How Paul Krugman Convinced Me to Support Miles Kimball's E-Money Idea

Paul Krugman wrote a post over the weekend in response to the speech that Larry Summers gave at the IMF about the possible stagnation of the U.S. economy due to the zero lower bound (ZLB). The post gives a good summary of Summers' speech and issues facing the economy due to the ZLB. A key argument in the post is that the economy has been fighting against a liquidity trap decades through successive economic bubbles.

So with all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither – this was the era of the Great Moderation, a time of low inflation and generally low interest rates. Without all that increase in household debt, interest rates would presumably have to have been considerably lower – maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles.  

An argument that bubbles have been good for the economy is a counter intuitive claim that is likely to be met with heavy resistance, but that reaction is precisely why (according to Krugman's logic) the economy is having trouble escaping the fallout of the housing bubble. Less serious bubbles in the past have been met with painful, yet short, recessions because the economy was able to essentially shrug off its past mistakes and move on to new productive investments. However, the housing bubble was a widespread phenomenon that has personally impacted a massive proportion of the population. Huge negative effects hit individual consumers much harder than previous bubbles, which has caused a fear of economic instability within the population that is unrivaled since the Great Depression.

People are now afraid of bubbles and are actively trying to prevent future bubbles from disrupting the economy. The response and fear of the public has lead to overwhelming support for financial reform like Dodd-Frank. The movement for financial reform might actually be impairing economic growth, as Krugman states:

He goes on to say that the officially respectable policy agenda involves “doing less with monetary policy than was done before and doing less with fiscal policy than was done before,” even though the economy remains deeply depressed. And he says, a bit fuzzily but bravely all the same, that even improved financial regulation is not necessarily a good thing – that it may discourage irresponsible lending and borrowing at a time when more spending of any kind is good for the economy.

It is a particularly terrifying idea that financial reform is harming the economy because it is discouraging irresponsible lending, which would help to create another bubble that leads us to a temporary recovery. It is plausible that the economy could stagnate, a la Japan, due to handcuffed monetary policy and regulation acting to prevent a bubble-fueled recovery. This one blog post by Krugman is perhaps the best argument yet for Miles Kimball's idea of e-money (read Miles on e-money here).

The Summers speech/Krugman post has lead me to closely examine my beliefs on monetary policy and has convinced me that e-money offers the best alternative to the current policy regime. E-money can provide large social benefits by avoiding an arbitrary boundary on perhaps the one policy mechanism that economists understand very well. If Summers and Krugman are correct about the possibility of stagnation, support for e-money (or other similar policy alternatives) is almost a moral imperative for economists. It is the duty of economists to use the influence they hold to improve the economy and the lives of the people in it. I am now convinced that e-money is perhaps the best example of socially beneficial policy changes that can occur because of the influence of the economics profession.

The Economic Damage of Political Instability in the United States

There is a significant amount of literature that discusses the impact on inequality on economic growth and political stability. One logical hypothesis is that inequality impact economic growth through political instability. Political instability in its extreme form is open conflict between the government and its population. This form of political instability is all too common in Latin America. Developed nations are more likely to experience sub-optimal fiscal policy and government regulation as a less threatening, but still damaging, form of political instability. The United States is a good example of how the second form of political instability can hamper economic growth.

The current levels of inequality is the United States created a less stable economy that has struggled to recover from a debt driven financial crisis in 2008. Fed Governor Sarah Bloom Raskin gave a speech at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies in April that strikes at the heart of how inequality has weakened the economy. Member of the middle class and below had the majority of their wealth tied up in home equity that was destroyed by the collapse of the housing bubble. The past five years has been a painful period of deleveraging (see chart) as many families were stuck with unrealistic mortgages as a result of irrational exuberance in the housing market. Families most damaged by the housing collapse were also the ones most vulnerable to the increase in unemployment. The wealthiest members of society have fared well since the financial crisis while others are still struggling to regain financial stability.

The result of the dramatic disparities in economic circumstances for the different income classes since 2008 has lead to a disturbing increase in political polarization. Below is the Political Polarization Index developed in a study by Marina Azzimonti at the Philadelphia Fed. Polarization has been trending sharply upward since 2008 and reach its highest level at any point from 1981-present during the 2012 election. To a large degree, the political polarization of the country has been driven by inequality and the result of the 2008 financial crisis. Republicans are sternly on the side of low taxes and reduced welfare benefits, which is supported by many extremely wealthy donors and social conservatives. Democrats have been advocating increased taxation of the rich and financial relief for those hit hardest by the financial crisis. The two sides of the wealth spectrum have been placed on opposite ends of the wealth spectrum, and the result has been a contentious partisan environment.

The polarized political environment has done far more than slow down the legislative branch and inspire hateful debates in the last election cycle. It has created sub-optimal policy initiatives that are actively harming economic growth in both the short and long-term. Political polarization has created instability in the legislative process that has damaged fiscal policy in the U.S. Sequestration was intended as a bitter pill to end debt ceiling squabbles that Republicans have been all too eager to swallow. In reality, Sequestration is a temporary band-aid that serves very little purpose in the long-term debt ceiling or budget battles but causes very real damage to portion of society that have been hurt the most by the financial crisis. Long-term unemployment is still a pressing issue for legislators who are barely able to keep the government operational. The future growth path of the economy gets bleaker every day as long-term unemployment remains an issue that politicians are content to stash on their shelves until it becomes politically useful during 2014 or 2016.

Political instability even shares part of the blame for the botched implementation of Obamacare. The Obama administration has been forced to expand the scope of the federal exchange due to state-level intransigence and even the development of the project was damaged by party politics. The administration felt the need to be secretive and insular during the development of the federal exchange because of constant attacks from the right. Now the country gets to wait with bated breath for another doomsday deadline to see if the exchange can be fixed in time to avoid extensive damage to insurance markets. Politics is not an excuse for the mismanagement of the launch, but it is still a reality of the situation.

There is a long strand of literature in academic economic journals discussing the theory of how economic growth might be damaged by inequality and political instability. Lucky for us, we get to see the dirty details of it firsthand.

Labor Market Impacts of a Basic Income Initiative

I wrote a blog post earlier about the Swiss basic income initiative and the political arguments to be made for/against it from a liberal and conservative perspective (from an American political perspective to be clear). But now I am drawn to the economic impact of such an initiative on labor markets.

Earlier in the year, the minimum wage was given a healthy dose of debate thanks to President Obama's minimum wage proclamation during his State of the Union. A national basic income would be an even more dramatic program impacting minimum wage labor markets. In a perfect world (i.e. economic theory), a government-provided basic income would result in the abolishment of the minimum wage. Wages paid out in minimum wage service jobs would drop to the level where wage is equal to marginal revenue product. However, it is much harder to reduce wages in reality than it is in economic theory. The idea of a minimum wage is entrenched in the collective social consciousness and the elimination of that policy would prove difficult, even with the advent of the national basic income. In Switzerland, the effective minimum wage is set through collective bargaining agreements, which might provide the country more flexibility in adjusted its minimum wage policy to fit the new paradigm. Without an adjustment to the new paradigm, a small rise in unemployment as a result of the basic income initiative is likely.

In other sectors of the economy, the initiative might have more impact on wage growth than unemployment. The initiative has the potential to cause upward pressure on wages as workers have more financial security to pursue entrepreneurial projects or commit more time to social responsibilities. Perhaps it won't be reflected in wages but instead in other benefits provided to workers. Work-life balance and the work environment will be more powerful bargaining chips with the increased financial security that a basic income will provide.

The aggregate impact on unemployment will be dependent on how the basic income program is financed. Significant funding could be made available through the elimination of old welfare programs, but an increase in tax revenue would be necessary to make the program anywhere near budge neutral. Anywhere near a significant rise in unemployment would only be likely if the business community was forced to bear the majority of the new tax burden for the program. It might give additional incentive for firms to move toward more capital or technologically intensive operations. For example, the fast food industry might accelerate its process toward automation by replacing workers with kiosks.  

However, there might be interesting long-term trends that could develop as a result of the basic income initiative. It might give additional incentive for firms to move toward more capital or technologically intensive operations. For example, the fast food industry might accelerate its process toward automation by replacing workers with kiosks. Over the past few decades, the return on labor has been fairly stagnant while the return on capital has increased. In the United States, labor is receiving a smaller and smaller proportion of GDP in wages, as shown in the graph below:

The blue line represents the % of GDP that is paid in wages and accrued salary. Paul Krugman wrote about his phenomenon back in December in an attempt to bring the role of the capital/labor relationship to the attention of people worried about rising income inequality. Current trends have capital receiving a far greater share of GDP than it did 30-40 years ago. Real wages have largely stagnated, including in Switzerland. The average growth of real wages in Switzerland has averaged around 0.5% per year as shown below.

 A basic income initiative might be a logical response to the changing composition of the world economy. As capital continues to earn a larger share of GDP, it might be in society's best interest for the government to find a way to distribute the returns to capital among a larger portion of the population. One way to do that would be to increases taxes on capital were increased in order to fund the basic income initiative. Krugman's article brings up fears of a return to the Marxist battle of capital vs. labor but government might be able to help transition society toward a new equilibrium through programs such as a basic income initiative.

Why the GOP Should Embrace the Beauty of Human Irrationality

There is the often criticized assumption in economics about the rationality of individuals. In theoretical economics, people are generally assumed to be perfectly rational which entails a number of caveats. The assumption does have great value in the field of economics but it tends to be bastardized when used as a pro-free market talking point for politicians. Politicians fail to mention the conditional assumption when they mention the rationality of market participants. The political notion of rationality seems to more closely adheres to the idea of personal responsibility for the cause/effect relationship of one's actions. However, the two different definitions of rationality are often confused because the political definition is never clearly stated. This confusion leads to petty arguments and frustration.

The beauty of the free market and America's economic/political system is its creativity. Advocates of the free market often cite America's leadership in innovation as the ideal of an economic system. The Randian uprising in the past decade in American politics stems from the wish to protect America's economy from developing an incentive structure that halts innovation. Unfortunately, the free market political movement has moved away from its core strength toward an anti-welfare message. The shift in message doesn't change the root of the movement at the grass roots level. People are attracted to the idea of America as a nation of dreamers and idealist who strike oil where everyone else has failed. The strength of the free market message is not in the idea of individual rationality but in individual irrationality. Steve Jobs did not make a rational decision by dropping out of college in order to sit in on random courses and eventually take a job with Atari. Many people have taken similar paths in life and ended with much less desirable outcomes than if they had received a college degree. However, we hear about the one that helped build an international empire that has sales rivaling the GDP of entire nations. We celebrate his decision despite the fact that it was irrational in the face of overwhelming statistics about his probability of success. Americans are a romantic people who worship the trailblazer and not the everyday foot soldier.

 Republicans should embrace the romantic version of the free market by praising the irrational confidence and passion of Americans who attempt to innovate by starting new businesses or applying for patents. The current free market philosophy of the Republican party comes off as a form of paternalism where people need to take responsibility for their lot in life. A shift toward policy objectives centered on patent/copyright reform, deregulation that favors new business formation, and state level changes to professional licensing laws would help to significantly improve the party's public image. The free market can be a great source of hope and inspiration but the current strategy of the GOP has made it seem like a punishing environment that advocates Social Darwinism. The support of the people can be won if the message is focused on the creativity of society instead of its jealousy of the rich.

The Value of Economic Assumptions

A common complaint made against the field of economics is that simplifying assumptions made in economic models are unrealistic. Economists are definitely prone to making bad assumptions and certain models (ex. DSGE) suffer because of unrealistic assumption, but that is not sufficient cause to dismiss simplifying assumptions as a whole. I have been inspired to write this post based on Krugman's Crib Sheet post.

Assumption in theoretical economics have the benefit of removing the noisiness of human behavior and decision-making. Human behavior is immensely complex and difficult to predict based on observation alone. Modeling assumption help to cancel out some of the noise associated with human behavior and allow economists to isolate a topic of interest. Essentially, theoretical models try to build a perfect world to serve as a benchmark to the real world. It might not be able to full encompass human behavior but it can provide a much clearer picture to help analyze a basic problem. If we understand how people would act in a perfect world, then we have a better framework to understand real world deviations.

The analytic framework made possible by simplifying assumption is one area where economics has the potential to follow the scientific method. A formal economic theory provides a hypothesis that has the potential to be tested based on available data or observation of the real world. Great economic theory inspires a vast stream of literature that continue to evolve and correct itself based on new data. The macroeconomic revolution started by Keynes is a wonderful example of the potential to apply the scientific method to economics.

However, it a danger to economics is theory induced blindness that widely accepted models and assumptions can create. Daniel Kahneman and Amos Tversky's development of prospect theory is a perfect example of how economics can develop a blindness to the weaknesses of widely accepted assumptions. It is important to treat models as a tool to be used to understand the real world and not an actual representation of it. The rise of behavioral economics has helped to keep the unrealistic nature of most assumptions at the forefront of the field. Behavioral economics is another development that will improve the development of economic theory in the future.

The development of prospect theory is an important event in economics, not only because of the improvement of utility theory but because it highlights the need for collaboration with fields outside of economics. The inclusion of psychology, sociology, and other social sciences will only serve to improve and enrich economic economic theory.