Improving Econ 101

In a recent BloombergView article Noah Smith argues that the reason introductory economics classes are so bad is that they have few empirical demonstrations of their basic insights.  He draws a contrast between Econ 101 and introductory Physics classes.  While the physics classes actively demonstrated that their theories had merit, in Econ 101 and 102, 

… there were no demonstrations. There was basically nothing but theory — all the pretty little theories of comparative advantage and monopoly pricing and loanable funds, and not a whiff of evidence to back them up.

This observation leads Noah to conclude that introductory economics classes need a greater emphasis on empirics — much the way that the profession has shifted emphasis towards empirics recently.  

There might be some truth to Noah’s argument and his recommendation but I have some doubts all the same.  

Introductory economics – particularly introductory microeconomics – introduces students to, as Greg Mankiw summarizes it, “comparative advantage, supply and demand, market efficiency and market failure.”  That sounds about right but I would say that supply and demand reasoning is the most important tool the students are exposed to. Supply and demand models have a huge number of applications: labor markets, rental markets, the market for illicit drugs, the market for video rentals, the market for foreign currency, the market for short term lending, etc.  Moreover, there are many compelling empirical examples of supply and demand analysis in action. Obviously there is a huge literature on the effects of minimum wages which requires nothing more than supply and demand. There is a literature on rent control. There is the famous empirical study of labor markets (and capital markets) during the Black Death. There are empirical results on tax subsidies, tariffs, farm subsidies, … There are empirical studies of the market for banking reserves. Empirical studies of the effects of entry on prices (think jetBlue) and so on.  Instructors should definitely expose the students to these results — none of which are really new.  

I’m a bit surprised that Noah didn’t mention the increasing prevalence of in-class experiments. (I’m surprised because Noah’s Ph.D thesis focused on experimental analysis of asset pricing games). There are tons of fun in-class demonstrations that can be run.  In-class auctions, bank-run experiments, prisoner’s dilemma experiments, price ceiling experiments, and so forth. Students often really appreciate these demonstrations and they have a way of bringing to the material to life in the way that a review of empirical studies cannot.  

However, if I were to guess, the most important problem holding back many introductory classes is inadequate preparation on the part of the instructors. The textbooks (conspicuously the principles texts) are actually pretty good but if the instructor doesn’t take the time to draw in his or her knowledge about real-world applications, or to introduce interactive demonstrations of the material, then the class will be a typical example of a “chalk and talk” class. I should mention that professors at most universities are not encouraged to be particularly good teachers.  Most universities pay lip service to the idea that teaching is valued but tenure, promotions, salaries etc. are not based on teaching – they are based on research. Assistant professors in particular are well advised to spend a minimal amount of time on preparing classes. Even faculty who want to teach well often have limited training in *how* to teach well. In the typical Ph.D. sequence, virtually no time is spent developing teaching skills even though many grad students go on to work in academia.  

Noah is right to point out that introductory classes are often bad. Fixing them however will require more than just importing empirical results though.  It’s going to require real work.  It might even require a change in the attitude toward good teaching that prevails in academia. 

Christian Zimmerman’s Blog on DSGE Modelling

Christian Zimmermann has a blog devoted to DSGE modelling and macroeconomics. This is definitely worth adding to your bookmarks if you are interested in quantitative analysis of macroeconomic events and policies.  [Originally I described this as a “new” blog — in fact it’s been around for a really long time.  Oh well, it’s new to me I guess.  By the way, have you heard about this great new movie, The Matrix? — it’s awesome!]

Larry Summers on Piketty

Larry Summers has an excellent review of Thomas Piketty’s Capital in the Twenty-First Century. In many ways, his reaction is similar to Greg Mankiw’s. He agrees completely with the factual record but does not fully endorse Piketty’s proposed explanation for the patters or Piketty’s policy recommendations. Some excerpts that caught my eye …

On Piketty’s argument that the returns to wealth are “largely reinvested”:

The determinants of levels of consumer spending have been much studied by macroeconomists. The general conclusion of the research is that an increase of $1 in wealth leads to an additional $.05 in spending. This is just enough to offset the accumulation of returns that is central to Piketty’s analysis.

On the prevalence of inherited wealth among the ultra-rich :

[…] the data […] indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.

On the role of labor income:

Piketty, being a meticulous scholar, recognizes that at this point the gains in income of the top 1 percent substantially represent labor rather than capital income, so they are really a separate issue from processes of wealth accumulation. The official data probably underestimate this aspect—for example, some large part of Bill Gates’s reported capital income is really best thought of as a return to his entrepreneurial labor.

On the substitution of capital and labor in the future:

[M]y guess is that the main story connecting capital accumulation and inequality will not be Piketty’s tale of amassing fortunes. It will be the devastating consequences of robots, 3-D printing, artificial intelligence, and the like for those who perform routine tasks. Already there are more American men on disability insurance than doing production work in manufacturing. And the trends are all in the wrong direction, particularly for the less skilled, as the capacity of capital embodying artificial intelligence to replace white-collar as well as blue-collar work will increase rapidly in the years ahead.

My comments: 

Larry’s remarks about the role played by labor income in generating much modern inequality has received some attention from readers and seems to cause some discomfort for those who are strongly tied to the traditional narrative of class struggle between the capitalist owners on the one hand and the workers on the other. (For some reason, John Quiggin really wants us to believe that this source of income inequality will go away.) Indeed, this feature of modern society does not fit particularly well with the kind of wealth tax Piketty himself advocates.

It’s actually not surprising that a good deal of income inequality flows directly from labor income differences rather than differences in capital holdings. If you think of a typical “ultra-rich” person, it’s quite likely that you are  going to think of someone who gets his or her income from labor rather than capital income. CEOs for instance are largely compensated for their “work” rather than their ownership. The same is true for hedge fund managers [1], actors, stars athletes, rock stars, TV hosts, Oprah Winfrey, J.K. Rowling, and so on … [2]. Even among people in the broader (more terrestrial) 1 percent – doctors, lawyers, financial analysts, building contractors, etc. – you often find examples of people who are highly compensated for their work rather than their financial (or other capital) wealth.

Summers’ comments on labor and capital substitution are also interesting. Traditionally in our models we are accustomed to assuming that capital accumulation enhances labor productivity and thus wages. Empirically, countries with high capital to labor ratios also tend to have high wages. This doesn’t have to be the case however. The type of input substitution that Summers is drawing attention to is real and could be an important determinant of compensation in the future.

[1] The classic case of this concerns “carried interest“.  Carried interest is income earned by fund managers that is tied to the overall performance of the fund. If the fund manager is managing his or her own money then this income would be a mix of labor and capital income. If however the manager is directing investments of someone else’s money (pretty common today) then the payment is entirely for their effort. This would be entirely labor income. There is an effort on the part of hedge fund managers to have this income treated as capital gains income rather than labor income because the tax rates on capital gains are much lower than the tax rates on labor income. This is just an effort to dodge taxation however. The payment is a payment for labor in this case and it should be taxed exactly the same as typical labor income.  

[2] While I’m not so sure that CEO’s “deserve” their extraordinary income I am willing to believe that celebrities like Oprah Winfrey and J.K. Rowling have made contributions to society that are in rough proportion to her compensation. J.K. Rowling, for instance, deserves every penny she has earned from Harry Potter.  Rowling has been paid an astonishing amount for her work — I think about $1 billion — but this is nothing compared with the amount of money governments spend to try to improve education in the world. Every year the U.S. government spends more than $50 billion on education at the Federal level. What Rowling has managed to do for reading for young kids is staggering particularly given the E-culture/ immediate gratification world we live in. She probably deserves more, not less…

Can Anyone Spare $150 billion?

The trade-off between equality and efficiency mentioned in Sargent’s 2007 Berkelee commencement address generated a surprising amount of commentary online (surprising to me anyway). Much of the online posts were directed at dispelling the existence of this trade-off.  Matt Yglesias described it as “one of the big myths of our time.” Noah Smith argued that there might be important opportunities to improve equality and efficiency. Several other commenters pointed out that nations with relatively high per capita GDP have relatively more equal income distributions and so on.

Instead of arguing these points one by one (and yes, they’re basically all either wrong or practically wrong), I thought that perhaps it would be more constructive to present a realistic policy option that might actually make an impact on income inequality in the U.S.  I want to make clear at the outset that I am not necessarily endorsing this policy.  I’m just presenting it as a device to make the trade-offs and policy options clear.

Before I begin, let me mention a few facts so we can appreciate the issue a bit.

The U.S. labor force is roughly 156 million people and the U.S. population is 314 million people.

U.S. Gross Domestic Product (GDP) is currently roughly $17.15 trillion though it should probably be higher. As most of you know, GDP is total annual income.  If we divide by the population we get income per person or GDP per capita.  U.S. per capita GDP is approximately $54,600.  (If you didn’t know about the extent of income inequality in the U.S., for a family of four people you might expect a yearly pre-tax income of almost $220,000).  Typical household income is nowhere close to this however. Median household income is only $52,000.  (The median household is the household that would be exactly in the middle if I lined up all households from lowest income to highest income.)  The reason for this discrepancy is that there are a small number of extremely wealthy households who get enormous incomes.  To be fair, there are many households with only one person (singles) and this is comforting to an extent.  Don’t fool yourself though.  There are many, many households with 4, 5 or more people who take home a combined income that is well below $50,000 per year.

The minimum wage law under consideration (increasing the minimum wage from $7.25 to $10.10) would provide a transfer of $6,240 for every full time worker earning the current Federal minimum.  Unfortunately, if you earn $10.10 or more, you won’t get anything from the minimum wage.  If workers were evenly distributed between $7.25 and $10.10 then the average transfer would be $3,120.  That still sounds like a lot, however there are only about 4 million workers (about 2 percent of the labor force) currently at or below the Federal minimum wage. Also, many of these people are teenagers working part-time and living in middle class households.  Compare a teenager who works a minimum wage job flipping burgers with a worker who supports a family but earns $11.00 an hour as a waiter.  The minimum wage will transfer money to the teenager even if she lives in a family that is fairly well off.  The policy does nothing for the other worker.  How many examples like this are there?  Lots. About 30 percent of all workers earning the minimum wage are teenagers.

Suppose we wanted a policy that helped out a greater number of lower income Americans.  Specifically, let’s target the bottom 1/3 of all income earners.  Given the size of the U.S. labor force, this is approximately 50 million people.  50 million workers is a convenient figure.  To transfer $1,000 to each of one million workers would require $1 billion.  So, to afford an average transfer of $1,000 to the bottom 50 million workers, we would need $50 billion.  The proposed minimum wage policy transfers about $3,000 to each worker at the lowest end of the income scale.  If we wanted a policy that did essentially the same, we would need to come up with $150 billion dollars per year.  We could have the policy phase-out gradually as most transfer programs do. The very lowest earners could get a transfer of $6,000 and the workers at the top end of the phase-out would get nothing.

How would we achieve this transfer? I would suggest a wage subsidy with an explicit negative tax withholding feature.  If you get a job for $7 an hour, the government would subsidize the worker with by contributing roughly an extra $3 per hour and the wage subsidy would slowly phase-out.  Eligibility for the wage subsidy would be dependent on household income to avoid paying teenagers and focus instead on low-income primary and secondary earners (a teenager earning $7 per hour but living in a household that earns $150,000 would not get the subsidy).

Unlike the minimum wage law, this law would phase-out at around $20.00 per hour rather than $10.10 – this policy helps a large number of working Americans (50 million workers rather than 4 million).  Unlike the minimum wage, this policy encourages employment of low-income workers.

Now the bad news… Where do we get the $150 billion required to fund the program? Well one way of getting it would be a substantial tax increase on upper income Americans.  This is not entirely implausible.  The Piketty and Saez study shows that earners in the top 0.1 percent of the income distribution get roughly 10 percent of all income – roughly $1.7 trillion.  If we could get an additional 10 percent of their income in tax revenue we would have enough for this program just by raising taxes on the top 1/1000 of the working population.  Unfortunately, this is easier said than done and there are serious costs which would need to be carefully considered were we to take this path.  Among these costs are, first (1), introducing a new top marginal tax 10 percent greater than the current maximum tax rate would not be enough.  Much of this income is not taxed at the top marginal tax rate so the marginal rate would have to go up by more than 10 percent. [Note: currently, the top marginal tax rate is 39.6 percent. A 10 percentage point increase would make the top rate close to 50 percent (ouch).] Second (2), much of this income is capital income. Taxing capital income is not a very good idea since it compromises business expansion in the long run.  Third (3), these households will take steps to shield their income from the additional taxes.  Fourth (4), such a tax increase will reduce work for upper income Americans. Some working spouses will leave the labor force and stay at home.  Some workers will retire early.  Some businesses will shift operations overseas, etc.  Fifth (5), there will be significant administrative and enforcement costs associated with the policy.  These last costs could easily add another 10-20 percent to the overall cost of the program.

These costs (1-5) represent the tradeoff between efficiency and equity that Noah Smith, Paul Krugman and Matthew Yglesias want to de-emphasize (Yglesias seems to think they don’t exist). There are other options to getting this revenue. For instance, we could raise taxes on the top 1 percent rather than just the top .1 percent. We could cut spending in other areas, etc. In any case, this policy would require either cutbacks or heavy taxes or both to implement.

In many respects, this policy option is a lot like the Earned Income Tax Credit (EITC). The EITC requires a budget outlay of roughly $50 billion per year. The above proposal would differ in a couple of ways.  First, the EITC is targeted to low income workers with children while the proposal outlined above would transfer to all low income workers regardless of family size. Second, the EITC is a smaller program.  It is fairly generous to very low income workers with children but the phase-out occurs much faster.

Ignoring the problem of income inequality is not an option (that said, the minimum wage policy is one way of taking a passive stance to inequality to put off dealing with the problem directly).  If we really want to make a noticeable dent in U.S. inequality, we will need to get aggressive and we will need to be prepared for policies with serious price tags.  There are real costs to achieving a more equitable distribution of income.  Exactly how costly, is up to us.