The American Scene

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Articles filed under Economics

Myhrvold's Gulch

Recently some friends and I were discussing the left-intellectual move of noting positive state economic institutions and arguing from there that the state is constitutive of the economy and therefore what the state giveth, the state taketh away. From my disciplinary perspective as an economic sociologist, a field that was greatly influenced by Polanyi, it strikes me as self-evident that all economic activity is shaped by institutions like the state enforcement of property rights. The right has it’s own version of this which underlies suspicion of cronyism and monetary policy. So basically, you didn’t build that.

However, the thing is that most of the time I think the state basically does it right, and in particular that enforcing (natural) rights is different from creating (positive) rights. However, it gets interesting when you think the state institutions are really really bad and so allocations of wealth are based on terrible institutions. There’s a big difference here between the Yglesias “neoliberal + T&T” types and the Myerson “#fullcommunism” types in that the former support our basic institutions but occasionally use their contingent nature as one of several justifications for the welfare state, whereas the latter would ideally like to radically reshape the institutions themselves. Aside from the punitive laicite, I would be pretty happy in a Yglesias utopia (I’ve visited Scandinavia, it’s nice) but in the Myerson utopia I plan to live in the mountains with my high school football team and shout “Wolverines!” after ambushing the Bolivarian Guard convoys.* However there’s something logically consistent about the #fullcommunism view of let’s change the institutions vs the “you didn’t build that” non sequitur to justify Medicaid expansion.

I like to think about the social nature of economic institutions as a continuum. On the one hand you’ve got the fact that part of the reason I enjoy privacy in my home is because I could call the cops if squatters tried to force their way in, but aside from sophistry or freedom of association gotcha, who cares? On the other hand, it can be helpful to imagine situations where we have really awful institutions that have resulted in allocations of wealth.

Let’s call this the Myhrvold’s Gulch problem.**

Intellectual property law is much more obviously socially constructed than our other economic institutions if for no other reason than property rights to rivalrous goods are partially self-enforcing whereas property rights to non-rivalrous goods are very obviously positive institutions of the state (and in historical perspective look more like royal monopolies than property rights, as seen with the stationers’ guild, etc). Moreover, they result in great wealth, and it is easiest to see this not in companies like Disney or Microsoft that benefit from the Bono Act and trade diplomacy to suppress foreign piracy but also created incredibly useful art and software, but with companies like Intellectual Ventures that are purely parasitical and whose only useful purpose for society is to give a more concrete focus to our musing on the nature of positive economic institutions as a sort of Lisbon earthquake of economics.

So what is to be done? Do we say that Nathan Myhrvold’s legal but unjust wealth means that we should let him continue to extract it but the state will apply confiscatory taxation? Or maybe the kludgeocracy version of the same thing, which is to not tax him but mandate that Intellectual Ventures cross-subsidize socially useful and/or redistributive activities? Or even vaguer but more realistic versions that since Myhrvold benefitted from bad laws that therefore all rich folks should be taxed more heavily or that all companies should pay at least $10/hour to unskilled workers? This is essentially the logic of you-didn’t-build-that-ism. However it seems like if you’ve got a problem with our IP institutions (as I most certainly do), the more logical thing is to reluctantly let Myhrvold keep his millions, but reform patent law so that we don’t have problems with patents going forward.

* I didn’t actually play high school football. However, I’m hoping though that there will be some group of athletic young people who will accept a man in his late 30s in mediocre shape with minimal outdoors or firearm experience as one of their own. ** I shudder to make an Ayn Rand reference even in jest. I’m not an objectivist, I’ve never read any of her books, I had to look up the “Galt’s Gulch” reference, and I frequently chuckle thinking about nasty things that Whitaker Chambers said about Ayn Rand decades before I was born.

A Criticism Of Pope Francis

Ok, so I’ve been playing a little bit the role of Pope Francis’ Busiris* and, I think, appropriately so, but I’ve always left the door open to criticism, and here I am going to do that.

No, Pope Francis is not a Marxist. He is not a free marketer either. But what he gives us in his latest interview is an example of why these categories are not necessarily the most useful in looking at Petrine Chair’s economic magisterium.

Here’s what Pope Francis said about world hunger:

With all the food that is left over and thrown away we could feed so many. If we were able to stop wasting and start recycling food, world hunger would diminish greatly. […] If we work with humanitarian organisations and are able to agree all together not to waste food, sending it instead to those who need it, we could do so much to help solve the problem of hunger in the world.

(Pope Francis is so easy to love because this stuff is interspersed with such a lovely story of encouraging a mother to breastfeed.)

Here’s the thing: the reason why so many go hungry is not that people in the West throw away food. That’s just not the reason. The reason is not free market capitalism. The reason isn’t even socialism (or only marginally, these days). The main reason—and I’m pretty sure this is something all serious observers of this question would agree with—is quite simply corruption. Everyday corruption of functionaries. Corruption in the broader sense of war. Corruption.

This fact, if it is a fact, makes Francis’ words disheartening, and this for many reasons.

First, its pollyannaish quality. No, it’s simply not true that if we in the West stopped wasting food kids in Africa would have it. It wasn’t true when my parents told me so** to make me clean my plate, and it’s still not true. And pretending it is is, well, infantile. And not in a Matthew 18 way. And we can “rescue” this Francis comment by elevating it to the theological level, by saying that by wasting food we are, in a powerful sense, being ungrateful towards God’s good creation and being selfish. And that perhaps if we rid ourselves of this ungratefulness we will be made holier by grace and better able to follow Jesus’ command to feed the hungry. And I believe this is true! But that’s not what Francis is saying or, at the very least, it’s not only what he’s saying.

Second, it shows that so much can be accomplished at the level of social doctrine without getting into econo-philosophical debates about “free markets” and “trickle-down economics.” You don’t need to reform or reinterpret or innovate Catholic social doctrine to say that corruption of government officials is scandalous.

Third, because if there is any institution in the world that should put this issue front and center, it’s the Catholic Church. First because, as I’ve said, it’s already well within the bounds of Tradition and flows naturally from the Gospel. Second, because it has a unique legitimacy and presence in doing so. Who else has both the moral language and the on-the-ground presence in so many of these countries to be able to denounce corruption forcefully and effectively? The World Bank? The UN? How much great would be done if, every day, every bishop in sub-Saharan Africa and India and other places saw his number one pastoral priority as denouncing and combatting corruption by government officials, instead of (I’m sorry) bloviating platitudes about wasting food? Isn’t this something the Vicar of Christ should exhort the other bishops to do?

How much good this would do not only to the world, but to the Church! Bishops becoming signs of contradiction against corruption in the developing world would be a great evangelical sign. (And yes, I am sure that many today already do this.) And, of course, it would raise up the Church to a higher standard since a Church that crusades against corruption must therefore be all the more exemplary with regard to its own corruption. And to do so, it must be holy, because you can be sure that if bishops start all of a sudden denouncing corruption day and night, some will be shot and earn the crown of martyrdom.

Then Jesus told his disciples, “If anyone would come after me, let him deny himself and take up his cross and follow me. For whoever would save his life will lose it, but whoever loses his life for my sake will find it.

Matthew 14:24-25

★ In Jean Giraudoux’s comedy The Trojan War Will Not Take Place Busiris is a lawyer who gives an airtight, brilliant legal argument that the Greeks are justified in going to war against Troy. Hector then threatens Busiris’ life, and Busiris then immediately gives an equally airtight and brilliant legal argument that the Greeks are unjustified in going to war against Troy.

★★ They didn’t tell me so.

The Bloomberg Hedge Fund Poker Game Is Everything That Is Wrong With Wall Street

Poker, as many other things that have a certain macho flair in our culture, is a fairly popular pastime on Wall Street, and that’s fair enough.

But when Bloomberg TV hosts a celebrity poker game with hedge fund titans, strongly implying that there is a big overlap between the qualities required to be a great poker player and a great fund manager, we are looking at a paradigm of everything that is wrong with Wall Street.

Yes, poker is a gambling game, and investing is a form of gambling (don’t let anyone tell you different).

But if we think about what makes poker such a fascinating and enthralling game (and I was a relatively serious poker player in law school—playing mostly with finance types), it has very little to do with odds. In fact it’s the things that don’t have to do with odds that make poker interesting. Calculating the odds of a poker hand is trivial.

What makes poker interesting is that it’s a game of a) incomplete information; and b) psychology. By design, in poker, you don’t have all of the information, and you must take other players’ psychology into account to win.

Of course, at least in theory, our financial markets are designed to work precisely the other way around. In the game “financial markets”, all players have complete information, and decisions are supposed to be purely rational and numbers-based.

I would suggest that poker is a pretty good game for entrepreneurs, precisely because to be an entrepreneur is to deal mainly with the psychological, and to always have incomplete information. But for public markets investors, this is completely backwards.

Of course, it’s possible to be a great poker player and a great investor, just like it’s possible to be a great physicist and a great swimmer, but no one would suggest that what makes you a great swimmer would make you a great physicist or vice versa. But this is clearly what we’re led to believe with TV programs that put hedge fund managers together for a poker game, asking them for poker tips the way they’re usually asked for stock tips.

One exception aside*, poker will teach you all the wrong things about investment. A world where we ask our investment managers to be poker players is a world where we’re asking to be fleeced.

I guess it’s no coincidence Warren Buffett plays bridge.

(* What’s the one good thing about investment that poker can teach you? It’s this: what I would call psychological endurance. Once you’ve been playing poker for many hours, you will find yourself much much more likely to make an irrational, big bet. One which you know is irrational but, having had your psychological endurance worn down by many hours of stressful playing, you still do. Being able to keep your head when all about you are losing theirs is useful both in poker and in investing, and playing a lot of poker can help you with that.)

Announcing The DeLong Club

My main contention about the healthcare system in the United States is that the main problem/opportunity is a lack of bottom-up, consumer-driven innovation.

Many economists, wonks and pundits have over the years advocated the idea that the way to have bottom-up innovation in healthcare while also achieving social justice goals is through the medium of health savings accounts (HSAs). A portion of your income every year would be put on such an account, which you would use to consume healthcare services.

HSAs aren’t perfect*, nor is any healthcare system, but many people who understood the trials of healthcare reform as encouraging both fairness and innovation thought that HSAs should be part of any healthcare reform.

This has become important now, of course, because of the healthcare reform act, which takes a centralizing approach to reform the healthcare sector, and basically sees no role for HSAs. I believe this is a grievous error.

The idea of HSAs is chiefly associated with the political Right in the US, but over the years countless economists, wonks and pundits associated with the political Left have advocated HSAs as a way to reform the US healthcare system. One of the most prominent is Berkeley economist and superblogger Brad DeLong.

As the ACA rollout moves from trouble to trouble and as the Right inchoately stumbles and gropes towards some sort of alternative proposal, I think it behooves people of good will on both sides of the political divide to think in good faith about positive reforms to the healthcare system.

THEREFORE, inspired by Greg Mankiw’s Pigou Club of “economists and pundits who have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes” I am starting the DeLong Club, an elite group of Left-wing economists and pundits who have advocated health-savings accounts as a part of healthcare reform.

Here’s the list I’ll start with:
- Brad DeLong
- David Goldhill
- Dylan Matthews
- Matt Miller
- Jason Furman (Hat tip to Michael Hendrix )

I’m sure there’s more. Give me nominations (with sources, preferably).

Noah and Alan on growth

I tried to restrain myself from responding to Alan’s latest post on growth because the last time he did I unleashed what I have to say was a big honking rant. Then Noah responded.

Noah’s post, characteristically, is very smart, very eloquent, and makes a lot of good points. And yet it’s mistaken, in a subtle, but serious and deep way.

Let’s start with the things Noah gets right:

- “Growth” is actually hard to measure.

- Not all kinds of growth are equal. Growth that comes from productivity gains is much more desirable than growth that simply comes from longer hours worked.

- Growth is a moral imperative insofar as it helps people in truly bad living circumstances raise their conditions of living.

And yet Noah makes errors on growth because he misunderstands it in some key ways.

As we’ve said, growth is hard to define, and economists have a hard time understanding where it comes from. And as we said, not all kinds of growth are equal.

So to better understand growth, then, we had better understand value. The “growth” that we want is a growth of the value of the things we produce and consume.

Now “value” is also a fuzzy concept so let me try to explain what I mean.

If Apple (or Dell) produces a better computer that costs less, that might not register as “growth” on the national statistics, and yet we understand it as essential to growth, at least in the long term (I hope), because it creates more value for society—value for Dell (or Apple) but more importantly value for consumers in terms of consumer surplus. And even more importantly value for society in terms of how this computer helps me do things better, more effectively, etc.

To think about things differently: society gets value out of Google because Google generates profits for its shareholders and jobs for its employees (jobs that then go on to generate more economic activity). That’s how we generally understand the benefits of “growth.” Society actually gets a lot more value out of Google (orders of magnitude) out of the consumer surplus that Google generates—that is to say, the difference between what consumers of Google would be willing to pay for the service, and what they actually pay. That’s how many economists generally understand the benefits of “growth.”

But actually Google generates even more value. It generates value in the sense that it makes our lives easier and better. This is what is actually meant by “consumer surplus” but of course if I am willing to pay X for something it means I am getting something more than X of value out of it. And in the case of Google it is very high. Here the example would be the time I save by doing Google searches instead of looking things up in books or hard-to-use and disparate databases. That would be the types of “productivity improvements” that would lead to “growth” that we would crave. But that is actually a minuscule amount of the value that Google creates.

Thanks to Google (and the internet more generally, I am here talking about “Google” in abstract) I have read many things that I would never otherwise have read. I have met people that I wouldn’t otherwise have met. I met the investor in my first company through Twitter. Business Insider gave me a job because I got in touch with people who worked there over the internet. Again, the point isn’t that I generated $X dollars of economic activity thanks to the internet—I probably would have earned more money by going to work at Goldman Sachs rather than Business Insider—the point is that I got to experience things, and meet people, and collaborate with people on things, in a way that simply wouldn’t have been possible otherwise. And that this is a tremendous amount of value in any sense of the word that makes sense (economic or not).

Or think about the car revolution. The car revolution created value not because it created big car companies that made a lot of people rich and gave even more people jobs, although that’s nice. The car revolution created value because it gave people a profound autonomy that they didn’t otherwise have, it transformed the culture (drive-in cinemas) etc. etc. etc.

This type of value seems incredibly hard to quantify and is certainly impossible to integrate in macroeconomic statistics in any meaningful way, and yet it is without a doubt the much bigger quantity of value and the more precious one.

If we define tautologically value as what we value, things like cars and the internet (and penicillin, and electricity, and…) have value not just because people can put a dollar amount on them, they have value because they allow them to do things or to experience things that they find valuable.

Why carp on this?

Because once you understand what value is and how it’s created, you understand not just why it’s precious but how to get more of it.

As Noah notes, to be vague about it economic growth (at least the good kind) comes from some combination of the use of energy and productivity, that is, more output per unit of energy. And meanwhile, “productivity” is this mysterious black box that probably includes things like technology, but also other things like better know-how—skilled labor, but also production processes and so forth.

But once you’ve said this, you have to realize that all value comes from cooperation. Energy must be extracted (whether from the ground or from the sun or from uranium). Technology must be invented, and then tested, and then built, and then marketed, and then market-tested, and refined, and iterated upon—all things which are done by people working together, whether as members of firms, or as firms collaborating together, or as participants in marketplaces (literal or metaphorical, e.g. the “marketplace of ideas”).

Coase describes how economies of information make it better for us to collaborate as firms or not to accomplish some things. Schumpeter and Christensen describe how how some innovations lead some firms or industries to be destroyed and yet simultaneously lead to more value creation. Hayek describes how our poor handling of information makes central planning destroy value while bottom-up collaboration creates value. Bhidé describes how the interplay of departments within a firm (R&D, manufacturing, sales, marketing) and the interplay of actors within a marketplace (venturesome consumers, market feedback) create innovation through an iterative, decentralized process.

Value, then, is what happens when you allow people to cooperate. Economic value, but also culture, communities, all the things that make the good life. Now, the details on how to accomplish that are fiendishly complicated, and there’s good reason (though not always) why economic policy is so complex and, at times, so powerless.

But once you understand what makes value you can’t make some of the errors that Noah makes, and that are all-too common. That is to say, the error of thinking that growth comes from stuff. If there’s enough oil, then there will be growth. If there’s not enough oil, then there won’t be growth. If we have super-duper computers (or robots or Big Data or spaceships to Mars or whatever) then there will be growth, and if we don’t, we won’t. (True enough on the latter, but it only begs the question of who builds the robots or the supercomputers.)

So Noah writes “of course, once resources are exploited beyond a certain degree, population growth just means sharing those resources across more people – a decline in per-capita wealth” as if “resources” was some finite concrete thing even though human ingenuity and industry is the only resource that creates value.

And Noah writes that we have to “limit the costs of growth” by “restraining population growth.” That makes sense if you think growth comes from stuff, from a fixed pie that we have to share. But that’s simply not how value creation works.

There is nothing to indicate that there is any resource constraint on humanity. We are producing a lot more food than we need, and that is by exploiting only a tiny amount of land and “resources.” If you took just Iowa and replaced all the corn field by vertical farms, you would have enough food to feed ten planet Earths.

Same thing about energy. Just build enough pebble-bed reactors. They’re safe, plus they also generate lots of hydrogen which is great if you want to build fuel cell cars.

Earth is not densely inhabited at all.

We’re just not running out of anything.

And yet this inexplicable fear is there. It comes, most of all, from a failure of imagination. For example, Noah wonders whether if we achieved Star Trek-like cold fusion, it would even register as economic growth. Um, yes? Like, if you dramatically lower the cost of a unit of energy for a unit of production, you will get more units of production?

And yet, while all of this is true, it is also true that growth is slowing, and that it is at least worth asking whether this will continue forever and what to do about it.

First of all, there is little question that given how “growth-oriented” our societies are, if we don’t reignite growth we are headed for societal collapse.

But second of all, it is also true that once you realize where value comes from, it also becomes a lot easier to see how we might get more of it. First, since people cooperating is what creates value, the more people cooperate the more value we get, so we should really get more people, not less. (And it becomes obvious that a civilization that adopted a neo-Malthusian frame and decided to lower its population growth rate in fear of lower economic growth would trap itself in a self-fulfilling prophecy.) Second, it also becomes clear that there are lots of avenues for cooperation that have been blocked. One example is immigration. Another example is the numerous regulations that hold back many sectors of the economy, particularly the most promising (pharma, transportation, space, etc.).

But that’s not even the point. The point is that, to go back to the beginning, once you really understand value and how it’s created, you understand how it’s precious, and you at least understand what you must not do.

Alan on me on growth

(Since TAS Alum @ayjay has disabled comments on his blog, I’m responding here, so this will not be like a regular blog post. Here’s me and here’s Alan. )

With regard to grammar, a subject on which you’re more qualified than me, I take your point, though only to some extent. I am not merely arguing that “in conditions of economic growth many heated debates would become less heated or would disappear altogether.” I am arguing that these debates arise as a result of decelerating economic growth and that the only sustainable solution to these debates is higher economic growth.

With regard to, say, pensions, it couldn’t be clearer. We are arguing about “saving” Social Security, and whether the way to “save” it is to raise taxes, or lower benefits, or raise the retirement age, or move to some form of private accounts, or some combination of those things, or whatever. There’s only one problem with this: absent long run economic growth none of these solutions will “save” Social Security and Social Security will be in serious trouble whatever we do. And on the other hand, if there is long run economic growth, “Social Security” under whatever form will do fine.

This is rather like being stuck in a car on railroad tracks with a freight train rapidly approaching and arguing about whether the way to avoid it is to change the car’s paint job or install a different sound system. These things may well be desirable and these questions are worth posing. But if your objective is to avoid getting crushed by the freight train, they are also quite irrelevant. If you want a better paint job that’s a very legitimate thing to want. But if you want to avoid being pancaked you have to put the pedal to the metal. And everyone is acting under the assumption that getting the right paint job will stop the freight train. It won’t.

These debates are “about” economic growth in the sense that any rational outside observer would view “avoid the incoming freight train” (prevent a Social Security collapse) and “move the car off the railroad tracks” (reignite economic growth) as essentially identical propositions. The debate “about” avoiding the freight train is the debate about moving the car off the tracks. Now maybe the accelerator is stuck or the engine is out, or something, and in that case that’s something really worth looking into. But that’s not even the debate we’re having.

So that’s with regard to the point about semantics, which is incidental.

With regard to your points about economic growth…

Except that we don’t know what policies generate and sustain growth. At best we might be able to discover and eliminate some policies that inhibit growth, but economic flourishing in any given society depends on a great many unpredictable and uncontrollable factors. Often the stars just have to align.

First of all, I would vigorously dispute just about all of these points. (And also note that if all we know is what the bad policies are, then that’s already a place to start.)

But second of all, I would note that if you’re saying all these things, then at least we’re having the right debate, which was my whole point to begin with.

If we spent all the time we’re spending debating the deficit, unemployment, Social Security, immigration reform, etc. instead debating how to reignite economic growth (including, perhaps, whether that’s possible) we would be in a much, much, much better place. Which, again, is my point.

Now, on to this:

As James Poulos has recently argued, in these matters as in so many others we are susceptible to the illusion that proper planning can both eliminate failure and ensure success, which means that if growth doesn’t happen someone has screwed up and is to be blamed. That is wrong, but more than that, as James argues, it’s a mode of thought that misses a vital truth: The planned life is not worth living.

So my response to PEG’s post is this: we need to strive to articulate and commend visions of the good life, of human flourishing, that do not depend on economic growth. Then, if the growth comes, well and good — what a delightful bonus.

Now, why didn’t I think of that? Yes, Marie Antoinette, it’s possible to live the good life without bread. Why, I’m sure many vagrants lead a much happier life than many people with their fancy McMansions and their cars and their indoor plumbing! All this fretting about material concerns is so bourgeois, so materialistic.

Sorry for being sardonic, but this is where I lose my patience with the Poulos-Jacobs “critique” of politics and policy. Yes, it’s important to realize that politics and policy can’t solve all our problems, and certainly not “save” us in any metaphysical sense. It’s important to realize that we as individuals have a duty to first change our own lives and those of people around us, and to realize that we can transfigure one another in our private lives in a way that politics never can. It’s important to realize that culture matters a great deal. It’s important that wonks have some humility. Yes to all these things.

But we also live in the real world. In this world, people organize collectively—as they always have, as they always will, those political animals. In the parts of the world we live in, they do so through things called governments. They have things called elections where they appoint representatives. These representatives then implement things called policies. Out of the universe of possible policies, some are more desirable than others. The more desirable ones will improve the lives of millions upon millions of people in countless tangible ways. The less desirable ones will make the lives of millions upon millions of people worse in countless tangible ways. That stuff, like, matters.

The wonder of the life to come does not absolve us of the duty to serve our brothers in this life—indeed, it reinforces it. In a world of angels, we wouldn’t need politics and economics, but that’s not the world we live in (didn’t you write a book about that? I recall it was quite good). As Pascal (the better one) said, man is neither angel nor beast, but he who would make him an angel turns him into a beast. This is pretty basic stuff.

If you want us to prepare for a world without growth, I assume you’ve been really happy with the state of the United States for the past 5 years, because you got your wish. I hope you’ll visit the 50% of unemployed Southern European youngsters to see how wonderful a zero-growth world is. I hope you’ll experience the deep social malaise of Japan, with its suicide rate and its bone-deep risk aversion. This is not just about material living conditions. Societies tear apart. Neighbors and strangers stop trusting each other. No one wants to take a chance on other people. When the pie gets smaller people fight like dogs over the scraps. The young turn against the old and the old against the young, the rich against the poor and the poor against the rich, the white against the brown, the citizen against the migrant. Maybe you’ll say “See? What was PEG worrying about?” But I doubt it.

A further reason why your line of thinking is so pernicious is that these things have a self-fulfilling quality, what Keynes called the paradox of thrift. If no one expects growth, people will invest and consume less, and the zero growth will continue.

The stubborn fact of the matter is that modernity relies on economic growth. I don’t know which revolutionary said the Revolution is like a bicycle, if it doesn’t keep moving forward it falls down, but communists have a strange way with insight sometimes, and while that may not be true of revolution, it’s certainly true about the modern world. It is a world built on growth—built by growth and also built on the expectation of future growth.

And if your response is “Well if we have to always have growth then maybe we’ve been on the wrong track all this time” I would respectfully suggest that living past 40, not starving to death, not dying of a toothache, not losing half your children before they take their first steps, not being forced to watch a warlord rape your wife are all pretty cool things and that only modernity brings this. But hey, the Dark Ages produced lots of saints, so that’s cool too.

Several generations of Americans have organized their lives in expectation of a government program called Social Security that will serve them through retirement, and this expectation will be dashed if growth is too low for the next 20 years. “Sorry Grandma, time to eat cat food now, but remember that Jesus loves you and you can still make friends with your neighbors” is, simply, not acceptable as a response to this problem. Oh, but “the planned life is not worth living.” (Said the tenured professor to the entrepreneur.) Okay then.

Just because ships sink sometimes does not mean that it’s irrelevant who the captain is and what she does, or that sinking is somehow equally valid as an option as not sinking. I mean, who can tell? Sometimes we hit icebergs, sometimes we don’t. It’s all a big mystery. Ashes to ashes and all that, lad. All we can do is put on life jackets and be nice to the people in the next cabin and pray. And if we do get to port, why, “what a delightful bonus.”

And if you don’t like my analogy of society as a ship with a captain—well, tough. This is the City of Man.

Replacing less desirable policies with more desirable policies is not “the planned life” in any by me comprehensible sense of those words. And by the way I am very inclined to believe that in many instances the more desirable policy is “the government should just leave it to private initiative”—but that is still a policy decision and “decide to do nothing” is just as much “planning” as “decide to do X”. A vision of the good society is put forward, with certain government policies considered as a means of getting closer to it. This is what human beings do.

PEG News

For those still watching this space and who don’t follow on Twitter, here are some PEG-related news which may be of interest:

I have started a market research firm, which is called Noosphere — right now our website is a placeholder where you can sign up for updates (please do!), but over time we will have interesting announcements, I’m sure.

Meanwhile, I am also blogging at Forbes. Here it is. I will be writing not just about technology, but also about economics, general business strategy and global issues.

Because Forbes isn’t the best place to do it, if and when I want to write about culture/philosophy/theology, I may do it here. In the meantime, if that’s what you’re into, you should definitely read this interview of Leah Libresco by Eve Tushnet.

The Case for Regressive Taxation

Please bear with me as this is more of a thought experiment than a manifesto… We’re talking equality again. Here’s Bain Capital executive Edward Conrad, putting forth the case for inequality, and here’s TAS Alum and all around genius extraordinaire Jim Manzi, guest-blogging for Friend of the Scene Megan McArdle and arguing that inequality is a bug, not a feature. Conard has set off a firestorm of discussion, and while I’m not sure I agree with him I think he is at least not easily discounted.

With that in mind…

Believe it or not, I’m quite sympathetic to the idea of progressive income taxation. The moral argument according to which, when one earns a lot of money, one should give back more (more proportionally, even), is one which I am wholly untroubled by and even endorse.

Some will point out that progressive taxation is not “giving back” more, it’s “being forced to hand over” more, and to these I say: humbug! Elizabeth Warren’s right: if you become rich in a developed country, you are the beneficiary of the common goods established by a nation (education, enforceable contracts, infrastructure and so on) and financed by taxation, and you are a party to a social contract that says that in exchange for these common goods if you use them to make lots of money you shall hand over lots of it. From a moral and legal perspective, the state is not the same as society, no, but it is a representative of it which is legitimate through elections and the enforcement of the rule of law and certain fundamental rights. It is therefore entitled to as much as your earnings and wealth as it wants until that share shades into expropriation, and while we can argue about where the border to expropriation lies, I don’t think you can straightfacedly argue that it lies westerly of any progressive tax.

I’m even untroubled by the idea that taxation can have moral goals beyond economic policy. As long as you’re not collectivizing the kulaks, it is legitimate (desirable is another question, but legitimate) for a polity to say “Even if we get slightly less economic growth, we think it’s morally right to use redistributive/progressive taxation as a means to reduce income inequality, because we believe income inequality is intrinsically wrong.”

In fact, it seems to me that there is a strong presumption for progressive taxation. From an efficiency perspective, the correlation between low tax rates and prosperity is, at best, unclear. From a moral perspective, the case for progressive taxation, at least the weak case (“If you make lots of money you should give back more”, as opposed to the strong case “Redistribution/high income reduction is desirable in itself”) seems to have a lot going for it.

These long prolegomena as a way of saying that I am not approaching the question of how progressive taxation should be from the perspective of a rabid anti-tax activist.

Now, if we accept that there is a strong presumption for progressive taxation, what could the case for regressive, or at least flat, taxation be?

For such a case to be convincing, one would have to show that the “spillover effects” of great wealth are indeed massive to overcome this presumption.

There are two basic kinds of spillover effects you can argue: there’s “trickle down” effects, and then there’s what I’ll call “the Model T” effect.

Let’s take trickle down first. The very mention of “trickle down” is likely to elicit hilarity since the idea of beneficial “trickle down” wealth is seen to have been ridiculed as a political ploy to redistribute wealth to the rich.

That being said, the case for trickle down effects cannot be wholly dismissed. The basic economic case for wealth trickling down is unassailable: the rich do spend and invest money and that money, in turn creates lots of economic activity. The question is not whether wealth trickles down, it’s how much, and whether this effect is sufficient to overcome a presumption against progressive taxation.

Based purely on anecdotal gut instinct, I’d say that trickle down wealth is pretty awesome. If you look at the great cities of the world, these are cities where there is a lot of concentrated wealth trickling down. From my perspective, New York is a much greater city than London which is a much greater city than Paris, and it is no coincidence that the better cities have large concentrations of rich people. By “better”, I mean with more cultural amenities, better restaurants, nicer neighborhoods, better business and employment opportunities and all the stuff that makes city life worth living.

When I look at Brooklyn, for example, I see a resurgence of a crafts, shop-class-as-soulcraft economy which I view as a great harbinger of the future of the economy, with small-scale, global-reach entrepreneurship displacing conventional employment. While most of the actors of this economy probably view themselves as embarked on a progressive endeavor, it seems obvious to me that this economy could never have seen the light if there wasn’t a high concentration of rich people with plenty of disposable income in New York, willing to pay higher margins for pickles and artisanal cheese. It’s hard for me not to find a very strong correlation between the awesomeness of a place and the number of superwealthy people who live there.

Same with culture and arts: one strong argument in favor of progressive taxation is the idea that rich people with too much money will engage in negative-sum competition to acquire positional luxury goods, and that it’s therefore better to just redistribute that money away. But while it’s hard to make the case for (lavishly subsidized, by the way) multiple megamansions as socially productive positional competition, positional competition among the superrich also takes the form of patronage for the arts, culture and well-being, either through the for-profit market (ie buying fine art or pursuing angel investments) or through non-profit markets (ie donations to various charities). In fact, one might argue that socially wasteful positional competition occurs among the merely rich, while socially productive positional competition occurs among the superrich: while you might impress a fellow multimillionaire with your huge new house, you’re definitely not going to impress a fellow multibillionaire with your private jet—but you might if you fund lots of charity. If indeed moderate wealth leads to socially destructive positional competition but large wealth leads to socially productive positional competition, the counterintuitive solution to socially destructive positional competition among the wealthy might be to cut their taxes even further.

It also seems obvious to me that what is thought of as deleterious effects of concentrated wealth are really deleterious effects of regulation: concentrated wealth drives up New York rents, but the reason why the rents are too damn high is because of regulation rather than just wealth concentration. Another problem with New York wealth is education: mediocre public schools on the one hand, absurdly expensive private schools on the other; but I hope I don’t have to spell out for frequent Scene readers why it’s the gummit that’s to blame here.

This isn’t by itself an argument against progressive taxation. You’d have to find out whether and how much spending by rich people creates these positive externalities, and whether and how much those externalities are countered by the virtues of progressive taxation. And I don’t think there’s a way to “prove” it one way or another, because these things can be measured and modeled in all sorts of different ways. But my strong feeling is that the benefits of trickle-down tend to be severely discounted.

Ok, so that’s trickle down. The other benefit to low taxes on the rich is what I call the “Model T” effect.

What’s that?

I take it after a quote by Silicon Valley investor Paul Graham: “You need rich people in your society not so much because in spending their money they create jobs, but because of what they have to do to get rich. I’m not talking about the trickle-down effect here. I’m not saying that if you let Henry Ford get rich, he’ll hire you as a waiter at his next party. I’m saying that he’ll make you a tractor to replace your horse.”

I think this is a crucial insight. It’s both accepted and misunderstood.

It’s accepted because, as we saw at the death of Steve Jobs, most people will actually not begrudge the wealth of someone who built wonderful products.

We have a model where, in essence, Steve Jobs is like Adam Smith’s baker: we know he’s selfish, and we don’t necessarily like that he’s selfish, but his selfishness has positive spillover effects that make the world a better place, so we should let him be selfish. Okay.

Another point which is important is that this effect happens because of “what people have to do to get rich.” In some societies, like Nigeria or France, the way you get rich is by getting cozy with people in government who will redistribute advantages to you. In other societies, possibly, the way you get rich is by providing useful goods and services to a marketplace and thereby make the world a better place. (I will leave it as an exercise to the reader to determine in which category financial wizardry falls. (Hint: the former, mostly.)) So it’s very important that we have good institutions and the rule of law and so forth. So the case for free market capitalism is, at minimum, a case for good government and the rule of law. It might even be a case for small government, insofar as the less things are controlled by government, the less unjust advantages it can confer. Maybe.

Anyway, the Model T aspect cannot be discounted. You don’t have to fall into John Galt worship to recognize that entrepreneurship, and more generally a vibrant free market economy, creates massive positive externalities in the form of consumer surpluses and products and services that improve people’s lives.

The question is, again, whether and to what extent high taxes deter this activity. Whether high taxes would have deterred Henry Ford.

This dynamic is related to the rise in income inequality around the world. Let’s stipulate this for starters: income inequality has increased around the world because of some combination of technology and globalization, with taxes playing only a marginal role. (Inequality increased in most developed countries; it increased more in the US, arguably because of taxes, but it increased everywhere.)

If this is true that technology and globalization are driving more inequality, and that we don’t want to destroy technology and globalization, what should tax policy be?

One answer, which I’ll call the Yglesias answer, is that precisely because of this effect there should be more progressive taxation. The “excess” gains that our galtian overlords get is not due to their increased talent or winsmanship, but to a global economic context, and so those excess gains can and should be shaved away by taxation.

But there’s another way to look at it: because of technology and globalization, what happens is that entrepreneurial outcomes follow a power-law rule, where the winners win very big, and the “second-best” or “third-best” actually don’t win out that much. Thus Facebook is worth $100 billion, MySpace was worth half a billion, and everyone else is worth zero.

This can be viewed as “unfair” and therefore more argument toward redistributive taxation. But there’s a flip side to that coin: you want these power-law outcomes.

They’re best regarded as a lottery. The rational response to a lottery is to not play, because the statistical value of a lottery ticket will always be negative. But in the power law lottery, we want people to play, and what reality teaches us is that more people play when the gains are truly outsized: witness the success of the recent mega millions lottery.

In theory, the response to a lottery with huge gains and a lottery with ginormous gains should be the same. In practice, it’s not. In practice, you want the possibility of truly outsize gains to motivate people to join the lottery.

And this is not just true of entrepreneurs—again, we shouldn’t become Galt-worshippers—but more importantly of the ecosystem around them, such as angel investors, institutional investors, risk-taking purchasers and so on.

The pro-market case for progressive taxation paints a picture of a world where progressive taxation leads to a “same, but less” world. Sure, well-meaning advocates allow, you might get slightly less innovation and risk-taking at the margin, but on the whole you’re going to get roughly the same. You will still have Jobses and Zuckerbergs, and you will have a better safety net.

Except that if we’re in a power-law world, that risks being much less true. It’s obviously not a Manzi-level controlled experiment, but it’s striking to look at the fates of technological innovation in Europe and in the US. In the US, there are dozens of publicly traded internet companies worth more than one billion dollars. In Europe, there are three, and up until a couple years ago there were zero. It’s a massive difference. None of these European companies has global reach. All three are part of protected markets; one is Betfair, which deals in online gambling where US companies are prohibited from competing and the other two are Yandex and, Russian companies that no one doubts benefit from implicit government protections. Its not “same, but less.” It’s completely different.

And even though Silicon Valley is, at a first approximation, the only place in the world which invests in innovation, you can make an argument that it dramatically under-invests in innovation, as Peter Thiel among others has argued. Institutional venture capital has dramatically failed at its mission.

When we talk about billionaires and Model Ts, it’s striking to note that most of the new space ventures, for example, are by and large funded, not by institutional funds whose job it is to take risks with other people’s money, but by individual billionaires taking risks with their own money. In theory it is the institutionals who should have more incentive to take bigger risks; in practice, they don’t. But it’s not hard to see that Jeff Bezos might not fund so many space companies and robot companies if he was a “mere” billionaire and not a deca-billionaire.

Solving the Model T problem in a power-law world might indeed require regressive or at least flat taxation.

Now I want to reiterate what I’ve said at the outset: my gut moral instinct is to support progressive taxation; I’m not also convinced by this case for low taxes on the rich, though I think that this case is understated and poorly understood.

There are also many devils in the details: for example, the ways in which the tax code subsidizes Big Finance, which is also a big source of inequality. In my preferred financial system, you might see less superrich financiers, or at least for sure less superrich non-entrepreneur financiers.

Another important devil is that if more inequality is indeed desirable, this increases, not decreases, the impetus to “look after” the “losers”, and to design systems where, to coin a phrase, rising tides lift all boats.

How To Starve The Beast With A VAT

France’s technocratic state has created many monsters but one of the great things it did for the world was when a polytechnicien and inspecteur des finances (one of the worst technocratic beasts one might imagine) invented the VAT in the 1950s. Perhaps it is by chauvinism that I like the idea of the VAT.

Uniquely among industrialized economies, the US doesn’t have a VAT. Part of the opposition comes from conservatives, but some conservative wonks frequently make the argument for a VAT, now recently with the esteemable Josh Barro.

In a characteristically clever post, Will Wilkinson responds with the usual conservative argument that a VAT is a “money machine” that would make it hard to “starve the beast.”

(There’s a DC joke that goes something like: “We can’t get a VAT because conservatives think it raises lots of revenue and liberals think it’s regressive; we’ll get a VAT once conservatives realize it’s regressive and liberals realize it raises tons of revenue.”)

I should say at the outset that I do have sympathy for conservative objections to the VAT. I have a soft spot for American exceptionalism (and national exceptionalism in general); generally, to me, the idea that a US policy stands out is a presumption for that policy, not against it. I also strongly agree with the conservative insight that taxes need to, to put it frankly, hurt. It needs to sting to send your money to the taxman, that way (conservative version) you’ll want lower taxes (kindlier, good-government version) you’ll want more accountability out of your dollars.

But this idea that taxes need to hurt, or at least be felt, is connected to another conservative meme which has recently resurfaced: the idea that there is some kind of injustice to the fact that a large number of Americans pay no income tax. If most people aren’t hurt by taxes, they’ll demand ever more taxes on Other People to pay for ever more services that they don’t pay for directly. I have a lot of sympathy for that idea. It’s also one reason why I am such a staunch opponent of payroll taxes (the other being that it’s a tax on jobs).

I remember when I was a teenager and a student, I would argue to family members that taxes are great because they pay for public services and so on. (I think taxes should be low; still, they’re awesome.) The inevitable patronizing response would come: “You’ll see, you’ll feel differently when you have to pay taxes.” This would send me into fits of boiling anger. First of all, was the presumption that I couldn’t—that no one should—differentiate between my own particular situation/interest and the general interest. But most of all, I would scream (inwardly, in most cases), I DO pay taxes! Every day! Twenty cents out of every franc/euro I spend goes to the government in VAT!

And indeed, when Republican politicians opine that lots of people “don’t pay tax”, a lot of wonks would note that most who don’t pay income tax do pay various other taxes, and those that don’t are so poor that it would be cruel (and impractical) to force them to.

What does this all have to do with VAT?

Well, if you want to achieve the conservative policy goal of making most people “feel” taxes and even have them hurt a little bit, you should have a VAT. But you should do it right: along with the VAT, you should mandate that all prices be shown pre-tax (as it already is in most US states for sales tax, I believe), and forbid the showing of post-tax prices.

Whenever someone buys something, they would have to do some basic arithmetic (and forcing all Americans to jog their brains by doing basic arithmetic on a daily basis would certainly be a judicious policy achievement in itself) and think about how much of their money goes to the tax man. It would ingrain in everyone that things have a “real” price, plus money that goes to Uncle Sam that they have to pay on top of it. And that daily reminder would be associated with the minute, but real pain of having to do math in your head, which is unpleasant for the vast majority of people. (Heck, it is for me, and I have a job that requires non-trivial numeracy and involves lots of playing with numbers.)

It’s obviously impossible to be 100% sure (Jim Manzi would have to design an experiment), but I’m inclined to think that in such a context, citizens would be highly attuned to proposed raises in the VAT, since they’d have to compute new numbers several times a day, and more inclined to demand accountability for the newly-raised dollars.

You would also achieve the conservative/good-government goal of making everyone, not just a few, feel/realize that they and everyone else are paying into the Treasury for common goods, instead of a nebulous Other paying for their services.

The Future Of Jobs

On Twitter, I recently had a discussion with @keptsimple81 (the liberal writer of the funny @GingrichIdeas ) where we discussed the future of jobs in advanced economies where mass industrial employment is a think of the past (at least as a provider of 50s style “broad middle-class prosperity”) and office drone jobs are probably headed that way too.

The discussion afforded me the opportunity to list the articles and resources that inform my thinking on this important issue. I’m doing it here, as much for me as for you. Regular readers will be familiar with most of them, but perhaps not all of them, and even the ones we’re not familiar with deserve re-reading.

Here goes:

Matt Crawford, The New Atlantis, Shop Class as Soulcraft

Sara Horowitz, The Atlantic, The Freelance Surge is the Industrial Revolution of Our Time

Paul Graham, Hiring is Obsolete

Adam Davidson, New York Times, Don’t Mock the Artisanal Pickle-Makers

Chris Dixon, The internet is reshaping our economy from one of huge corporations with lots of jobs to huge platforms with lots of income streams

Left unwritten: why the shop-class, crafts, freelance, internet-fueled economy will be particularly good for women.

Romney & Bain: Intention versus Method

Yuval, Avik Roy, Ramesh, Michael Walsh and Jonathan Last at The Weekly Standard, among many others, have all written perceptively about the relationship between Mitt Romney’s work at Bain Capital and our political economy.

I think that this paragraph from Jonathan Last gets to the nub of the issue:

Romney’s work at Bain differs in some important ways from how he has characterized it thus far. When Romney says that his goal at Bain was to “create jobs,” that’s not entirely true. As a private equity firm, Bain’s goal was to maximize return on investment (ROI) for a small group of high net worth investors. Sometimes that meant giving seed money to a promising start-up. Sometimes it meant rescuing a company and turning it around. Sometimes it meant finding revenue streams a company hadn’t realized—including government bailouts. Sometimes it meant off-shoring a company’s jobs. And sometimes it meant finding a company whose component parts were worth more than the whole—and dismantling it.

Without respect to the electoral politics and messaging for a moment, the predominant form of “bad” capitalism in contemporary America is created by the joining of a capitalist enterprise with the coercive power of the state, not by the impurity of the motivations of the capitalist. This distinction is crucial for defenders of free enterprise.

This perversion of capitalism normally arises in one of two ways: (1) the crony capitalism of state-backed enterprises, or (2) the implicit violence of lawbreaking by dishonest capitalists. The root problems that need to be addressed in finance in the U.S. are things like Fannie / Freddie, too-big-to-fail, government bailouts of specific companies and so forth, on one side, and Madoff-type scandals, on the other. No real political economy is ever textbook-pure, so there will always be some of both of these, but they ought to be reduced from their current levels.

But requiring that businesspeople make decisions based on some putative idea of altruism, even if such a stricture could be defined and enforced, would be a terrible idea. Capitalists should not be restricted as to intention, but as to method. As a rough-and-ready rule, they should be forbidden from using force. The government may also choose to place additional regulations on them (weights and measures rules, minimum wage laws, non-discrimination laws, etc.). While any given regulation is debatable, some formal regulation is required for real markets, and capitalists should have to obey the law. Further, real markets depend to some extent on informal norms – e.g., general commercial honesty, an ethic of a “deal’s a deal,” and so on. This last point can obviously get somewhat fuzzy, but is still important.

Within these constraints, we should generally want capitalists to pursue their self-interest in business dealings. This is not some falling short of humanity, but the way we grow the material wealth of the society as a whole over time. This is the meaning of Adam Smith’s famous aphorism that:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own neccessities but of their advantages.

The valid criticism of Romney as a capitalist would be that he worked government angles to seek advantage for himself, or broke laws or crucial norms. Seeking to make more money within the rules is a good thing, not a bad thing, for a capitalist to do. That is, Romney’s immediate goal was almost certainly to make money, not to “create jobs.” But the effect of Romney’s actions was to do this – though most of these jobs were created indirectly. This is Adam Smith’s famous “invisible hand.”

Romney was working to “create jobs” only in the sense that if you believe in this, you can have confidence that you are doing your part to increase overall material well-being of society by acting as a self-interested capitalist. More precisely, if all capitalists act this way, then over time, society will advance materially. Tracking your indivudal contribution, or even knowing if it was positive or negative, is a fool’s errand. This is why the very act of trying to count the jobs created at Staples, assessing how many would have been created had Mitt Romney not agreed to take the job running Bain Capital instead of somebody else, estimating how many of these Staples jobs need to be netted against other jobs that therefore were not created at other business supply stores, and so forth is so self-defeating. If we could accurately calculate things like that, we would have much less need for markets in the first place.

The key argument made by critics of “financial capitalism” that can be construed as consistent with all of this relates to the idea of informal norms. In simplified and illustrative terms, this argument would be that by doing something like breaking a norm against laying people off after age 50, these firms create value for themselves, but at the expense of the long-term degradation of society, and therefore the transfer of wealth from almost everyone else to themselves. This is a huge subject that will not be resolved in a blog post, but the key problems that critics of leveraged buyouts seem to point to are layoffs and moving production offshore. Restraining business from doing either of these things is a terrible idea for long-run wealth (and job) creation, and goes to the heart of the creative destruction inherent to real free enterprise.

Obviously there are shades of gray, and as I said all markets require regulation, but we need to be grown-ups about the choices we face. Enjoying the growing wealth created by free markets without the pain, uncertainty and risk that they involve is a fairy tale for an advanced economy.

To end with a word on the politics, I agree with Yuval that this implies that Romney’s work at Bain is only a partial preparation for high political office. On one hand, it would presumably help him to see the economy in a more practical light; but on the other, participating in a capitalist economy is a very different task than regulating it. I have no idea how the politics of this will play out, what is the best way for a Romney campaign to communicate these ideas, or even if they should be communicated at all. But I am convinced that “de-politicizing” our now much politicized economy is very important for America’s future growth and prosperity.

(Cross-posted to The Corner)

Re: Apple’s Cash

One of the great things about Karl Smith is that he usually responds to critical comments thoughtfully and collegially. His response to my post on Apple is no exception. Let me take his responses one at a time.

Smith begins his response by writing that:

So, I am not actually making any statement about whether Apple’s stock price is “too high” or “too low.”

Smith wrote in his original post that:

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

He wasn’t saying that there is a risk that Apple will never pay out enough cash to shareholders to justify the price of the stock, but that there is “approximately zero probability” of this happening. If a share of Apple stock has the same value as a pile of ashes, then it is not only worth less $375, it’s worth less than $1. That sure sounded to me like he was arguing that Apple’s stock price of $375 is “too high.”

Smith goes on to respond to my observation, based on my experience, that it can be very beneficial to shareholders for a company to hold cash on its balance sheet so that it can act decisively when opportunities arise, by writing that:

In Jim’s scenario he has a lot of cash on his balance sheet and that allows him to make strategic purchases. But, by construction you know who doesn’t have that cash – Jim’s shareholders.

If Jim had paid out the cash to his shareholders then they would have it. And, if Jim could convince them that he really did have all of these great opportunities they could give it back to him. The fact that no one wants to give Jim cash should be taken as evidence that giving Jim cash is not a good idea.

On a blackboard, maybe. If we lived in a world where it was free, instantaneous and riskless to go through the fundraising process, I guess this might work. Actually raising cash from investors can take anywhere from days to months, and you can lose the chance to buy the asset, or lose the chance to get the best price; it is often expensive, especially in the time and attention of senior managers; and, it often results in information about the potential investment or acquisition leaking out to the market while you are raising the money, which can materially increase whatever you have to pay for the asset, and maybe cause you to lose the deal entirely.

In response to my point that maybe Apple is keeping cash on its balance sheet in part to work a tax angle, Smith writes that:

Yeah, this is just akin to saying that I am reading their signals wrong which of course could be true.

This is a very different statement than “a share of Apple stock is worth the same as a pile of ashes.” If Smith is saying that his actual argument is that it is possible that Apple is just never going to deliver cash to shareholders, because of a principal-agent problem or some other issue, then I have misunderstood what he wrote, and we are in agreement. My argument is that Smith has not come close to making the case for what a rational expectation for future cash dividends to shareholders from Apple ought to be.

In response to my point that maybe Apple is using the cash in part to deter potential competitors, Smith writes that:

Again, its clear why this is good for Apple. Its not immediately clear why its good for a diversified shareholder who also own stocks in the companies that Apple is deterring.

Except that an Apple shareholder might not have the opportunity to invest in such a competitor because it is private, or because it is a division of another company that requires making a compound bet on that division plus the rest of the company, or because the investor has finite time and attention to devote to her portfolio, or for any other of a large number of reasons. I don’t think it’s especially bizarre that a shareholder of company X tends to be made better off when company X succeeds versus competition.

Smith concludes with this:

Key in my claims is that under none of these hypotheses is it in the interest of the Management to take these actions. Whether its in the interest of shareholders to take some action different than what they are taking I am not taking a stand on.

What is true – and a puzzle – is that under some variants of my claims it would be in the interest of private equity to take over the firm. The private equity problem is difficult as well though. Because, its clear how given these principle-agent problems one can create discounted present value using private equity.

Its not perfectly clear how one extracts that value.

Smith has argued that a given shareholder will get more free cash flow by paying $380 for a bunch of ashes in a trash can than by paying $382 for a share of Apple stock. The important exception is that she can get cash in pocket by selling this share to some other buyer of the stock. Smith is arguing that any investor who counts on that is counting on a greater fool buying it, because Smith can see what they cannot, which is that Apple will not ever pay dividends. (Once again, if he is really saying that it’s possible they won’t pay dividends, then we have no disagreement.) But exactly this judgment is the contested issue. This is what markets price.

Here’s the most obvious way that you extract the value if you are convinced that a stock’s market price overestimates its true value: you short it. If Smith doesn’t believe that the market will, in any feasible investment horizon, figure out that he’s right and begin to heavily discount Apple’s stock price, then you have just defined an asset that will, with respect to this issue at least, retain its value – otherwise known as “a good investment.”

(Cross-posted to The Corner)

Blogging About Business versus Doing Business

Both Matt Yglesias and Karl Smith have blog pieces that claim businesspeople are doing pretty dumb things. The claims are in some ways mirror images. Yglesias claims that Barnes & Noble is foolishly spending money developing and selling Nook, when instead it should just return the cash to shareholders. Smith is claiming (as far as I can tell) that Apple investors haven’t figured out that Apple can’t really return much of its immense pile of cash to shareholders, because this money is required to run the business.

Yglesias says that it is an obviously bad use of shareholder funds for Barnes & Noble to invest in Nook, because their expertise is in running brick-and-mortar stores. But by this kind if logic, why would movie company Disney invest shareholder funds opening theme parks, why would brick-and-mortar retailers Walmart, Target and Macy’s invest shareholder funds developing web businesses, and why would computer company Apple invest shareholder funds developing phones?

Core competencies and intangible assets are notoriously tricky to define and quantify for a real company, but for Barnes & Noble they almost certainly include the power of their brand name as a place to look for book-related merchandise, their expertise in developing and managing relationships with publishers, and their existing back catalog of titles. I don’t know enough about the specific situation to know whether Barnes & Noble should have developed and sold an e-reader, but based on what is in the piece, Yglesias doesn’t either.

Karl Smith is a very smart guy, but keeps digging himself in deeper and deeper on his criticism of Apple’s shareholders as foolish, in direct contradiction to the fact that Apple shareholders seem to have done very, very well for some time.

Smith argued in an earlier post that because Apple has not paid real cash dividends to shareholders, that it is more valuable to put money in a trash can and burn it than to invest it in Apple shares. I did a long post pointing why I don’t think this is true. Smith has subsequently done several posts on this same topic, amplifying and clarifying his point.

His most recent post on this subject develops an analogy between the workforce of a tech company and the particles in a sub-critical fission reactor. This is meant to be literally (as far as I can tell) a sketch of a mathematical model for why Apple requires a huge amount of cash on hand to retain its employees. At best, it is pure speculation. And based on any practical experience in a tech company, it’s also extremely implausible that Apple would start to shed important engineers, or be at a disadvantage in recruiting, if it had built up, say, $40 billion on the balance sheet instead of $80 billion.

Smith is arguing that Apple shareholders are suckers who depend on greater fools coming along, because there are hidden requirements for cash in the business that mean the true free cash flow available for distribution to shareholders is less than it seems to investors based on accounting statements. This is not a crazy idea (though his argument that specific hidden requirement is that this amount cash is needed to retain employees does strike me as very implausible). It is also not a new question to ask, and in my experience is one that is debated by professional equity investors in relation to many stocks, ranging from technology companies to convenience store chains.

I have no idea whether Apple stock should be a buy, sell or hold, but if Smith is right that the current shareholder base of Apple massively misunderstands the true capital requirements of the business, then he has a huge moneymaking opportunity. If he really believes in his investment thesis, he should borrow a lot of money and short Apple’s stock.

Antitrust as Self Medication

Reihan Salam, in a characteristically excellent post here at NRO, points to a paper by Michael Mandel, who is one of the most interesting blogospheric commentators on innovation from a “New Democrat” perspective. Mandel makes the basic point that progressives should not be so gung ho about antitrust enforcement, because big organizations like AT&T Bell Labs and Apple are the anchors of business eco-systems that drive innovation.

My experiences – my first job out of grad school was at Bell Labs, and I’ve since started and built a global enterprise software company – lead me to agree with the conclusion, but to be a little more jaded about exactly how big firms contribute to innovation in the kinds of industries he discusses.

Just as Mandel indicates, there is some straight-up development of new technologies in big labs that is then deployed by the parent company (I was involved in some). And further, consciously planned eco-systems of the type he cites – for example, developers building apps for the iPhone and iPad – can help to identify and then scale successful new technologies efficiently. Both of these things matter a lot. But here’s what I have seen big companies actually do to drive innovation that I think is most important for overall job creation and long-term growth:

1. Because innovation can only be partially planned, even the best research labs that create enormous value for the parent company also inevitably discover things that cannot be practically exploited by the parent firm. In the more extreme cases, they produce innovations that would threaten the parent company’s business model. Xerox’s comparatively tiny PARC lab invented the laser printer, which Xerox turned into a multibillion-dollar business. It also developed the graphical user interface, Ethernet computer networking, and most of the other elements of the modern personal computer that Steve Jobs famously exploited to make Apple, not Xerox, a leading personal-computer company.

2. Big companies provide a cash exit for successful start-ups, either before or after IPO. In this way they act as informed allocators of capital that intermediate between general investors and the complex technology landscape. Think of most software start-ups and IBM, Oracle, SAP, Microsoft and HP.

3. Big companies also use partnerships and other vehicles to act as marketing arms and integrators for successful technologies developed by start-ups. Think of biotech and big pharma.

What’s critical about these roles for big companies is that they require that you have lots of entrepreneurial firms to compete with the incumbents. And, in fact, if my characterization is correct, you would expect most of the job creation to happen in the successful new entrants as they grow, which is just what we see. According to the National Venture Capital Association, venture capital–funded firms employ a majority of all workers across many of the most productive and growing sectors of the economy, including the software, biotech, semiconductor, electronics, telecommunications and computer industries.

I’m glad to see somebody on the Left arguing for a modernized view of antitrust, but I think that what is essential if we are to do this is to reduce simultaneously the political power of large companies to stifle competition, as manifest in manipulation of patents, financial regulation, safety rules and the endless list of regulations, subsidies and tax breaks that govern the modern economy. This is similar to what Reihan called in his post “completing the neoliberal revolution.”

The market process is imperfect and takes time, but in my view is preferable to one in which we allow large companies (who will always have an advantage in lobbying and compliance) to use the political process to protect their position, which we then counter-balance with antitrust regulation. No real system of political economy is ever pure, so we will always have some amount of political jockeying and counter-jockeying; but in general, the more we get government out of the way of innovation, the better off we will be.

I think that “de-politcizing” the economy would be an important and powerful component of a Republican presidential campaign in 2012.

(Cross-posted to The Corner)

Storytime with Joseph Stiglitz

Arnold Kling points to an article in which famous economist Joseph Stiglitz lays out a theory for a common structure for the causes of the Great Depression and what Stiglitz calls the current Long Slump.

Here is what Stiglitz has to say:

At the beginning of the Depression, more than a fifth of all Americans worked on farms. Between 1929 and 1932, these people saw their incomes cut by somewhere between one-third and two-thirds, compounding problems that farmers had faced for years. Agriculture had been a victim of its own success. In 1900, it took a large portion of the U.S. population to produce enough food for the country as a whole. Then came a revolution in agriculture that would gain pace throughout the century—better seeds, better fertilizer, better farming practices, along with widespread mechanization. Today, 2 percent of Americans produce more food than we can consume.

What this transition meant, however, is that jobs and livelihoods on the farm were being destroyed. Because of accelerating productivity, output was increasing faster than demand, and prices fell sharply. It was this, more than anything else, that led to rapidly declining incomes. Farmers then (like workers now) borrowed heavily to sustain living standards and production. Because neither the farmers nor their bankers anticipated the steepness of the price declines, a credit crunch quickly ensued. Farmers simply couldn’t pay back what they owed. The financial sector was swept into the vortex of declining farm incomes.

He then goes on to describe how this problem propagated through the rest of the economy.

It’s interesting that in the first paragraph Stiglitz specifies that “more than a fifth” of all Americans worked on farms at the beginning of the depression, and that “2 percent” do today, but makes the non-numerical statement that “a large portion” of the population did so in 1900. I assume this would tend to lead most casual readers to think that most workers were on farms at that time. In fact, about 34% of the American labor force was in agriculture in 1900, and about 21% in 1930.

The proportion of Americans working on farms has been in continuous decline since at least 1800, when about three-quarters of the labor force was in agriculture. The decade with the biggest reduction in this proportion appears to have been the 1840s, when the percentage of the workforce in farming went from 67.2% to 59.7% (a reduction of 7.5 points). The rate of reduction from 1900 to 1960 appears to have been between 4 and 5 points per decade. As far as I can tell, this was roughly the rate of reduction from about 1860 – 1960.

The Great Depression occurred around the middle of a century-long, steady decline in the percentage of the labor force on farms. How could this decline have been the special cause of a spectacular economic collapse that occurred in one of these ten decades, but in none of those before or after?

(Cross-posted to The Corner)

How Elite Business Recruiting Really Works

There has been a lot of discussion in the blogosphere about a research paper by Lauren Rivera that describes how elite professional service firms (top investment banks, law firms, and management consulting firms) go about hiring. The argument is that it is basically a self-perpetuating old boys’ network. Reading the reactions of smart, well-intentioned people with no first-hand experience of this process, and who therefore take her paper at face value, this seems to be feeding into a meme of “the capitalist game is all rigged.”

I think that there is an element of truth to Rivera’s description, but it is mostly pretty misleading. I’ll focus my comments on management consulting, where I used to work for about ten years. I participated in every stage of the process from job candidate to new junior consultant to hiring partner.

Start with some quick industry background. You can divide management consulting into “strategy consulting” and “other.” Strategy consulting is the elite end of the consulting business. Most of strategy consulting can be sub-divided into two tribes: McKinsey and “Bruce Henderson’s children.” McKinsey is the industry leader. Bruce Henderson founded the Boston Consulting Group (BCG) in the 1960s. A number of BCG spin-offs have occurred since (e.g., Bain, SPA, LEK, etc.), and some of these have created further spin-offs. By far the largest and most important is Bain. Together, McKinsey, Bain and BCG (“MBB”) are the dominant elite recruiters for consulting, though a swarm of smaller strategy firms can compete successfully for the best talent.

There is a lot wrong with Rivera’s picture of how recruiting works, but I’ll focus on three important issues.

Rivera grossly exaggerates the degree to which access is limited to graduates of 4 super-elite schools.

Rivera says that:

Employers formally restricted competition to students at the nation’s most prestigious campuses and, contrary to common sociological assumptions about the role of institutional prestige in occupational attainment, having attended a highly selective school (e.g., top twenty five) was typically not sufficient for access to elite labor markets.

Here are about 40 schools in America where BCG and/or Bain are doing on-campus recruiting this year (meaning not just that they will accept resumes, but that they are doing things like on-campus presentations to get students interested, and then doing on-campus interviews): Duke University; Amherst College; Brigham Young University; Brown University; California Institute of Technology; Claremont Colleges; Columbia University; Cornell University; Dartmouth College; Harvard University; The University of Virginia; Princeton University; Yale University; UCLA; University of Michigan; Northwestern University; University of Chicago; Massachusetts Institute of Technology; New York University; University of Notre Dame; University of Pennsylvania; Emory University; Rice University; Southern Methodist University; Stanford University; University of California at Berkeley; University of Southern California; University of Texas; Georgia Tech; Morehouse College; UNC Chapel Hill; Washington University, St. Louis; University of California at San Francisco; Vanderbilt University; Baylor University; Texas A&M University; Georgetown University; Davidson College.

They also hire a lot of people from these campuses. Consider MBA hiring into the Associate position, which is the most common starting point for the climb to partner. The top MBA programs are usually considered to be Harvard and Stanford (please save your emails, as the point will hold if you move a couple of schools up or down a notch). In the next tier, MBB hired the following numbers of MBAs by campus this year: Northwestern (88), Wharton (85), Chicago (76), Columbia (60), MIT (55), Michigan (40), Duke (36), Dartmouth (24), Berkeley (23), and UVA (20). That’s over 500 hires, or more MBAs than these firms typically hire in a year from Harvard and Stanford.

This is nothing like a random sample of American universities, but it is a much bigger pool than Rivera implies. It’s not the top 4 schools, but more like 40 or 50 highly competitive schools, and 10 or 15 highly competitive MBA programs, that get you access to these firms. Further, while the odds of getting an offer are higher from the most highly-ranked schools, a large fraction of each incoming class normally comes from schools not ranked 1 – 4.

If you get into, for example, Michigan, UCLA, Emory or the University of Texas, work hard to get good grades in a difficult major, and score very well on standardized tests, you will likely be able to get an interview with one of the leading strategy firms.

Which brings me to the next point…

Rivera grossly overestimates the importance of extracurriculars, and grossly underemphasizes the importance of standardized test scores, and especially, case interviews.

Rivera says of elite employers that:

They restricted competition to students with elite affiliations and attributed superior abilities to candidates who had been admitted to super-elite institutions, regardless of their actual performance once there. However, a super-elite university affiliation was insufficient on its own. Importing the logic of university admissions, firms performed a strong secondary screen on candidates’ extracurricular accomplishments, favoring high status, resource-intensive activities that resonated with white, upper-middle class culture.

There will be exceptions to everything I say, but the way the actual selection process usually works is like this.

Interview slots with the best strategy consulting firms are a scarce commodity. Your resume gets you selected for an interview (though in rare cases, the cover letter and any interaction you may have had with the firm at campus recruiting events can matter a little). Take the example of undergraduate resume screening. Candidates are required to submit resumes, complete transcripts, and SAT scores. As an operational matter, the pile of resumes plus supporting materials submitted for all the candidates for school X is assembled, and each of these candidates is scored independently by three members of a school recruiting team (typically consultants who went to that school). These scores are then combined to create an aggregate rank for all candidates in that school. So, school prestige, which looms large in Rivera’s artificial mock resume screens, matters in selecting target schools, but is not usually relevant in real resume screening because you are screening resumes within a school.

In my experience as a resume screener, the logic normally goes something like this.

If you don’t have at least 750 on the math SAT, you’re out. The most common score is 800. Math plus verbal scores should be well over 1500, and typically over 1550. GRE, GMAT and other scores should be scaled similarly.

Then, your degree should be in something hard: math, physics, electrical engineering, analytical philosophy, computer science and so on. It’s OK to major in history or literature, but you better have some really tough quantitative or analytical classes on your transcript, and have done very well in them. If your GPA is below about 3.5, you’re out unless there is some really compelling rationale for why. The average successful candidate has a GPA above 3.7. Everyone understands how bad grade inflation is, and that it’s worst in the most elite schools. Any reasonably smart person with good instincts about course selection can figure out how to get a decent GPA at one of these schools. A GPA-plus-major screen is not about IQ, as much as it is a quick screen to see who is capable of figuring out how to succeed in a new environment, and of doing at least some sustained work. Screeners and interviewers will typically look at the transcript to make judgments about raw candlepower; for example, checking which calculus sequence the candidate completed, and if it was the most difficult track, what grades were achieved.

Prior summer internships at an MBB firm, Goldman, etc. are a strong positive. The reason is not that this means somebody is “clubbable.” The recruiting process for internships has similar resume screen / interviewing steps, and there are even fewer internship slots available each than there are slots for full-time jobs. Therefore, it means that this candidate has succeeded already in a similar, very difficult, selection process.

Finally, extracurriculars matter; but they are marginal compared to these other factors. They are mostly relevant if they show incredible drive. For example, working your way through school in some crap job where you have to deal with people is a big plus.

If you get an interview slot, there are then typically three rounds of interviews. Rivera’s paper claims directly that these are pretty loosey-goosey affairs which people are trying to get a sense of how polished the candidates are:

Interviews – which followed screens – were reported to be highly subjective assessments, where abstract notions of “fit” and “chemistry” routinely drove hiring decisions

Here’s how interviews really work, in my experience.

Interviews begin with first-rounds on campus. Each candidate is given a 45 minute interview, about 44 minutes of which is devoted to presenting the candidate with analytical challenges, and seeing how he or she works through them. The goal is to understand how the candidate can reason analytically – translating an unrehearsed real world problem to a mathematical representation, doing the math, and then translating this back to a real world solution, with awareness of all the simplifications that were necessary – under pressure. This is an attempt to recreate the most challenging part of the job, and is termed a “case” interview. Based on these, a majority of first-round candidates are cut. Second-rounds normally happen the next day on campus. It is a repeat, except that each candidate is normally interviewed twice that day, and each interview is longer. Based on these, a majority of second-round candidates are cut. The remaining candidates are invited back for third-rounds. This takes place at the company’s offices over a full day. Each candidate is subjected to 10 or more additional interviews, most of which are case format, but some of which are more typical “let’s talk about you and us” discussions.

Each candidate is then considered holistically, but because so few people in this final selection group have anything but extremely strong grades and test scores, the interviews are usually the crucial way to try identify the highest potential performers. A small fraction of those who started the interview process are offered jobs.

Which brings me to my third point…

Firms sell into a competitive marketplace.

Almost everybody would love to live in the cozy club atmosphere that Rivera described, and it is always creeping into hiring, promotion and compensation decisions at these firms, as in any human institution. Discipline is maintained only because you have to sell into a competitive commercial market. Unlike how it works in the movies, it is very rare that the COO of a Fortune 500 company hires your case team to do a six month project at $375K per month so that you can sit around and reminisce about rowing crew together at Old Eli. The more vibrant, competitive and open the overall corporate environment is, the more you will see continued emphasis on finding people who can produce, because the corporations will only pay for what creates commercial value for them. The more the corporate environment becomes dominated by crony capitalism, the more you will see the reverse. And to be more precise, you will see the characteristics that define a competitive consultant become more the kind that Rivera describes: fit, smoothness and familiarity with the ruling class.

In an earlier post, Steve Hsu made a useful distinction between what he calls the “soft” elite firms that Rivera profiles (investment banks, law firms and management consultancies) versus “hard” elite firms such as hedge/venture funds, startups and technology companies. He argues that the hard elite firms produce something more measurable, and therefore rely less on prestige in selecting people. This distinction is a useful starting point, but what has been happening over the past 20 years or so is the increasing migration of value from soft to hard; basically, to math, technology and analytics-intensive work. This is happening within firms and industries – the emphasis on math ability was growing within consulting in the period I worked in it, as it was within banking – and across sectors as technology start-ups and math-intensive finance became the most obvious ways to make real money in America. This isn’t random, but is happening because these are huge opportunities to create value. This is in part why I left consulting to start an analytics software company. It became obvious that this was the way to create value for clients. This won’t last forever, but has been true for some time.

This should emphasize that the people selected for these jobs are in no sense a “meritocracy.” Most obviously, it has nothing to do with moral worth, as people don’t earn their genes or parents. But more broadly, what I have described is not a hunt for the “best and brightest” in some general sense, but rather for people who have an incredibly arcane bent of mind and set of ambitions that fit into an environmental niche that they didn’t create. This is as true of “hard” elite firms as “soft” elite firms. Despite all the chest-pounding, 50 years ago most of these people would have clerks; a couple hundred years ago, not especially successful farmers. 50 years from now, for all we know, these will no longer be especially valuable talents.

Ironically, moving away from the idea that firms are looking for “the best” or “most worthy” in some general sense, and simply recognizing that they should look for predictors of success within a given business model relevant to a specific point in economic history, allows not only more effective hiring decisions, but also a little much-needed humility.

(Cross-posted to The Corner)

Nobody Ever Went Broke with Money in the Bank

That’s something that one of the smartest venture capitalists I ever knew once told me.

Matt Yglesias and Karl Smith find the fact that Apple is holding a huge cash hoard instead of paying dividends to shareholders to be pretty ridiculous. Felix Salmon finds Yglesias’s argument “trivially wrong.” All three are smart observers with interesting things to say, but I don’t think any of them presents this situation very well.

Yglesias says that this cash hoarding has caused Apple’s declining Price / Earnings (P/E) ratio:

The crux of the matter, as I see it, is Apple’s ever-growing cash horde which went from $70 billion in liquid assets at the end of Q2 to $82 billion in liquid assets at the end of Q3. The company is earning huge profits, which is great, but since it seems determined to neither return those profits to shareholders nor to re-invest them in expanded operations it’s hard to see how investors aren’t going to discount the value of the enterprise.

I’ve started and run a pretty successful enterprise software company, and I generally held a lot of cash on the balance sheet. From the perspective of shareholders, there can be many good reasons for this. First, do you know when cash-on-hand is most important? When nobody else has any. You can buy up the best talent, patents and assets when they are cheap; you can make big technology investments when they are cheaper; you can make big marketing pushes for the resulting new products when competition for customer mindshare is lower, and so on. When times are good (or at least not catastrophic) it seems like you could always get your hands on cash when you needed it, but that’s least true when you most want it. Cash is the option to act decisively at the moment when this can create large advantages for the company. Another example is that Apple is apparently holding the cash outside the U.S., and might be playing for time before repatriating it because they think corporate tax rates might come down. They might be playing any one of a million tax angles. Another example is that a massive cash pile can discourage potential competitors from entering important markets, because they know you can retaliate by either crushing their foray into your territory or by going after their cash cows. The U.S. will hopefully never launch its nuclear weapons, but we use them every day.

There are also not-so-good-for-shareholders reasons for it. There is an armchair psychology theory that because Jobs went through so many close calls in business, he had an irrational desire for cash on hand. That is at least plausible. But even if so, it’s not as simple as the shareholders just ordering Jobs to disburse the cash. If you believe that Jobs had this irrational desire, but part of the package required to get Jobs to continue run the company was to allow this kind of cash build-up, and that he increased shareholder value enough versus the next best alternative CEO to more than offset the impact of holding this much cash, then it still might be rational for shareholders to let him do it. In my experience, exactly this kind of dynamic happens in the real world all the time. More generally, sometimes a very large cash balance is an indicator that there is a principal-agent problem between shareholders (who want to maximize risk-adjusted returns on a portfolio of assets that includes this stock) and management (who want an operational cushion). Though sometimes, a large cash balance is an indicator of a disciplined management team that refuses to make poor investments in acquisitions or fanciful projects.

In short, there are tons of reasons – some good and some bad – why Apple might be holding this much cash. Apple’s P/E is being affected by some combination of their growing cash pile, changing overall market conditions, the death of Steve Jobs, projections of market saturation, beliefs about future Apple investment plans, competitive behavior, and many other factors. I don’t know whether or not Apple’s cash balance is too high or not; but based on this post, neither does Yglesias.

Salmon says of Yglesias’s argument:

This is trivially wrong. If Apple’s cash pile is growing, that will increase its p/e ratio, rather than decrease it.

In simplified terms, Salmon’s argument is the following. Consider stylized company X that has: $2 of earnings today; a market projection of present value of cash returned to shareholders of $10; 10 shares of stock outstanding; and no net cash on hand. In theory, the company should be worth its present value of cash flows, or $10. This would produce a share price of $10 / 10 shares = $1 per share. This implies a P/E of $1 / $2 = 0.5. If nothing else changes except the company has $2 of cash on its balance sheet, then in theory the company should be worth $10 + $2 = $12. This would produce a share price of $12 / 10 = $1.2. This implies a P/E of $1.2 / $2 = 0.6. So, Salmon argues, Apple piling up cash should increase P/E.

But, what this ignores is that the fact that Apple management has decided to retain the cash can rationally influence investor beliefs about the present value of future cash returned to shareholders in relation to current earnings. Yglesias illustrates the size and rate of growth of Apple’s cash balance by citing a quarter-to-quarter change, but his argument refers to a chart of Apple’s P/E over nine quarters. On this kind of timescale, the fact that management has decided to retain this much cash – rather than either invest it in the business, or pay dividends, or buy back shares – could be a signal to outside investors that management believes growth prospects are lower than previously believed, or that management has become irresponsible in its use of cash, or any other of many possible positive or negative signals. Different investors almost certainly read it different ways. Yglesias is not “trivially wrong.” He might even be right. I just don’t think either he or Salmon knows.

Smith is even more scathing than Yglesias about the point that Apple isn’t using the cash to pay dividends to shareholders:

I have a theory.

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

Now that’s not quite true. Apple’s stock price is sustained by the fact that if it goes low enough someone will buy the whole company and liquidate it. However, current investors shouldn’t be under any delusions that Apple has any plans whatsoever to provide them with a return on their investment.

I think that Smith’s point is that because Apple has not paid dividends, therefore I never get paid back real cash in return for the cash I pay for a share of Apple stock, and the only thing I can do with it is to sell it on to some greater fool. The only exception is if Apple gets to a sufficiently low value that owners band together and sell off the land, buildings, inventories, desks, patents and so on in an auction, and then divide up the proceeds.

Assuming that’s what he means, I don’t think it makes a lot of sense.

First, big tech companies often don’t pay dividends for a long time, until they do. Sometimes, these dividends are massive and continuing. Second, if there are continuing growth prospects for Apple that require cash (sometimes in ways that aren’t obvious, as per the first part of this post), then it makes sense for me as a shareholder to not want dividends for some time. The present value of the anticipated dividend stream is higher by getting more money later. If, at a future date, I have a desire for liquidity, I can sell my share of stock to another investor at that time. That investor may go through the same cycle, and the person he sells to may go through the same cycle, and so on. As long as the profit growth prospects are real, nobody has been a fool. Ultimately, the purpose of equity is to be converted into cash (or more precisely, consumption); but for a company like Apple, this can take a long time, and not every investor wants to go along for the whole ride. Third, the “exception” of shareholders banding together is not an exception, but something that often happens to companies well before their stock price reaches liquidation value. This is called the market for corporate control.

I don’t believe in anything approaching purely efficient markets. But when a journalist or academic makes claims that some company could just obviously create enormous value by taking some simple action, the obvious question to them is “Why aren’t you a billionaire?”

(Cross-posted to The Corner)

In the Long Run, We're All German

I argued last week that the right way to think about what’s going on in Europe is as a game of chicken. The ECB was unwilling to act as a lender of last resort to Italy because it did not want Italy’s chronic indebtedness to drive Europe-wide inflation rates. If it loosened the money spigots and allowed high enough nominal growth for Italy to continue to service and pay down its debts, but there was no European institution capable of enforcing fiscal discipline on Italy, then there was the risk of moral hazard – Italy could operate in a business-as-usual manner, and rely on the ECB to keep it from paying the price, which would instead be paid by northern Europe (preeminently Germany).

Of course, it would be absurd for the ECB to actually destroy the Euro in its efforts to prevent this hypothetical future problem. But it’s not obviously absurd for the ECB to play chicken – to withhold help until the moral hazard problem is resolved, and some mechanism is put in place to, in so many words, give Berlin a veto over Rome’s budget. It’s just a bet that Rome will blink first.

But Ryan Avent makes a good case that the ECB hasn’t just played chicken as the crisis has unfolded, but that the ECB engineered the crisis:

The ECB raised its benchmark interest rate in April of this year. It raised that rate yet again in July. Each move was just 25 basis points, but the signaling power of those moves was significant: the ECB, markets were informed, would not let dormant core inflation, a fragile economy, high unemployment, and an intensifying financial crisis stand in the way of its commitment to low headline inflation. As Paul Krugman and David Beckworth point out, the market impact of the ECB’s actions was dramatic. Inflation expectations tumbled. Nominal output across most of the euro zone switched from expansion to contraction. And as the OECD pointed out today, euro economies are now in recession.

The ECB successfully engineered a collapse in demand (not without assistance from governments, of course). It would be shocking if this didn’t feed into a move from a solvency to an insolvency equilibrium in economies relatively close to the threshold.

The conclusion of his piece points to why the ECB might have wanted to engineer the crisis, and it’s consistent with my views:

Some might argue that responsibility for the crisis must nonetheless sit with the debtors. The Italian economy is a mess, Tyler Cowen says, and though Italy could make a substantial dent in its debts through a large tax on wealth it opts not to. It is broken Italian governance that dooms the euro. Neither Germany or the ECB can be expected to save an Italian economy that won’t take reasonable steps to meet its obligations. But as Mr Cowen is fond of saying in other contexts, the central bank moves last. If the ECB is willing to permit contagion, then no Italian action is a sufficient defence. If the ECB is willing to engineer a recession to wring out inflation, then no Italian reform will generate strong growth.

Some might well argue that responsibility sits with the debtors – more specifically, creditors might argue that. In other words: Germany might argue that. Central banks are generally biased in favor of creditors; the ECB was specifically organized to be biased in favor of Germany. (That was the price for getting Germany to agree to give up the Deutschemark in the first place.) One way of looking at the sequence of events is to say that the ECB was willing to permit contagion in order to wring out inflation. I think a better way of looking at it is to say that the ECB was willing to threaten Italy with insolvency in order to give Germany more formal control over Italy’s finances.

That’s incredibly hard-ball politics, but if you are not accountable to anybody (which the ECB, basically, is not) then you can play really, really hard-ball politics.

And, at a high human cost, the bet seems to be working:

“I will probably be the first Polish foreign minister in history to say this,” he said, “but here it is: I fear German power less than I am beginning to fear its inactivity.”

That’s Radek Sikorski yesterday, calling for new budget procedures that would give European institutions – the Commission, the Council and the Court of Justice – formal veto power over member states’ budgets, and to suspend the voting rights of member states that repeatedly violate the rules. When the Polish foreign minister is begging Germany to turn other European states into quasi-colonies, I’d say you’re getting some traction.

Re: Wealth, Innovation and "Job Creation"


Thanks for the, as always, great post. You start by asking:

First, if it’s very uncertain how tax policy is going to affect innovation, why does that imply that taxes on the wealthy should be low?

I did not argue that that premise implies that conclusion. Krugman made an affirmative claim (or, as I went into in the post, he used language that Ozimek showed, I think correctly, could only be interpreted reasonably as implying) that innovators capture materially all of the economic value that they create. Ozimek provided a thought experiment that shows that this seems to violate common sense. Common sense is sometimes wrong, but I think the burden of proof is on those who make an affirmative claim. Krugman doesn’t provide any evidence for his claim beyond waving his hand at “textbook economics,” and Ozimek called him on it. I applauded this.

My only addition was to make an observation. Krugman claimed a contradiction between the belief in free-market principles and the belief that innovators can create material economic value that they do not capture, because the textbook economics that he believes is the foundation for belief in free market principles also claims that workers will capture the economic product of their labor. In fact, at least some people who hold free-market principles (e.g., me) do not ground their beliefs in Krugman’s textbook economics. So I am free to simultaneously hold the beliefs that innovators often cannot capture the full value of their work, and free markets are a good general organizing principle for the economy, without (at least this specific) contradiction.

Wealth, Innovation and "Job Creation"


First, if it’s very uncertain how tax policy is going to affect innovation, why does that imply that taxes on the wealthy should be low? One assumption would be that innovators are very sensitive to the taxes imposed on them, and that if they are taxed too much they will just stop working (and live off their already-accumulated wealth, I suppose). But the opposite assumption – that, to the extent that people are motivated to work for monetary reasons, it’s generally to achieve a certain level of consumption – seems at least as plausible. And it implies that higher taxes would make those motivated to innovate by the promise of financial reward more likely to work harder – because they’d have to work harder to reach that level of consumption. (And those who are motivated just by the desire to innovate, and those who are motivated just by the desire to see their bank balance go up, would be unaffected by their tax rates – innovating is still the only way to innovate, and earning money is still the only way to make the bank balance go up.)

If we knew that, at any given level of taxation, higher taxes would depress innovative activity, I could see how skepticism about our ability to predict how far it would be depressed would militate in favor of low taxes. But if we are uncertain about the sign of the effect at a given level of taxation, how do you conclude that low taxes are always preferable?

It seems to me that the consequences of high taxation that we really need to worry about are uneconomic efforts to recharacterize income as something non-taxable, and the risk of high-earning individuals changing jurisdictions to avoid tax (which is a particular concern for states with high income taxes neighboring states with low ones – Massachusetts versus New Hampshire, for example). But, again, it seems to me that simply declaring that you can’t possibly estimate these effects doesn’t get you anywhere.

Second, Adam Ozimek’s argument is, basically, that there are positive externalities to the efforts of very innovative people that cannot be captured by them because they aren’t part of their product. Thus: even if Steve Jobs captured exactly 100% of the value he added to Apple, he can’t have captured 100% of the value he added to Apple’s employees, whose human capital was upgraded by working at Apple, value they will be able to monetize when they go off to start their own firms. Nor can he have captured 100% of his contribution to the creation of the massive cluster of innovation that is Silicon Valley.

But I’m not clear why Ozimek thinks this should be the case. If we posit a truly efficient market, then Apple employees know that they are getting experience at Apple that they will not get elsewhere – and Apple will know they know this. And Apple will therefore offer lower salaries than other firms that do not provide such experiences. Doctors who want to work in Boston often get paid less than those who are willing to work in Fargo in part because Boston has better weather and sushi restaurants – but largely because Boston is a huge medical hub and Fargo isn’t. That is to say: getting a job in Boston will do more to upgrade your human capital than getting a job in Fargo will.

I’m not saying I believe everyone earns 100% of the value of their marginal product. I’m just saying that I don’t see why Ozimek is so confident that high earners are an exception, and earn less than they contribute, for the reason he gives. And given that it’s pretty easy to find real-world examples of high earners who make more than their marginal product because they have found ways to extract rents, it strikes me as a little peculiar to take this particular tack against Krugman’s argument.

Third, it seems to me that Krugman doesn’t address the real implicit reason why people refer to high-earners as job creators: to whit, because they are good at deploying capital.

It’s not true, after all, that if Steve Jobs, say, earned exactly 100% of his marginal product that therefore nobody else benefited from his innovations. That would be true if he took his earnings with him to Mars, and never recirculated them into the terrestrial economy. But people don’t generally take their accumulated wealth to Mars; they usually spend or invest it.

Assuming no effect whatsoever on incentives, taxing high earners transfers their earnings to other people – either to the government, which then makes the decisions about spending or investment, or to the citizenry at large if the money is simply redistributed. If you do the former, you’re substituting the government’s views on how optimally to spend or invest the money for those of the high-earning individual. If you do the latter, you’re substituting the citizenry’s.

Saying, “these people are job creators” is another way of saying, “I think these people will be good investors, will deploy their wealth in ways that will further increase the productivity of society.” It’s basically saying: these are the right people to bet on if you want to deploy capital optimally.

(I want to stress: I’m not making this case; I’m just stating what I think the case is. I’m not sure what a good empirical test would be of the proposition.)

I think the “textbook economics” answer to this would be: if these individuals are genuinely better at deploying capital, capital – whether they own it or not – will flow into their hands to be deployed. A rich entrepreneur doesn’t actually need his own wealth to start a new business – he’d be able to borrow any money that was taxed away and make the same investments he would otherwise. If the government taxes a bunch of money away from great investors, that doesn’t actually reduce the amount of capital they have to deploy – because the money will flow back to these investors and out of other investors’ hands, and it’s most marginal investors who will lose their access to capital, to be replaced, effectively, by the government.

This question, “who will be a better investor” is not so simple a question to answer. It matters greatly what you mean by “better” – better for whom, and over what time horizon, and under what circumstances. Which is why I keep coming back to the question of what our spending priorities – not just the government’s, but our whole society’s – ought to be. But at this point I think we’re out of the textbook.

In my own opinion, if you want to encourage innovation, I wouldn’t focus on keeping taxes low; I’d focus on keeping them simple, because complexity rewards large firms with the wherewithal to do the financial engineering necessary to optimize their tax position, which in turn gives them an unearned competitive edge. And more generally, I’d focus on what other barriers incumbents have erected to prevent disruptive innovation and to extract rents. The existing patent system, which imposes a huge burden on small, young firms, is one good example of where to look. Most broadly, we should be trying to reduce the friction associated with innovation, rather than focusing on the monetary returns to innovation.

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