will have on different parts of the economy.

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Fair Tax-Effect on Macroeconomic Variables

We saw in the previous section that a simple analysis cannot help us determine what will happen to consumer spending. However from that analysis we can see that a change to a national sales tax is likely to have the following effects:

Production is likely to rise as marginal income tax rates fall to zero which induces people to work extra hours.

Take home income will rise as people are not being taxed on income. Spending within the United States may or may not rise. Saving and spending abroad will increase, which will cause:

A weakening of the U. S. dollar as Americans who want to buy foreign goods will need to exchange their U. S. dollars for foreign currency. We should expect to see the U. S. dollar become less valuable relative to other currencies, particularly the Canadian dollar.

The price of investment goods such as bonds will rise as people wish to save more, so interest rates will fall. The link between interest rates, and the demand for investments can be seen in my article The Dividend Tax Cut and Interest Rates

The after tax price of consumer goods will go up due to the sales tax. However, the pre-tax price of consumer goods is likely to fall since increased productivity will cause an increase in the supply of goods. We have seen that we cannot be sure whether or not there will be an increase or decrease in demand for consumer goods purchased within the United States. The price of these consumer goods will increase but not by the full amount caused by the tax increase.

The price of goods outside of the United States (particularly in Canada) will increase because of this increased demand. Cities such as Windsor, Ontario should expect to see even more American visitors than they do already.

Not all consumers will be effected equally by these changes. We’ll next look at who will lose and who will win under a national sales tax.

Fair Tax – Who Loses?

Not all consumers will be effected equally by these changes. We’ll next look at who will win under a national sales tax and who will lose. Changes in government policy never effects everybody equally. Americans for Fair Taxation estimates that the typical American family will be over 10 percent better off than they would be under the income tax. Even if you believe these claims, not all individuals and families are typical, so some will benefit more and some will benefit less.

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Who might lose under a national sales tax?

Seniors. People do not earn income at a steady rate during their lifetime. The bulk of most people’s earnings occur before the age of 65. People over the age of 65 have vastly reduced incomes and live off the savings they earned while employed.

A switch to a sales tax will be in effect taxing them twice. They’ve already paid a lifetime of income taxes and now they have the opportunity to live off of their savings and consume, they’ll be taxed on that consumption. Unless special consideration is given to the current generation of seniors, they will end up paying a disproportionate share of taxes.

The Poor Generally the working poor pay very little (if any) income tax. However everybody needs to consume to survive. The poor get hit twice under such a scheme. Currently the poor pay little tax, where now they’ll have to pay taxes on their consumption, so their total tax bill will rise dramatically. The poor also spend a larger proportion of their income on consumption goods to survive, so they’ll pay a larger percentage of their income in taxes than wealthier individuals. The Fair Tax advocates realize this, so their plan includes sending each American family a rebate or “pre-bate” check each month to cover the necessities of life. The size of the checks will be designed so that a family right at the poverty line would not pay a cent in taxes. Of course, the higher the allowance made for the poor, the higher the tax rate everyone else will pay in order to cover federal spending.

Economist William G. Gale at the Brookings Institute has determined that most low income families will pay more taxes. “Under the Americans for Fair Taxation proposal, taxes would rise for households in the bottom 90 percent of the income distribution, while households in the top 1 percent would receive an average tax cut of over $75,000.”

Families Currently the income tax has all sorts of deductions for small families such as earned income credits and a child care credits. These would disappear with the elimination of the income tax. A sales tax, other than for purposes of the rebate, would not distinguish between families and individuals. Gale states that the “enactment of a broad-based, flat-rate consumption tax like the sales tax…would hurt families with incomes less than $200,000, because of the loss of tax preferences, but would help families with income above $200,000, due to the dramatic reduction in the top tax rate.” Given that the rebates are given based on the poverty line, and the poverty line does not dramatically increase between a one-person and two-person family, this is not surprising.

IRS Employees and income Tax Lawyers Part of the appeal of the proposal is that it will make the IRS irrelevant.

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Who might win under a national sales tax?

People who are inclined to save – A consumption tax can be avoided by not consuming. So it makes sense that people who do no consume a lot will benefit from the plan. Gale admits that there are savings for a large portion of the population, stating “If households are classified by consumption level, a somewhat different pattern emerges. Households in the bottom two-thirds of the distribution would pay less than currently, households in the top third would pay more. Still households at the very top would pay much less, again receiving a tax cut of about $75,000”.

People who can shop in other countries – This includes people who take a lot of overseas vacations and Americans living near either the Canadian or Mexican border who can do their shopping in those countries to avoid taxes.

The wealthiest one percent – As stated they will see an average tax cut of $75,000 per person.

The ability to get such a tax plan implemented will depend on the political power these different groups hold. It also may not be political feasible because of some flaws in the proposal. There are a few basic flaws with the Fair Tax proposal:

The 23 percent tax rate quoted is a tax-inclusive rate. However tax rates are normally quoted as a tax-exclusive rate. The Fair Tax plan has a tax-exclusive rate of over 30 percent, which may be difficult to sell to voters.

The ease of tax-avoidance and tax-evasion – Since consumers can either make their purchases in another country, or claim their purchases as business expenses, the tax may not generate the necessary amount of revenue.

The desire for exemptions – Many desirable goods would be subject to the Fair Tax. Health insurance is one such good. It is likely that various political interests would suggest that certain goods not be taxed. It is likely that some of these appeals would be successful. If they are successful however, the tax rate would have to be raised even higher, or large deficits would occur.

The possibility of having both an income tax and a sales tax – The national sales tax is desirable because it replaces income taxation. However there is nothing restricting the government from having both a nation sales tax and an income tax. Repeal of the 16th amendment would make income taxes illegal, but repeal seems incredibly unlikely. If the government was able to tax income, they probably would.

Like the flat tax before it, Fair Tax is an interesting proposal which is unlikely to ever be implemented. While implementation of the Fair Tax would have several positive (and a few negative) consequences for the economy, groups that lose under the system would make their opposition felt. The constant need of government to offer rebates and refunds to segments of the population would cause the rate to rise to levels which are politically unfeasible. It is, however, an interesting idea worth discussing.

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37 Simplifying the Federal Tax System (Don’t Hold Your Breath)

Although the dictum that “nothing is certain except death and taxes” seems ingrained in our society today, it wasn’t always so. Indeed, except briefly during the Civil War, the US had no federal income tax until after the addition of the Sixteenth Amendment in 1913. As one lawmaker pointed out during the debates at that time, with a federal income tax, “a hand from Washington will stretch out to every man’s house.” The Sixteenth Amendment passed nonetheless.Despite the intense debate over its initiation, the federal income tax was not so onerous in the beginning. Congress exempted individual incomes below about $50,000 in today’s dollars and married couples’ incomes below about $65,000. Moreover, tax rates were low, and the design of the system was quite simple, as reflected in Table 18-1, which shows the very first system we had in 1913.In addition to imposing a low burden even on those who paid taxes, the federal income tax code in the beginning was easy to understand and applied to very few Americans. Those who did pay filled out a simple one-page form. Consider now how far we have come from “the good old days.”

Table 18-1 The Original Federal Tax Code, 1913 Income Level Equivalent IncomeTax Rate in 1913 Level in 2007 _ 1% Up to $20,000 Up to $358,800 2% $20,001-$50,000 $358,801-$896,650 3% $50,001-$75,000 $896,651-$1,345,000 4% $75,001-$100,000 $1,345,001-$1,793,250 5% $100,001-$250,000 $1,793,251-$4,483,150 6% $250,001-$500,000 $4,483,151-$8,966,350 7% Over $500,000 Over $8,966,350

Our Complex Internal Revenue Code

Just try to grasp the following passage from a page out of the Internal Revenue Code-a passage that is not at all atypical:

Line 20b(1).-You must complete this line if there is a gain on Form 4797, Line 3; a loss on 4797, Line 12; and a loss on Form 4684, Line 35, Column (b)(ii). Enter on this line and on Schedule A (Form 1040) Line 22, the smaller of the loss on Form 4797, Line 12; or the loss on Form 4684, Line 35, Column (b)(ii). To figure which loss is smaller, treat both losses as positive numbers.

Now, if you can figure that out, you are probably a certified public accountant with many years of experience. It’s not just taxpayers who think the tax code is complicated. Just a few years ago, the head of the Internal Revenue Service asked for thirty thousand more agents because “the tax system continues to grow in complexity, while the resource base of the IRS is not growing.”

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Why is the Internal Revenue Code so complicated? The problem is that Congress enacts change after change in our tax laws, layering new provisions on top of old ones, seemingly without much regard for the web it is weaving. From 1998 through 2002, Congress enacted over three hundred such changes. In 2003, Congress went through the tax code from top to bottom, making hundreds more changes. To understand our current complicated tax code, it helps to appreciate the action-reaction syndrome.

Action-Reaction Syndrome

People are not assessed a lump-sum tax each year; each family does not just pay $1000 or $10,000 or $20,000. Rather, individuals and businesses pay taxes based on tax rates. The higher the tax rate-the governments’ claim on a person’s earnings in a given year-the greater the public’s reaction to that tax rate, either by trying to hide income or by attempting to convince Congress to lighten the burden. It is all a matter of costs and benefits.If the highest tax rate (called the marginal tax rate) you pay on the income you make is 15 percent, then any method you can use to reduce your taxable income by $1 saves you 15 cents in tax liabilities that you owe the federal government. Therefore, those individuals paying a 15 percent rate have a relatively small incentive to avoid paying taxes. But consider individuals who faced a tax rate of 94 percent in the 1940s. They had a tremendous incentive to find legal ways to reduce their tax liabilities by 94 cents.One way that individuals and corporations facing high tax rates react is by making concerted attempts to get Congress to add loopholes to the tax laws that allow them to reduce their taxable incomes. Indeed, it is commonplace that when Congress changes the Internal Revenue Code to impose higher tax rates on high incomes, it also provided for more loopholes, either immediately or soon thereafter. For example, special provisions enable investors in oil and gas wells to reduce their taxable incomes. Other loopholes allow people to shift income from one year to the next. Still other loopholes permit individuals to avoid some taxes completely by forming corporations outside the US. Every loophole means another paragraph or page in the tax code. Furthermore, because loopholes lower tax receipts, the tax rate imposed on other people has to be that much higher, if the government wishes to collect a specific amount of tax revenues.There are literally thousands of loopholes scattered throughout the tax code, garnered by hundreds of interest groups. As long as one group of taxpayers sees a specific benefit from getting the law changed and that benefit means a lot of money per individual, the interest group will lobby aggressively and support the election and reelection of members of Congress who will push for the loopholes desired by that group. If the benefits from influencing tax legislation are high enough, the affected parties will exert such influence-and will likely get their way. The result: a few more paragraphs or pages in the tax code and a slightly higher tax rate imposed on the rest of the populace.

Some Possible Simplifications in the Federal Tax System

Every several years, presidential candidates, candidates for Congress, and economists in and out of academia consider alternatives to the current federal tax system. Let’s look at some of those possibilities.

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A Value-Added Tax

A tax on value added is a type of sales tax, currently used throughout Europe. It involves taxing only the value that is added at each stage of production of a good or service. By the time this tax gets around to the ultimate consumer, it averages around 20 percent in Europe. Yale Law Professor Michael Graetz has calculated that a 15 percent value-added tax could be used to eliminate the federal income tax for families earning less than $100,000 a year. Those earning over $100,000 a year would still have to pay some income taxes, but at a rate lower than today and under a greatly simplified system.Of course, a proposal such as this might present a few political problems. Would health-care expenditures be subject to the value-added tax? Probably not, because senior citizens (who consume most of the nation’s health-care resources) would convince politicians that this would impose an “unfair” burden on them. The result would be a few more paragraphs or pages added to the code and slightly higher value-added tax on everything else. What about housing expenditures-would they be subject to the value-added tax, too? Probably not, because the housing industry’s lobbyists are so strong that they would likely get an exemption, and we would get a few more pages in the tax code. Of course, every time a new exemption was applied, the value-added tax would have to be raised-which would add to the pressure for more loopholes. Moreover, although young people might like the system retired people would probably object to the implicit “double taxation” they would face under such a scheme. After all, today’s working people would get lower income taxes in return for the new value-added tax. But retirees, who paid income taxes through out their working careers, would now simply be getting stuck with the new value added tax. Politicians would probably agree that this would be unfair, and so a few more paragraphs or pages would be added to the new tax code, and the rate paid by young people would have to be raised-just a bit, of course.

A National Sales Tax

A straightforward national sales tax sounds simple. Eliminate the federal income tax and simply tax everything that is sold to consumers. The problem is that such a national sales tax would have to be over 20 percent to start with. Then, if food, clothing, and health-care costs were exempted (perhaps on the grounds that taxes on such items would impose an unfair burden on the poor and the elderly), the national sales tax would have to be even higher. Another issue is how we would transition to a national sales tax. A massive one-time shift to the new system would likely generate huge swings in working and spending behavior as people tried to take advantage of the switch from a tax on earnings to a tax on spending. Moreover, some would argue that low income earners would be hit harder by a sales tax because they spend a higher percentage of their income than high-income earners do. Politicians responding to this plea would have to add only a few more pages to the tax code and perhaps impose just a slightly higher sales tax on those not exempt.

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38 The Myths of Social Security

You have probably heard politicians debate the need to reform Social Security. If you are under the age of thirty, this debate has been going on for your entire lifetime. Why has nothing been done? The reason is that the politicians are debating over “facts” that are not facts: Most of the claims made about Social Security are myths-urban legends, if you like. Sadly, the politicians have been repeating these myths so often for so long that they believe the myths, and so do their constituents (perhaps including you). As long as these myths persist, nothing meaningful will be done about Social Security, and the problem will simply get worse. So let’s see if we can’t cut through the fog by examining some of the worst Social Security myths.

Myth 1: The Elderly Are Poor

The Social Security Act was passed in 1935 as the US was coming out of the Great Depression. The unemployment rate at the time was the highest in our nations’ history. Bank runs and the stock market crash of 1929 had wiped out the savings of millions of people. Many elderly people had little or no resources to draw on in retirement, and their extended families often had few resources with which to help them. In the midst of these conditions. Social security was established to make sure that the elderly had access to some minimum level of income when they retired. It was never meant to be the sole source of retirement funds for senior citizens.Given the circumstances of the program’s founding, it is not surprising that many people associate Social Security with poverty among the elderly. The fact is that both the Social Security program and the financial condition of older people have changed dramatically over the years. For example, measured in today’s dollars, initial Social Security payments were as little as $110 per month and reached a max of $450 per month, or about $5,400 per year. Today, however, many recipients are eligible for payments in excess of $20,000 per year. More important, people over age sixty-five are no longer among the poorest in our society.As a result of many years of a strong economy and their own saving habits, today’s elderly have accumulated literally trillions of dollars in assets. These assets include homes that are fully paid for and substantial portfolios of stocks and bonds. In addition, millions of older Americans are drawing private pensions, built up over years of employment. Social Security payments, for example, now provide only about 40 percent of the income of the average retired person, with the rest coming about equally from private pensions, employment earnings, and investment income. Far from being the age group with the highest poverty rate, the elderly actually suffer about 25 percent less poverty than the average of all US residents. To be sure, Social Security helps make this possible, but just as surely, only about 10 percent of the elderly are living in poverty. In contrast, the poverty rate among children is twice as high as it is among people over age sixty-five.

Myth 2: Social Security Is Fixed Income

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Most economic and political commentators and laypersons alike treat Social Security benefits as a source of fixed income for the elderly, one that supposedly falls in real purchasing power as the general price level rises. The myth, too has its roots in the early days of Social Security, when payments were indeed fixed in dollar terms and thus were subject to the ravages of inflation. But this is no longer true. Thirty-five years ago, Congress decided to link Social Security payments to a measure of the overall price level in the economy. The avowed reason for this change was to protect Social Security payments from any decline in real value during inflation. In fact, because of the price level measure chosen by Congress, the real value of payments actually rises when there is inflation.Although there are many potential measures of the average price of goods and services, Congress decided to tie Social Security payments to the consumer price index (CPI). The CPI is supposed to measure changes in the dollar cost of consuming a bundle of goods and services that is representative for the typical consumer. Thus a 10 percent rise in the CPI is supposed to mean that the cost of living has gone up by 10 percent. Accordingly, the law provides that Social Security benefits are automatically increased by 10 percent.As it turns out, however, as we noted in Chapter 11, the CPI actually overstates the true inflation rate: It is biased upward as a measure of inflation. This bias has several sources. For example, when the price of a good rises relative to other prices, people usually consume less of it, enabling them to avoid some of the added cost of the good. But the CPI does not take this into account. Similarly, although the average quality of goods and services generally rises over time, the CPI does not adequately account for this fact. Overall, it has been estimated that until recently, the upward bias in the CPI amounted to about 1.1 percentage points per year on average. Revisions to the CPI have reduced this bias to about 0.8 percent per year. Thus currently, if the CPI says prices have gone up, say, 1.8 percent, they’ve really gone up only 1.0 percent. Nevertheless, Social Security payments are automatically increased by the full 1.8 percent.Now, 0.8 or 1.1 percentage points don’t sound like much. And if it happened only once or twice, there wouldn’t be much of a problem. But almost every year for the last thirty-five years, this extra amount has been added to benefits. And over a long time, even the small upward bias begins to amount to a real change in purchasing power. Indeed, this provision of the Social Security system has had the cumulative effect of raising real (inflation-adjusted) Social Security benefits by over 40 percent over this period. So despite the myth that Social Security is fixed income, in reality the benefits grow even faster than inflation.

Myth 3: There is a Social Security Trust Fund

For the first few years of Social Security’s existence, taxes were collected but no benefits were paid. The funds collected were used to purchase US Treasury bonds, and that accumulation of bonds was called the Social Security Trust Fund. Even today, tax collections (called payroll taxes) exceed benefits paid each year currently by more than $100 billion per year so that the trust fund now has well over $1 trillion in Treasury bonds on its books. Eventually, after the fund reaches a peak of around $2.6 trillion, retiring baby boomers will drive outgoing benefits above incoming tax collections. The

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bonds will be sold to finance the difference; by around 2040, all of them will be sold, and thereafter all benefits in excess of payroll taxes will have to be financed explicitly out of current taxes.The standard story told (by politicians at least) is that the bonds in the trust fund represent net assets, much like the assets owned by private pension plans. This is false. Congress has already spent the past excess of taxes over benefits and has simply given the trust fund IOUs. These IOUs are called US Treasury bonds, and they are nothing more than promises by the US Treasury to levy taxes on someone to pay benefits. When it is time for the trust fund to redeem the IOUs it holds, Congress will have to raise taxes, cut spending on other programs, or borrow more money to raise the funds. But this would be true even if there were no Treasury bonds in the trust fund: All Social Security benefits must ultimately be paid for out of taxes. So whatever might have been intended for the trust fund, the only asset actually backing that fund is nothing more and nothing less than an obligation of Americans-you-to pay taxes in the future.

Myth 4: Social Security Will Be There for You

Social Security was a great deal for Ida Mae Fuller, who in 1940 became the firs person to receive a regular Social Security pension. She had paid a total of $25 in Social Security taxes before she retired. By the time she died in 1975 at the age of 100, she had received benefits totaling $23,000. And although Ida Mae did better than most recipients, the average annual real rate of return for those early retirees was an astounding 135 percent per year. (That is, after adjusting for inflation, every initial $100 in taxes paid yielded $135 per year during each and every year of that person’s retirement.)

People retiring more recently have not done quite so well, but everyone who retired by about 1970 has received a far better return from Social Security than could likely have been obtained from any other investment. These higher benefits relative to contributions were made possible because at each point in time, current retirees are paid benefits out of the taxes paid by individuals who are currently working. Social Security is a pay as you go system; it is not like a true retirement plan in which participants pay into a fund and receive benefits according to what they have paid in and how much that fund has cumulatively earned. So as long as Social Security was pulling in enough new people each year, the system could offer benefits that were high relative to taxes paid. But membership in Social Security is no longer growing so fast, and the number of retirees is growing faster. Moreover, today’s added trickle of new retirees will soon become tomorrow’s flood, as the baby boom generation exits the workforce. The result is bad news all around.

One way to think about the problem facing us-which is chiefly a problem facing you-is to contemplate the number of retirees each worker must support. In 1945, forty-two workers shared the burden of one Social Security recipient. By 1960, nine workers had to pick up the tab for each person collecting Social Security. Today, the burden of a retiree is spread out among a bit over four workers. Within twenty-five years, fewer than three workers will be available to pay the Social Security benefits due each recipient.

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The coming tax bill for all of this will be staggering. If we immediately raised Social Security (payroll) taxes from 15.3 percent to a bit over 19 percent-more than a 24 percent increase-and kept them there for the next seventy-five years or so, the system’s revenues would probably be large enough to meet its obligations. But this would be the largest tax increase in US history, which makes it extremely unlikely that it will occur. Yet every day that Congress delays, the situation gets worse. If Congress waits until 2030 to raise taxes, they will have to be increased by more than 50 percent. Indeed, some commentators are predicting that without fundamental reforms to the system, payroll taxes alone will have to be hiked to 25 percent of wages in addition to regular federal, state, and local income taxes, of course.

And what form are these reforms likely to take? Well, rules will specify that people must be older before they become eligible for Social Security benefits. Existing legislation is already inching the age for full benefits up to sixty-seven from its previous sixty-five. Almost certainly, this age threshold will be hiked again, perhaps to seventy. Moreover, it is likely that all Social Security benefits (rather than just a portion) will eventually be subject to federal income taxes. It is even possible that some high-income individuals-you, perhaps-will be declared ineligible for benefits because their income from other sources is too high.

So what does all this mean for you? Well, technically, a Social Security system will probably be in existence when you retire, although the retirement age will be higher than today, and benefits will have been scaled back significantly. It is also likely that, strictly speaking, the Social Security Trust Fund will still be around when you hit the minimum age for benefits. But whatever else happens to the Social Security system between now and your retirement, you can be secure in you knowledge of one thing: You will be getting a much bigger tax bill from the federal government to pay for it.

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39 Social Security, and Market Crashes

The recent gyrations in the stock market have led to a chorus of I told you so’s from opponents of social security privatization. Responding to the drop of several months ago, Robert Reich, the former labor Secretary, crows that it “has taken the wind out of privatization.” The drop is a “reality check” for those pushing for privatization according to Joe Ervin, political director of the National Council of Senior Citizens. Opponents of privatization in Congress seem positively gleeful, Jim McDermott, (Rep., D-Wash.) says the drop is “serendipitous” and is glad of the “ammunition” it provides for the anti-privatization forces. Nevermind that the market has recently recovered, none of this should be taken very seriously. The arguments for privatization are not based on the short run movements of the market whether those movements are in the up or down direction.

Over the past 50 years the annual real rate of return on the S&P 500 has been 9.5 percent.Depending on the exact time period and stock market index, returns have been somewhat higher or lower than on the S&P 500. But a 7 to 8 percent rate of return is a reasonable forecast of what investors in a broad index over say a 30 year time period can expect from a privatized social security system. In contrast, today’s young workers can expect a negative rate of return from social security. On a present value basis, a young worker can expect a mere 50 cents of benefits for every dollar of taxes paid into the system. Yet even over the 1928 to 1957 period, the worst 30 year period for stocks since 1926, a worker would have received $5.79 in present value benefits for every dollar paid into the market. Astoundingly, these figures make social security look even better than it probably will be because they assume that future benefits will not be lowered and current taxes not raised, an outcome now considered to be impossible.

Some opponents of privatization recognize that it offers workers much higher rates of return over the long run but they worry that a market drop could “devastate” a worker on the verge of retirement. No one wants to wake up on their 65th birthday to find that their nest egg has dropped in value by 20% but in a paper for the Cato Institute Melissa Hieger and William Shipman calculate that even if a worker were unlucky enough to withdraw his lifetime savings on the day of a terrible market crash the chances that his total return would be lower that that offered by social security are almost nil. Even more fundamentally, the tragic figure of the Black Monday retiree is absurd.

Why would anyone liquidate all their savings on a single day, especially on a day like Black Monday? To avoid precipitous declines, investors in a privatized system can do what most financial experts advice and slowly reduce the percentage of their assets held in stocks as they near retirement. Market risks can be managed through a judicious choice of financial instruments. But what concurrent workers do to avoid the risk that politicians will raise their payroll taxes, cut their future benefits, or raise the retirement age? Politicians who claim that social security benefits are risk free are selling stock in a more fraudulent enterprise than any the SEC would tolerate.

Defenders of the current system like to refer to social security taxes as “contributions” which “accumulate” thereby creating the worker’s “pension savings.” Of course, all thisis

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nonsense. With the exception of a small surplus, all of the revenues from social security taxes are immediately paid out to current retirees. Privatizing social security, however, will increase national savings. At first the increase in savings will be small because of the necessity of paying current and some future retirees, but as the transition to a privatized system is completed net savings will increase. A higher savings rate will raise national income and permanently increase the rate of economic growth. Economist Martin Feldstein of Harvard University estimates that the higher savings of a privatized system plus the elimination of inefficient payroll taxes could increase national wealth by 10 to 20 trillion dollars. No other policy promises anything like the increase in living standards made possible by a privatized social security system.

The arcane and Byzantine rules governing social security ensure that for most workers there is little connection between what they pay in taxes and what they take out as benefits. One result is that social security reduces the incentive to work another is that wealth is redistributed in unintended ways which are difficult to defend. Why should two singles pay more of the social security burden than a married couple with the same total income? Would the taxpayers vote for such a redistribution if they knew of its existence? Probably not. Yet calculations by Eugene Steurle of the Urban Institute show that social security will impose a burden on singles more than three times as high as the burden imposed on the married couple (On a present value basis, young singles and young married couples of average income will both pay hundreds of thousands of dollars more in taxes than they will ever receive in social security benefits.) arbitrary wealth redistribution is not an accident of the current system, it is an almost inevitable result of any system in which workers don’t own their savings.

Whether the stock market is up or down, if we begin the process of privatization now, future generations will remark on our wise planning and foresight. But is we throw away trillions of dollars and the chance to establish a more equitable system because of a few fluctuations in the market, future generations will wonder incredulously at

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40 The Enduring Political Illusion of Farm Subsidies

Something is definitely rotten down on the farm. The General Accounting Office, Congress’ fact-finding agency, released in mid-June a study of the U. S. Department of Agriculture’s management of the farm-subsidy program, a multibillion-dollar system of direct payments to farmers. The findings should horrify lawmakers but probably won’t.

The GAO revealed that government employees are ill-trained and federal laws too vague to properly monitor the hundreds of thousands of farm-subsidy payments granted each year. The GAO found many of the approved recipients were ineligible for subsidies. (The USDA fact-checks only about 1,000 applications each year,) A GAO sample of USDA-reviewed and approved subsidies revealed that 30 percent of even these scrutinized farm subsidies were going to people who shouldn’t be receiving them.

The lack of USDA oversight is outrageous, given how much America spends on subsidies. From 1995 to 2002 the U.S. taxpayer doled out more than $114 billion to farmers, and in 2002 President Bush upped subsidies to $190 billion over the next 10 years. For perspective, consider that in the year 2000 alone, U.S. spending on farm subsidies exceeded the gross domestic product of more than 70 nations, based on federal government figures.

With so much money being freely handed out, the GAO report should lead to some tough questions for USDA officials on Capital Hill. Yet, for all its detail, the 75-page report artfully avoids the bigger question that no lawmaker wants to hear: Why do we even have farm subsidies?

One popular misconception that contributes to support for farm subsidies is that because they result in lower food process, they are a boon to consumers. This ignores that fact that taxes pay for these subsidies. Any reduction in supermarket process is paid for by your taxes, or someone else’s, whether you buy that ear of corn or not.

Farm subsidies are not intended to reduce the cost of food significantly. Of prices fell too much, farmers would lose money. To prevent this, Congress also has “environmental” conservation subsidies that pay for crops that are thus made scarcer. Consequently, from 1995 to 2002 we paid $14 billion for farmland conservation subsidies that increased the price of out food.

Another myth is that farm subsidies can help U.S. exports, and therefore the U.S. economy, because they make our food cheaper for foreigner to buy. This claim ignores at least two realities. First, just as farm subsidies are wealth transfer from some taxpayers to some domestic consumers, so they are a wealth transfer to foreign consumers. Second, farm subsidies are starting to cost U.S. exporters. Last April, the World Trade Organization ruled that U.S. cotton subsidies violated global trade rules, which could lead to billions of dollars in retaliatory tariffs or fines. The ruling will encourage developing countries to bring lawsuits against other subsidized U.S. exports.

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If the United States were to stop subsidizing agriculture, it could encourage others to do the same. Franz Fischler, the European Union’s agriculture commissioner, announced at the Doha Round of international trade negotiations in May that, “Provided we get a balanced deal, we are ready to put all of [Europe’s] export subsidies on the table.” Given that European agriculture subsidies are almost six times greater per land unit than U.S. subsidies, American exporters would gain tremendously from an end to subsidies. Farmers in the developing world, who struggle in the face of unfair competition from crops subsidized by governments of the developed world, would also gain.

The most enduring political illusion is that farm subsidies are necessary to maintain the small family farmer. In fact, 77 percent of Americans support giving subsidies to small family farms, according to a 2004 poll by the PIPA/Knowledge Network. Small family farmers are not the primary dollar recipient of federal subsidies, however. According to the subsidy watchdog, Environmental Working Group, 71 percent of farm subsidies go to the top 10 percent of subsidy beneficiaries, almost all of which are large farms. In 2002, 78 farms, none small or struggling, each received more than a million dollars in subsidies. The bottom 80 percent of recipients average only $846 per year.

The result of subsidizing the rich, more landed farmers is that they can reduce the process of their goods, making it much harder for small farmers to compete. Rather than being the small family farmers’ savior, subsidies work against them.

Rich farmers are a powerful lobby in American politics. In the last election, crop producers gave $11.5 million in campaign contributions, according to the Center for Responsive Politics, and they are likely to give much more by this November.

So don’t be surprised that the GAO’s report won’t be taken too seriously on Capital Hill. Farm subsidies are more than just payoffs for loaded, large landowners. They’re subsidies for elected officials, too.

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41 The Graying of America

America is aging. The 78 million baby boomers who pushed the Beatles and the rolling Stones into stardom are well into middle age. In twenty years, almost 20 percent of all Americans will be sixty-five or older. Just as the post-World War II baby boom presented both obstacles and opportunities, so does the graying of America. Let’s see why.

Two principal forces are behind American’s “senior boom.” First, we’re living longer. Average life expectancy in 1900 was forty-seven years: today, it is seventy-eight and is likely to reach eighty within the next decade. Second, the birthrate is near record low levels. Today’s mothers are having far fewer children than their mothers had. In short, the old are living longer, and the ranks of the young are growing too slowly to offset that fact. Together, these forces are pushing up the proportion of the population over age sixty-five; indeed, the population of seniors is growing at twice the rate of the rest of the population. In 1970, the median age in the United States—the age that divides the older half of the population from the younger half—was twenty-eight; it is now thirty-eight and rising. Compounding these factors, the average age at retirement has been declining as well, from sixty-five in 1963 to sixty-two currently. The result is more retirees relying on fewer workers to help ensure that their senior years are also golden years.

Why should a person who is, say, college age be concerned with the age of the rest of the population? Well, old people are expensive. In fact, people over sixty-five now consume over one-third of the federal government’s budget. Social security payments to retirees are the biggest item, now running over $500 billion a year. Medicare, which pays hospital and doctors’ bills for the elderly, costs around $350 billion a year and is increasing rapidly. Moreover, fully a third of the $300 billion-a-year budget for Medicaid, which helps pay medical bills for the poor of all ages, goes to those over the age of sixty-five.

Under current law, the elderly will consume 40 percent of all federal spending within fifteen years: Medicare’s share of the gross domestic product (GDP) will double, as will the number of very old—those over eighty-five and most in need of care. Within twenty-five years, probably half of the federal budget will go to the old. In a nutshell, senior citizens are the beneficiaries of an expensive and rapidly growing share of all federal spending. What are they getting for our dollars?

To begin with, today’s elderly are already more prosperous than any previous generation. Indeed, the annual discretionary income of Americans over sixty-five averages 30 percent higher than the average discretionary income of all other age groups. Each year, inflation-adjusted Social Security benefits paid to new retirees are higher than the first-year benefits paid to people who retired the year before. In addition, for almost thirty-five years, cost-of-living adjustments have protected Social Security benefits from inflation. The impact of Social Security is evident even at the lower end of the income scale: the poverty rate for people over sixty-five is much lower than for the population as a whole. Retired people today collect Social Security benefits that are two to five times what they and their employers contributed in payroll taxes plus interest earned.

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Not surprisingly, medical expenses are a major concern for many elderly. Perhaps reflecting that concern, each person under the age of sixty-five in America currently pays an average of more than $1,600 a year in federal taxes to subsidize medical care for the elderly. Indeed, no other country in the world goes to the lengths that America does to preserve life. Some 30 percent of Medicare’s budget goes to patients in their last year of life. Coronary bypass operations, costing over $40,000 apiece, are routinely performed on Americans in their sixties and seventies. For those over sixty-five, Medicare picks up the tab. Even heart transplants are now performed on people in their sixties and paid for by Medicare for those over sixty-five. By contrast, the Japanese offer no organ transplants. Britain’s National Health Service generally will not provide kidney dialysis for people over fifty-five. Yet Medicare subsidizes dialysis for more than one hundred thousand Americans, half of them over age sixty. The cost: More than $4 billion a year. Overall, the elderly receive Medicare benefits worth five to twenty times the payroll taxes (plus interest) they paid for this program.

The responsibility for the huge and growing bills for Social Security and Medicare falls squarely on current and future workers, because both programs are financed by payroll taxes. Thirty years ago, these programs were adequately financed with a payroll levy of less than 10 percent of the typical worker’s earnings. Today, the tax rate exceeds 15 percent of median wages and is expected to grow rapidly.

By the year 2020, early baby boomers, born in the late 1940s and early 1950s, will have retired. Late baby boomers, born in the early 1960s, will be nearing retirement. Both groups will leave today’s college students, and their children, a staggering bill to pay. For Social Security and Medicare to stay as they are, the payroll tax rate may have to rise to 25 percent of wages over the next fifteen years. And a payroll tax rate of 40 percent is not unlikely by the middle of the twenty-first century.

One way to think of the immense bill facing today’s college students and their successors is to consider the number of retirees each worker must support. In 1946, the burden on one Social Security recipient was shared by forty-two workers. By 1960, nine workers had to foot the bill for each retiree’s Social Security benefits. Today, roughly three workers pick up the tab for each retiree’s Social Security and Medicare benefits. By 2030, only two workers will be available to pay the social Security and Medicare benefits due each recipient. Thus a working couple will have to support not only themselves and their family but also someone outside the family who is receiving social security and Medicare benefits.

Paying all the bills presented by the twenty-first century’s senior citizens will be made more difficult by another fact: Older workers are leaving the workplace in record numbers. We noted earlier that the average retirement age is down to sixty-two and declining. Only 30 percent of the people age fifty-five and over hold jobs today, compared with 45 percent in 1930. so even as the elderly are making increasing demands on the federal budget, fewer of them are staying around to help foot the bill.

Part of the exodus of the old from the workplace is due simply to their prosperity. Older people have higher disposable incomes than any other age group in the population and are using it to consume more leisure. Importantly, however, the changing work habits of older individuals have been prompted—perhaps inadvertently—by American businesses. Career advancement often slows after age forty—more than 60 percent of American corporations offer early retirement plans, whereas only about 5 percent offer

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inducements to delay retirement. Looking ahead to career dead-ends and hefty retirement checks, increasing numbers of older workers are opting for the golf course instead of the morning commute.

Recently, however, the private sector has begun to realize that the graying of America requires that we rethink the role of senior citizens in the workforce. Some firms are doing more than just thinking. For example, a major chain of home centers in California has begun vigorously recruiting senior citizens as salesclerks. The result has been a sharp increase in customer satisfaction: The older workers know the merchandise better and have more experience in dealing with people. Moreover, turnover and absenteeism have plummeted. People with gray hair, it seems, are immune to “surfer’s throat” a malady that strikes younger Californians when sunny weekends are forecast.

Other firm have introduced retirement transition programs. Instead of early retirement at age fifty-five or sixty, for example, older workers are encouraged to simply cut back on their workweek while staying on the job. Often it is possible for workers to get the best of both worlds, collecting a retirement check even while working part-time at the same firm. Another strategy recognizes the importance of rewarding superior performance among older workers. At some firms, for example, senior technical managers are relieved of the drudgery of mundane management tasks and allowed to spend more time focusing on the technical side of their specialties. To sweeten the pot, a pay hike is often included in the package.

Congress and the executive branch have seemed unwilling to face the pitfalls and promises of an aging America. Although the age of retirement for Social Security purposes is legislatively mandated to rise to sixty-seven from sixty-five, the best that politicians in Washington, D. C., appear able to do is appoint commissions to “study” the problems we face. And what changes are our politicians willing to make? We got a sample of this in 2003, with new legislation promising taxpayer-funded prescription drug benefits for senior citizens. Even people in favor of the new program called it the largest expansion in entitlement programs in forty years. Before passage of the law, President Bush claimed it was going to cost $35 billion a year, but within a couple of months, that estimate had been hiked to over $50 billion. In fact, the benefits of the program will be less than claimed, and the costs will be even higher, because more than three-quarters of senior citizens had privately funded prescription drug plans before the new law took effect. These private plans are already disappearing, leaving seniors with fewer choices and sticking you with a larger tax bill.

By now you may be wondering how we managed to commit ourselves to the huge budgetary burden of health and retirement benefits for senior citizens. There are three elements to the story. First, the cause is worthy: After all, who would want to deny the elderly decent medical care and a comfortable retirement? Second, the benefits of the programs are far more concentrated than the costs. A retired couple, for example, collects more than $20,000 per year in social Security and consumes another $15,000 in subsidized medical benefits. In contrast, the typical working couple pays only about half of this each year in social Security and Medicare taxes. Hence the retired couple has a stronger incentive to push for benefits than the working couple has to resist them. And finally, senior citizens vote at a far higher rate than members of any other age group, in no small part because they are retired and thus have fewer obligations on their time. They

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are thus much more likely to make it clear at the ballot box exactly how important their benefits are to them.

It is possible for government to responsibly address the crisis in funding programs for senior citizens. Chile, for example, faced a national pension system with even more severe problems than our Social Security system. Its response was to transform they system into one that is rapidly (and automatically, as time passes) converting itself into a completely private pension system. The result has been security for existing retirees, higher potential benefits for future retirees, and lower taxes for all workers. Americans could do exactly what the Chileans have done—if we chose to do so.

In the meantime, if social Security and Medicare are kept on their current paths and older workers continue to leave the workforce, the future burden on today’s college students is likely to be unbearable. If we are to avoid the social tensions and enormous costs of such an outcome, the willingness and ability of older individuals to retain more of their self-sufficiency must be recognized. To do otherwise is to invite a future in which the golden years are but memories of the past.

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42 Inner City High Finance

Take a ride through virtually any low-income community and you will see billboards and other large signs advertising “check-cashing” services. At the beginning of the 1990s there were fewer than 2000 check cashers nationwide. Today, there are well over 5000 and the number is growing at a 10 percent annual rate. Along this same ride, you are also likely to see numerous pawn shops, offering “Quick Loans” or “Instant Cash.” For many years in America, the number of pawnshops had been declining; but between 1986 and 1995, their yellow-page listings across the country more than doubled, to roughly 9,500.

Is the spread of check-cashing services and the rebounding vitality of pawnshops related? And if so, why is their spread confined to inner-city areas, rather than across middle America or even into posh areas such as Beverly Hills or Palm Beach? The explanation for this rapid and peculiar change in the structure of inner-city financial markets can be found by examining some unintended consequences of regulation – specifically, consequences arising from Congress’s expressed desire to rehabilitate the inner cities of America.

Our story begins roughly 20 years ago. During the 1970s, many members of Congress became concerned that the banking system was taking advantage of low-income, inner-city residents. Specifically, it was argued, although banks were happy to accept deposits from people and businesses located in inner-city areas, they were not interested in making loans to those very same people and firms. Because many of these inner-city residents and business owners were minorities, this behavior by banks was seen as discriminatory. Just as important, it was argued, is that the financial capital created in low-income neighborhoods wasn’t getting recycled there; as a result, inner-city economic development was being stifled.

In an avowed effort to stimulate inner-city loans by banks. Congress passed the Community Reinvestment Act (CRA) of 1977. under the terms of this act, banks were directed to make extra efforts to solicit loans in older and lower income neighborhoods, so that residents of these areas would be able to participate in, and indeed stimulate, the economic redevelopment of these inner-city areas.

Initially, the CRA had only a relatively modest impact. Over the last 10 years however, Congress and the key regulatory agencies charged with enforcing the act (the Comptroller of the Currency and the Federal Reserve) have intensified their efforts to strengthen the CRA, presumably in the hope of stimulating inner-city lending. Yet the result of these changes has been to substantially increase the regulatory burdens of the CRA, and to actually discourage banks from doing any business in the nation’s inner cities.

For example, regulatory agencies have proposed that banks be required to produce data on the race, sex, and marital status of the owners of all businesses that request loans. In a slightly different vein, banks once received “credit” under the CRA for any of a variety of investments they made in small businesses; under more recent guidelines, banks are credited only if the investments benefit “low-and moderate-income geographies and

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persons.” Even more important, however, is that when banks seek to expand their operations (e. g. by opening a branch) the regulatory agencies have begun scrutinizing in great detail whether or not existing branches of the bank are fulfilling their obligations under the CRA.

Presumably the new information on loan applicants is to be used by regulators to make sure the individual bank branches are making their quotas of loans to minority groups. Similarly, the new investment guidelines are intended to more carefully guide bank decisions so that quite specific individuals and businesses benefit from the CRA. And of course, by tying expansion approval to performance under the CRA, the intention is presumably to put additional teeth into the low’s enforcement. In fact, the actual consequence of these and other features of the CRA has been to discourage banks from locating branches in low-income areas, and to close any existing branches in such areas.

Under the terms of the CRA, if a branch’s deposits come from a particular low income area, then a certain minimum percentage of its loans and investments must go back into that area- virtually without regard to the profitability or risk associated with those loans and investments. Hence, any bank that has a branch in an inner-city area runs the risk of having its loan and investment decisions being made by a federal regulator on political grounds, rather than being made by its loan and investment officers on the basis of financial prudence. If federal regulators are unsatisfied with a banks CRA performance, they can subject the bank to stiff penalties; just as important is the regulators’ ability to prevent banks from expanding their operations into a new market area if they are dissatisfied with the bank’s performance in an existing area.

Because the law ties loan requirements to areas where banks have deposits, the only sure way to avoid sanctions for not lending enough in the inner cities is to ensure that no deposits are coming from inner-city areas. Thus, if a bank has a branch in a low-income area, it has an incentive to close it; and if it was thinking of opening one there, those plans will almost surely be shelved. Although the CRA was intended to promote lending in low-income areas, its effect has been to discourage banks from locating there; on balance, it appears that the net effect of the legislation soon will be –or perhaps even now is—to actually reduce rather than increase lending in America’s inner cities.

One of many examples of the law’s impact on branch-banking decisions can be found in a comparison of the inner-city area known as South Central Los Angeles with the more affluent city of Gardena located right next door. Because of the massive exodus of banks over the last 10 years, there are only 20 bank branches serving the 270,000 residents of South Central L. A., but 133 fee-charging, check-cashing outlets. In neighboring Gardenia, which ahs a population of only 50,000, there are only a handful of check-cashing services, but there are 21 bank branches. Across the country in the New York city, area, 14 percent of Brooklyn’s bank branches closed between 1980 and 1994; most of those closures came in the lower-in-come areas of the borough. And in low-income Bedford-Stuyvesant, there are only 3 bank branches to serve 129,000 people.

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Into the void come check-cashing services. Most outlets charge 1.5 percent to 6 percent of the face value of the check to cash it, but their fees can run as high as 10 percent for an out-of-state or other risky check. Once customers receive their money, many of them then buy money orders – at .50 cents to $1 apiece- to pay their bills. Overall, check-cashing patrons can easily pay more than triple the fees they would pay for low-cost checking accounts at banks. One New York study, for example, found that the typical annual “banking” services consumed by a person bringing home $650 every two weeks would cost $232 if performed by a check-cashing service, but only $68 if done by a bank. Of course the check casher is in the neighborhood, while the nearest bank may be a thirty-minute bus ride away, so the apparent economy of the bank is no economy at all. For those people who find it inconvenient to leave their homes of job sites there is even an outfit offering “Mobile Money” check-cashing trucks that will come to the customer’s location to “turn paper into cash’ for a fee.

Some check-cashing outlets have also gone into the lending business-although they typically don’t call it this. They make the loans by taking “post-dated” checks from customers. Customers pay a fee to get cash immediately, along with an agreement that their checks will not be cashed until their next payday. For example, a customer might write a check for $300, receiving in return $250 in immediate cash, together with an agreement that the check will be held until the next payday. The $50 fee represents 20 percent of the money loaned. On an annualized basis, if the check is held for two weeks, that represents an interest rate of over 500 percent!

The departure of banks from inner cities has also stimulated borrowing from pawn shops, which are lending institutions where a person can borrow money on items that are pawned—that is, left with pawnshop as security for the loan. The customer is given a pawn ticket and a certain amount of cash, say, 50 percent of the wholesale value of the pawned item. Every month, the pawnshop charges a “fee” for keeping the pawned item, so that the amount that must be repaid to reclaim the item increases over time. These monthly fees can amount to the equivalent of annual rates of interest between 100 and 300 percent.

The market void created by the Community Reinvestment Act has turned inner-city high finance into big business. Indeed, there are now even publicly traded chains of pawn shops springing up throughout the country. Cash American, started by Jack Daugherty, has over 230 outlets, generating about $150 million in revenues and $15 million in net income. The value or the shares of stock in Cash American has increased dramatically in the decade that the stock has been on the market.

If the decline in bank branches continues, there are likely to be many more Jack Daughertys and Mobile Money trucks providing services in the future. As the depute superintendent of banks in New York puts it, such institutions “serve a purpose in the real world.” And what of the high fees and service charges that customers pay for the services of check chasers and pawnshops? Rick Price, whose family runs six check-cashing stores in the New York metropolitan area, notes that “We’re no different than people out there

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selling sneakers to kids in poor neighborhoods…Our prices are an economic hardship only if they are compared against ‘free’.”

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43 Central Bank

A central bank (reserve bank or monetary authority) is an entity responsible for monetary policy of its country (or in the case of the EU, group of member countries). Its primary responsibility as a central bank is for the stability of the national currency and money supply, including interest rates; and acting as a lender of last resort to the banking sector and the national financial system as a whole. It may also have supervisory powers to ensure that banks and other financial institutions do not behave recklessly or fraudulently. Central bank is usually headed by a Governor, President in the case of the European Central Bank or Chief Executive/Managing Director in the case of Hong Kong Monetary Authority and Monetary Authority of Singapore.

In most countries the central bank is state-owned and has some degree of autonomy, which allows for the possibility of government intervening in monetary policy. An “independent central bank” is one, which operates under rules designed to prevent political interference; examples include the US Federal Reserve, the UK Bank of England (since 1997) and the European Central Bank. The Australian central bank is called the Reserve Bank of Australia, which sets its independent of government policy.

Activities and responsibilities

Functions of a central bank (not all functions carried out by all banks):

monopoly on the issue of banknotes the Government’s banker and the bankers’ bank (“Lender of Last Resort”) manages the country’s foreign exchange and gold reserves and the Government’s

stock register; regulation and supervision of the banking industry; setting the official interest rate – used to manage both inflation and the country’s

currency exchange rate.

The central bank’s main responsibility is the management of monetary policy to ensure a stable economy, including a stable currency. It aims to manage inflation (rising average prices) as well as deflation (falling prices). It is the lender of last resort, and will (at a price) assist banks in cases of financial distress (see also bank runs).

Furthermore, it will hold reserves of foreign currency, usually in the form of sovereign bonds, and gold and have a range of influence over exchange rates. Some exchange rates are managed; some are market based (free float) and many are somewhere in between (“managed float”) or (dirty float).

Typically a central bank seeks to impose centralized control over interest rates, the price of credit. These are seen as important, since they influence the stock – and bond markets as well as mortgages and other credit rates. The European Central Bank for example announces its interest rate at the meeting of its Governing Council (in the case of the Federal Reserve, the Board of Governors).

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Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its polices. In the case of the Fed, they are the local Federal Reserve Banks, for the ECB they are the national central banks.

Instruments of monetary policy

Open Market Operations

With the Open Market Operations, a CB directly influences the money in an economy. Each time it buys securities, exchanging money for the security, it raises the money supply; conversely, selling of securities lowers the money supply. Buying of securities thus amounts to printing new money while lowering supply of the specific security.

The main Open Market Operations are:

Lending money for collateral securities (“Reverse Operations”). These operations are carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the ECB) are auctioned off.

Buying or selling securities (“Direct Operations”) on ad-hoc basis. Foreign exchange operations such as swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the Chinese Central Bank and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasures, presumably in order to stop the decline of the U.S. Dollar versus the Renminbi and the Yen.

Interest rates

A central bank has several interest rates it can set to influence markets.

Marginal Lending Rate (currently 3% in the Eurozone) A fixed rate for institutions to borrow money from the CB.

Main Refinancing Rate (2% in the Eurozone) This is the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans (in the US this is called the Discount rate).

Deposit Rate (1% in the Eurozone) The rate parties receive for the deposits at the CB.

These rates directly affect the rates in the money market, the market for short-term loans.

Reserve requirements

Every bank over a minimum size needs to delegate a percentage of its deposits (2% in the Eurozone) as reserves. Such legal reserve requirements were introduced in the nineteenth

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century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks. See also money multiplier.

Banking supervision and other activities

In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by government department such as The Ministry of Finance, or an independent government agency (eg UK’s Financial Services Authority). It examines the banks’ balance sheets and behavior and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the “bank of banks”. The Fed also auctions off Treasuries.

Independence

Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles (“boom and bust”), as politicians may be tempted to boost the economy in advance of an election, to the detriment of the long-term health of the economy. In addition, it is argued that the independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect.

Governments generally have some degree of influence over even “independent” central banks; the aim of independence is primarily to prevent short-term interference. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the U. S., and his choice must be confirmed by the Congress.

History

One of the oldest banks that performed some of the duties of a central bank was the Bank of Sweden that was opened in 1668 with help form Dutch businessmen. This was followed in 1694 by the Bank of England, created by a businessman in the City of London at the request of the British government to help pay for a war. The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill, signed by the President Woodrow Wilson on December 23, 1913.

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44 Monetary Policy and Interest Rates

“The Fed lowers interest rates by one-half point.” That is one of the numerous headlines seen in the financial press during the early part of the 2000s. The Fed-short for the FEDAERAL RESERVE SYSTEM-is America’s central bank. Interest rates can be affected by the fed; when they are, that is part of monetary policy, defined as the use of changes in the amount of money in circulation so as to affect interest rates, credit markets, inflation, and unemployment.

The theory behind monetary policy is relatively simple. An increase in the rate of growth of the money supply by the Fed increases spending on goods and services and thus stimulates the economy, tending to lower unemployment in the short run and raise inflation in the long run. (One important version of the money supply is compromised of checking-type account balances and currency in the hands of the public) T flip side is that a decrease in the rate of growth of the money supply reduces spending, thereby depressing the economy; the short-run result is higher unemployment, while the longer-run effect is a lower inflation rate.

Congress established the Federal Reserve System in 1913. A Board of Governors consisting of seven members, including the very powerful chairperson, governs it. All of the governors, including the chair, are nominated by the president and approved by the Senate. Their appointments are for fourteen years (although the chair serves in that role for only fourteen years at a time).

Though the Fed, and its Federal Open Market Committee (FOMC), decisions about monetary policy are made eight times a year. The Federal Reserve System is independent; the Board even has its own budget, financed with interest earning on the portfolio of bonds it owns. The president can attempt to convince the Board, and Congress can threaten to merge the Fed with the Treasury or otherwise restrict its behavior. But unless the Congress took the radical step of passing legislation to the contrary, the Fed’s chair and governors can do what they please. Hence, talking about “the president’s monetary policy” or “Congress’s monetary policy” is inaccurate. To be sure, The Fed has, on occasion, yielded to presidential pressure to pursue a particular policy, and it’s true that the Fed’s chair follows a congressional resolution directing him to report on what the Fed is doing on the policy front. But now, more than ever before, the Fed remains the single most important and truly independent source of economic power in the federal government.. Monetary policy is Fed policy and no one else’s.

Federal Reserve monetary policy, in principle, is supposed to be counter-cyclical. That is, it is supposed to counteract other forces that might be making the economy contract or expand too rapidly. The economy goes through so-called Business cycles, made up of recessions ( and sometimes depressions) when unemployment is high, and boom times when unemployment is low and businesses are straining their productive capacity. For the Fed to stabilize the economy, it must create policies that go counter to other forces affecting business activity. Although Fed policy can be put into place much faster than most federal policies, it still does not operate instantaneously. Indeed, researchers have

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estimated that it takes almost fourteen months for a change in monetary policy to become effective. Thus, by the time monetary policy goes into effect, a different policy might be appropriate.

Researchers who have examined to evidence over the period from 1913 until the 1990s have concluded that, on average, the Fed’s policy has turned out to be pro-cyclical, rather than counter-cyclical. That is, by the time the Fed started pumping money into the economy, it was time to do the opposite; by the time the Fed started reducing the rate of growth of the money supply, it was time for it to start increasing it. Perhaps the Fed’s biggest pro-cyclical blunder occurred during the Great Depression. Many economists believe that what would have been a severe recession turned into the Great Depression in the 1930s because the Fed’s action resulted in almost a one-third decrease in the amount of money in circulation, drastically reducing aggregate spending. It has also been argued that the rapid inflation experienced in the 1970s was importantly the result of excessive monetary expansion by the Fed.

In the 1990s, few commentators were able were able to complain about monetary policy. Inflation almost disappeared by the end of the decade, which also saw the unemployment rate drop to its lowest level in nearly forty years. Why the Fed was successful in the 1990s remains unclear. It could have been due to the uniquely superior insights of its chair, Alan Greenspan. Or, it might simply have bee a run of good luck. But whatever the reason, it is clear that the Fed remains far from perfect. Late in the decade it tightened monetary policy sharply, reducing monetary growth and thereby contributing to the recession that began in 2001. Moreover, some economists are worried that the Fed may have increased the rate of growth of the money supply too in 2001 and 2002 to counter that recession. If they are correct, this means that the Fed will have set the stage for renewed inflation later.

Most newspaper discussions of Fed policy focus on its decisions to raise or lower interest rates. Before we can make any sense out of such discussions, we need to first understand the relationship between nominal interest rates, that is, the rates that you see in the newspaper and pay for loans, and the expected rate of inflation.

Let’s start in a hypothetical world in which there is no inflation and so expected (or anticipated) inflation is zero. In that world, you might be able to borrow-obtain a mortgage to buy a home, for example-at a minimal rate of interest of, say, 6 percent. If you borrow the funds and your anticipation of zero inflation turns out to be accurate, neither you nor the lender will have been fooled. The dollars you pay back in the years to come will be just as valuable in terms of purchasing power as the dollars that you borrowed, In this situation, we would say that the real rate of interest (defined to be the nominal rate of interest minus the anticipated rate of inflation) was exactly equal to nominal interest rate.

Contrast this to a situation in which the expected inflation rate is, say, 5 percent. Although you would be delighted to borrow at a 6 percent interest, lenders would be reluctant to oblige you, and based on exactly the same reasoning you would be using: the

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dollars with which you would be repaying the debt would be declining in purchasing power every year of the debt. Lenders would likely insist upon (and you would agree to) and inflationary premium of 5 percent, to make up for the expected inflation. Hence, the nominal interest rate would rise to about 11 percent, keeping the real rate at its previous level of 6 percent.

There is strong evidence that inflation rates and nominal interest rates move in parallel: During periods of rapid inflation, people come to anticipate that inflation fairly promptly, and thus higher nominal interest rates are the result. In the early 1970s when the inflation rate was between 4 and 5 percent, nominal interest rates on mortgages were around 8 to 10 percent. At the beginning of the 1980s, when the inflation rate was near 9 percent, nominal interest rates on mortgages had risen to between 12 and 14 percent. By the middle of the 1990s, when the inflation rate was 2 to 3 percent, nominal interest rates had fallen to between 6 and 8 percent.

Now let’s go back to Fed policy and the headlines. When the chair of the Fed states that the Fed is lowering “the” interest rate from, say, 5.75 percent to 5.25 percent, he rally means something else. In the first place, the interest rate referred to is the federal funds rate, or the rate at which banks can borrow excess reserves from other banks. Any effects of Fed policy here will show up in other rates only indirectly. More importantly, even when the Fed decides to try to alter the federal funds rate, it can do so only by actively entering the market for federal government securities (usually Treasury bills). So if the Fed wants to lower “the” interest rate, it essentially must buy Treasury bills from banks and other private holders of them. This action bids up the prices of these bills, and simultaneously lowers the interest rates on them. This in turn lowers the interest rates at which banks are willing to lend to each other and to the public. (In terms of our earlier discussion, this policy also has the effect of increasing the money supply, and so increases spending throughout the economy.) Conversely, when the Fed wants to increase “the” rate on interest, it sells Treasury bills, driving their prices down and pushing interest rates up. The result is a reduction in the money supply and a reduction in spending throughout the economy. The pre-announcement of the policy change, which comes in the form of a Fed declaration that interest rates are going to change, simply serves to alert people that a new policy is on the way.

The other key point to note is that the changes in interest rates we have been talking about here are very much short-term changes-and are occurring over a period of time short enough that the expected inflation rate is constant. Once the effects of the Fed’s new policy begin to kick in, however, the expected inflation rate will tend to respond, which can create a whole new set of problems. For example, suppose the Fed decides to “lower interest rates,” i.e., increase the money supply by buying Treasury bills. In the early weeks and months, this will indeed lower interest rates and stimulate spending. But for a given level of productive capacity in the economy, this added spending will eventually get translated into higher inflation rate. This will soon enough cause nominal interest rates to rise, as inflationary expectations get added onto the real interest rate.

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The fact of the matter is that although the Fed can cause interest rates to move up or down in the short run via its choice of monetary policy, forces beyond its control determine what interest rates will be in the long run. The real rate is determined by the underlying productivity of the economy and the consumption preferences of individuals, and the expected inflation rate is determined by people’s beliefs about future policy. Thus, when you read that the chair of the Fed has lowered “the” interest rate, you know that the money supply has been increased. But you also now know that whether the Fed likes it or not, if this policy persists long enough, the eventual result will be more inflation in the future, and thus higher, not lower, interest rates.

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45 Controlling Interest: Are Ceilings OnInterest Rates a Good Idea?

Do ceilings always result in lower rates?Can ceilings reduce the amount of available credit?Do some borrowers tend to benefit from ceilings more than others?

No one wants to pay more interest than is necessary when they use credit. Whether shopping for mortgages, business loans, or auto loans, we usually are concerned about rates and terms and want to make sure we do not pay too much for the use of someone else’s money. Just as in any other purchase, when we buy credit we want to pay the lowest price possible.

In the past, the government often tried to ensure that we pay “a fair rate” of interest by implementing usury ceilings or limits on the rates that lenders can charge. Curing the 1980s there was a general trend toward eliminating or raising these limits as policy-makers reacted to the high inflation and record interest rates of the late 1970s. during the early 1990s, however, the trend reversed as some suggested that caps should be placed on credit card rates, which remained at historically high levels while other key interest rates declined significantly.

On the surface, capping interest rates seems to be perfectly logical. To protect people from paying interest rates that are perceived as “too high,” the government can simply mandate that rates be kept below a certain level. However, interest rate ceilings can have unintended consequences. This essay examines these possible consequences by discussing the economic theory behind the arguments for and against usury ceilings.

Just Another Market

Laws designed to prevent usury, or the taking of “excessive” interest, have long been the subject of controversy. While advocates of usury ceilings claim that such controls protect consumers from abusive lending practices and enable them to obtain loans at reasonable rates, their critics argue that they work to consumers’ disadvantage by restricting credit flows and distorting financial markets.

In economic theory, the credit market is viewed like any other market. There are buyers (borrowers) and sellers (lenders) of credit; the price of credit is the interest rate. The credit market is easily represented in a conventional supply and demand diagram like the one shown below.

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Standard Supply and As illustrated, the demand curve (DD)Demand Curve for indicates the amount of credit borrowersThe Credit Market are willing to purchase at various prices

Or interest rates. Since borrowers areInterest rate typically willing and able to borrow more

At lower prices, the demand curve slopesDown and to the right, illustrating that

SS higher prices, in this case interest rates,result in a lower quantity of creditof credit demanded and vice versa.

Equilibrium Price (rate)

DDQuantitywhere supplyand demandare balances

quantity of credit

the supply curve (SS) reflects the amount of credit lenders are willing to provide at various rates. The curve slopes upward because lenders costs, including the cost of funds, increase as more credit is supplied. At the same time, higher rates (the price of credit) offer an incentive for savers to provide more funds for lending. That is, lenders are able and willing to offer more credit at higher rates of interest than at lower rates.

In a competitive market, as borrowers increase their demands for a limited supply of credit they compete with one another, thus “bidding up” prices. But at prices (rates) rise, lenders will want to offer more credit thereby increasing supply and helping to satisfy demand. In addition, as prices increase, demand will generally decrease. This “bidding” process continues until borrowers and lenders eventually establish an equilibrium price that balances the supply of and demand for credit. This price is called the market rate of interest, which is represented on the second diagram as the point where the demand curve and supply curve intersect.

Lower Rates Can Be Bad – Sometimes

Usury laws establish a legal maximum interest rate (or price) that lenders may charge for a loan or extension of credit. These laws are, in effect, a form of price control.

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When a usury law is introduced, it may have no impact on the credit market or it may alter the way in which price and quantity are determined. Exactly what happens depends on where the usury ceiling is relative to the market rate.

When the legal ceiling is above the market rate of interest, the law has no effect at all. The market forces of supply and demand are not bound by the usury ceiling, and the equilibrium price and quantity of credit are unchanged. However, when the legal ceiling is below the market rate of interest, the regulation can affect the market outcome. Such a usury ceiling is said to be binding or effective. A binding ceiling obviously alters the price of credit – the ceiling rate becomes the rate of interest charged.

But, establishing a lower-than-market interest rate by means of a usury ceiling will also bring about a decrease in the quantity of credit supplied. Given lenders costs, the amount of credit they will provide when the interest rate is held down is limited. Like any other business, if a lender does not recoup its costs and earn an adequate return on its resources, it will put those resources to work elsewhere.

The Effect of a Binding CeilingInterest rate

SS

equilibriumprice (rate)

usury ceiling credit crunch DD

Since the amount of credit offered will not satisfy all those who are willing to borrow at the ceiling price, excess demand is created, giving rise to a situation in which the reduced amount of credit must be rationed among borrowers by some means other than price.

The diagram above illustrates a binding ceiling. The usury ceiling intersects supply and demand below the equilibrium price, indicating that the quantity demanded exceeds the quantity supplied at the legal maximum rate or price. The gap between the supply and demand curves represents a “credit crunch,” in which credit is not available despite the fact that there is demand for it.

Who Gets Hurt and Who Gets Credit?

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Many of the strategies lenders are likely to follow in a “credit crunch,” such as setting rigid loan terms, screening borrowers more rigorously, or increasing non-interest fees and charges, tend to concentrate the impact of usury ceilings on certain borrowers. For example, imposing more stringent loan terms such as shorter maturities and higher minimum loan size reallocates credit toward those who are able to afford larger down payments or larger monthly payments, generally those with higher incomes. Basing lending decisions heavily on individual characteristics, such as borrowing history or income without the flexibility of adding risk premiums, can ration credit away from new or high-risk consumers who might be willing to pay higher-than-ceiling rates. Finally, adding non-interest charges (such as higher fees) eliminates from the market those for whom these extra costs are too great.

By encouraging these lending practices, usury ceilings may fail to give consumers the protection and benefits that they were intended to provide. That is, usury laws may actually reduce the amount of credit that is available to low income or inexperienced borrowers. Low-priced credit is not useful to those who cannot meet the requirements for obtaining it.

Thus, when lenders ration credit by some means other than price, first-time borrowers, small borrowers, low-income and high-risk borrowers are likely to find it more difficult to obtain credit. The most creditworthy borrowers, on the other hand, may obtain more credit than they would have at normal market interest rates.

Furthermore, when lenders institute non-interest charges such as fees to compensate for interest rate ceilings, they effectively raise the cost of credit for all successful borrowers. Therefore, while a ceiling may reduce the explicit price of credit (interest rate), it may not result in lower overall costs of borrowing even for those able to obtain loans. Additionally, non-interest charges make it more complicated for customers to comprehend the total cost of borrowing and more difficult to make well-informed credit decisions.

While these lending practices and their undesirable consequences may exist in the absence of interest rate ceilings, several studies on the effects of usury ceilings have established that loan terms do become less favorable to borrowers when usury ceilings become more restrictive.

Increased Competition and Consumer Responsibility

A common argument in favor of usury laws is that without them, borrowers would be forced to pay exorbitant interest rates, or at least rates that are unreasonable in relation to the cost of supplying credit.

According to economic theory, a competitive market is sufficient to prevent lenders from exercising power over pricing or earning more than a normal return. The price established in a competitive market reflects suppliers’ costs of providing the given amount of that good. To be sure, removing a binding usury ceiling will result in higher interest rates.

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However, if credit markets are competitive, the resulting market rate of interest will not exceed lenders costs (including a fair return) of supplying credit. It is when competition is absent that consumers may fact unreasonable interest rates. Thus, the consequences of not having usury ceilings depend importantly on the competitiveness of credit markets. Indeed, the absence of competition is the only reason for imposing a usury ceiling that can be justified by economic theory.

Some of the responsibility for ensuring a competitive marketplace must be placed on borrowers themselves, since knowledgeable, informed borrowers help to foster competition in credit markets. When consumers do not know or cannot compare rates being charged by various lenders, each lender has more freedom to charge any rate – fair or unfair. A high level of borrower awareness can create a natural protection from unreasonable interest rates, in lieu of the external constraint of a usury ceiling.

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46 Money, Credit, and Security Markets

These statistics measure the amount of money in the economy as well as interest rates and include:

Money Stock (M1, M2, and M3) [monthly]Bank Credit at All Commercial Banks [monthly]Consumer Credit [monthly]Interest Rates and Bond Yields [weekly and monthly]Stock Prices and Yields [weekly and monthly]

Nominal interest rates are influenced by inflation, so like inflation they tend to be procyclical and a coincident economic indicator

Stock market returns are also procyclical but they are a leading indicator of economic performance.

Federal Finance

These are measures of government spending and government deficits and debts:

Federal Receipts (Revenue) [yearly]Federal Outlays (Expenses) [yearly]Federal Debt [yearly]

Governments generally try to stimulate the economy during recessions and to do so they increase spending without raising taxes. This causes both government spending and government debt to rise during a recession, so they are countercyclical economic indicators. They tend to be coincident to the business cycle.

International Trade

These are measure of how much the country is exporting and how much they are importing:

Industrial Production and Consumer Prices of Major Industrial CountriesU.S. International Trade in Goods and ServicesU.S. International Transactions

When times are good people tend to spend more money on both domestic and imported goods. The level of exports tends not to change much during the business cycle. So the balance of trade (or net exports) is countercyclical as imports outweigh exports during boom periods. Measures of international trade tend to be coincident economic indicators.

While we cannot predict the future perfectly, economic indicators help us understand where we are and where we are going. In the upcoming weeks I will be looking at

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individual economic indicators to show how they interact with the economy and why they move in the direction they do.

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47 Don’t Get into a lather over Sweatshops

SAN JOSE, CALIF. – San Francisco Mayor Gavin Newsom is pushing the city council to adopt an ordinance that forbids the use of municipal funds to purchase uniforms and other clothing made in “sweatshops.” Across the country, colleges often adopt similar standards for clothing displaying their school logos. North American unions, such as Unite here, the apparel and housekeeping workers’ union, often lobby to impose working standards for developing countries similar to San Francisco’s proposed ordinance. Though these efforts are intended to help poor workers in the third world, they actually hurt them.

We use “sweatshop” to mean those foreign factories with low pay and poor health and safety standards where employees choose to work, not those where employees are coerced into working by the threat of violence. And we admit that by Western standards, sweatshops have abhorrently low wages and poor working conditions. However, economists point out that alternatives to working in a sweatshop are often much worse; scavenging through trash, prostitution, crime, or even starvation.

Economists across the political spectrum, from Paul Krugman on the left, to Walter Williams on the right, have defended sweatshops. Their reasoning is straightforward: people choose what they perceive to be in their best interest. If workers voluntarily choose to work in sweatshops, without physical coercion, it must be because sweatshops are their best option. Our recent research—the first economic study to compare systematically sweatshop wages with average local wages—demonstrated this to be true.

We examined the apparel industry in 10 Asian and Latin American countries often accused of having sweatshops and then we looked at 43 specific accusations of unfair wages in 11 countries in the same regions. Our findings may seem surprising. Not only were sweatshops superior to the dire alternatives economists usually mentioned, but they often provided a better-than-average standard of living for their workers.

The apparel industry, which is often accused of unsafe working conditions and poor wages, actually pays its foreign workers well enough for them to rise above the poverty in their countries. While more than half of the population in most of the countries we studied lived on less than $2 per day, in 90 percent of the countries, working a 10-hour day in the apparel industry would lift a worker above—often far above—that standard. For example, in Honduras, the site of the infamous Kathy Lee Gifford sweatshop scandal, the average apparel worker earns $13.10 per day, yet 44 percent of the country’s population lives on less than $2 per day.

In 9 of the 11 countries we surveyed, the average reported sweatshop wages equaled or exceeded average incomes and in some cases by a large margin. In Cambodia, Haiti, Nicaragua, and Honduras, the average wage paid by a firm accused of being a sweatshop is more than double the average income in that country’s economy.

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Our findings should not be interpreted to mean that sweatshop jobs in the third world are ideal by US standards. The point is, they are located in developing countries where these jobs are providing a higher wage than other work.

Antisweatshop activists—who argue that consumers should abstain from buying products made in sweatshops—harm workers by trying to stop the trade that funds some of the better jobs in their economies.

Until poor nations’ economies develop, buying products made in sweatshops would do more to help their-world workers than San Francisco’s ordinance. By purchasing more products made in sweatshops, we create more demand for them and increase the number of factories in these poor economies. That gives the workers more employers to choose from, raises productivity and wages, and eventually improves working conditions. This is the same process of economic development the US went through, and it is ultimately the way third-world workers will raise their standard of living and quality of life.

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48 Are the Rich Getting Richer?

More and more in today’s media we read about the widening gap between the “haves” and “have-nots.” The problem the aforementioned reports have is that they don’t show if any particular individuals are staying at the same level, as they don’t prove if we are losing our birthright: a chance at upward mobility. If upward mobility is in fact being lost, we would have to show that the poorest remain stuck where they are.

The University Of Michigan did a panel survey on income dynamics, the longest tracking study ever done on American’s earnings. Since 1968, the university collected detailed information on more than 50,000 Americans. A sample from this database was taken for 17 years, enough to capture the real stories of all hired, being fired, windfalls, financial setbacks, etc. The survey shows that only 5% of those Americans in the bottom fifth of income earners in 1975 were still there in 1991. A majority of them made it to the top three-fifths of the income distribution, which is middle class or better. What is the most amazing point of all is that almost 3 out of every 10 of the low income earners from 1975 had risen to the top 20% by 1991. In addition, among the second-poorest 20% in 1975, more then 70% had moved to higher bracket in 1991.

What the study found was that wage and salary income was the factor responsible for pushing people upward in the distribution. Therefore, NOT LUCK is the widest path to upward mobility. The rich may indeed be getting richer, the poor are also getting richer.

Let’s take a look at income patterns over our lifetime. Income tends to rise rapidly in the early years, then peaks out during middle age and falls toward retirement. This is due to the fact that our economy is no longer as industrial as it used to be, when Americans “worked with their hands and their backs.” Today, Americans owe their paychecks to their brains, “mental talents continue to sharpen long after muscles and dexterity begin to falter. It is our shift from an economy that produces products to an economy that provides services as to why the peak earning years has shifted to older groups in the past two decades.

Put another way. Workers reap greater rewards for what they’ve learned on the job, and earnings therefore rise with experience; so, it’s not that the younger workers are falling behind their counterparts from earlier generations, it’s that older workers are getting wealthier than they used to.

Furthermore, the old axioms are still true; data confirm what our elders always told us: study hard, work hard and save.

1) Get an education. Nearly 60% of all Americans in the top fifth of income earners graduated from college. Only 6% did in the bottom fifth.

2) Work full time, year round. 80% of Americans in the top earnings bracket work at least 50 weeks a year. Full-time is the remedy for poverty.

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3) Form a family. In the bottom fifth income bracket, 64% live in non-family households. It’s not that poorer Americans don’t create families; to prove that, we see large families below the poverty line all the time. To be sure, if one creates a family, there is added responsibility that pushes one to be more serious about earning a living.

4) Be willing to move. Employment opportunities and wages differ from community and from region to region. Geographical mobility is one way Americans can find opportunity and close the income gap.

5) Be willing to retrain. Take the textile industry and compares it to the computer company industry. The number of computer jobs is rising and the hourly wages for a computer programmer are almost three times the hourly wages for a textile worker.

6) Become computer-savvy. Workers who know how to operate a computer earn as much as 15% more than those who don’t know, and doing the same job. Machines made us more productive, so companies would find those that know how to operate a machine more valuable.

7) Stick to it. Average income tends to rise quickly in life as workers gain experience and knowledge.

8) Save money. Savings can make a big difference for retirement. For individuals in

the bottom fifth income bracket, 83% of income comes from Social Security, whereas in the top income bracket, only 20% comes from Social Security.

…

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49 Should Profits Be Shared with Workers?

When most people argue that firms should share profits with workers, they are not interested in the general distribution of business receipts. Rather, they are pointing to firms experiencing exceptionally high profits and claiming that fairness requires that most of those profits be passed on to workers. For example, management consultant Alfie Kohn states, If a company has had a profitable year, I see no reason those gains should not be distributed to the employees; after all, their work is what produced the profits.

At a superficial level, it may seem only right that when a firm is doing well, its good fortune should be shared with the workers who made it possible. And, indeed, workers do benefit when their firms are profitable and expanding because their jobs are more secure and opportunities for promotion are greater. But shouldn’t firms making high profits directly share some of those profits with their workers by increasing their wages much more than in leaner times? Workers and their union representatives are frequently quick to use high profits as justification for demanding large wage increases, but is it wise to acquiesce?

It is generally true that those fortunate enough to work for highly profitable firms receive higher wages than those who work for barely profitable firms. But this is not the same as a firm giving its workers a large wage increase whenever it experiences a large profit increase. Firms seldom do this for reasons of efficiency, fairness, and the best interest of their workers.

Efficiency

Consider first the efficiency of sharing profits with workers. Although many people see profits as nothing more than rich people accumulating more wealth, profits serve a vital function in creating wealth by allowing consumers to communicate how they want scarce resources allocated among competing productive activities. A firm earning a large profit is using resources to create more value (as measured by what it sells its output for) than those resources could create elsewhere in the economy (as measured by what the firm has to pay for its inputs). The total value of production can then be increased, with the same use of resources, by reallocating resources to highly profitable firms and away from less profitable firms elsewhere in the economy. And this is exactly the reallocation of productive resources financed and motivated by high profits. Firms typically reinvest high profits right back into the productive activity that generated them by bidding resources, both human and non-human, away from less profitable activities. Output expands in the high-profit firms (driving their rate of return down) and contracts in the low-profit firms (driving their rate of return up) until additional inputs are worth no more in the former than in the latter.

This efficient reallocation would be impossible if a firm that began making high profits, say because of an increase in the demand for its product, used those profits to increase the wages of its workers. Firms are forced by competition to pay their workers at least as much as they are worth in their best alternative employments. If a firm devoted its high

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profits to paying its current workers more than is justified by their productivity, it would be unable to attract the additional resources it needs to expand. The workers receiving the higher wages would be obviously better off in the short run, but their gains would be more than offset by the losses (forgone opportunities) suffered by others in the economy.

Fairness

Quite apart from the adverse effects on efficiency, paying workers higher wages when the profits of the firm they work for are high forces firms to behave in ways that will be widely seen as unfair. If, because of high profits, a firm offers wages well in excess of their opportunity cost (the amount needed to attract workers with the appropriate skills from other employments), more people will want to work for that firm than it can afford to hire. This creates a situation where firms find themselves having to choose workers on the basis of non-economic considerations. Regardless of how firms make those choices, they will be criticized for practicing favoritism and unfair discrimination by those who are not chosen, and may be with justification. Certainly the fairest approach, and the one that penalizes discriminating on non-economic grounds, is to give all workers the opportunity to compete for jobs on the basis of their productive ability. This opportunity is denied to most workers when some are being paid more than their productivity warrants.

But even those who would get large wage increases because they work for firms creating high profits would probably not benefit from a policy of sharing in those profits, and certainly not if the policy were fairly implemented. If workers receive large wage increases when their firm is making large profits, then fairness would require that they also receive wage cuts when profits decline. Indeed, if workers favored a consistent policy of sharing in the profits, then they should be prepared to give money back (receive negative wages) when their firm (as firms often do) loses money. But workers obviously would not be happy with such a policy. It would expose them to all the risks that confront the owners of the firm, risks that few workers are willing to bear. People willing to accept large risks typically start their own businesses, or invest in businesses that others start, in return for a higher average, but very uncertain, return.

Workers are typically more risk averse, as evidenced by the fact that they choose to work for others for a lower average, but more certain, return in the form of a fixed salary or wage.

The Free-Rider Temptation

Profit-sharing arrangements are easily frustrated by the free-rider temptation. Although it is collectively rational for all employees to work harder in response to profit sharing, it is not individually rational to do so. Each worker will recognize that if others work harder, that he will reap the benefits from higher profits without extra effort. Each worker also recognizes that if others don’t work harder, then his share of the additional profit generated by extra effort is too small to be worth the effort.

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For example, assume that there are 1,000 workers in a firm, each earning $15.00 per hour. Also assume a profit-sharing plan is established that would increase total worker productivity, and therefore worker compensation, by $40,000 per week if all workers reduce their shirking on the job by one hour per week. this is clearly a good deal for the workers, since each one stands to receive $40 for putting in just one more hour of genuine effort. But consider the payoff each individual would realize from his decision to shirk an hour less. The individual who puts in one more hour of work would be responsible for increasing total compensation by $40 (assuming that each individual’s impact on productivity is the same as everyone else’s, and independent of what others do). but since the additional $40 is spread over all 1,000 workers, his share, in the form of higher wages is only $.04. How many would be willing to give up an hour of on-the-job leisure for $.04? At that hourly rate a person would have to work an entire 40-hour week to make enough to buy a small box of popcorn at the movies.

So having workers share consistently in the profits of their firm is not a policy many workers would find attractive. Such profit-sharing arrangements do little to motivate more productive effort, while imposing risk on workers that few are comfortable accepting. This explains why profit-sharing arrangements are often short-lived.

For example, Wal-Mart Stores has experienced some difficulties with its profit-sharing plan. Probably no other U. S. company has used stock incentives more than Wal-Mart to motivate hard work and loyalty from its workers. And for years it worked as Wal-Mart stock steadily increased in value (100 shares of Wal-Mart stock, which cost $1,650 in 1970 when it first went public, were worth $3.5 million in February 1993). But then the stock experienced a decline, going from $34.125 a share in February 1993 to $20,875 on the first trading day in 1995. During this decline, the profit-sharing plan became a source of worker complaints and demands for more pay and union representation. As reported in the Wall Street Journal, The world’s largest retailer is also discovering the risks in a profit-sharing plan heavily invested in its own stocks.

Unless workers are willing to take the losses that are inevitable in business activity, as well as the gains, the argument that fairness requires that workers share in the profits of their firms is an empty one. Many workers, and their representatives who call for sharing profits with workers, seem to believe that fairness means Heads I win, tails you lose. All workers are better off, and treated more fairly, when most profits are retained by firms to expand the production of goods and services that consumers are communicating with those profits that they want more of.

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50. Sex, Booze, and Drugs

Prior to 1914, cocaine was legal in this country; today it is not. Alcohol (of the intoxicating variety) is legal in the United States today; from 1920 to 1933 it was not. Prostitution is legal in Nevada today; in the other forty-nine states it is not. All these goods-sex, booze, and drugs-have at least one thing in common; The consumption of each brings together a willing seller with a willing buyer; there is an act of mutually beneficial exchange (at least in the opinion of the parties involved). Partly because of this property, attempts to proscribe the consumption these good have (1) met with less than spectacular success, and (2) yielded some peculiar patterns of production, distribution, and usage. Let’s see why.

When the government seeks to prevent voluntary exchange, it generally must decide whether to go after the seller or the buyer. In most cases-and certainly when sex, booze, or drugs have been involved-the government targets sellers, because this is where the authorities get the most benefit from their enforcement dollars. A cocaine dealer, even a small retail pusher, often supplies dozens or even hundreds of users each day, as did speakeasies (illegal saloons) during Prohibition; a hooker typically services anywhere from three to ten tricks per day. By incarcerating the supplier, the police can prevent several-or even several hundred-transactions from taking place, which is usually much more cost-effective than going after the buyers one by one. It is not that the police ignore the consumers of illegal goods; indeed, sting operations-in which the police pose as illicit sellers-often make the headlines. Nevertheless, most enforcement efforts focus on the supply side, and so shall we.

Law enforcement activities directed against the suppliers of illegal goods increase the suppliers’ operating costs. The risks of fines, jail sentences, and possibly even violence become part of the costs of doing business and must be taken into account by existing and potential suppliers. Some entrepreneurs will leave the business, turning their talents to other activities; others will resort to clandestine (and costly) means to hide their operations from the police; still others will restrict the circle of buyers with whom they are willing to deal to minimize the chances that a customer is a cop. Across the board, the costs of operation are higher, and at any given price, less of the product will be available. There is a reduction in supply, and the result is a higher price for the good.

This increase in price is, in a sense, exactly what the enforcement officials are after, for the consumers of sex, booze, and drugs behave according to the law of demand: The higher the price of a good, the lower the amount consumed. So the immediate impact of the enforcement efforts against sellers is to reduce the consumption of the illegal good by buyers. There are, however, some other effects.

First, because the good in question is illegal, people who have a comparative advantage in conduction illegal activities will be attracted to the business of supplying (and perhaps demanding) the good. Some may have an existing criminal record and are relatively unconcerned about adding to it. Others may have developed skills in evading detection and prosecution while engaged in other criminal activities. Some may simply look at the

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illegal activity as another means of thumbing their noses at society. The general point is that when an activity is made illegal, people who are good at being criminals are attracted to that activity.

Illegal contracts usually are not enforceable through legal channels (and even if they were, few suppliers of illegal goods would be stupid enough to complain to the police about not being paid for their products). Thus, buyers and sellers of illegal goods frequently must resort to private methods of contract enforcement-which often means violence. Hence, people who are relatively good at violence are attracted to illegal activities and are given greater incentives to employ their talents. This is one reason why the murder rate in America rose to record levels during Prohibition (1920-1933) and then dropped sharply when liquor was again made legal. It also helps explain why the number of drug-related murders soared during the 1980’s, and shy drive-by shooting became commonplace in may drug-infested cities. The Thompson submachine gun of the 1930’s and the MAC-10 machine gun of the 1980’s were importantly, just low-cost means of contract enforcement.

The attempts of law enforcement officials to drive sellers of illegal goods out of business have another effect. Based on recent wholesale prices, $50,000 worth of pure heroin weighs about two ounces; $50,000 worth of marijuana weighs about twenty pounds. As any drug smuggler can tell you, hiding two ounces of contraband is a lot easier than hiding twenty pounds. Thus, to avoid detection and prosecution, suppliers of the illegal good have an incentive to deal in the more valuable versions of their product, which for drugs and booze mean the more potent versions. Bootleggers during Prohibition concentrated on hard liquor rather than beer and wine; even today, moonshine typically has roughly twice the alcohol content of legal hard liquor such as bourbon, scotch, or vodka. After narcotics became illegal in this country in 1914, importers switched from the milder opium to its more valuable, more potent, and more addictive derivative, heroin.

The move to the more potent versions of illegal commodities is enhanced by enforcement activities directed against users. Not only do users, like suppliers, find it easier (cheaper) to hide the more potent versions, there is also a change in relative prices due to user penalties. Typically, the law has lower penalties for using an illegal substance than for distributing it. Within each category (use or sale), however, there is commonly the same penalty regardless and a bottle of more expensive, more potent hard liquor were equally illegal. Today, the possession of one gram of 90 percent pure cocaine brings the same penalty as the possession of one gram of 10 percent pure cocaine. Given the physical quantities, there is a fixed cost (the legal penalty) associated with being caught, regardless of value per unit (and thus potency) of the substance. Hence, the structure of legal penalties raises the relative price of less potent versions, encouraging users to substitute more potent versions-heroin instead of opium, hashish instead of marijuana, hard liquor instead of beer.

Penalties against users also encourage a change in the nature of usage. Prior to 1914 , cocaine was legal in this country and was used openly as a mild stimulant, much as

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people today use caffeine. (Cocaine was even included in the original formulation of Coca-Cola) This type of usage-small, regular doses over long time intervals becomes relatively more expensive when the substance is made illegal. Extensive usage (small doses spread over time) is more likely to be detected by the authorities than is intensive usage (a large dose consumed at once), simply because possession time is longer and the drug must be accessed more frequently. Thus, when a substance is made illegal, there is an incentive for consumers to switch toward usage that is more intensive. Rather than ingesting cocaine orally in the form of a highly diluted liquid solution, as was commonly done before 1914, people switched to snorting or even injecting it During Prohibition, people dispensed with cocktails before dinner each night; instead, on the less frequent occasions when they drank, they more often drank to get drunk. The same phenomenon is observed today. People under the age of twenty-one consume alcoholic beverages less frequently than do people over the age of twenty-one. But when they do drink, they are more likely to drink to get drunk.

Not surprisingly, the suppliers of illegal commodities are reluctant to advertise their wares openly; the police are as capable of reading billboards and watching TV as are potential customers. Suppliers are also reluctant to establish easily recognized identities and regular places and hours of business, because to do so raises the chance of being caught by the police. Information about the price and quality of products being sold goes underground, often with unfortunate effects for consumers. With legal goods, consumers have several means of obtaining information. They can learn from friends, advertisements, and personal experience. When goods are legal, they can be trademarked for identification. The trademark may not legally be copied, and the courts protect it. Given such easily identified brands, consumers can be made aware of the quality and price of each. If their experience does not meet expectations, they can assure themselves of no further contact with the unsatisfactory product by never buying that brand again.

When a general class of products becomes illegal, there are fewer ways to obtain information. Brand names are no longer protected by law, so falsification of well-known brands ensues. When products do not meet expectations, it is more difficult (costly) for consumers to punish suppliers. Frequently, the result is degradation of and uncertainty about product quality. The consequences for consumers of the illegal goods are often unpleasant, sometimes fatal.

Consider prostitution. In those counties in Nevada where prostitution is legal, The prostitutes are required to register with the local authorities, and they generally conduct their business within the confines of well-established bordellos. These establishments advertise openly and rely heavily on repeat business. Health officials test the prostitutes weekly for venereal disease and every month for AIDS. Contrast this with other areas of the country, where prostitution is illegal. Suppliers generally are streetwalkers, because a fixed physical location is too easy for the police to detect and raid. Suppliers change location frequently, to reduce harassment by police. Repeat business is reported to be

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minimal; frequently, customers have never seen the prostitute before and never will again.

The difference in outcomes is striking. In Nevada, the spread of venereal disease by legal prostitutes is estimated to be almost nonexistent; to date, none of the 9000 registered prostitutes in Nevada has tested positive for AIDS. By contrast, in some major cities outside Nevada the incidence of venereal disease among prostitutes is estimated to be near 100 percent. In Miami, one study found that 19 percent of all incarcerated prostitutes tested positive for AIDS; in Newark, New Jersey, 52 percent of the prostitutes tested were infected with the AIDS virus, and about half of the prostitutes in Washington D.C., and New York City are also believed to be carrying the AIDS virus. Because of the lack of reliable information in markets for illegal goods, customers frequently do not know exactly what they are getting; as a result, they sometimes get more than they bargained for.

Consider alcohol and drugs. Today, alcoholic beverages are heavily advertised to establish their brand names and are carried by reputable dealers. Customers can readily punish suppliers for any deviation from the expected potency or quality by withdrawing their business, telling their friends, or even bringing a lawsuit, Similar circumstances prevailed before 1914 in this country for the hundreds of products containing opium or cocaine.

During Prohibition, consumers of alcohol often did not know exactly what they were buying or where to find the supplier the next day if they were dissatisfied. Fly-by-night operators sometimes adulterated liquor with methyl alcohol. In extremely small concentrations, this made watered-down booze taste like it had more kick; in only slightly higher concentrations, the methyl alcohol blinded or even killed the unsuspecting consumer. Even in “reputable” speak-easies (those likely to be in business at the same location the next day), bottles bearing the labels of high-priced foreign whiskeys were refilled repeatedly with locally (and illegally) produced rotgut until their labels wore off.

In the 1970s, more than one purchaser of what was reputed to be high-potency Panama Red or Acapulco Gold marijuana ended up with low-potency pot heavily loaded with stems, seeds, and maybe even oregano. Buyers of cocaine must worry about not only how much the product has been cut along the distribution chain, but also what has been used to cut it. In recent years the purity of cocaine at the retail level has ranged between 10 percent and 95 percent; for heroin, the degree of purity has ranged from 5 percent to 50 percent. Cutting agents can turn out to be any of various sugars, local anesthetics, or amphetamines; on occasion, rat poison has been used.

We noted earlier that the legal penalties for the users of illegal goods encourage them to use more potent forms and to use them more intensively. These facts and the uncertain quality and potency of the illegal products yield a deadly combination. During Prohibition, the death rate from acute alcohol poisoning (i.e. due to an overdose) was more than thirty times higher than today. During 1927 alone, 12,000 people died from acute alcohol poisoning, and many thousands more were blinded or killed by

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contaminated booze. Today, about 3,000 people per year die as a direct result of consuming either cocaine or heroin. Of that total, it is estimated, roughly 80 percent die from (1) an overdose caused by unexpectedly potent product, or (2) an adverse reaction to the material used to cut the drug. Clearly, caveat emptor (let the buyer beware) is a warning to be taken seriously if one is consuming an illegal product.

We noted at the beginning of the chapter that one of the effects of making a good illegal is to raise its price. one might well ask, by how much? During the early 1990s, the federal government was spending about $2 billion a year in its efforts to stop the importation of cocaine from Columbia. One recent study concluded that these efforts had hiked the price of cocaine by 4 percent (yes, 4 percent) relative to what it would have been had the federal government done nothing to interdict cocaine imports. The study estimated that the cost of raising the price of cocaine an additional 2 percent would be $1 billion per year.3

The government’s efforts to halt imports of marijuana have been more successful, presumably because that product is easier to detect than cocaine. Nevertheless, suppliers have responded by cultivating marijuana domestically instead of importing it. The net effect had been an estimated tenfold increase in potency due to the superior farming techniques available in this country, as well as the use of genetic bioengineering to improve strains.

We might also consider the government’s efforts to eliminate the consumption of alcohol during the1920s and 1930s. they failed so badly that the Eighteenth Amendment, which put Prohibition in place, was the first (and thus far the only) constitutional amendment ever to be repealed. As for prostitution – it is reputed to be “the oldest profession,” and by all accounts continues to flourish today, even in Newark and Miami.

The government’s inability to halt the consumption of sex, booze, or drugs does not in and of itself mean that those efforts have failed. Indeed, the “successes” of these efforts are manifested in their consequences – ranging from tainted drugs and alcohol to disease-ridden prostitutes. The message instead is that when the government attempts to prevent mutually beneficial exchange, even its best efforts are unlikely to meet with spectacular success.

3Federal attempts to prevent cocaine from entering the country are, of course, supplemented by other federal, as well as state and local, efforts to eradicate the drug once it has crossed our borders. To date, there are no empirical estimates of the extent to which these other efforts have increased prices.

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51 Rich Nation, Poor Nation

Why do the citizens of some nations grow rich while the inhabitants of others remain poor? Your initial answer might be “because of differences in the natural resource endowments of the nations.” It is true that ample endowments of energy, timber, and fertile land all help increase wealth. But natural resources can be only a very small part of the answer, as witnessed by many counterexamples. Switzerland and Luxembourg, for example, are nearly devoid of key natural resources, and yet decade after decade, the real income of citizens of those lands has grown rapidly, propelling them to great prosperity. Similarly, Hong Kong, which consists of but a few square miles of rock and hillside, is one of the economic miracles of the twentieth century, while in Russia, a land amply endowed with vast quantities of virtually every important resource, most people remain mired in economic misery.

Unraveling the Mystery of Growth

A number of recent studies have begun to unravel the mystery of economic growth. Repeatedly, they have found that it is the fundamental political and legal institutions of society that are conducive to growth. Of these, political stability, secure private

Table 1-1 Differing Legal Systems

Common Law Nations Civil Law NationAustralia BrazilCanada EgyptIndia GermanyIsrael GreeceNew Zealand ItalyUnited Kingdom MexicoUnited States Sweden

Property right, and legal systems based on the rule of law are among the most important. Such institutions encourage people to make long-term investments in improvements to land and in all forms of physical and human capital. These investments raise the capital stock, which in turn provides for more growth long into the future. And the cumulative effects of this growth over time eventually yield much higher standards of living.

Professor Paul Mahoney of the University of Virginia, for example, has studied the contrasting effects of different legal systems on economic growth. Many legal systems around the world today are based on one of two basic models: the English common law system and the French civil law system. Common law systems reflect a conscious decision in favor of the judiciary in constraining the power of the executive and legislative branches of government. In contrast, civil law systems favor the creation of a

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strong centralized government in which the legislature and the executive branch have the power to grant preferential treatment to special interest. Table 1-1 shows a sample of common law nations.

The Importance of Secure Property Rights

Mahoney finds that the security of property rights is much stronger in nations with common law systems, such as the United Kingdom and its former colonies, including the United State. In nations such as France and its former colonies, the civil law systems are much more likely to yield unpredictable changes in the rules of the game-the structure of property and contract rights. This, in turn, makes people reluctant to make long-term fixed investments in nations with civil law systems, a fact that ultimately slows their growth and lowers the standard of living of their citizens.

The reasoning here is simple. If the police will not help you protect your rights to a home or car, you are less likely to acquire those assets. Similarly, if you cannot easily enforce business or employment contracts, you are much less likely to enter into those contracts-and thus less likely to produce as many goods or service. Furthermore, if you cannot plan for the future because you don’t know what the rules of the game will be in ten years or perhaps even one year from now, you are far less likely to make productive long-terms investments that require years to pay off. Common law systems seem to do a better job at enforcing contracts and securing property rights and thus would be expected to promote economic activity now and economic growth over time.

When Mahoney examined the economic performance of nations around the world from 1960 until the 1990s, he found that economic growth has been one-third higher in the common law nations, with their strong property rights, than it has been in civil law nations. Over the years covered b his study, the increase in the standard of living-measured by real per capita income was more than 20 percent greater in common law nations than in civil law nations. If such a pattern persisted over the span of a century, it would produce a staggering 80 percent differential in terms of real per capita income in favor of nations with secure property rights.

The Importance of Other Institutions

The economists William Easterly and Ross Levine have taken a much broader view, both across time and across institutions, assessing the economic growth of a variety of nations since their days as colonies. These authors examine how institutions such as political stability, protection of persons and property against violence or theft, security of contracts, and freedom from regulatory burdens contribute to sustained economic growth. They find that it is key institution such as these, rather than natural-resource endowments that explain long-term differences in growth and thus present day differences in levels of real income. To illustrate the powerful effect of institutions, consider the contrast between Mexico, with a real per capita income of about $10,600 today, and the United States, with a real per capita income of about $44,000. Easterly and Levine conclude that

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if Mexico had developed with the same political and legal institutions that the US has enjoyed, per capita income in Mexico today would be equal to that in the US.

The Historical Roots of Today’s Institutions

In light of the tremendous importance of institutions in determining long term growth, Easterly and Levine go on to ask another important question: How have countries gotten the political and legal institutions they have today? The answer has to do with disease, of all things. The seventy-two countries Easterly and Levine examined are all former European colonies in which a variety of colonial strategies were pursued. In Australia, New Zealand, and North America, the colonists found geography and climate that were conducive to good health. Permanent settlement in such locations was attractive, and so the settlers created institutions to protect private property and curb the power of the state. But when Europeans arrived in Africa and South America, they encountered tropical diseases such as malaria and yellow fever that produced high mortality among the settlers. This discouraged permanent settlement and encouraged a mentality focused on extracting metals, cash crops, and other resources. This, in turn, provided little incentive to promote democratic institutions or stable long-term property right systems. The differing initial institutions helped shape economic growth over the years, and their persistence continues to shape the political and legal character and the standard of living in these nations today.

No Property Rights, No Property

Recent events also illustrate that the effects of political and legal institutions can be drastically accelerated at least in the wrong directions. When Zimbabwe won its independence from Great Britain in 1980, it was one of the most prosperous nations in Africa. Soon after taking power as Zimbabwe’s first (and thus far only) president, Robert Mugabe began disassembling that nation’s rule of law, tearing apart the institutions that had helped it grow rich. He reduced the security of property rights in land and eventually confiscated those rights altogether. Mugabe also has gradually taken control of the prices of most goods and services in his nation and even controls the price of its national currency, at least the price at which Zimbabweans are allowed to trade it. The Mugabe government has also confiscated large stocks of food and most other things of value that might be exported out of or imported into Zimbabwe. In short, anything that is produced or saved has become subject to confiscation, so the incentives to do either are to put it mildly reduced. As a result, between 1980 and 1996 it has fallen by an additional third. Unemployment exceeds 70 percent of the workforce, investment is nonexistent, and since 2002 the inflation rate in Zimbabwe has averaged 500 percent per year. In only twenty five years, the fruit of many decades of labor and capital investment has been destroyed because the very institutions that made that fruit possible have been eliminated. It is a lesson we ignore at our peril

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52 Raising Less Corn and More Hell

When politician Mary Lease stumped the Kansas countryside in 1890, she urged the farmers to raise “less corn and more hell,” and the is just what they have been doing ever since.

The two decades before WWI witnessed unparalleled agricultural prosperity in the US. This “golden age of American farming” continued through the war as food prices soared. The end of the war, combined with a sharp depression in 1920, brought the golden age to a painful halt. Even the long economic recovery from 1921 to 1929-the Roaring Twenties-did little to help American farmers. European countries were redirecting their resources into agricultural production, and new American tariffs on foreign goods severely disrupted international trade. Because food exports had been an important source of farmers’ incomes, the decline in world trade reduced the demand for American agricultural products and cut deeply into food prices and farm income.

The sharply falling food prices of the 1920s led farmers to view their problem as one of overproduction. Numerous cooperative efforts were made, therefore, to restrict production, but virtually all of these efforts failed. Most crops were produced under highly competitive conditions, with large numbers of buyers and sellers dealing in products that were largely undifferentiated: One farmer’s corn, for example, was the same as any other farmer’s corn. Thus producers were unable to enforce collective output restrictions and price hikes on a voluntary basis. But what farmers failed to do by voluntary means in the 1920s, they accomplished via government directives in the 1930s. An effective farm price-support program was instituted in 1933, marking the beginning of policy of farm subsidies in the US that continues today.

We can best understand the results of price supports and other government farm programs by first examining the market for agricultural commodities in the absence of government intervention. In that competitive market, a large number of farmers supply any given commodity, such as corn. The sum of the quantities that individual farmers supply at various prices generates the market supply of a commodity. Each farmer supplies only a small part of the market total. No one farmer, therefore, can influence the price of the product. If one farmer were to raise the price, buyers could easily purchase from someone else at the market-clearing, or equilibrium, price. And no farmers would sell below the market-clearing price. Thus every unity of output sold by farmers goes for the same price. The price received for the last (or marginal) unit sold is exactly the same as that received for all the rest. The farmer will produce corn up to the point that if one more unit were produced, s production cost would be greater than the price received. Notice that at higher prices, farmers can incur higher costs for additional units produced and still make a profit. Because all farmers face the same basic production decisions, all farmers together will produce more at the market-clearing price, which will equal the costs of production plus a normal profit.

Now, how has the usual price-support program worked? The government has decided what constitutes a “fair price”. Initially, this decision was linked to the prices farmers received during “good” years--such as during agriculture’s golden age. Eventually, the government-established price was simply the result of intense negotiations between

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members of congress from farm states and those from non-farm states. The key point, decreed by the government has generally been well above the equilibrium price that would have prevailed in the absence of price supports. This has encouraged farmers to produce more, which ordinarily would simply push prices back down.

How has the government made its price “stick”? there have been two methods. For the first several decades of farm programs, it agreed to buy the crops, such as corn, at a price, called the support price, that was high enough to keep farmers happy but not so high as to enrage too many taxpayers. As a practical matter, these purchases have been disguised as “loans” from a government agency-loans that never need be repaid. The government then either stored the crops it purchased, sold them on the world market (as opposed to the domestic market) at prices well below the U.S support price, or simply gave them away to foreign nations under the Food for Peace program. In each instance, the result was substantial costs for taxpayers and substantial gains for farmers. Under the price-support system, the American taxpayers routinely spent more than $10 billion each year for the benefit of corn farmers alone. Smaller but still substantial subsidies were garnered by the producers of wheat, peanuts, soybean, sorghum, rice, and cotton, to name but a few.

In an effort to keep the size of the surpluses down, the government has often restricted the number of acres that farmers may cultivate. Under these various acreage-restriction programs, farmers wishing to participate in certain government subsidy programs were required to keep a certain amount of land out of production. About 80 million acres, an area the size of New Mexico, have at one time or another been covered by the agreements. Enticed by high support prices, farmers have always been ingenious in finding ways to evade acreage restrictions. For example, soybeans and sorghum are both excellent substitutes for corn as a source of livestock feed. So farmers agreed to cut their corn acreage and then planted soybeans or sorghum on the same land. This action aggravated the corn surplus and forced the government to extend acreage restrictions and price supports to soybeans and sorghum. Similarly, faced with limitations on the amount of land they could cultivate, farmers responded by cultivating the smaller remaining land far more intensively. They used more fertilizers and pesticides, introduced more sophisticated methods of planting and irrigation, and applied technological advances in farm machinery at every opportunity. As a result, agricultural output per man hour is now twelve times what it was sixty years ago.

There were a couple of problems with the price-support system. First, because it kept crop prices high, it kept consumers’ food bills high as well. People were spending an extra $5 to $10 billion on food each year. Another problem with the price-support system was the fact that the surplus crops piled up year after year in government warehouses. Not only was storing the surpluses expensive, but it also eventually became politically embarrassing. For example, at one point, the federal government had enough wheat in its storage bins to make seven loaves of bread for every man, woman, and child in the world.

To help get rid of accumulated surpluses, in the early 1980s the government tried a new payment-in-kind (PIK) program. Instead of writing checks to farmers, the PID scheme authorized the US Department of Agriculture to give farmers surplus commodities that were left in storage due to price supports. Farmers could use the commodities as livestock feed or simply sell them at the going market price. The PIK program got rid of

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leftover surpluses and encouraged exports initially, but many farmers into growing the same crop year after year, regardless of market conditions. If farmers didn’t plant a specified percentage of their “crop base” each year, their subsidy payments were subsequently reduced. The result was huge crop costs for the government in the lucrative (for farmers) corn and wheat programs.

The federal government also switched to a system in which it set a target price that was guaranteed to farmers but let the price paid by consumers adjust to whatever lower level it took to get consumers to buy all of the crops. Then the government simply sent a check to farmers for the difference between the target price and the market price. This brought consumers’ food bills down and eliminated government storage of surplus crops, but it also meant that the cost to taxpayers up to $25 billion per year was painfully clear in the huge checks being written to farmers.

The original price-support program hid its subsidies by making it appear as though the crop surpluses were the result of American farmers’ simply being “too productive” for their own good. With the direct cash payments made under the target-price system, however, it became apparent that the government was taking money out of taxpayers’ pockets with one hand and giving it to farmers with the other. Moreover, the target-price system, like our other agricultural programs, geared the size of the subsidies to the amount of output produced by the recipients. Thus small farmers received trivial amounts, while giant farms-agribusinesses-collected enormous subsidies. The owners of many huge cotton farms and rice farms, for example, received payments totaling more than $1 million apiece.

This fact illustrates who actually benefits from federal farm programs. Although these programs have traditionally been promoted as a way to guarantee decent earning for low-income farmers, most of the benefits have in fact gone to the owners of very large farms, and the larger the farm, the bigger the benefit. In addition, all of the benefits from price supports ultimately accrue to landowners on whose land price-supported crops are grown.

In the mid-1990s, the Republican-controlled Congress made what turned out to be a futile attempt to reduce agricultural subsidies. On April 5, 1996, a New York Times headline read, “Clinton Signs Farm Bill Ending subsidies,” reflecting the fact that Congress had enacted and Clinton signed the seven-year Freedom to Farm Act. The 1996 reforms were supposed to increase farmer flexibility and remove market distortions by moving away from price-support payments for wheat, corn, and cotton. In their place, farmers would receive “transition payments.” The taxpayer was supposed to save billions of dollars.

It was not to be. Beginning in 1998, Congress passed large farm “supplemental bills” each year, each costing billions of dollars per year—in money that goes directly from your paycheck to the bank accounts of the largest agribusiness corporations in America. Then, in 2002, Congress passed the most expensive farm bill in the history of the United States, with an advertised price tag of over $191 billion for a ten-year period. (The actual price tag is turning out to be even higher.) President Bush said, when he signed the bill, “This nation has got to eat.” He further said, “Our farmers and ranchers are the most efficient producers in the world…. We are really good at it.”

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We are also really good at subsidizing farmers, and most of them are not poor. In one recent year, when farm profits were $72 billion, the federal government handed out $25 billion is subsidies to farmers, almost 50 percent more than it spent on welfare payments for poor families. Millionaires such as Ted Turner and David Rockefeller receive hundreds of thousands of dollars a year in taxpayer-financed agricultural subsidies. When you add to the $191 billion of direct subsidies to the almost $300 billion of higher food prices that will result over the ten years of the program, you will see that the average American household will pay almost $4,400 in higher food prices and higher taxes. As always, two-thirds of all farm subsidies will go to the top 10 percent of farms, most which earn over $250,000 annually. Thus, large agribusinesses continue to be the chief beneficiaries of our generous agricultural policy.

Farmers can now receive payments for growing crops they used to grow but don’t grow anymore. In fact, if they sell their land to someone else, the right to receive these payments goes with the land. So in many cases, even if the land is subsequently carved up into lots on which people build homes, the happy home owners are eligible for such “direct payments,” made because years ago the land was used to grow, say, rice. The price tag in one recent year: $1.3 billion. Farmers also receive payments to compensate them for losses they don’t actually incur. To see how this works, let’s suppose the government’s target price for corn is $2.00 per bushel and that a farmer manages to sell his crop for $2.30 per bushel during a period of the year when prices were a bit higher than $2.00, say, to $1.80, the farmer can claim a “deficiency payment” from the government. In this case, he would be eligible for 20 cents per bushel (= $2.00 - $1.80) for every bushel produced, even though he actually sold his corn at $2.30.

Perhaps we should not complain too much about farm programs in the United States, for at least we don’t have Japanese farm programs. In Japan, a combination of subsidies for domestic farmers and tariffs on imported food have pushed farm incomes to a level roughly double the average income in the country as a whole. They also have driven up the price of an ordinary melon to $100 (yes, one hundred dollars). Even the Europeans seem to find lavishing largesse on farmers irresistible. In recent years, Americans have been shelling out about $40 billion a year for farm subsidies. The European Union (EU) has been spending more than $130 billion a year on farm subsidies. To be sure, the EU is about 50 percent more populous than the United States, but even adjusting for this, the huge spending there means that the average EU citizen is spending twice as much subsidizing farmers as we spend here.

Politicians from the farming states argue that we cannot abandon our farmers because the United States would end up with too many bankrupt farms and not enough food. But there is evidence from at least one country that such a scenario is simply not correct. In 1984, New Zealand’s Labor government ended all farm subsidies of every kind, going completely “cold turkey” without any sort of transition to the new era of free markets for food. Agricultural subsidies in New Zealand had accounted for more than 30 percent of the value of agricultural production, even higher than what has been observed in the United States. The elimination of subsidies in New Zealand occurred rapidly, and there were no extended phaseouts for any crops. Despite this, there was no outbreak of farm bankruptcies. Indeed, only 1 percent of farms have gone out of business in New

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Zealand since 1984. Instead, the farmers responded by improving their techniques, cutting costs, and aggressively marketing their products in export markets.

The results have been dramatic. The value of farm output in New Zealand has increased by more than 40 percent (in constant-dollar terms) since the subsidy phaseout. The share of New Zealand’s total annual output attributed to farming has increased from 14 percent to 17 percent. Land productivity has increased on an annual basis a little over 6 percent. Indeed, according to the Federated Farmers of New Zealand, the country’s experience thoroughly debunked the myth that the farming sector cannot prosper without government subsidies.

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53 Shortages under Rent Control: The New Evidence

What happens to price and availability of unregulated housing in a rent-controlled market? To determine this, this author collected data on all the available apartments advertised in eighteen major cities around North America. The advertised prices were taken from a single Sunday edition of the largest paper in each city during the month of April 1997. The advertised price of every listed apartment was recorded. (Three newspapers were used for New York.) Rented houses were also included. Some older urban areas − Chicago, Cleveland, New York, Philadelphia − have very few rental houses, while in Sunbelt cities such as Dallas, Houston, Phoenix, and San Diego, they make up a large portion of the rental market. To make sure this regional phenomenon was not distorting the figures, rental houses were omitted in two cities, Atlanta and Phoenix. Six of the surveyed cities have rent control− Los Angeles, New York, and San Francisco, San Jose, Toronto, and Washington. In addition, Boston ended rent control in January 1997. The median rent shown on each graph is based on the 1990 U.S. Census.

The most striking observation is that the graphs of rents in free-market cities follow a standard bell curve. The vast majority of advertised rents cluster around the median, with between 33 and 40 percent below the census median. The median advertised rent is rarely more than $50 above the census median. This may be because the very cheapest apartments are not likely to be advertised in the newspaper and because landlords often raise rents when apartments become vacant. The mode −the number where the graph peaks −usually occurs below both medians. Characteristically, there is a steep climb on the low-rent side of the curve, followed by a long tail toward the “luxury” end of the market.

It is also striking how affordable housing is in most free-market cities. In Philadelphia, the nation’s fifth largest city, the most common advertised then, the mode, is between $450 and $500−below both the advertised and census medians. In Chicago, the mode was $500 to $550., also below both medians. Unregulated cities such as Philadelphia, Chicago, San Diego, Phoenix, and Seattle seem to have almost perfectly competitive housing markets, with housing available at every price level but clustered at the low end.

The two cities with strict rent control are glaring exceptions to this pattern. In both New York and San Francisco, advertised rents peaked at $2,000−more than triple the U.S. Census median rent for each city. The median advertised rent in New York was $1,350, in San Francisco, $1,400−both more than double the census median. More important, there were almost no rental units available at the low end of the market. In both San Francisco and New York, less than 10 percent of advertised rents were below the census median. (The New York figures also included listings from the Daily News and the New York Post, which are slanted toward the lower end of the market.) Rent control in both these cities appears to make housing spectacularly unaffordable.

San Jose and Boston both show strong symptoms of the rent control disease. San Jose rents peak at $1,500, with rents pushed more toward the expensive end. Boston shows the usual “median hump,” but displays overtones of the rent-control effect at the upper end.

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Los Angeles, Washington, and Toronto −all of which practice milder forms of rent control than New York and San Francisco −show little or no signs of the rent control effect.

What is going on in these markets? The explanation seems fairly straightforward. Rent control splits the housing market into two sectors, the regulated segment and the shadow market. AS prices in the regulated sector are forced lower, prices in the shadow market go higher. At a certain point, the differential between the two markets becomes so stark that tenants in the regulated sector begin hoarding their apartments. They hardly ever move. In New York, 88 percent of tenants living in pre-war, rent-controlled apartments have not moved in more than 25 years.

If they do abandon their apartments, regulated tenants pass them on to friends or relatives, or sell them to strangers through “key money” that reflects their true market value. As a consequence, a regulated apartments are essentially withdrawn from the market. In New York, where regulated apartments make up 63 percent of the market, only 85 or 3 percent of the 2,800 listings in the New York Times, Daily News, and New York Post, were identified or identifiable as rent regulated.

With the regulated portion market locked away, all new demand is funneled into the unregulated sector−the shadow market. Eventually the competition for these limited number of apartments creates highly inflated prices. It is like squeezing a balloon at one end−the pressure will simply create a bulge at the other end.

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54 A Farewell to Jobs

Let’s take a trip back to the late 1980s. The foremost problem on some economists’ minds is the merciless competition that American firms face from Asian manufacturers. “Japan, Inc.” and its neighbors, for example, have started turning out computer memory chips at ever lower prices. The result is sharply declining profits for U. S. chipmakers and—according to chipmakers and their political supporters—a dire threat to U. S. jobs. The issue of looming job losses in this and other industries dominates the political scene. Chip industry leaders try to persuade members of Congress that the United States will lose its technological edge unless the federal government steps in to protect U. S. chipmakers. Expects are even prophesying that without government protection and help, U. S. microelectronics will be “reduced to permanent, decisive inferiority within ten years.

Now flash forward to the mid-2000s, when the most frequently recurring issue in domestic-policy debates has been much the same. To be sure, the details—which country is “stealing” jobs from which industry—have changed, but not by much. Indeed, as early as the presidential election of 2004, so-called foreign outsourcing of white-collar jobs had become as un-American as desecrating our flag. A well-known TV business analyst on CNN, Lou Dobbs, even began a listing of all of the “unpatriotic” U. S.-based companies that were “sending this country’s jobs overseas.” The House of Representatives tried to pass measures to prevent any type of outsourcing for the Department of State and the Department of Defense. Representative Don Manzullo (R.-Ill.) said, “You just can’t continue to outsource overseas time after time after time, dilute the strategic military base, and then expect this Congress to sit back and see the jobs lost and do nothing.” (This was from a member of the same House of Representatives that, twenty years earlier tried to outlaw competition from foreign automakers because the U. S. auto industry supposedly faced “imminent collapse.”)

According to Craig Barrett, CEO of Intel (the world’s largest chipmaker), American workers today face the prospect of “300 million well-educated people in India, China, and Russia who can do effectively any job that can be done in the United States.” In a similar vein, Forrester Research has predicted that 3.3 million service jobs will “move offshore” by 2015. Five hundred thousand of those jobs will supposedly be in computer software and services. The 2004 Democratic presidential nominee, John Kerry, had a name for the leaders of companies that “export” such jobs: “Benedict Arnold CEOs.” And when the chair of the Council of Economic Advisers publicly stated that foreign outsourcing of service jobs wasn’t such a bad idea, numerous politicians lambasted him, arguing that foreign outsourcing of domestic service jobs was the biggest plague ever to hit the U. S. economy.

To understand the hot-button issue of outsourcing service employment to workers located abroad, you have to go back to our chapter-opening scenario. What actually happened after the “Asian invasion” of computer chips and other high-tech items in the late 1980s? The result was not the demise of Silicon Valley. Rather, American high-tech companies responded to the challenge by identifying the things at which they were best and leaving the rest to foreign competitors. They became innovative. They led the way in personal computing and the development of the Internet. They became the engine of job creation throughout the 1990s. Indeed, we can look back through American business

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history and find numerous other periods in which foreign competition has threatened a particular sector of the economy. In spite of that competition—and regardless of the outcome for the sector involved—the American economy has continued to prosper.

This was not the first time the resilience of the labor market surprised people. Back in the 1960s, for example, numerous experts predicted that the rise of the computer and robots for use in businesses was going to lead to mass joblessness and poverty. Instead, computers and automation have produced staggering productivity increases throughout nearly every industry. They have helped make possible the 72 million jobs created over the past forty years and the doubling of real per capita income over that span. This is hardly the outcome predicted by experts in the 1960s, but then, predicting the future of the labor market has never been easy. Consider the track record of the Bureau of Labor Statistics (BLS), recognized as America’s foremost source of information and expertise on the labor market. Twenty years ago the BLS predicted that the number of gas stations attendants and travel agents in America would rise sharply; in fact, employment in both occupations has fallen. And of the twenty occupations that the BLS predicted would suffer the greatest job losses over those twenty years, fully half of them have grown, often robustly.

What we have witnessed is a continual testing of a concept that is central to all of economics: comparative advantage. The nineteenth century economist David Ricardo got it right two centuries ago, and no one has disproved him since—although U. S. corporate executives facing stiff foreign competition try to do so all the time. In a nutshell, the principle of comparative advantage says that if an individual, firm, or nation is singularly good at doing one thing (has low costs of doing it), it must, by definition, be less good at doing other things (face higher costs of doing them). Comparative advantage implies that there is a niche for every one and that those niches can best be filled (and our wealth increased the most) if we permit unfettered freedom of trade, both domestically and internationally, and allow all participants to focus on what they do best.

Consider the current situation: like their counterparts in the United States, engineers and technicians in India have the capacity to provide both computer programming and innovative new technologies. Indian programmers and high-tech engineers earn one-quarter of what their counterparts earn in the United States. Consequently, India is able to do both jobs at a lower dollar cost than the United States; India has an absolute advantage in both. In other words, it can produce a unit of programming for fewer dollars than the United States, and it can also produce a unit of technology innovation for fewer dollars. Does that mean that the United States will lose not only programming jobs but innovative technology jobs, too? Does that mean that our standard of living will fall if the United States and India engage in international trade? David Ricardo would have answered no to both questions—as we do today. While India may have an absolute advantage in both activities, that fact is irrelevant in determining what India or the United States will produce. India has a comparative advantage in doing programming in part because such activity requires little physical capital. The flip side is that the United States has a comparative advantage in technology innovation partly because it is relatively easy to obtain capital in this country to undertake such long-run projects. The result is that Indian programmers will do more and more of what U. S. programmers have been doing in the past. In contrast, American firms will shift to more innovation; India will specialize in programming. The business managers in

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each country will opt to specialize in activities in which they have a comparative advantage. As in the past, the U.S. economy will continue to concentrate on what are called the “most best” activities.

The principle here is no different from what we regularly observe among world-class athletes. Typically, they have the physical and mental skills that would enable them to beat virtually anyone else in any of several sporting activities. They have an absolute advantage in athletics. Yet they invariably end up specializing in one sport, the one in which they have a comparative advantage. They do this because they are so good in that sport relative to other sports that their earnings would be lower if they “wasted” their time in those other sports. Exactly the same thing is happening with the Indian engineers and technicians, just as it happens in all other endeavors.

Let’s return to the general issue of outsourcing services to foreign workers. Computer programming is just one area in which such outsourcing is occurring. This outsourcing also extends, somewhat amazingly, to U. S. income tax return preparation. The fact is that accounting firms small and large use workers in India to prepare returns for U. S. clients. At least a quarter of a million returns each year are being prepared by Indians in Bangalore and Mumbai. Moreover, U. S. hospitals are sending (via the Internet, of course) computer-image X-rays to India for physicians and medial technicians there to prepare before the images are resent to the United States for a final diagnosis.

Sending overseas white-collar jobs that are labor-intensive—answering simple complaints, taking orders over the phone, explaining basic computer setup, and reading simple medical-test results—is no different from what we did when we bought lower-priced computer chips from Japan and other Asian countries in the 1980s. Nor is it fundamentally different from what we did when we started importing more labor-intensive textiles in the 1980s and 1990s. Because of foreign competition, specific industries throughout time have been forced to be more innovative and cost-conscious, but overall, the number of jobs in the United States has consistently grown, decide after decade. Indeed, at least for the high-tech industrial sector, the aftermath of the “Asian invasion” of the 1980s was a productivity boom.

The fact is that there is little evidence that well-paying jobs are being “sent overseas.” The average unemployment rate for college-educated workers in the postrecession year 2003,was only 3 percent. The average for 1992, the last postrecession year, was higher—3.2 percent. And since 2003, employment growth among college-educated workers has been six times greater than for less educated workers.

Jobs disappear in this economy and everywhere else—normally, because of technological change. (Actually, jobs disappear in the U. S. economy at the rate of 1 million per week as workers quit or are fired; but in a typical year, slightly more than a million jobs per week are created as workers accept new employment.) It is also true that manufacturing employment in America continues to shrink. But the decline in manufacturing jobs is not unique to the United States. Indeed, despite talk of “losing” manufacturing jobs to China and elsewhere, the number of manufacturing jobs in foreign countries such as china is shrinking faster than it is in the United States!

Wealth-enhancing technological change is relieving human beings of the necessity of performing mind-numbing, repetitive, dangerous factory jobs. It is making us

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more productive, and we are collectively better off as a result, even thought some individuals may be worse off. But the only way to protect everyone form the effects of technological change is to prevent all technological change. Not only would this impoverish us if we tried it, but we would fail in our attempts because other nations would gleefully step into the technology-leading shoes we had vacated.

Indeed the reason that U.S. companies can outsource service jobs to India, china and elsewhere is because of technological change-dramatic improvements din telecommunications and computing. One thing you can be absolute certain of is this: The political brouhaha over “exporting” jobs will eventually die out, but technological change will never stop. We don’t know what the next great innovation cycle will be or which sectors will be affected. When they are affected, though, some politicians will jump on the bandwagon and declare that a new threat to the American economy has emerged. You’ll then hear much pontification about how foreigners are destroying the U.S. economy. But remember this: for the past 250 years, technological change is what has enabled us to become richer as a nation; indeed in the United States, every generation over this span has been roughly 50 percent richer than one that preceded it. It is that along the way, some people in the whale blubber-rendering and buggy-whip industries have had to move on to other employments. But as long as humans con think technology will change, and jobs along with them. Our only option is to decide whether we want to get rich by embracing these changes or get poor by rejecting them.

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55 To Drill or Not to DrillLet the Environmentalists Decide

High Prices of gasoline and heating oil have made drilling for oil in Alaska’s Arctic National Wildlife Refuge (ANWR) an important issue. ANWR is the largest of Alaska’s sixteen national wildlife refuges, containing 19.6 million acres. It also contains significant deposits of petroleum. The question is, Should oil companies be allowed to drill for that petroleum?

The case for drilling is straightforward. Alaskan oil would help to reduce U. S. dependence on foreign sources subject to disruptions caused by the volatile politics of the Middle East. Also, most of the infrastructure necessary for transporting the oil from nearby Prudhoe Bay to major U. S. markets is already in place. Furthermore, because of the experience gained at Prudhoe Bay, much has already been learned about how to mitigate the risks of recovering oil in the Arctic environment.

No one denies the environmental risks of drilling for oil in ANWR. No matter how careful the oil companies are, accidents that damage the environment at least temporarily might happen. Environmental groups consider such risks unacceptable; they argue that the value of the wilderness and natural beauty that would be spoiled by drilling in ANWR far exceeds the value of the oil that would be recovered. For example, the National Audubon Society characterizes opening ANWR to oil drilling as a threat “that will destroy the integrity” of the refuge.

So, which is more valuable, drilling for oil in ANWR or protecting it as an untouched wilderness and wildlife refuge? Are the benefits of the additional oil really less than the costs of bearing the environmental risks of recovering that oil? Obviously, answering this question with great confidence is difficult because the answer depends on subjective values. Just how do we compare the convenience value of using more petroleum with the almost spiritual value of maintaining the “integrity” of a remote and pristine wilderness area? Although such comparisons are difficult, we should recognize that they can be made. Indeed, we make them all the time.

We constantly make decisions that sacrifice environmental values for what many consider more mundane values, such as comfort, convenience, and material well-being. There is nothing wrong with making such sacrifices because up to some point the additional benefits we realize from sacrificing a little more environmental “integrity” are worth more than the necessary sacrifice. Ideally, we would somehow acquire the information necessary to determine where that point is and then motivate people with different perspectives and preferences to respond appropriately to that information.

Achieving this ideal is not as utopian as it might seem; in fact, such an achievement has been reached in situations very similar to the one at issue in ANWR. In this article, I discuss cases in which the appropriate sacrifice of wilderness protection for petroleum production has been responsibly determined and harmoniously implemented. Based on this discussion, I conclude that we should let the Audubon Society decide whether to allow drilling in ANWR. That conclusion may seem to recommend a foregone decision on the issue because the society has already said that drilling for oil in ANWR is unacceptable. But actions speak louder than words, and under certain conditions I am willing to accept the actions of environmental groups such as the Audubon society as the

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best evidence of how they truly prefer to answer the question, To Drill or Not to Drill in ANWR?

Private Property Changes One’s Perspective

What a difference private property makes when it comes to managing multiuse resources. When people make decisions about the use of property they own, they take into account many more alternatives than they do when advocating decisions about the use of property owned by others. This straightforward principle explains why environmental groups’ statements about oil drilling in ANWR (and in other publicly owned areas) and their actions in wildlife areas they own are two very different things.

For example, the Audubon Society owns the Rainey Wildlife Sanctuary, an 26,000 acre preserve in Louisiana that provides a home for fish, shrimp, crab, deer, ducks, and wading birds, and is a resting and feeding stopover for more than 100,000 migrating snow geese each year. By all accounts, it is a beautiful wilderness area and provides exactly the type of wildlife habitat that the Audubon society seeks to preserve. But, as elsewhere in our world of scarcity, the use of the Rainey Sanctuary as a wildlife preserve competes with other valuable uses.

Besides being ideally suited for wildlife, the sanctuary contains commercially valuable reserves of natural gas and oil, which attracted the attention of energy companies when they were discovered in the 1940s. clearly, the interests served by fossel fuels do not have high priority for the Audubon Society. No doubt, the society regards additional petroleum use as a social problem rather than a social benefit. Of course, most people have different priorities: they place a much higher value on keeping down the cost of energy than they do on bird-watching and on protecting what many regard as little more than mosquito-breeding swamps. One might suppose that members of the Audubon Society have no reason to consider such “anti-environmental” values when deciding how to use their own land. Because the society owns the Rainey Sanctuary, it can ignore interests antithetical to its own and refuse to allow drilling. Yet, precisely because the society owns the land, it has been willing to accommodate the interest of those whose priorities are different and has allowed thirty-seven wells to pump gas and oil from the Rainey Sanctuary. In return, it has received royalties of more than $15 million (Baden and Stroup 1981; Snyder and Show 1995).

Back to ANWR

Without private ownership, the incentive to take a balanced and accommodating view toward competing land-use values disappears. So, it is hardly surprising that the Audubon Society and other major environmental groups categorically oppose drilling in ANWR. Because ANWR is publicly owned, the environmental groups have no incentive to take into account the benefits of drilling. The Audubon Society does not capture any of the benefits if drilling is allowed, as it does at the Rainey Sanctuary; in ANWR, it sacrifices nothing if drilling is prevented. In opposing drilling in ANWR, despite the fact that the precautions to be taken there would be greater than those required of companies operating in the Rainey Sanctuary, the Audubon society is completely unaccountable for the sacrificed value of the recoverable petroleum.

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The evidence is overwhelming that the risks of oil drilling to the arctic environment are far less than commonly claimed. The experience gained in Prudhoe Bay has both demonstrated and increased the oil companies’ ability to recover oil while leaving a “light footprint” on arctic tundra and wildlife.

Improvements in technology now permit horizontal drilling to recover oil that is far from directly below the wellhead. This technique reduces further the already small amount of land directly affected by drilling operations. Of the more than 19 million acres contained in ANWR, almost 18 million acres have been set aside by Congress—somewhat more than 8 million as wilderness and 9.5 million as wildlife refuge. Oil companies estimate that only 2,000 acres would be needed to develop the coastal plain.

This carefully conducted and closely confined activity hardly sound like a sufficient threat to justify the rhetoric of a righteous crusade to prevent the destruction of ANWR, so the environmentalists warn of a detrimental effect on arctic wildlife that cannot be gauged by the limited acreage directly affected. Given the experience at Prudhoe Bay, however, such warnings are difficult to take seriously.

Before drilling began at Prudhoe Bay, a good deal of concern was expressed about its effect on caribou herds. As with many wildlife species, the population of the caribou on Alaska’s North Slope fluctuates (often substantially) from year to year for completely natural reasons, so it is difficult to determine with confidence the effect of development on the caribou population. It is noteworthy, however, that the caribou population in the area around Prudhoe Bay has increased greatly since that oil field was developed, from approximately 3,000 to a high of some 23,400 (see “Oil Development on the Coastal Plain of AWRW” at http://www.anwr.org.case.htm). Some argue that the increase has occurred because the caribou’s natural predators have avoided the area—some of these predators are shot, whereas the caribou are not. but even if this argument explains some or even all of the increase in the population, the increase still casts doubt on claims that the drilling threatens the caribou. Nor has it been shown that the viability of any other species has been genuinely threatened by oil drilling at Prudhoe Bay.

Conclusion

I an not recommending that ANWR actually be given to some consortium of environmental groups. In thinking about whether to drill for oil in ANWR, however, it is instructive to consider seriously what such a group would do if it owner ANWR and therefore bore the costs as well as enjoyed the benefits of preventing drilling. Those costs are measured by what people are willing to pay for the additional comfort, convenience, and safety that could be derived from the use of ANWR oil. Unfortunately, without the price communication that is possible only by means of private property and voluntary exchange, we cannot be sure what those costs are or how private owners would evaluate either the costs or the benefits of preventing drilling in ANWR. However, the willingness of environmental groups such as the Audubon Society and the Nature Conservancy to allow drilling for oil on environmentally sensitive land they own suggests strongly that their adamant verbal opposition to drilling in ANWR is a poor reflection of what they would do if they owned even a small fraction of the ANWR territory containing oil.

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56 Ethanol Madness

Henry Ford built his first automobile in 1896 to run on pure ethanol. If Congress has its way, the cars of the future will be built the same way. But what made good economic sense in the late nineteenth century doesn’t necessarily make economic sense in the early twenty-first century—although it does make for good politics. Indeed, the ethanol story is a classic illustration of how good politics routinely trumps good economics to yield bad policies.

Ethanol is made in the Midwest just like moonshine whiskey is made in Appalachia: Corn and water are mixed into a mash, enzymes turn starch to sugar, yeast is added and heat ferments the brew. Once this is distilled, the liquid portion is ethanol and the solids are used as a high-protein animal food. The high-proof ethanol is combustible but yields far less energy per gallon than gasoline does. Despite this inefficiency, the Energy Policy Act of 2005 requires that ethanol be added to gasoline, in increasing amounts through 2012. This requirement is supposed to conserve resources and improve the environment. It does neither. Instead, it lines the pockets of American corn farmers and ethanol makers and incidentally enriches some Brazilian sugarcane farmers along the way.

Federal law has both encouraged and subsidized ethanol as a so-called alternative fuel for more than thirty years. But it was not until 2005 that ethanol really achieved national prominence. The use mandates of the Energy Policy Act, combined with surging gas prices and an existing 51-cent-per-gallon federal ethanol subsidy, created a boom in ethanol production. By 2006, ethanol refineries were springing up all over the Midwest, and imports of ethanol from Brazil reached record-high levels.

Three factors are typically used to justify federal use mandates and subsidies for ethanol. First, it is claimed that adding ethanol to gasoline reduces air pollution and so yields environmental benefits. That may have been true fifteen or twenty years ago, but even the Environmental Protection Agency acknowledges that ethanol offers no environmental advantages over other modern methods of making reformulated gasoline. Hence neither the congressional mandate to add ethanol nor the 51-cent-per-gallon subsidy for its use as a fuel additive can be justified on environmental grounds.

A second argument advanced on behalf of ethanol is that it is “renewable,” in that fields on which corn is grown to produce ethanol this year can be replanted with more corn next year. This is true enough, but we are in little danger of running out of “nonrenewable” crude oil any time in the next century. Indeed, proven reserves of oil are at record-high levels, and the price of oil would have to exceed $80 per barrel to match the inflation-adjusted level of twenty-five years ago. Perhaps more to the point, the production of ethanol uses so much fossil fuel and other resources that under most circumstances, its production actually wastes resources overall compared to gasoline. In part, this is because ethanol is about 25 percent less efficient than gasoline as a source of energy. But it is also because the corn used to make ethanol in the United States has a high opportunity cost: If it were not being used to make fuel, it would be used to feed humans and livestock. Moreover, because ethanol production is most efficiently conducted on a relatively small scale, it must be transported by truck or rail, which is far more costly than the pipelines used for gasoline.

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The third supposed advantage of ethanol is that its use reduces our dependence on imports of oil. In principle, this argument is correct, but its impact is tiny, and the likely consequences are not what you might expect. Total consumption of all biofuels in the United States amounts to less than 3 percent of gasoline usage. To replace the oil we import from the Persian Gulf with corn-based ethanol, at least 50 percent of the nation’s total farmland would have to be devoted to corn for fuel. Moreover, any cuts in oil imports will likely not come from Persian Gulf sources. Canada and Mexico are the two biggest suppliers of crude oil to the Unite States, and both countries send almost 100 percent of their exports to the U. S. market.

All of this raises an interesting question: if ethanol doesn’t protect the environment, conserve resources, or have any compelling foreign policy advantages, why do we mandate its use and subsidize its production? The answer lies at the heart of political economy, the use of economics to study the causes and consequences of political decision making. It is true that a critical component of what the government does (such as providing for national defense and law enforcement) provides an institutional structure necessary for the creation and retention of our total wealth. Nevertheless, the essence of much government policy making has nothing to do with making the size of the economic pie larger than it otherwise would be. Instead, many government policies are directed at dividing up the pie in new ways so that one group gets more resources at the expense of some other group. To do this successfully, politicians must be adept at concentrating the benefits of policies among a few favored recipients while dispersing the cost of those policies across a larger number of disfavored individuals.

At first blush, such an approach sounds completely at odds with the essence of democracy. After all, under the principle of “one person, one vote,” it seems like benefits should be widely spread (to gain votes from many grateful beneficiaries), and costs should be concentrated (so that only the votes of a few disfavored constituents are lost). The concept of rational ignorance explains what is really going on. It is costly for individuals to keep track of exactly how the decisions of their elected representatives affect them. When the consequences of political decisions are large enough to outweigh the monitoring costs, voters swiftly and surely express their pleasure or displeasure, both in the voting booth and in their campaign contributions. But when the consequences to each of them individually are small relative to the monitoring costs, people quite sensibly don’t bother to keep track of them—they remain “rationally ignorant.”

In the case of ethanol, almost one-fourth of all ethanol for fuel is made by one company: Archer Daniels Midland (ADM). Clearly, even small changes in the price of ethanol are important to ADM. Because federal use mandates and the federal ethanol subsidy both increase the profitability of making ethanol, ADM has strong incentives to ensure that members of Congress are aware of the benefits (to ADM) of such policies. Similarly, corn farmers derive most of their income from sales of corn. Federal ethanol policies increase the demand for corn and thus increase its price; again, because the resulting benefits are highly concentrated on corn farmers, each has a strong incentive to ensure that his or her members of Congress understand the benefits (to the farmer) of such policies.

Contrast this with the typical taxpayer or consumer of gasoline. It is true that the $3 billion or so spent on ethanol subsidies each year must come out of taxpayers’ pockets. Nevertheless, this amount is spread thinly across tens of millions of federal

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taxpayers. Similarly, although the mandated use of ethanol in gasoline is estimated to raise the cost of gas by about 8 cents per gallon, this amounts to no more than $50 per year for the typical driver. Neither taxpayer nor motorist is likely to spend much time complaining to his or her senator.

Thus it is that farmers and ethanol producers are quite rationally willing to lobby hard for use mandates and subsidies at the same time that taxpayers and drivers put up little effective resistance to having their pockets picked. It may make for bad economics, but it is classic politics. And for the producers, farmers and politicians involved, it just as surely turns corn into “yellow gold.”

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57 Heavenly Highway

If you’ve ever been caught in a rust-hour traffic jam, you understand what happens when a scarce good has a price of zero. In this case, the scarce good is highway travel, and when the money price of travel is zero, something else must be used to ration the quantity of the good demanded. During rush hour (and much of the rest of the day in places such as Los Angeles, New York, Seattle, and Atlanta), the “something” that rations travel demand is time—the time of the motorists caught in traffic.

Whenever a person drives a car, he or she generates a variety of costs. First are the private costs of driving: fuel, oil, vehicular wear and tear, and the value of the driver’s time.1 These are all borne by the driver, so when deciding whether and how much highway travel to consume, the driver weights these costs against the benefits of that travel. If these were the only costs of driving—and on some roads at some times they are—this discussion would end here. Drivers would bear the full cost of their activities, just as the consumers of pizza do, and there would be no further issues to consider. But in most places in the world, during parts of most days, driving generates another cost—congestion—that is not borne by the individuals responsible for it.

On any road, after traffic volume reaches some level, additional cars entering the road slow the flow of traffic. Once this process of congestion occurs, every additional car entering the road slow the flow of traffic. Once this process of congestion occurs, every additional car slows traffic even more. Eventually, traffic may come to a complete halt. Under these circumstances, each driver is implicitly using, without paying for it, a valuable resource that belongs to other people—the time of other drivers. Unless drivers are made to bear the congestion costs they generate, we know two things must be true: first, the money price of traveling on the road is too low, and second, the value of motorists’ time spent in traffic must be rationing the quantity of travel demanded.

Why do economists worry about congestion? Because its existence raises the possibility that the people using the road could actually be made better off if they were charged a money price for using the road. This money price would induce fewer motorists to drive because some would carpool, others would use public transit, and still others might telecommute rather than come into the office at all. The reduced driving would reduce congestion and so conserve the valuable time of those people who continued to drive. In fact, it is even possible that by charging drivers a monetary fee or toll to drive on a road, more people would succeed in reaching their destination in any given time period. It is easiest to see this when traffic is so bad that it comes to a halt. The toll would discourage some people from entering the road and so permit the remaining traffic to move and thus reach its destination. But the general principle holds true even when traffic is just greatly slowed down by the congestion: Road tolls can both improve traffic flow and make drivers better off—surely a heavenly combination for those sick of being stuck in traffic.

Why, then, do we not see more widespread use of tolls on highways? There are three reasons. First, toll collection is not free, and until recently, the costs were often large enough to offset many of the benefits. If you’ve ever traveled on older toll roads, such as the Pennsylvania or New Jersey turnpikes, you have some notion of these costs. The toll booths there must be constructed and then manned twenty-four hours a day, and

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traffic must come to a halt to pay the toll. The result is that the tolls are creating some of the congestion they are supposed to relieve.

But over the past couple of decades, electronic toll collection systems have been developed that reduce these costs substantially. Small, inexpensive electronic devices called transponders can be installed in cars that will be using the toll road. The transponders transmit identifying information to receivers at the toll stations, which are suspended above the roadway. (The toll stations are also equipped with cameras to record the license plate number of anyone passing through with a missing or malfunctioning transponder.) Cars need not even slow down from cruising speeds to have their identification recorded as they pass through. At the end of the month, each motorist receives a bill in the mail for the toll charges (or a ticket if the driver tried to avoid the toll). Clearly, such a system is designed for roads or bridges heavily trafficked by regular commuters, but in these circumstances, such as on the bridges in the New York City area, electronic toll collection has drastically lowered the costs of using monetary prices to ration roadway use. The result has been reduced congestion and improved economic efficiency. Drivers are better off, and local governments have extra revenue to spend on other services.

California, Texas, and Minnesota all offer examples of how modern toll collection technology can be used to speed highway travel, even during the heaviest traffic periods. Along stretches of multilane roads in Orange County, San Diego, Houston, and Minneapolis, specified lanes are designed as high-occupancy toll (HOT) lanes. These are limited access highway lanes that provide zero- or reduced-price access to qualifying high-occupancy vehicles (HOVs) and also provide access (at a price) to other vehicles not meeting passenger occupancy requirements. In San Diego, for example, a driver alone in a transponder-equipped care can pay a toll of 50 cents to $4.00 (depending on traffic conditions) to use the HOT lane on Interstate I-15. In doing so, the motorist can expect to travel at or near the speed limit even when traffic in adjacent lanes is bogged down during rush hour. In Orange County, California, the HOT lane charges on State Route 91 range from $1.15 in the middle of the night to $8.50 during the worst of the afternoon rush. As in other locations where HOT lanes are in use, the result is smooth sailing for a fee, even as drivers in the regular lanes spend their time playing stop-and-go. And it is not just the high-income crowd that gets to enjoy the trip. Surveys reveal that drivers at all points in the income distribution are users of the HOT lanes—because the value to them of the time saved is worth the added monetary cost.

Despite such successes, tolls are sometimes eschewed because pricing highway travel can yield radical and unpredictable consequences of changes in the cost of travel. Unlike a typical privately provided good, each road is part of a network of roads; a change in costs on one segment of the system can sometimes have striking and substantial consequences elsewhere—consequences that can largely or completely offset the benefits of the tolls.

The island nation of Singapore, for example, has some of the worst traffic in the world. As a result, its government has been experimenting with pricing roads since 1975, charging a special fee for vehicles entering the central business district during peak traffic periods. When combined with other traffic-control measures, the fee helped cut traffic in central Singapore by 45 percent during peak hours, enabling traffic speed to almost double, to about 22 miles per hour. But these positive effects in the central city between

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7:30 and 9:30 A.M. were accompanied by deleterious effects elsewhere. For example, just outside the central city, traffic jams got worse as drivers sought routes they could use without paying. Moreover, on the roads leading into the central city, the drop in rush-hour traffic was nearly matched by a sharp increase in traffic just before 7:30 and after 9:30.

Tolls don’t always have to have such adverse side effects, however, as illustrated by a successful implementation in London, England. Beginning in 2003, drivers entering the central area of London were charged a fee of L5 (about $10 at recent exchange rates), with fines ranging in excess of L200 if they failed to pay. The result has been a 20 percent reduction in traffic and about a 5 percent increase in average speeds—which doesn’t sound like much until you realize that average traffic speeds in London actually fell during the twentieth century as cars first replaced horses and then simply got in each other’s way. The big difference between Singapore and London seems to be the magnitude of the charge: London got it roughly right, but Singapore tried to charge too much—a point to which we shall return.

Perhaps the biggest impediment to efficient pricing of roads is that roads are typically operated by governments rather than by private-sector firms. Decisions to price roads must pass through the political process, which necessarily means that the efficiency concerns of the economist are often outweighed by political concerns over who shall pay how much for what. Public opinion polls from densely populated and heavily congested Hong Kong help us understand the consequences.

Although almost identical proportions of drivers and nondrivers in Hong Kong agree that traffic congestion is a serious problem (84.5 percent and 82.0 percent, respectively), they differ sharply on what they think should be done about it. Drivers favor new road construction, presumably because this would shift to taxpaying nondrivers part of the cost of relieving congestion. In contrast, nondrivers believe that financial disincentives to driving (such as tolls and licensing fees) should be given the top priority, presumably because this would shift more of the burden to drivers. These divergences of public opinion have slowed the use of private-sector remedies for the congestion on publicly owned roads, just as they have elsewhere in the world. The result is too many roads on which monetary prices are too low (or nonexistent) and congestion is correspondingly too high.

Japan offers us an illustration from the other end of the spectrum on the hazards of having politicians set prices. Unlike in the United States, where “freeways” are commonplace, all 4,350 miles of expressways in Japan’s national highway system are toll roads. The nation began building the expressways in 1956 with loans from the World Bank, imposing tolls to pay off the loans. The loans are long-since paid off, but the tolls remain—generating $15 billion a year to help the national government pay off its $360 billion debt for other public-works projects. Yet the government is so addicted to tolls as a revenue source that many of its citizens think it has gone off the deep end. Tolls are so high that if you were to drive the length of Japan (a nation smaller than California), you would rack up $330 in tolls. Just making the ten-minute trip across Tokyo Bay from the airport will set you back $25, which is actually an improvement over the $42 that drivers used to pay. With fees like this, you can imagine the response: People buy airline tickets rather than drive when making trips of 200 miles, and trucking companies devise elaborate routing schemes for their trucks to keep toll costs down. And how’s traffic?

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Well, along many of the pricier portions of the Japanese highway system, you may find yourself alone on the road.

The message is quite simple. For a variety of reasons, highways, unlike hamburgers, are tricky things to price correctly. But as the experiences of congestion pricing in central London and the HOT lanes in America attest, modern technology combined with political gumption can produce a heavenly trip. It is a lesson that could be profitably applied in many other locales.

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58 Ticket Brokers and Ticket Scalping

If you want to see a concert, a game, a race, or any other event that is sold out, you probably know that you can always get a ticket for a price. Some events are “once in a lifetime” while others are just something many people want to see. In recent years, tickets to events like Michael Jordan’s last game as a Chicago Bull and the game in which Mark McGwire hit his home run number 62 in St. Louis commanded prices many times their face value. There are other events, not once in a lifetime, where demand continues to be extraordinarily high. The Supper Bowl, the World Series, and the Daytona 500 are events that are important enough to some people that they are willing to pay more than face value for a ticket.

While many cities it is illegal to sell a ticket for more than face value, in every major city there is a way of getting such tickets when they are the only ones available. Economists are almost always against laws that prevent people from selling things they possess. They reason that if one person would rather have $500 than a ticket to a game and another person would rather have a ticket to a game than $500, then both are better off with the trade than without it.

DEFINING BROKERING AND SCALPING

Brokering tickets is the act of buying a ticket and selling it at a price higher than its face value when such a transaction is legal. Scalping tickets is the act of buying a ticket and selling it at a price higher than its face value when such a transaction is illegal. Thus the practice is scalping only when it is done illegally. Regardless of semantic differences, for many fans and performers, scalpers and brokers are the worst form of predator; they obtain large blocks of tickets before other people get them, then they sell the tickets at prices that net them a profit. They do not produce anything. Those who engage in this trade view themselves as simply providing a service from which they make a living. To others, they are simply leeching off the talents of others.

For economists, scalpers perform a function that “fixes” pricing that promoters get wrong. As we will see, scalping can exist profitably only when enough fans are willing to pay more for tickets than the face value of the ticket and there are more buyers willing to pay face value than there are seats.

This does not necessarily mean the performance is a sellout. If some seats are really good and others are really terrible, then the good ones, at courtside, say, might remain unsold. What is true is that there cannot be unsold seats right next to seats for which scalpers wish to charge more than face value. When traditional ticket outlets that sell for face value have open, decent seats, these will be sold out before scalpers can sell any.

The Promoter as Monopolist

When promoters are attempting to maximize profits and are trying to figure out what price to charge for events, they have to gauge what the demand will be for the event.

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Once they have done that, they can look at this problem as any other monopolist would. Recall that we have always assumed that firms are profit maximizers An interesting aspect of this is that it may make sense for promoters to see that the arena is only partially filled. Promoters hold back tickets when they would have to lower the price too far in order to sell out the facility. You should not be surprised by this conclusion, especially if you are at a school that does not have a popular athletic program. Consider a school whose men’s basketball team draws between 4000 and 6000 fans a game, while the women’s team draws fewer than 1000 a game. If the athletic department were to price tickets to sell out the arena, tickets would be nearly free for the men’s games and the department would have to pay people to see the women. That is not a slam at the women; it is just a fact of life at a school without a national sports reputation. Clearly, it makes sense for this university to charge more for the men’s games and to charge something for the women. The university makes the most money possible that way, even with only one sellout per decade.

The Perfect Arena

To a promoter, the size of the facility is significant. In a promoter’s eyes, the perfect facility would be where the capacity is exactly the number of seats that the promoter wants to sell anyway. That is, the facility with perfect capacity is the one where marginal cost intersects marginal revenue at the quantity that is exactly the capacity of the facility. Of course, promoters cannot always find the perfect facility. Most medium and small cities have only one or two places to hold an event like a concert hall may not be available.

In a big city with many venues of many different sizes, a promoter should seek the facility whose size ensures that the marginal cost will cross marginal revenue at exactly the capacity. On the assumption that facilities that are unnecessarily large cost the promoter more to rent, booking this “perfect” facility maximizes profit.

In each case mentioned so far there is no market for scalpers because the face value of the ticket is the price at which it is sold. Scalping makes sense only if the market price of the ticket is greater than the face value. The only way for that to happen is if the promoter charges less than the profit maximizing amount.

WHY PROMOTERS CHARGE LESS THAN THEY COULD

Why might promoters sell out a facility rather than maximize profits? First, they may not have good information on the price they ought to charge. This uncertainty might motivate them to err on the safe side and charge a lower price. Second, there may be some “excitement” factor to a full stadium that appeals to the performers and that is worth loss or profit. Third, the performers may want a reputation of charging a “fair price” for their events and be willing to forgo maximum profit in order to further that reputation. Fourth, the performers may want some mechanism other than price to separate the “real fans” from those who go to events simply because they have money. Fifth, ancillary sales of shirts and other memorabilia are important sources of revenue for

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performers and promoters alike. Since it may be that the revenue gained by these sales exceeds that lost by having low ticket prices, low ticket prices may lead to increasing audience size and may therefore maximize profit after all. Last, it may be in the long-run best interest of the performers to charge a low price for tickets so that the largest possible audience can provide word of mouth advertising for them and generate interest for their talent.

Sometimes promoters do not have an exact idea of what price to charge for an event. More often than not, promoters of a new act must guess what the market will bear for the ticket. If they guess too low, scalping may ensue. In addition, promoters may want to play it safe and not run the risk of pricing too high, thereby purposefully pricing less than even their best guess. This might also result in scalping.

There is an excitement to being at a sold-out event in a large arena. The sound and feel are different for a sold out event than for one in a half-full auditorium. The performer enjoys it more and the fans enjoy it more. Although this may not seem like an important function for a promoter, consider that promoters are hired by athletes or performers to promote the event as effectively as possible. It may be in the promoters’ best interests to cater to the performer, regardless of what maximizes profit.

Some performers try to establish closeness with their fans. Some try to signal their empathy by making sure ticket prices are low enough that “ordinary” fans can afford to go. This means that performers and promoters are wiling to accept less money for the good feeling that charging “fair” prices gives them.

Performers may appreciate fans that are wiling to camp out for tickets more than those simply willing to pay a lot of money. You have to be much more excited about a band to camp out than to simply buy tickets. The people who are willing to camp out to get front-row seats are far more likely to convey enthusiasm for performers than those with deep pockets.

When you go to a concert, you often spend as much on shirts and other promotional items as you did on the ticket. If promoters keep you out by charging a price that is too high, they forgo that important other revenue as well. In the big picture, low ticket prices may be profit maximizing after all.

Promoters of new bands may decide that it is in their long run interest to keep ticket prices low so that the band is seen by as many people as possible. By setting low ticket prices early in a performer’s career, they may be more likely to turn a one hit wonder into a star.

For any one of the reasons just outlined promoters may choose to sell their tickets at prices below their monopoly market value and perhaps even below the price that would guarantee a sellout. In any event, a price below what they see as the free market value will cause scalpers to buy tickets at the lower price in order to sell them at a higher price.

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LEGITIMATE SCALPERS

In some states, all forms of scalping are legal; in others, none are. In a growing number of states scalping remains illegal but “brokers” are allowed to sell tickets for more than they pay for them. The only difference between a scalper and a broker is that the scalper walks around an event’s perimeter trying to sell tickets, while the broker does it from a desk and a phone. The scalper demands cash; the broker takes credit cards.

Another way that scalpers have become legitimate is by pairing their services with that of a travel agent. It is legal in nearly every state for travel agents to create packages with hotel rooms, cab rides, and the like, and then offer these along with the tickets. Suppose you want a ticket to the latest “fight of the century.” If it is in a no scalping state and you cannot get tickets the normal way, you can still get the ticket because travel agents now can combine a $100 ticket with a $100 hotel room and a $10 cab ride and call it a $500 excursion. (Do the math!) This is legal nearly everywhere, even when “scalping” is not. It is also what an economist would call a distinction without a difference.

It must be reinforced, therefore, that economists generally disapprove of anti-scalping regulations. Whether as legal brokers or illegal scalpers, the sellers are providing services. They are not only fixing the market shortage left over by the promoter; they are also providing convenience. The hours of ticket offices at major arenas are not always amenable to customer desires. Lines at the ticket booth or at “will call” windows are often very long the day of the event. Because scalpers and brokers provide us with a convenience and harm no one in the process, there is little economic reason to ban their activities.

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59 Head Start

Established in 1965, the Head Start program serves nearly 800,000 children under the age of five at an annual cost of more than $4 billion dollars. It began on the seemingly sound premise that early intervention in the lives of children can pay dividends later in the form of improved educational outcomes, reduced crime rates, and other socially desirable outcomes. Thus Head Start has enjoyed broad political support, despite the almost total absence of evidence that it has engendered a long run positive influence.

HEAD START AS AN INVESTMENT

The Early Intervention Premise

When social scientists looked at the problem of poverty in the 1960s, many hoped that with enough money, poverty could be significantly reduced and perhaps permanently eliminated. Early evidence gave them great hope. The poverty rate fell from more than 20 percent in 1960 to less than 11 percent a decade later, but it never fell below that. Though more than $300 billion has been spent each year on poverty programs, the official poverty rate has continued to hover between 11 percent and 15 percent ever since.

More troubling has been the degree to which people whose annual incomes are lower than the poverty line have settled into habits that almost guarantee they will remain in poverty permanently. The poor are far more likely than the non poor, for example, to drop out of school, father children or become pregnant as teens, use illegal drugs, or get arrested. At the inception of Head Start people thought that early intervention in the lives of children could lessen or even eliminate some of the sources or causes of poverty. Theoretically, children given academic skill, life skills, and health care to promote a “head start” on life would be more likely to succeed.

The early intervention premise suggests two things about money spent on a quality early education. By interrupting a cycle of poverty, we save future taxpayers money. This can be analyzed using concept of present value. What is also implied about this premise is that people other than the child and the parent benefit when a child gets high-quality care. We examine this aspect as well.

Present Value Analysis

Those who founded Head Start hoped that money invested early in the education of young children would pay for itself in the long run: students who were not judged among the likely to succeed would graduate from school, live with good standards of hygiene, earn respectable incomes, and pay taxes. Ideally, using the economic concept of present value, we would be able to prove that, like any good investment, such early childhood education would pay for itself. As you know, present value is arrived at by discounting future payments by projecting interest rates in a way that puts future and present dollar

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figures on an even basis. Because human nature is to want things now rather than later, dollars paid now are more valuable to people than dollars paid in the future. Therefore, if the present value of the dollars spent on early education is less than the present value of the stream of benefits, then any such early education program is a good investment

Suppose it could be shown that having a child in Head Start reduced a child’s likelihood of dropping out of school, of getting pregnant, or committing crimes for which jail time was required. Suppose it could also be shown that Head Start increased the likelihood that the child would grow up to be a fully functional taxpayer. If all that were true it still would not necessarily justify the investment. From a strictly economic perspective, the present value of the increased costs associated with Head Start would have to be exceeded by the present value of the benefits as measured by the increased taxes and reduced welfare and imprisonment costs.

External Benefits

When people other than the consumer or producer of a good get a benefit from a good, economists refer to this as a positive externality. The argument here is that when parents choose the child care for their child, people other than themselves, their child, or their daycare worker are affected. By choosing a high quality option, other parts of society stand to benefit because the presumption is that the child is more likely to be a productive citizen in the future. Whenever there are such external benefits, economists will generally concede that some form of subsidy is warranted.

The Early Evidence

The efficacy of the premise underlying the desirability of early intervention was fortified by studies from the 1960s through the 1980s that showed how effective early childhood education could be. The most prominent of these studies followed several hundred young, poor children, half of whom were given an excellent preschool experience free for two years, and half of whom were given nothing. The half that got the schooling not only performed better on IQ tests when they entered school, but they performed better in school, they were less likely to commit crimes as teens, and they graduated at far higher rates than the group that did not get that early education. By nearly every measure the children given the “head start” stayed ahead.

Advocates of Head Start maintained that for every dollar spent on early childhood education, five dollars would be returned in increased tax revenues and reduced welfare spending. While not reported in present value terms, recalculating it that way using reasonable interest rates suggests that such an investment would be a good one. Armed with threat early evidence, Head Start began with great hope that in a generation or two, early childhood education would make significant inroads into poverty in the US.

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The Remaining Doubts

Even in the early years, some people questioned the premise that the investment in early childhood education could have the kind of return that was projected. These doubts were based mainly on the implausibility that a few years of preschool could enable children to overcome the effect of poverty and other social problems. Although most Head Start programs are offered for half days during the school year, even children in the all day, all-year for of Head Start spend only 4600 hours in the enriching environment. The rest of their childhood, 153,000 hours is spent in poverty stricken homes, crime ridden neighborhoods, and educationally deficient schools. Regardless of how good the 4600 hours is, it is hard to imagine that its influences would be strong enough to enable children to prevail over all other the influences in their lives.

Critics also point to flaws in the original study that showed the great potential for early intervention. Children in the original study were placed in a classroom that was nearly ideal, and their teachers were better equipped, physically and educationally, than any national program could ever hope to be. Critics doubted whether the program could be duplicated and used for the rest of the country.

THE HEAD START PROGRAM

Ever since its beginning in 1965, Head Start has enjoyed significant growth in appropriations but has never had a budget sufficient to be called “fully funded.” A fully funded program would have enough money, staff, and facilities to handle all children who are eligible for the program. In reality there have been long waiting lists in some cities for Head Start services.

Head Start is much more than day care, and it is not merely a preschool. Under reforms enacted in the early 1990s, it has become a center of learning for the entire family. Teachers are charged not only with creating a wholesome environment for children, but also with making sure parents know of the available social resources for economically troubled families. The teachers make sure that immunization and health records are up to date, and they advise parents on a host of other matters related to child rearing as well.

The early evidence is that Head Start centers are performing these tasks very well. Professional accreditation agencies have found that centers are well within the standards for early childhood education, certifying the vast majority of centers as “good” or better.

By 1997 there were nearly 800,000 children enrolled in Head Start, at an average cost per child of nearly $5,000. Inflation-adjusted spending and enrollment stayed relatively flat from 1965 to 1990. Though enrollment began at nearly 750,000 and fell through the 1970s to a low of 333,000, it rebounded through the early 1980s to half million, where it stayed until 1990. Similarly, inflation-adjusted spending on the program stayed between 750 million and spending on the program stayed between 750 million and 1 billion 1982 dollars from its inception through 1990.

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THE CURRENT EVIDENCE

Evidence that Head Start Works

The evidence that Head Start works comes mostly from myriad studies which test Head Start children at or near their exit from the program. Head Start children do dramatically better on IQ tests than equally situated non-Head Start children on entrance into kindergarten. Virtually all of the studies that examine the program have found some significant advantage for these children in the year or so after they exit the program.

The improvements can be seen in lower numbers of children being retained in the first grade and in higher reading and verbal test scores. In addition, Head Start children are healthier than equally situated non-Head Start children, in large measure because part of Head Start is parental education and because children in Head Start are fed nutritious meals while they are in the program. In the teacher-parent contacts, immunization records are reviewed and, when necessary, doctor and dentist referrals are made. Parents of Head Start children are more aware of the many services available to them and their children an awareness which explains, in part why 60 percent of them are enrolled in Medicaid.

Evidence that Head Start does Not Work

Head Start’s detractors have evidence to support their position as well. While there are limited studies that show success for Head Start education that extends beyond the second grade, there are companion studies that show that it does not. As the General Accounting Office (GAO), the investigative wing of Congress, reported in 1997, there are no national studies that show, in a compelling way, that anything long lasting is achieved in Head Start. A study by Janet Currie and Duncan Thomas put it quite well: “In summary, despite literally hundreds of studies, the jury is still out on the question of whether participation in Head Start has any lasting beneficial effects.”

Although some studies do show that using some measures of success, some types of students do better, the patterns in the literature on Head Start are not consistent. Some show lasting effects for black children and other do not. Some show lasting effects for white children and others do not.

The basic premise of Head Start is that it is literally an educational “head start” and that the students who graduated from it ought to do better down the road than similarly situated students who did not participate. There is very little evidence, however, that suggest that test scores, dropout rates, graduation rates, or any other measure of educational achievement in later years is enhanced when students have Head Start in their background. Most of the studies that show a waning influence find that most of the benefit of Head Start is gone by the third grade and that none is evident by the sixth grade.

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THE OPPORTUNITY COST OF FULLY FUNDING HEAD START

If tax money had no opportunity cost, Head Start would not be controversial. In the tradition of the medical profession’s Hippocratic Oath, Head Start clearly does no harm. Whether it does any good and, if so, whether that good is enough to justify the costs are other questions. Head Start costs $5,000 per year per student, more than most day-care centers charge for a year of service, even though most day care is nine hours a day, all year, and Head Start is only four days a week during the school year. According to the census bureau, day care costs per child approach $5,000 per year, though costs vary widely by location.

If the federal government wants to provide free day care for poor children, it can do it for less money than it spends on Head Start. If Head Start genuinely provides a measurable head start, it should have showed up in long term studies in an unmistakable and consistent fashion. On the other hand, some of the impact of Head Start is such that it will not show up in educational achievement data, but is still important. When Head Start works with parents, they may become less abusive, they may be more likely to deal effectively with their children’s other problems, and they may be more likely to succeed themselves. Then again, there is no solid evidence, positive or negative.

On the issue of long term impacts, there is no evidence that Head Start alone improves graduation rates, decreases teen pregnancies, or lowers crime rates. There is no evidence that it has any long-term impact on any other long term measures of social or academic success either. Even Head Start’s staunchest advocates now suggest that the premise of Head Start, that a short boost in the early years would remain throughout a lifetime, was overly optimistic. Their view now is that programs like Head Start need to be carried on throughout childhood, and they also need to be implemented in schools. Head Start’s detractors suggest this is sending good money after bad.

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60 Poverty, Capitalism, and Growth

Fifty years ago, nearly half of the world’s population lived in poverty; today, the proportion is about 17 percent. In fact, compared to fifty years ago, even though the world’s population has doubled, there are actually fewer people now living below the poverty line. Despite the human misery that is evident to varying degrees in virtually every nation of the world, there is little doubt that economic prosperity has made great strides.

The Sweep of History

The past half-century is but a small part of a story that has evolved over the course of 250 years. In the middle of the eighteenth century, perhaps 90 percent of the world’s population lived in a state of abject poverty, subsisting on the equivalent of less than $1 per person per day, measured in today’s terms. In fact, for most of human history, abject poverty-including inadequate nutrition and rudimentary shelter-were the norm for almost everyone, everywhere. This began to change in the eighteenth century with the Industrial Revolution and its associated mechanization of tasks that had always been laboriously done by humans or animals. Stimulated in the early years by the invention and application of the steam engine, the Industrial Revolution initiated a massive cascade of innovations in transportation, chemistry, biology. This continuing process of invention and innovation has made little headway in many parts of the world, but where it has taken hold, there has been a sustained rise in average real per capita income and a corresponding decline in poverty. By 1820, the extent of abject poverty had fallen from 90 percent to 80 percent; by 1990, it had dipped below 70 percent; and it has continued to decline since. Before the Industrial Revolution, more than five out of six people lived in abject poverty; today, it is one out of six.

Uneven Progress

This story of human progress has been uneven across countries, Europe, North America, and a few other locations have witnessed the greatest increases in real per capita income and the greatest decreases in poverty in most nations in Africa have changed little over the past 250 years. Even within given countries, progress has sometimes been erratic. If we go back ninety years ago, for example, the standard of living in Argentina was the sixth highest in the world; today, that nation ranks seventieth in living standards. In contrast, thirty years ago, 250 million people in China lived in abject poverty; that number has since been cut by 90 percent.In Chapter 1, “Rich Nation, Poor Nation,” you saw the key institutional factors that determine average levels of per capita income. Secure property and contrast rights and the rule of law were the institutions under which the Industrial Revolution flourished best, and it is thus in nations that have embraced these institutions that people are most likely to be prosperous. These same institutions are the ones typically associated with capitalism, economic systems that depend primarily (Though not necessarily completely) on markets to allocate scarce resources. Of course, no country in the world is

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completely capitalist; in the US, for example, less than two-thirds of resources are allocated by the private sector, while the rest are allocated by federal, state, or local government. At the other end of the spectrum, even in Communist countries such as Cuba, Vietnam, and North Korea, markets play at least some role in allocating resources.Despite some ambiguities, then, it is possible to measure the degree of capitalism (or, as some would term it, economic freedom) in each country around the world. Doing so yields measures that seem to correspond reasonably well with what many people would think is true about the economies of those countries. For example, using the measures constructed by Canada’s Fraser Institute, Hong King’s economy is rated the most capitalist, while the US is tied for third (with Switzerland and New Zealand). Singapore, Canada, Ireland, and Australia are some other nations whose economies are judged among the ten most capitalist in the world. If you know much about economic prosperity around the world, you will be aware that these countries are also among the world leaders in real per capita income. Indeed, the association of capitalism with prosperity is everywhere quite strong.

Capitalism and Prosperity

It is convenient for our purposes to divide all the nations in the world into five groups, ranging from “most capitalist” to least capitalist.” Data limitations prevent doing this with every single nation in the world. Nevertheless, it is possible to do it for about 125 of them, putting 25 nations into each of the five groups. Thus among the top 25 “most capitalist” nations, in addition to the countries we mentioned earlier, many (but not all!) of the original members of the European Union (EU) would be included, along with Chile, Costa Rica, and Kuwait. At the other end of the spectrum, the economies of Russia, Algeria, Venezuela, and Zimbabwe would all fall into the group of the 25 “least capitalist” nations.As we suggested earlier, people who live in the most capitalist nations in the world also tend to have the highest average income. For example, average per capita income for people living in the group including the 25 most capitalist nations averages over $23,000 per year. For people living in the next most capitalist group of nations, per capita income averages about $13,000 per year. Once we get down to the 25 least capitalist nations, average income has dropped to but $3,300 per year. And because rates of economic growth are also higher in more capitalist nations, the difference in income between the most and least capitalist nations are growing over time.Of course, this is a chapter about poverty, and the average income in a nation may bear little relation to the income earned by its poorest residents. Many people believe, for example, that capitalist nations promote excessively competitive behavior so that people who are not good at competing end up much poorer in capitalist than in non-capitalist nations. If the rich get richer in capitalist countries while the poor get poorer, then even if the average person in capitalist nations is doing well, the same might not be true for people at the bottom of the income distribution. As it turns out, however, the poor do not do worse in capitalist countries; in fact, they do better.

Capitalism and Poverty

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Consider the 25 most capitalist nations in the world. On average, the poorest 10 percent of the population receives about 2.5 percent of total income in these countries. Indeed, if we look across all countries, we see that although there is some variation from nation to nation, the poorest 10 percent of the population typically gets between 2.0 and 2.5 percent of total income. One way to put this is that on average, capitalism does not lower the share of total income going to the people at the bottom of the income distribution. Capitalist or Communist, in Africa or in the Americas, the per capita income of the poorest 10 percent of the population in a nation ends up being about one-quarter of what it is in the middle of the income distribution for that country.Now if you followed the numbers earlier about average income and capitalism, you may already have figured out the next point: Because capitalism raises total income in a nation without reducing the share of income going to the poor, capitalism ends up raising income at all points in the income distribution. Thus for the poorest 10 percent of the population in highly capitalist countries, average per capita income is about $5,900 per year ( or just under $24,000 per year for a family of four). For the poorest 10 percent of the population in the least capitalist countries, average income is under $750 per year (about $3,000 for a family of four). Expressed somewhat differently, poor people in the most capitalist nations can expect average income levels eight times higher than poor people in the least capitalist nations.The radically higher standard of living experienced by the poor in capitalist nations is reflected in many other statistics indicative of quality of life. For example, life expectancy in the 25 most capitalist nations is about seventy-seven years; in the least capitalist, it is about fifty-seven. Similarly, infant mortality rates are eight times higher in the least capitalist countries than in the most capitalist. Moreover, because people at the top of the income distribution have access to health care in both rich and poor nations, these differences in life expectancy and infant mortality are chiefly due to differences among people at the bottom of the income distribution. In capitalist nations, compared to non-capitalist countries, it is the poor whose newborns are surviving infancy and whose adults are surviving to old age.There is another compelling difference between capitalist and non-capitalist countries that sheds light on what the future may bring. In the 25 most capitalist countries of the world, fewer than 1 percent of children under the age of fifteen are working rather than in school. In the 25 least capitalist nations, one child of every six under the age of fifteen is working rater than in school a rate nearly twenty times higher. Thus in capitalist nations, children are much more likely to be getting the education necessary for them to learn the skills of the future. This in turn means that economic growth is likely to be higher in capitalist than in non-capitalist nations, and this is exactly what we observe. Growth in per capita income in the 25 most capitalist countries averages about 2.3 percent per year, enough to double income at all levels over the next thirty years. In contrast, average per capita incomes are actually falling in the least capitalist countries, implying that the misery of today’s poor in these nations is likely to get worse.

More than Numbers

It is easy to get too wrapped up in numbers, so it may be useful to make a few simple head to head comparisons. Consider North Korea and South Korea. Both emerged from

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WWII with shattered economies, only to fight each other in the Korean War. When the war was over, South Korea embraced capitalism, building and economy based on the rule of law, secure property rights, and a reliance on the market as the primary means of allocating scarce resources. North Korea rejected all of these, choosing instead a Communist system that relied on centralized command and control to allocate resources a system ruled not by law but by one man at the top. South Korea became a world economic powerhouse, with per capita income of almost $23,000 per year. North Korea stagnated and, with a per capita income of only $1,700 per year, must now rely on foreign aid to feed many of its people.If we were to look at East Germany and West Germany between WWII and the fall of the Berlin Wall in 1989, we would see the same story repeated. West Germany embraced the central principles of a market based capitalist economy and prospered. East Germany rejected those principles, and its people were impoverished. A similar tale of two countries can be told in comparing the economies of Taiwan and China between 1950 and 1980: Capitalist Taiwan prospered while Communist China stagnated and people at the bottom of the income distribution suffered the most there.Indeed, as noted in Chapter 3, China itself presents us with a tale of two countries: the Communist version before 1980 and the increasingly capitalist one of the years since. After decades of post WWII stagnation under communism, the gradual move toward market-based resource allocation in China since 1980 is transforming life for people at all levels of income. Overall, real per capita income is now roughly doubling every decade. Moreover, at least in those areas of the country where the Communist have let the capitalist try their hand, this economic progress has been widespread and sustained. So even though political freedom in China is not yet to be had, the growing economic freedom in that nation is having the same impact it has had around the world and over time: When people are able to enjoy secure property rights, the rule of law, and a reliance on markets as allocators of scarce resources, people at all points in the distribution benefit.

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