"Misapplying the theory I mislearned in college."

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Why Is Connecticut Giving Its Employees’ Money to the Asset Management Industry?

Mon, 01/30/2017 - 07:43

By James Kwak

In general, the State of Connecticut offers pretty good defined contribution retirement plans to its employees. Most importantly, it offers several low-cost index funds in institutional share classes. For example, you can invest in the Vanguard Institutional Index Fund Institutional Plus Shares, which tracks the S&P 500 for just 2 basis points, or the TIAA-CREF Small-Cap Blend Index Institutional Class, which tracks the Russell 2000 for just 7 basis points. Administrative fees are unbundled, and are only 5 basis points. For no good reason I can discern, however, you can also invest in actively managed stock funds like the JPMorgan Mid Cap Value Fund, which costs 80 basis points.

As I’ve previously said, I have mixed feelings about target date funds. In principle, they do the reallocation and rebalancing for you, so they could be appropriate for people who want to make one choice and then forget about their investments (which, in many ways, is a good strategy). The hitch is that a target date fund is only as good as the funds inside it. Fidelity, for example, puts twenty-five different funds inside one of its target date funds, including thirteen U.S. stock funds, eleven of which appear to be actively managed. This is just a clever way to sneak expensive active management back in through the back door.

The Connecticut retirement plans do have target date funds, but luckily they use Vanguard’s versions, which are made up of index funds and only charge 14–16 bp (as opposed to 77 bp for the Fidelity Freedom 2040 fund) … until now. As of February, the Connecticut defined contribution plans are switching away from Vanguard to something called “GoalMaker,” which takes your money and spreads it out among the various funds offered by the plan—including those expensive, actively managed funds. For example, if you say you have a moderate risk tolerance and want to retire in 2034, it puts your money in fourteen different funds—including six U.S. stock funds, three of which are actively managed.

This is just fake diversification. On one level, it may seem more prudent to have money in both the Vanguard S&P index fund and the Fidelity VIP Contrafund Portfolio (wow, “VIP,” that must be special!). But mutual funds are already diversified—particularly index funds. If you have some reason for thinking that the VIP Contrafund Portfolio will beat the index, then you might choose to invest in it—but, in fact, it’s trailed the S&P 500 over 1, 3, 5, and 10 years.

Most likely, the people who are currently invested in Vanguard target date funds will get shifted into GoalMaker portfolios. They will pay several times as much in fees for basically the same thing, except with a little additional risk due to managers’ attempts to beat the market. It’s hard to see how this makes anyone better off—except the asset managers themselves.

The Right to Have Rights

Fri, 01/27/2017 - 15:39

By James Kwak

There’s a story you hear often these days. The story is that America has too many lawsuits: too many lawyers, too many people filing frivolous suits, too many excessive damages awards by juries, and so on. This story is the reason for all the “litigation reform” in recent decades: the Private Securities Litigation Reform Act of 1995, Prison Litigation Reform Act of 1996, the state-level tort reform movement, Bell Atlantic v. TwomblyAshcroft v. Iqbal, and so on.

There are two problems with this story. The first is that it isn’t true. Take medical malpractice, for example—a frequent target of tort reform advocates. Only a tiny fraction—probably under 2%—of people harmed by negligent medical care actually file suit. Of suits that are filed, according to an after-the-fact review by unaffiliated doctors, 63% involved errors by doctors, and another 17% showed some evidence of error. According to the most basic economic theory of torts, we want people harmed by negligence to sue, because otherwise potential defendants (doctors, companies, etc.) will not have sufficient incentive to make the efficient level of investments in preventing injuries. In short, it is highly likely that we suffer from not enough lawsuits, not from too many lawsuits.

The second problem is more important, however. That problem is that while the costs of litigation are real—not just money but also defensive medicine, intimidation of startups by patent trolls, intimidation of the media by billionaires—the exclusive focus on costs overlooks the crucial role of litigation in our democracy. That is the focus of the new book In Praise of Litigation by Alexandra Lahav, a colleague of mine at the University of Connecticut School of Law. (The book is also where I got the statistics in the previous paragraph.)

Most people probably think it’s good that we have laws. As Lahav points out, there are three ways those laws actually get enforced: administrative agency regulation (e.g., the Office of the Comptroller of the Currency telling Wells Fargo not to foreclose on homeowners without proper documentation); lawsuits by administrative agencies (e.g., the OCC or the Department of Justice suing Wells for foreclosing on homeowners without proper documentation); and, when authorized, lawsuits by private parties (e.g., a class action by homeowners against Wells for foreclosing on them without proper documentation). Now, I didn’t choose those examples at random. We know that the federal regulatory agencies didn’t stop illegal foreclosures; then, after belatedly threatened to sue, they settled with the big banks for with largely illusory penalties; and the settlements insulated the banks from private liability for fraudulent foreclosures. (For the definitive word on that whole topic, see Chain of Title by David Dayen.) If you are skeptical about the ability or inclination of the federal government to enforce the law, you should be particularly protective of the ability to file a lawsuit on your own.

This is even more true if you care about individual rights. If you think that your rights have been violated, you can sue to enforce them. This is particularly important if your rights have been violated by a state or by the federal government, because in that case it’s unlikely that a government agency is going to take your side. The right to sue is arguably the most fundamental right that exists, because it is the right to have rights in the first place. For example, the Sixth Amendment (as interpreted in Gideon v. Wainwright) says that you have the right to an attorney if you are charged with a felony. But many states and localities refuse to pay for lawyers for the poor; see Dylan Walsh in The Atlantic, or the story of Jack Bailey on This American Life, for example. So you have to sue. A series of lawsuits by the Southern Center for Human Rights led to the creation of the Georgia public defender system, and the Southern Center continues to challenge judicial circuits that fail to provide sufficient representation for poor defendants.

But the right to sue is slowly being limited, not just by “litigation reform” acts but particularly by Supreme Court decisions that made it harder for plaintiffs to challenge secret wrongdoing by companies (Bell Atlantic), enhanced government officials’ immunity from private lawsuits (Iqbal), enforced mandatory arbitration clauses in standard form contracts (AT&T Mobility v. ConcepcionAmerican Express v. Italian Colors Restaurant), limited the jurisdictional reach of federal courts (J. McIntyre Mach. v. Nicastro), and prevented plaintiffs from obtaining injunctions against illegal government actions unless they could prove that they were likely to be harmed by those actions again in the future (City of Los Angeles v. Lyon). The common theme is increasing restrictions on the ability of ordinary people (or small businesses in some cases) to challenge illegal actions by large companies and governments. But no one ever said, “Your rights are being limited.” Instead, changes in legal procedure effectively increased the cost of enforcing those rights—in some cases to infinity.

The importance of lawsuits is something that conservatives have long understood. While conservatives are all in favor of restricting lawsuits against their investors (corporations, rich professionals other than lawyers)—which has the side benefit of taking money away from the trial lawyers, who tend to lean Democratic—litigation has been a central part of their strategy for decades. Think, for example, of the rewriting of the Second Amendment in District of Columbia v. Heller or the D.C. Circuit’s campaign against federal financial regulation (Business Roundtable v. SECMetLife v. FSOC).

In Praise of Litigation is only 149 pages (not including the copious notes that demonstrate Lahav’s command of the underlying material), and it’s simply written, because at the end of the day none of this is rocket science. We have three branches of government for a reason. The transformation of the judicial branch into a tool that is primarily accessible to the rich and the powerful is a serious problem in our democratic system of government. Sure, there are lawsuits that are only intended to harass people or extort settlements from companies that can’t afford millions of dollars in legal fees. But closing the door to the courthouse makes it harder both to enforce the law and to protect people’s rights.

Economism and Economics

Tue, 01/24/2017 - 12:12

By James Kwak

One point I try to be clear about in my new book is that economism—the assumption that simple Economics 101 models accurately describe the real world—is not the same as economics. There are people who think that all of economics, or at least all of modern, mathematically inclined, “neoclassical” economics, is at fault for the growth of neoliberal capitalism and the increase in inequality in rich countries. I am not one of them.

In my mind, the problem is knowing just a little bit of economics—the proverbial little bit of knowledge. (My favorite form of that proverb, despite its religious origins, is the following: “A little knowledge is apt to puff up, and make men giddy, but a greater share of it will set them right, and bring them to low and humble thoughts of themselves.”) When you learn more economics, you learn that the world has more than just supply, demand, price, and quantity.

Matt Yglesias has even tried to argue that “on a whole lot of issues the basic econ 101 view supports the liberal position.” I think he’s exaggerating his point—on a whole lot of issues, Economics 101 tells you that market failures are possible, but that doesn’t necessarily dictate a liberal policy outcome. But whatever is actually in an introductory textbook, the problem is that what people think they remember—or what people who never took economics think the subject teaches—is that competitive markets produce optimal outcomes. As Paul Samuelson wrote in the first edition of his textbook (and I never tire of quoting), the idea that “any interference with free competition by government was almost certain to be injurious … is all that some of our leading citizens remember, 30 years later, of their college course in economics.”

The historical development of economism, and its divergence from economics, is the subject of chapter 3 of my book, and also of my new article in the Chronicle Review. The article also includes some of my thoughts on how the teaching of economics might be modified to give students a richer and more balanced understanding of the discipline. For more, head on over there.

Economism and the Law

Mon, 01/23/2017 - 15:06

By James Kwak

Economism—the simplistic, unreflecting application of Economics 101 models to complex, real-world issues—is particularly influential in the law, including both legal academia and actual court opinions that decide important questions.

The "economism" that @jamesykwak talks about is at its worst in the legal profession: https://t.co/84oUoNl49r

— Noah Smith (@Noahpinion) January 17, 2017

Noah Smith, for example, points to a paper by a law professor arguing that forced prison labor deters crime because it effectively raises the price of crime in a supply-and-demand model. The problem with this model is that it doesn’t accurately describe criminal behavior. Smith quotes economist Alex Tabarrok on what happened when the United States dramatically increased the harshness of punishments:

In theory, this should have reduced crime, reduced the costs of crime control and led to fewer people in prison. In practice … the experiment with greater punishment led to more spending on crime control and many more people in prison.

I discuss economism and the law briefly in the historical chapter of my book, but the basic story is simple. Beginning in the 1960s, the law and economics movement, most closely associated with Richard Posner, re-conceptualized various areas of the law in economic terms. To simplify greatly, the central idea was that the law should be designed to promote economically efficient outcomes; for example, a product manufacturer should only be liable for failing to include some safety feature if the cost of that feature was exceeded by its expected benefits in the form of reduced injuries. Law and economics was and remains a valuable way to think about the law. At the time, however, few law professors knew very much about economics, and so there was an explosion of theoretical papers that assumed the accuracy of basic rational-actor models more or less swallowed whole from Economics 101. (The law and economics movement was also enthusiastically backed by conservative foundations, most notably the Olin Foundation, who saw in it a way to reorient the judiciary toward business-friendly, free-market principles.)

My go-to example of economism in the law is Frank Easterbrook’s opinion in Jones v. Harris Associates, 527 F.3d 627 (7th Cir. 2008). One of the issues was whether it is possible for mutual fund fees to be excessive. Easterbrook thought not, because those fees are set by a competitive market. Among other things, he wrote:

It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest. See Alan Schwartz [and] Louis Wilde, Imperfect Information in Markets for Contract Terms, 69 Va. L.Rev. 1387 (1983).

Now, I’ve looked at the article by Schwartz and Wilde: It’s about contract terms in general, its primary examples are warranties and security interests (not mutual funds), and it is entirely theoretical. By 2008, of course, the world had learned a lot more about how consumers make decisions—and it isn’t the way you would expect based on Economics 101. But Easterbrook had no need for reality, since the model sufficed to make his point.

I just read Richard Posner’s book Divergent Paths (the one in which he cites one of my anti- Bluebook rants), and he has another good example (beginning on page 192). It’s Edwards v. District of Columbia 755 F.3d 996 (D.C. Cir. 2014), a case in which a company that gives tours of Washington, DC challenged a city regulation requiring tour guides to pass a test of their knowledge of the city. The court overturned the regulation because the city did not provide evidence that “market forces are an inadequate defense to seedy, slothful tour guides”; in Posner’s words, “The opinion rejects the legitimacy of government regulation in any situation in which the market can in principle do an adequate job of regulation, whatever the reality” (emphasis added).

Posner fills in several reasons why markets will not protect tourists from being ripped off by tour guides, which really anyone could think of: tourists will not necessarily know they are being misled, Internet rating websites (on which the court relied) do not adequately police services aimed at tourists, and so on. And as an aside, can you guess what constitutional protection this regulation violated? That’s right: the First Amendment right to freedom of speech. As Posner points out, a person who fails the tour guide test is in the same situation as “an applicant for a teaching job who having flunked her licensing test cannot exercise her right of free speech at the front of a Washington schoolroom.”

In short, the D.C. Circuit invokes the magic tool of free markets without pausing to consider whether it can actually do the job it needs to do in this context. This is not economics; this is ideology. (Posner: “There is no plausible nonideological explanation for the decision.”) That’s what economism looks like in action.



Economism and Health Care

Fri, 01/20/2017 - 11:49

By James Kwak

A core feature of competitive markets, according to the basic model, is that they allocate goods to the people or companies that are willing to pay the most for them. In theory, and in many situations, this is a good thing: If I am willing to pay $1,000 for a custom portrait of my (daughter’s) dog, and you are only willing to pay $1 for it, then aggregate satisfaction is likely to be higher if I get the portrait. But not always: If I am willing to pay $10 for a turkey sandwich, but you are only willing to pay $1 because you only have $1, and have no borrowing capacity, then society may very well be better off if you get the sandwich. Yet in an ordinary, healthy market, I get the sandwich.

This problem is acutely apparent when it comes to health care. People place a high value on not dying, but when it comes to the allocation of medical treatment, they can’t bid more than their income allows. The obvious result is that markets deliver unnecessary procedures to rich people while denying essential care to poor people—because that’s what markets do. Obamacare attempted (with mixed success) to mitigate this problem. The Trump administration is rhetorically committed to deregulating health insurance; the question is whether they are willing to accept the political consequences of pricing millions of people out of not dying.

This is the topic of my new guest post, “Health Care and John D. Rockefeller’s Dog,” on Econbrowser (a fabulous economics blog, by the way, written by Menzie Chinn and James Hamilton). For more, head on over there.

Conflicts and Corruption

Thu, 01/12/2017 - 11:28

By James Kwak

To be clear, the idea that Donald Trump will be president while he or his children effectively own a company that does business all over the world is preposterous. (Quick primer on trust law: A trust is managed its trustees for the benefit of its beneficiaries. In this case, we know the trustees include two of Trump’s children, and the beneficiary is likely to be either Trump or his children.) If people, companies, and foreign governments want to pay bribes to the president of the United States, they need only give favorable deals to the Trump Organization. An in any of his official actions, the president will have the temptation to do what’s right for his company, not for the country.

The point I wanted to make in my Atlantic column today, however, is that this is just the most obvious and egregious example of the larger problem of corruption: government officials acting in the interests of themselves, their family and friends, or their business associates. The example I focus on is estate tax repeal, because that one thing alone would be worth more than $1 billion to the Trump family. It’s a classic example of a president doing what’s in his own personal interests and the interests of his core constituency of gazillionaires, while pretending it’s for the good of the country.

Betsy DeVos is another great example, perfectly illustrated by this graphic from the AFL-CIO:

The way American politics works is that people and organizations with money—today, largely billionaire families—invest in politicians and demand policies that favor their private interests. Donald Trump just eliminated the middlemen—not only winning the presidency, but also inviting fellow billionaires like DeVos into his cabinet. This is why, beyond the ongoing catastrophe that is the Trump presidency (which technically hasn’t even started yet), we still need to fix our democracy, so everyone has an equal say in our government.

For more, see the full article in The Atlantic.

Economism Typo Contest

Tue, 01/10/2017 - 07:56

By James Kwak

Today, you may be getting your copy of Economism: Bad Economics and the Rise of Inequality in the mail. Or you may even be able to buy it in a bookstore. But before you crack it open, I want to tell you something.

I hate typos.

I try to read each of my book manuscripts carefully before submitting them. I hire my own line editor to go through my writing for grammatical and stylistic errors. The publisher then does a copy edit. When I get the “galleys” back from the publisher, I hire my own proofreaders to scour them again for mistakes. But inevitably typos sneak into the published books. Here’s one from 13 Bankers:

(That should be “economic policy,” in case you’re wondering.)

Furthermore, I am almost incapable of reading anything that I’ve written before. It’s just too boring when you already know what the next sentence is going to say; at best I can skim. So it’s very hard for me to catch mistakes in anything that I’ve published. Out of sympathy to my fellow writers, I often circle typos when I find them in books that I am reading. Sometimes I even email the author out of the blue with a list of mistakes, if there is still time to fix them in the paperback version.

So, before you start reading, I’d like you to know about the Economism Typo Contest. If you are the first person to find and tell me about a mistake, I will send you a limited edition, spiral-bound, 5×8 notebook with the jacket cover of Economism on the front (signed on the inside if you like). Or, if you prefer, I will pay you ten dollars in cash money.

The detailed rules and instructions for submitting mistakes are over at the version of this post over at Medium.

Thanks for your help.

Economism and the Future of the Democratic Party

Mon, 01/09/2017 - 17:33

By James Kwak

I haven’t written much about the election itself (except to point out that the same data can be interpreted in diametrically opposing ways). That’s because the election was so close that the fact that Clinton lost can be explained by any number of but-for causes, and much of the Democratic Internet has been a cacophony of people insisting that their preferred cause (Comey, Russian hacking, not enough attention to African-Americans, too much attention to minorities, not enough attention to the white working class, too much emphasis on Trump’s personality, etc.) was the One True Cause.

I do think, however, that if Democrats (a group in which include myself) want to return to power and change the overall political dynamics of this country, one thing we need to recognize is that Republicans have been crushing us on the economic messaging front for decades. We have adapted by becoming Republicans Lite—no longer the party of jobs and the working person, but now the party of minimally intrusive market regulation, technocratic expertise, and free trade agreements.

This is the subject of my article in Literary Hub today, “The Failure of Democratic Storytelling.” Now that Democrats are out of power virtually across the board, we have the opportunity to develop a new vision, without having to compromise with Joe Manchin, Arlen Spector, and Susan Collins to squeak legislation through Congress. The question is what we make of that opportunity.

A Change Is in the Air

Fri, 12/30/2016 - 15:35

By James Kwak

There was one moment, when I was finishing up the manuscript of Economism, that I thought someone had already said what I was trying to say in the book. This is what I read:

“The beauty and the simplicity of such a theory are so great that it is easy to forget that it follows not from the actual facts, but from an incomplete hypothesis introduced for the sake of simplicity. … The conclusion that individuals acting independently for their own advantage will produce the greatest aggregate of wealth, depends on a variety of unreal assumptions …

“Individualism and laissez-faire could not, in spite of their deep roots in the political and moral philosophies of the late eighteenth and early nineteenth centuries, have secured their lasting hold over the conduct of public affairs, if it had not been for their conformity with the needs and wishes of the business world of the day. …

“These many elements have contributed to the current intellectual bias, the mental make-up, the orthodoxy of the day.”

That’s from the third section of “The End of Laissez-Faire,” the published version of a lecture delivered by John Maynard Keynes in 1924 and 1926.

Photo from Wikimedia Commons (CC BY-SA 3.0)

Keynes’s argument goes something like this:

  • Beginning in the late eighteenth century, economic theory extended the political philosophy of democratic individualism (epitomized by John Locke), providing a supposedly scientific basis for “the idea of a divine harmony between private advantage and the public good.”
  • That idea in its simple form, however, was not a correct statement of what leading economists actually believed. Instead, it was the work of “the popularisers and the vulgarisers”: “the dogma had got hold of the educational machine; it had become a copybook maxim.”
  • Economists themselves understand that the world is considerably more complicated. However, “many of those who recognise that the simplified hypothesis does not accurately correspond to fact conclude nevertheless that it does represent what is ‘natural’ and therefore ideal.”
  • The ubiquity of laissez-faire ideas is ultimately due to the interests that it serves: the business world. “To suggest social action for the public good to the City of London is like discussing the Origin of Species with a Bishop sixty years ago. The first reaction is not intellectual, but moral. An orthodoxy is in question, and the more persuasive the arguments the graver the offence.”

Although Keynes was writing in the 1920s, this also describes of the state of the intellectual and political world over the past few decades. The idea that market forces necessarily produce optimal outcomes, and that government should generally stay out of the way, has dominated public policy discourse since the late 1970s. This is obvious for Republicans, but consider also the deregulatory policies of Jimmy Carter, Bill Clinton proclaiming that “the era of big government is over,” the end to “welfare as we know it,” bipartisan financial deregulation, and Obamacare’s reliance on markets—indeed, the current Democratic orthodoxy that government should simply identify and correct for discrete market failures.

It is also widely claimed that the universal superiority of competitive markets is some fundamental law of economics—that the minimum wage necessarily increases unemployment (because it is a price floor), or that taxes on investment income necessarily reduce savings and investment (because they reduce the returns to saving). Yet, just as in the 1920s, few economists actually believe in such immutable laws, although some do think of them as some Platonic ideal for how the economy should behave. What happened is that a handful of simple economic concepts was picked up, vulgarized, and popularized by a network of foundations, think tanks, and media outlets. A few prominent economists played important roles in this process—notably Friedrich Hayek in The Road to Serfdom and Milton Friedman in Capitalism and Freedom and Free to Choose—but their ultimate influence depended on the reach of organizations such as the American Enterprise Institute, Heritage, and the op-ed page of The Wall Street Journal.

To take one example of how this works, consider the tens of millions of dollars that large company CEOs make, or the hundreds of millions of dollars that hedge fund and private equity fund managers take home. According to a simple Economics 101 model of the labor market, everyone’s compensation is exactly equal to her marginal product—the value of the work she does for her employer—and therefore those huge pay packages are both fair and necessary (or otherwise business superstars would choose to do something else with their time). Yet, as the Economist reminds us, academic economists have known for nearly half a century that information asymmetries undermine the textbook functioning of labor markets. (For a longer discussion of this topic, see chapter 4 of Economism).

The idea that pay equals marginal product is not economic truth, but ideology. Like any powerful ideology, it makes the interests of a class seem conterminous with the interests of society as a whole. As Marx wrote in The German Ideology, each ruling class “has to give its ideas the form of universality, and represent them as the only rational, universally valid ones.”

So when Ray Dalio says, “Society rewards those who give it what it wants. That is why how much people have earned is a rough measure of how much they gave society what it wanted,” he’s not speaking as someone who knows anything about economics. He’s speaking as a member of the ruling class—a billionaire hedge fund manager (and now Donald Trump cheerleader). If you’re a billionaire, it’s nice to think that your wealth simply reflects your contributions to society. It’s also useful for other people to think so, so they don’t raise your taxes. But that doesn’t make it true.

In the 1920s, Keynes thought the dominance of the laissez-faire ideology was coming to an end. “We do not even dance yet to a new tune,” he wrote. “But a change is in the air.” He was right. Increasing dissatisfaction with the unregulated capitalist system helped produce fascism in Germany and Italy and a much greater degree of government intervention in the United States, the United Kingdom, and France.

Could the same be true today? It is undeniable that the rapidly widening gap between the very rich and the middle class has undermined popular support for the economic status quo. Throughout the advanced, post-industrial democracies, there seems to be a brewing revolt against technocratic elites who appear insensitive to the plight of ordinary working people. In the United States, the Bernie Sanders insurgency demonstrated the tenuous hold of the Clinton-Obama-Hamilton Project-Center for American Progress coalition over the Democratic Party, while Donald Trump overthrew the Republican establishment.

While Trump has his own fascist, racist, and sexist tendencies, however, most of his actual policy proposals come straight out of the conservative playbook. This is not surprising, given that he is (probably) a billionaire, his most important backers are billionaires, and he shows few signs of intellectual curiosity, originality, or honesty. So in the short term, we are going to see four more years of economism triumphant—less regulation of businesses, particularly banks; lower taxes for corporations and the very rich; and a return of the bad old pre-Obamacare days, when people without employer health plans had to fend for themselves in an unregulated individual market. One thing we can be sure of is that a Trump presidency will do nothing to solve the economic problems facing the poor and the middle class, or narrow the widening gap between them and the 1%.

At the end of his essay, Keynes wrote:

“For the most part, I think that Capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that in itself it is in many ways extremely objectionable. Our problem is to work out a social organisation which shall be as efficient as possible without offending our notions of a satisfactory way of life.”

That remains our challenge today. If we cannot solve it, the election of 2016 may turn out to be a harbinger of worse things to come.

The Curse of Credentialism

Mon, 12/26/2016 - 07:30

By James Kwak

I just finished reading J. D. Vance’s memoir, Hillbilly Elegy. I don’t feel like adding to the torrent of instanalysis of the “white working class,” however, so I’ll just comment on the description of Yale Law School—which, in the book, serves the dramatic function of introducing the author to the Elite.

Photo by Shmitra at the English language Wikipedia (CC BY-SA 3.0)

There are a few details that seem unfamiliar to me—I can’t recall attending a single one of the “cocktail receptions and banquets” that Vance describes as the school’s social rituals—but then again I was thirty-nine and married with a child when I started law school. But there is one thing that Vance nails: the culture of credentialism.

Yale Law School is undeniably an elite institution, the undisputed number one school in a field that is intensely (and toxically) hierarchical. Also, because it is a law school—as opposed to other elite institutions such as West Point or the UConn women’s basketball team—it is filled with people who have never had any idea of what they wanted to do other than be successful and gain access to the best opportunities out there.

One of the curious things about Yale is that it is impossible to compete over grades; the first semester is pass/fail, and for reasons not worth going into the grading scheme is essentially meaningless after that point. I thought this was wonderful, but I’m sure at least some of my classmates experienced it as a disappointment. So what do you do if you’ve spent your life trying to prove that you’re smarter than other people? Some people use their newfound freedom to do truly great things: the Iraqi Refugee Assistance Project (now International Refugee Assistance Project), for example, was founded by a few students in the class before me. Many others pour themselves into clinics that make a huge difference in people’s lives. (The challenge to the Connecticut public school system that recently won in the trial court began in a Yale clinic.) I wrote a book.

But a common reaction is to find other things compete over. And, as Vance describes, the two primary candidates are membership of the Yale Law Journal and post-graduation federal court clerkships (which is a competition that goes on and on, because it takes at least a second, and often a third year of clerking to make it to the Supreme Court). The institutional culture communicates that the most prestigious distinctions are Journal membership and federal clerkships (I’m simplifying slightly, but that’s pretty close). As Vance writes:

“No one seemed to know what value the credential actually held. We were told that the Journal was a huge career boost but that it wasn’t that important, that we shouldn’t stress about it but that it was a prerequisite for certain types of jobs.”

This is like a mind-altering drug for those twenty-somethings whose modus operandi is to accumulate badges of excellence that will open as many doors as possible. Most students come to law school with little interest in 35,000-word legal theory articles (and no interest in editing and cite-checking those articles, which is mainly what law review editors do), yet come springtime they become intensely interested in the pathologically stupid citation formatting, or “Bluebooking” test (what Vance calls “the  most important test of our first year”) that represents the first step toward Journal membership.

The same goes for clerkships. I should point out that my friends who did clerkships—doing research and writing for a judge—generally thought they were a good experience (as opposed to the Journal). But that’s not why most Yale law students want them, at least not at first. It’s because they are the closest thing to graduating with honors, given that Yale doesn’t give honors at graduation. And because there are hierarchies among clerkships—appellate courts beat district courts, and within each level famous judges beat less-famous judges—a clerkship is the closest thing you can get to class rank at a school that has no class rank (or GPA, for that matter). Vance admits trying to get a clerkship with a “high-powered federal judge with deep connections to multiple Supreme Court justices” until his primary recommender—you have to have one of these to get a top-shelf clerkship, so the intermediate thing people compete for is relationships with well-connected professors—pointed out that he was doing it solely for the credential. He pulled out and got a less-prestigious clerkship where he could be close to his girlfriend. Good for him.

As you may have guessed, I didn’t apply to the Journal or to any judges. But that was because I had a family, and I didn’t want to spend any more evenings away from them to do cite checking. I also had a career and enough accomplishments behind me that I was emotionally secure enough not to pursue credentials for their own sake. But if I had been single and in my twenties, I’m sure I would have played the game. That’s what our educational system teaches smart young people: that there are universal, objective markers of achievement and ability, and that’s what you’re supposed to get.

At the end of my first year, I wrote an email to the school’s mailing list proposing that the Journal simply be opened to everyone. My basic point was that the Journal competition was an unnecessary zero-sum contest that existed solely for the purpose of having a something to compete over. If I recall correctly, the public email responses were in favor by a large margin. But the Journal gets to make its own rules, so nothing changed.

As things go, whether Yale Law School 1Ls waste dozens of hours immersing themselves in the stupidest citation system known to man  (“the acme of absurdity in legal expression,” says Judge Richard Posner in Divergent Paths*) is decidedly trivial. But the broader problem of credentialism is real. For one thing, the pursuit of brass rings because they are shiny creates unnecessary stress and unhappiness. More generally, when you give out prizes based on idiosyncratic criteria, ambitious people adjust their behavior to excel at those criteria—which may not be particularly valuable in the real world.

Then there’s the cost to society. A world in which success means Rhodes/Teach for America/Goldman/McKinsey followed by Yale Law School/Harvard Business School followed by Blackstone/Bridgewater/Facebook is one in which too many talented, well-intentioned people follow the same path and end up doing the same few things. (Since I graduated from college a quarter-century ago, the only real additions to the hierarchy have been TFA and the technology behemoths.) In their famous paper, Kevin Murphy, Andrei Shleifer, and Robert Vishny found that countries with more engineering majors tend to grow faster and those with more law students tend to grow slower. A society in which smart, hard-working young people with generic ambitions tend to become hedge fund and private equity fund managers, management consultants, corporate lawyers, and strategists for technology monopolies is probably not one that is allocating talent effectively.

The reasons for credentialism go beyond any easy cure. One is the innate (personal) conservatism of people who play by the rules and excel at school. One is the high degree of inequality in contemporary society, which inflates the costs of not landing at the top end of the income distribution. One is the homogenization of culture, which means that most smart young people in the United States grow up in the same informational environment, evaluating the same set of options. Finally, for the most part, credentialism is individually rational: it’s “work for Goldman now, save the world later.” But after too many years in that environment, people come to believe that working for Goldman is saving the world (I believe the phrase is “doing God’s work“). And that’s where credentialism can lead you.

* Posner is just getting started: “The law review editors who enforce its mindless dictates are pod people. Its relentless growth threatens to lobotomize the legal profession.”

Larry Kudlow and Economics in the Trump Administration

Fri, 12/23/2016 - 11:19

By James Kwak

Noah Smith (along with a fair section of the Internet) has some concerns about Larry Kudlow as chair of the Council of Economic Advisers: he’s overconfident, too much of a partisan, and fixated on nonexistent problems (e.g., inflation). I’m not so worried that he’s on Team Republican; after all, Donald Trump gets to pick the advisers he wants, and they shouldn’t be rejected solely because they take political sides. But I am worried about what Kudlow’s appointment means for the relationship between economics and policy.

The world is a complicated place. Anyone who studies society in depth should learn to have respect for that fact. At any given moment, we have only a hazy understanding of what combinations of transitory phenomena and underlying structural factors produce what outcomes. (For Exhibit A, see the election that took place on November 8.) This tweet at the beginning of Game 7 of the Cubs-Indians World Series, channeling the great French historian Fernand Braudel, is one of my all-time favorites:

Buck: Will we see history tonight?
Smoltz: Yes!
Braudel: No man can see history. This is the foam. The current of history is beyond our ken.

— Old Hoss Radbourn (@OldHossRadbourn) November 3, 2016

Contemporary research economists have become incredibly sensitive to the difficulties of explanation. The papers that get the most attention—like Chetty et al. on intergenerational mobility, or Autor-Dorn-Hanson on the impact of Chinese imports on labor markets—are no longer purely theoretical. Instead, they analyze large datasets, often compiled with tremendous amounts of effort, to try to tease out the relationships between different variables. Any empirical paper in a good journal will discuss which way the causal arrows points and include multiple robustness checks to try to ensure that the results are not the product of outlier observations or an idiosyncratic specification. Good economists know that the answer to most questions is: It depends.

This is one of the important contributions that economics can make to public policy: the understanding that the world is complicated, and the dedication to uncovering rather than masking that complexity. In a presidential administration, you would expect this perspective to come from the Council of Economic Advisers. The treasury secretary is a public spokesperson, a diplomat, and the manager of a huge organization; the director of the National Economic Council is a policymaking coordinator; and the director of OMB is a budget planner.

I don’t particularly care that Larry Kudlow doesn’t have a Ph.D. in economics. Paul Volcker didn’t have one either (as far as I can tell), and few Democrats would have seriously objected to him as chair of the CEA. What concerns me is that he has been working as an economist for decades—that is, he makes money by thinking and talking about economic issues—yet his conception of the discipline seems limited to the simple, theoretical relationships of Economics 101.

Most of Kudlow’s thinking about economic issues appears to boil down to three ideas. The first is that tax cuts increase economic growth—a mantra that conservatives have repeated for decades, yet is not supported by reviews of existing research. The second is that expanding the money supply will necessarily generate high inflation, on which basis Kudlow predicted a “major inflationary plunge” just as the Great Recession was beginning. The third is that an expensive currency—what politicians call a “strong dollar,” but Kudlow calls “King Dollar” (with the capitals)—is good for the economy.

The first two ideas are things you would expect to hear from a first-semester college freshman (like Jeb Hensarling in his Texas A&M days). They make sense on a two-dimensional diagram, but they are at best distant approximations of how the world works. The third—King Dollar—is just weird. The value of a currency is the outcome of various factors, such as interest rates, and it doesn’t make sense to think of that outcome in isolation from the things you would need to do to produce that outcome.

Studying economics is a process of indoctrination and then de-indoctrination. First you learn that competitive markets produce optimal outcomes; then you learn that this is only true in rare circumstances, that real markets are imperfect in a myriad of ways, and that in any case perfect market outcomes are not necessarily optimal in any meaningful sense. Larry Kudlow, whether naively or disingenuously, still seems to be stuck on Economics 101. That’s the essence of what I call economism, the subject of my new book: a worldview that assumes that society operates according to a small set of fundamental principles, and that public policy can be shaped on that assumption.

With Kudlow as chair of the CEA, Donald Trump is giving up even the pretense of trying to understand economic reality, instead doubling down on a handful of abstract slogans that have little to do with our current challenges. That’s hardly surprising, given that Trump is basically just an extreme caricature of contemporary conservatism, but that doesn’t make it any less concerning.

How Not to Invest

Wed, 12/21/2016 - 07:30

By James Kwak

Forty years after John Bogle launched the Vanguard 500 Index Fund, passive investment funds now account for about one-third of the mutual fund and ETF market. You would think this would pose a threat to traditional asset managers that charge hefty fees for actively managed mutual funds, and this is true in part. On average, index funds charge 73 basis points less than active funds, and the average expense ratios for actively managed funds have fallen from 106 bp to 84 bp over the past fifteen years (Investment Company Institute, 2016 Investment Company Fact Book, Figure 5.6).

The asset management industry, however, has been quite adept at defending its traditional share of investors’ assets. One response has simply been to go along with the index-fund wave—without lowering fees to reflect the considerably lower expenses of using simple algorithms instead of humans.

In the Wall Street Journal, Micah Hauptman summarized a recent paper by Michael Cooper, Michael Halling, and Wenhao Yang on mutual fund fees. They find, as did previous research, tremendous differences in prices for S&P 500 index funds. The variation between the fees charged for these virtually identical products has actually increased since it was first measured in 2004; in recent years, the difference between the 10th percentile and 90th percentile S&P index funds (by expense ratio) has been a staggering 116 basis points. That means there are people paying well over one percentage point of assets per year for a product that only costs 16 bp at Vanguard (5 bp for a minimum investment of just $10,000). Furthermore, Cooper, Halling, and Yang analyze variation in prices across all U.S. stock mutual funds, in part by identifying funds with similar holdings. Again, they find large price discrepancies that cannot be explained by fundamental fund characteristics.

For an investor, the lesson is very simple: If you are paying more than 16 bp for an S&P index fund (5 bp if you have more than $10,000 in the fund), you should get out and buy a cheaper one instead, unless you’re locked in because of large, unrealized capital gains.

For society as a whole, however, there is a more interesting takeaway. According to very basic economic theory—the kind you get early in your first year—this type of price dispersion cannot occur. It’s as if oil were selling for $16 per barrel in one place and $132 per barrel in another place. Now, that can happen with oil if, say, there’s an embargo or a blockade going on. But the market for U.S. stock mutual funds and ETFs is supposed to be highly transparent and liquid; it usually only takes few minutes and a computer to sell one and buy another. Wide variation among prices for identical products with minimal search and transaction costs is proof that the simple story taught in Economics 101—prices for identical products must converge because buyers will only buy the cheap ones—is sorely incomplete. Something else is going on, and therefore we cannot count on markets to protect investors. (For example, one thing that could be going on is retirement plan administrators only offering expensive index funds to captive plan participants.)

Yet that faith in markets is endemic in large parts of our political and legal systems. For example, Judge Frank Easterbrook of the 7th Circuit dismissed evidence of excessive mutual fund fees in 2008 as follows:

It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest.

As evidence, he cited a purely theoretical law review article written twenty-five years earlier—even though the evidence about index fund price dispersion was already out there for everyone to see. This absolute conviction that the world must operate the way it does in theory is another example of economism in its purest form. (Easterbrook was overruled by the Supreme Court, but on other grounds.)

The asset management industry’s other brilliant revenue-maintaining innovation was the target date fund. The theory behind these funds is plausible, although not entirely compelling. The idea is that you pick the date when you expect to retire, and the funds reallocate your holdings from an aggressive mix (more stocks) when you’re young to a conservative mix (more bonds) when you’re old. I say this isn’t entirely compelling because there is no particularly convincing theory of what your asset allocation should be (well, there’s the CAPM, but that doesn’t hold up in practice), let alone what it should be at any given age. For example, it makes no sense that a very rich person and a middle-income person should have the same allocation just because they are the same age.

That said, target date funds could be a solution for an investor who (a) follows the conventional wisdom that you should shift from stocks to bonds as you age and (b) doesn’t want to have to rebalance manually every few years. But in practice, they are just a clever marketing vehicle for complexity and high fees. I was looking at Fidelity target date funds for a friend (who is locked into Fidelity by her retirement plan, which is not too unusual). Here’s the Fidelity Freedom 2040 fund:

Thirteen U.S. stock funds? Remember, the whole point of a mutual fund is each one is already diversified; if you buy thirteen funds within the same market, you’re just getting lots of overlap in unknown quantities. The sole purpose here is to provide a veneer of sophistication (Wow, I can get twenty-five different investments with just one fund!) to justify a fee of 77 basis points. Vanguard, by contrast, puts your money in four index funds covering the global equity and bond markets, and charges just 16 bp.

Since 2006, the share of 401(k) plan participants holding target date funds has more than doubled, from 19% to 48% (ICI 2016 Investment Company Factbook, Figure 7.14). Because retirement plan administrators typically only offer one series of target date funds (rather than a passive option and an active option), by getting participants to focus on the benefits of target date funds, they can take the passive investing option off the table and quietly funnel everyone into actively managed funds.

Again, the lesson for the individual investor is this: If you are investing in a target date fund, figure out what’s in it, and figure out if you can make essentially the same investments more cheaply. And the lesson for society is this: Even when the products are basically pretty simple (U.S. stock funds), companies will manufacture complexity and barriers to entry in an effort to boost prices well above marginal cost. That’s how the economy works—not the way you learn on the Economics 101 blackboard.

Jeb Hensarling and the Allure of Economism

Tue, 12/20/2016 - 13:07

By James Kwak

The Wall Street Journal has a profile up on Mike Crapo and Jeb Hensarling, the key committee chairs (likely in Crapo’s case) who will repeal or rewrite the Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s clear that both are planning to roll back or dilute many of the provisions of Dodd-Frank, particularly those that protect consumers from toxic financial products and those that impose restrictions on banks (which, together, make up most of the act).

Hensarling is about as clear a proponent of economism—the belief that the world operates exactly as described in Economics 101 models—as you’re likely to find. He majored in economics at Texas A&M, where one of his professors was none other than Phil Gramm. Hensarling described his college exposure to economics this way:

“Even though I had grown up as a Republican, I didn’t know why I was a Republican until I studied economics. I suddenly saw how free-market economics provided the maximum good to the maximum number, and I became convinced that if I had an opportunity, I’d like to serve in public office and further the cause of the free market.”

This is not a unique story. Robert Bork, who took economics at the University of Chicago Law School, recalled the experience as a “religious conversion” that “changed our view of the whole world” (quoted in Sidney Blumenthal, The Rise of the Counter-establishment, p. 303).

Introductory economics, and particularly the competitive market model, can be seductive that way. The models are so simple, logical, and compelling that they seem to unlock a whole new way of seeing the world. And, arguably, they do: there are real insights you can gain from a working understanding of supply and demand curves.

The problem, however, is that the people who are most captivated by the first theorem of welfare economics (the one that says that competitive markets produce optimal outcomes) are often the least good at remembering the assumptions that don’t apply and the caveats that do apply in the real world. They forget that the power of a theory in the abstract bears no relationship to its accuracy in practice.* As Paul Samuelson said in one of my two favorite passages of the original edition of his textbook (p. 36):

“Even [Adam Smith] was so thrilled by the recognition of an order in the economic system that he proclaimed the mystical principle of the ‘invisible hand’: that each individual in pursuing only his own selfish good was led, as if by an invisible hand, to achieve the best good of all, so that any interference with free competition by government was almost certain to be injurious. This unguarded conclusion has done almost as much harm as good in the past century and a half, especially since too often it is all that some of our leading citizens remember, 30 years later, of their college course in economics.”

Hensarling, who likes to quote market principles in the abstract, doesn’t appear to have moved on much from Economics 101. The Dodd-Frank Act, he has said, “is gradually turning America’s largest financial institutions into functional utilities and taking the power to allocate capital—the lifeblood of the U.S. economy—away from the free market and delivering it to political actors in Washington.” The alternative he proposes is to “restore market discipline, end taxpayer bailouts and protect consumers with innovative, competitive markets policed for fraud and deception.” This ritual invocation of markets ignores the fact that there is no way to design a contemporary financial system that even remotely resembles the textbook competitive market: perfect information, no barriers to entry, a large number of suppliers such that no supplier can affect the market price, etc.

As Samuelson continued, our economy “is neither black nor white, but gray and polka-dotted.” Regulatory policy that presumes well-functioning markets that don’t exist is unlikely to work well in the real world. Actually, Bill Clinton and George W. Bush tried that already, and we got the financial crisis. But to people who believe in economism, theory can never be disproved by experience. Hensarling is “always willing to compromise policies to advance principles,” he actually said to the Journal. That’s a useful trait in an ideologue. It’s frightening in the man who will write the rules for our financial system.

* Actually, one could argue that, because of competition among theories, those that are more powerful in the abstract are less likely to be accurate in practice.

Economism: Special Holiday Offer

Mon, 12/05/2016 - 17:34

By James Kwak

As you may have noticed by now, I have a new book coming out. It could be a perfect holiday gift for, well, maybe a handful of people out there—the father-in-law who wonders why our country’s economic policies are so screwed up, or the annoying libertarian niece who insists that we should get rid of public schools and privatize the police force, or the progressive friend who studied anthropology and is unnecessarily intimidated by economics. But even if you pre-order it, you won’t get it until around January 10.

So, here’s the offer: If you pre-order a copy of Economism as a gift for someone, I will mail you a signed card with the image of the book jacket on the front and, on the inside, an explanation of what the recipient is getting (i.e., a book that will arrive in January). That way you can give the person the card instead of the book. If you want a card, send me an email at james.kwak@uconn.edu with your name and address and the name of the person I should inscribe it to. I am planning to mail the cards out by first class mail on Saturday, December 17 (from Massachusetts), which will give them a full week to get to you before Christmas. If you need one sooner for a different holiday, let me know and I’ll do what I can.

If you send me an email by Sunday (December 11), I expect to be able to send you a card. After that point I can probably do it, but I can’t guarantee it because it depends on how many extras I order in advance.

Have a happy holiday season.

More on the Deduction Fairy

Fri, 12/02/2016 - 14:50

By James Kwak

[Updated with Mnuchin’s position on charitable contribution deduction.]

I wrote two days ago about the fairy tale that you can lower tax rates for the very rich yet avoid lowering their actual taxes by eliminating those mythical beasts, loopholes and deductions. The basic problem with this story is that, at the very high end of the distribution, deductions and exclusions (with the possible exception of the deduction for charitable contributions) just don’t amount to very much as a percentage of income. Therefore, eliminating those deductions may increase rich people’s taxes by tens of thousands of dollars, but that is only a tiny proportion of their overall tax burden, and not enough to offset any significant rate decrease.

Unlike me, Daniel Hemel and Kyle Rozema are actual tax scholars (Hemel has a blog on Medium), and their detailed research largely tells the same story. They have a forthcoming paper that analyzes the mortgage interest deduction (MID) and shows that, while it is worth more dollars to rich people than poor people (for all the well-known reasons—bigger houses, higher marginal rates, itemizing), the MID causes people in the top 1% to pay a larger share of the overall tax burden. Therefore, eliminating the MID and using the increased tax revenue to reduce tax rates for everyone (what Mnuchin proposed in concept) would be a large windfall for the top 0.1% and a small windfall for the rest of the 1%.

The numbers are in the last column of this table:

The Proportionate column shows the distributional effects of repealing the MID and using the money to reduce everyone’s taxes in equal proportion, which are even worse. (The only good outcome is the Per Household column, which uses the revenue from eliminating the MID to give every household a flat $558 tax rebate, but no one is talking about that.)

Hemel and Rozema do a similar analysis of the deduction for state and local taxes, which I didn’t mention in my post (and which many rich families can’t take because of the AMT). The basic story is the same: repealing the deduction to lower rates is, again, a windfall for very rich families.

The only deduction that turns out to increase inequality under this approach is the one for charitable contributions, because there is no practical limit to the possible size of such donations. (And guess what? Mnuchin doesn’t want to touch this one!) Eliminating this deduction could cause the rich to pay more in taxes, but they could easily maintain the same level of disposable income simply by donating less to charity. In other words, tax revenues would go up, but the money would effectively be coming from charities, not from rich people.

So, there is no deduction fairy. You can’t cut tax rates in anything like the way the Trump administration proposes without vastly increasing inequality. Once again, it’s a conceptually plausible idea that is providing air cover for a massive raid on government services to benefit the very rich.


Economics 101, Economism, and Our New Gilded Age

Fri, 12/02/2016 - 09:40

By James Kwak

My new book—Economism: Bad Economics and the Rise of Inequality—is coming out on January 10 (although, of course, you can pre-order it from your local monopoly now). If you’d like more information about the book, the book website is now up at economism.net. (I used Medium instead of WordPress.com this time.) The post below, which is also the top story on the book website, summarizes the main themes of the book.

Income inequality is at levels not seen for a century. Many working families are struggling to get by, only kept afloat by Medicaid and food stamps. The federal minimum wage is just $7.25 per hour—below the poverty line even for a family of two. The bright outlook for corporate profits has driven the S&P 500 to record levels. Surely it makes sense to raise the minimum wage, forcing companies to dip into those profits to pay their workers a bit more.

But that’s not what you learn in Economics 101. The impact of a minimum wage is blissfully easy to model using the supply-and-demand diagram that dominates first-year economics courses.

A price floor in the labor market—that’s what a minimum wage is—causes demand to exceed supply. The difference is unemployment, and the reduction in the employment level represents value lost by society. People who want the minimum wage are well-meaning but muddle-headed do-gooders who don’t understand economics. As Milton Friedman wrote in Capitalism and Freedom, “minimum wage laws are about as clear a case as one can find of a measure the effects of which are precisely the opposite of those intended by the men of good will who support it.”

That’s what Economics 101 teaches you—but it’s not what many economists actually think.

Economists polled by the Chicago Booth School of Business are evenly split on whether an increase in the minimum wage to $9—or even $15—would significantly increase unemployment. Professional opinion is divided exists because detailed empirical research is inconclusive, with several recent studies (e.g., Dube, Lester, and Reich 2010 and 2014) and meta-studies (Doucouliagos and Stanley, Belman and Wolfson) showing no significant impact on employment.

In policy debates and public relations campaigns, however, what you are more likely to hear is that a minimum wage must increase unemployment—because that’s what the model says. This conviction that the world must behave the way it does on the blackboard is what I call economism. This style of thinking is influential because it is clear and logical, reducing complex issues to simple, pseudo-mathematical axioms. But it is not simply an innocent mistake made by inattentive undergraduates. Economism is Economics 101 transformed into an ideology—an ideology that is particularly persuasive because it poses as a neutral means of understanding the world.

In the case of low-skilled labor, it’s clear who benefits from a low minimum wage: the restaurant and hotel industries. In their PR campaigns, however, these corporations can hardly come out and say they like their labor as cheap as possible. Instead, armed with the logic of supply and demand, they argue that raising the minimum wage will only increase unemployment and poverty. Similarly, megabanks argue that regulating derivatives will starve the real economy of capital; multinational manufacturing companies argue that new trade agreements will benefit everyone; and the wealthy argue that lower taxes will increase savings and investment, unleashing economic growth.

In each case, economism allows a private interest to pretend that its preferred policies will really benefit society as a whole. The usual result is to increase inequality or to legitimize the widening gulf between rich and poor in contemporary society.

I became aware of the subtle power of economism during the 2009–2010 financial reform debate, when bank lobbyists invoked economic logic to protect their clients’ profits from new regulations. As far as I can recall, I first wrote about it in a 2011 blog post titled “The Smugness of Unintended Consequences.” My new book, Economism: Bad Economics and the Rise of Inequality, offers an intellectual history of the rise of economism in the late twentieth century, case studies of its impact in several different policy domains, and—I hope—the tools to enable readers to understand both the merits and the limitations of arguments based on Economics 101. Because the first step in overcoming an ideology is understanding how it works.

The Deduction Fairy

Wed, 11/30/2016 - 16:18

By James Kwak

Incoming Treasury Secretary Steven Mnuchin promised a big tax cut for corporations and the “middle class,” but not for the rich. “Any tax cuts for the upper class will be offset by less deductions that pay for it,” he said on CNBC.

This is impossible.

The tax cutting mantra comes in two forms. The more extreme one claims that reducing the overall tax burden on the rich will turbocharge the economy because they will save more, increasing investment, and will also work more, starting companies and doing all those other wonderful things that rich people do. The less extreme version is that we should lower tax rates to reduce distortions in the tax code, but we can maintain the current level of taxes paid by the rich by eliminating those famous “loopholes and deductions.” Donald Trump the candidate stuck with the former: his tax proposal, as scored by the Tax Policy Center, gave 47% of its total tax cuts to the top 1%, who also enjoyed by far the largest reduction in their average tax rate.

Mnuchin’s comment implies that he favors the latter version: lowering rates but making it up by “broadening the base.” This math might work for the merely rich—say, families making $200,000–400,000 per year. Take away the mortgage interest tax deduction, the deduction for retirement plan contributions, and the exclusion for employer-provided health care—which together can easily shield $50–75,000 in income—and you could probably fund several percentage points of rate decreases. (Of course, it would be politically impossible to completely eliminate those tax breaks, but that’s another story.)

When it comes to the truly rich, however, there just aren’t enough deductions out there to eliminate. You can only deduct interest on a mortgage up to $1 million. The fanciest employer-provided family health plan isn’t worth more than $30,000 or so. The aggregate limit for employer retirement plan contributions is around $50,000. At the top end of the wealth hierarchy, where people make millions or tens of millions of dollars per year, these are rounding errors; eliminating these deductions wouldn’t even make up for a reduction in tax rates of a single percentage point.

There are some tax breaks that matter for very rich families. Only one is technically a deduction: the deduction for charitable contributions. But obviously that only affects (to a significant degree) a small number of wealthy people in any given year, and those people can work around any limits in this deduction by simply cutting back on donations. (By contrast, if you get rid of the exclusion for employer-provided health care, employees won’t respond by foregoing health care altogether.)

The biggest tax breaks for the very rich (as I’ve written about before) are the preferential tax rate for capital gains, the deferral of taxes on those gains until you sell the assets, and the step-up in basis at death (which means that, if you pass on assets to your children, no one ever pays tax on the appreciation during your lifetime). Given that Republicans have been trying to reduce capital gains tax rates for decades (with Paul Ryan occasionally saying they should be zero), we can be sure that preferential rates aren’t going away. Taxing gains in assets when accrued is also certain not to happen. Trump has in the past supported a version of eliminating step-up in basis at death, but that was along with slashing tax rates and getting rid of the estate tax, which would be a net win for the wealthy.

In short, the idea that you can reduce tax rates without reducing the tax burden at the top end of the income distribution is a fantasy on par with the idea that you can increase tax revenue by raising rates—plausible in theory but impossible given current reality. That Mnuchin is taking this line is simply evidence that the Trump administration will try to reconcile a massive tax cut for the rich with their fake-populist rhetoric for as long as possible. In the end, we know which one will win out.

What You Can Do

Thu, 11/17/2016 - 08:00

By James Kwak

Several of my friends, some of whom I haven’t spoken with in a long time, have reached out to me over the past week to discuss what to make of last week’s election. I imagine this is happening with a lot of people.

Although I don’t have any simple answers, I do have some thoughts on what we can do in response to the prospect of Donald Trump and the Republicans controlling the entire federal government, as well as a large majority of states. But first, we need a short detour—for a bit of perspective.

Maurice Walker is a fifty-five-year-old man with schizophrenia whose only income is $530 per month in Social Security disability payments. On September 3, 2015, he was arrested by police in Calhoun, Georgia for being a “pedestrian under the influence”—something many of us have been guilty of at one time or another. If Walker had been able to come up with $160 (something most people reading this blog could do in seconds), he would have walked free. Instead, he was locked up in jail, without his medication.

The City of Calhoun has a fixed bail schedule, in which the amount of bail is set for each offense, without regard for ability to pay. People arrested for misdemeanors cannot see a judge until the next Monday court session (which would have been eleven days for Walker, because the next Monday was Labor Day). This means that, among those arrested on the same charges, poor people are locked up for several days while rich people walk out of jail. This violates the Constitution. In Tate v. Short, 401 U.S. 395 (1971), and Bearden v. Georgia, 461 U.S. 660 (1983), the Supreme Court has held that the Constitution prohibits policies that systematically result in the incarceration of indigent defendants while allowing those with money to go free.

And yet it happens. Of the more than 600,000 people in jail in this country (not counting those in state or federal prison), 70% have not been convicted of anything and hence are legally innocent. Many of them are behind bars solely because they cannot afford to buy their pretrial release.

Being locked up before trial doesn’t just mean you lose a few days of freedom. Will Dobbie, Jacob Goldin, and Crystal Yang are studying the impact of pretrial incarceration on trial results and long-term economic outcomes. They find that people who are released are 27% less likely to be convicted and 28% less likely to plead guilty than people who stay in jail—which makes perfect sense, since you are more likely to plead if it’s your only way to go home and see your family. These effects are even larger for defendants charged with misdemeanors and those with no prior offenses in the previous year. In the long term, pretrial release increases by 27% the likelihood that people will be working three to four years later, with a larger effect for those who were working at the time of arrest. Again, this is obvious: If you miss work because you’re in jail, you could lose your job; and if you plead guilty to get out of jail, the conviction makes it harder for you to find work.

(For those worried about sample selection issues—that is, people who make bail are different from those who don’t—this study takes advantage of the fact that bail judges are quasi-randomly assigned in Philadelphia and Miami. The relative harshness of the judge is the instrument for pre-trial release.)

Maurice Walker was lucky. He got a lawyer. In fact, he got some of the best: Sarah Geraghty and Ryan Primerano of the Southern Center for Human Rights, and Alec Karakatsanis of Equal Justice Under Law. Walker was arrested on a Thursday evening. The next Tuesday, his lawyers filed a class action lawsuit against the City of Calhoun; Walker was released the next day. On January 28, 2016, a federal judge sided with Walker:

Any bail or bond scheme that mandates payment of pre-fixed amounts for different offenses to obtain pretrial release, without any consideration of indigence or other factors, violates the Equal Protection Clause. . . .

The bail policy under which Plaintiff was arrested clearly is unconstitutional.

The city is appealing the case to the Eleventh Circuit Court of Appeals; the Department of Justice, the American Bar Association, and the Cato Institute have all weighed in on Walker’s side.

What does Maurice Walker have to do with last week’s election?

The sad truth is that many people in the United States already had very tough lives before November 8. Besides Walker and the thousands of people in jail because they are poor, they include Cleopatra Harrison, a domestic violence victim who was threatened with jail because she could not pay a $150 “victim assessment fee” assessed by a court; A.J. and hundreds of other children who face criminal charges in juvenile court without being represented by a lawyer, in violation of the right to counsel; Aron TuffWilmart Martin, Andre Mims, Jeremiah Johnson, and other people sentenced in Georgia to life in prison without the possibility of parole for nonviolent drug offenses (all of whom are African-American); and Tim Foster, who was sentenced to death by an all-white jury after the prosecutor struck every African-American from the jury pool.

There is an ocean of injustice out there. Many of the people harmed by it are poor, minorities, immigrants, or some combination of the above. I only know about the examples above because I’m on the board of the Southern Center for Human Rights, which took all of those cases and was able to help all of those clients. There is no doubt much, much more injustice of which I am unaware.

The perspective is this: Things didn’t suddenly go from wonderful to awful on Tuesday night last week. For many people, they were already pretty bad. A Trump presidency will no doubt make things worse. There will be more hate crime; more deportations of people whose only crime is wanting to work hard and make a better life for their children; more and higher hurdles for women who want an abortion; more people without health insurance; more gun violence; and more hungry children unable to rely on food stamps.

These are all problems that our country had on the morning of November 8, and there are already organizations dedicated to helping the people who face them. As I said, I’m on the board of the Southern Center for Human Rights. We had a board meeting and benefit dinner in Washington last week. And while no one was happy about the national election, it didn’t change what the organization does; it just meant that the struggle will be that much harder for the next four years.

So if you want to “do something” about President Trump, the first thing you can do is donate money to some of the organizations that actively protect people’s civil and human rights. If you’re inspired to give money to the Southern Center, I can assure you that it won’t be wasted; we have some of the best lawyers anywhere, working as hard as they can for remarkably little money. (Today, November 17 is Georgia Gives Day, too, if you prefer to give that way.) But there are many other worthwhile groups out there: the NAACP Legal Defense Fund, the ACLU (perhaps particularly important given Trump’s attempts to intimidate the media), Planned Parenthood, or your local food bank, soup kitchen, or homeless shelter, among many others. At the end of the day, ordinary people will be the victims of the Trump administration, and they will need your help.

That’s the point I wanted to make today, but I imagine that’s not where you expected this post to end. So I’ll add a few words about the other thing that we need to do: take back at least partial control of our government(s). That is a much more difficult issue. You might say that Hillary Clinton lost by only 107,000 votes; by that measure, we only need a slightly better candidate, a slightly better message, or slightly better luck to win in 2020.

More realistically, however, with the small-state bias of the Senate (and the forbidding 2018 electoral map), gerrymandering in the House, and overwhelming Republican dominance of state governments, Clinton’s loss reveals how weak the Democrats already were. This is what I wrote back in June:

Republicans are apoplectic at the idea that Hillary Clinton could appoint the deciding justice to the Supreme Court, but the smart ones realize that she will be able to accomplish little else; even if by some miracle Democrats retake the House, Republican unity will suffice to block anything in the Senate. Democrats, by contrast, are terrified because a Republican president means that they will get virtually everything . . . : not just the Supreme Court, but a flat tax, new abortion restrictions, Medicaid block grants, repeal of Dodd-Frank, repeal of Obamacare, Medicare vouchers, and who knows what else.

The Republicans are dominant not just because of Trump, but because of the decades of work that preceded him: promoting the ideology, cultivating the funders, motivating the base, building the media empire, stocking the judiciary, weakening unions, undermining campaign finance rules, buying state elections, redrawing districts, and suppressing the vote. Yes, Trump was an unlikely leader to take them over the top. (And yes, he is popular among white supremacists.) But even if he hadn’t, the GOP would still be just one election away from a sweep of the White House and Congress.

There is a raging debate right now over the identity of the Democratic Party. I don’t to argue the specifics of that debate right now. But if we want to compete, we need more than a new, focus-grouped brand that can win 51% of the popular vote in a general election. We need an ideology that can mobilize millions of new voters and motivate thousands of people to run in races for school board, town council, state assembly, and state senate, all over the country. We need a long-term political movement, not a quadrennial scramble to demonize the other guy just enough so voters pick our guy.

I don’t know how to create that movement. So all I can recommend, on a personal level, is that you find people whom you believe in—on all levels of politics—give them money or volunteer for their campaigns, and throw your little bit of weight into pushing the party in what you think is the right direction. (Or, if you’re up for it, run for office yourself.) It’s not a great answer, but there is no magic bullet.



Thu, 11/10/2016 - 08:56

By James Kwak

[Updated to add another headline leading with “white voters.”]

Two days later, some of the world’s leading newspapers—or their headline-writers, at least—are saying it was all or largely about race:

The respective roles of race and class in this year’s election are a highly contentious issue. I’d like to add to that contentiousness as little as possible while pointing out that this race-based framing isn’t really supported by exit poll data. I want to get ahead of the vitriol by stipulating that the exit polls don’t provide conclusive evidence for either side.

OK, here’s the data:


Those are vote shares in the presidential election by racial or ethnic group. The numbers at the right show you the shift from the previous election.* In this case, the Democratic-Republican gap among white voters shifted by 8 points toward the Republican. That’s evidence that the election was about white voters, right?

Except those are the 2012 exit polls. The 8-point shift is relative to the 2008 exit polls.

Here’s the equivalent chart for 2016:

As you can see from the right-hand column, Trump did better than Romney among every racial or ethnic group. In fact, if you subtract off how he did among all voters (2 points better than Romney), his performance among whites relative to his overall performance was 1 point worse than Romney’s.

What about income? This is 2016:

There are two factual statements you can make about this picture. One is that Trump lost the “working class” (under $50,000) vote. You will hear a lot of people make that statement. The other is that he did much, much better among the working class than Romney: about 11 points better (the <$30K and $30–50K groups are roughly equal in size). The Democrat always does better among poor people, in part because Democratic policies are always better for poor people, at least as a first-order matter. (The Republican theory is that their tax cuts for the rich eventually help everyone, and I don’t want to argue about that here.) But in 2016, relative to 2012, the Republican did much better among the poor and much worse among the rich.** His gains among the poor outweighed his losses among the rich by just enough to swing the election.

Looking at these pictures alone, at first glance, the story seems to be more about class than race. In politics, change happens at the margin. Trump is still not the candidate of the working class—Clinton is—but he was able to appeal to them much more successfully than Romney or McCain. As for whites, they have voted for the Republican in every election since at least 1968, and Trump didn’t expand that advantage significantly over where it stood in 2012.

But as I said earlier, I don’t think you can necessarily infer from the exit polls that class was the dominant factor and race was less significant. The problem is that we know a larger proportion of working class people voted for Trump than for Romney, but we don’t know why they voted for Trump, at least not from the data we have. We can make some guesses, but again the exit polls provide support for both stories:

(How each of these two questions provides support for a different story is left as an exercise for the reader.)

At the end of the day, we know that the “white working class” supported Trump much more strongly than it supported Romney, but we can’t tell from polling data if that was because of their judgments about Trump’s policies, their feelings about race, or their feelings about their economic status. In practice, different people in the same demographic group make political choices based on different combinations of those (and other) factors.

I think it’s important to try to understand the relative importance and the interactions of these different motivations, and how those have shifted over time. But if there’s one thing I want you take away, it’s that you can’t answer these questions by looking at aggregate polling data—even though many people will try to do exactly that in the next few days.

* Thanks to the Times for this presentation, and for the ability to switch easily from election to election. When anyone cites a poll number, your first question should be: “Relative to what?” In this case, I think the previous election is the most obvious baseline for interpretive purposes, although it certainly isn’t perfect.

** In 2012, Romney won the >$200K group by 10 points, while Trump won it by 1–2 points; you don’t see that shift in the picture because the 2012 data don’t have a break at $250K.

The Biggest Voter Suppression Campaign of All

Tue, 11/08/2016 - 07:00

By James Kwak

This election day, spare a thought for the largest group of citizens who aren’t eligible to vote: children.

My four-year old just learned that he doesn't get to vote tomorrow and he burst into tears and I feel for him.

— Justin Wolfers (@JustinWolfers) November 8, 2016

When I was in high school, I believed strongly that there should be no voting age whatsoever. Anyone should be able to vote, no matter her age. Well, I still feel that way, particularly after watching my ten-year-old daughter knocking on doors and explaining to adults why she doesn’t want her school to be grade-reconfigured. And I feel that way even though I also have a four-year-old son whose vote could be bought for a lollipop. (Whether he would stay bought is another question.)

There are two main arguments against a voting age. The first is that any plausible justification for a minimum voting age could be better served by some other test—which would be illegal. Many people think it is obvious that children shouldn’t be allowed to vote because they are uninformed, irresponsible, lack the necessary cognitive skills, are easily swayed by their parents, or something along those lines. (Note that similar arguments were made about all the other groups that used to be unable to vote.) But if the point of a voting age is to ensure that the electorate is properly informed about the issues and the stakes, we could administer a test, which would do a better job than an arbitrary age cutoff. (Who is the vice president? Which house of Congress approves judicial nominations? Etc.) That test would violate the Voting Rights Act, just like literacy tests.

If the point is to ensure that the electorate has the ability to process information and make rational decisions, again we could come up with a test for that—which would also probably violate the Voting Rights Act. And if we think that children are too easily swayed by their parents, what do we think about the undecided voters who are swayed by the types of television ads that every politician is running right now?

In short, the minimum voting age is supposedly intended to ensure certain characteristics in the voting population. Screening for those characteristics directly would be illegal. So why is OK to use a poor proxy for them?

The second, and more fundamental, argument against a voting age is that it undermines the whole point of our system of government. The reason we have a democracy isn’t that we think everyone is equally capable of making good decisions about who our leaders should be. It’s that we want our leaders to be accountable to ordinary people. This is called government by the consent of the governed. We want our representatives to take their constituents’ interests into account when making decisions; and if they don’t, we want to be able to vote them out of office. Because we want our government to be accountable to everyone, we don’t restrict the suffrage to certain classes of people; we don’t want some types of people to have more political power than others, simply by virtue of who they are.

Except that we do restrict the suffrage. Young people bear the costs of public policy as much as anyone (and arguably more so, since they will be alive for longer), but politicians can safely ignore them because they can’t vote. (Saying their parents will represent their interests is just silly; by that logic, we could simply have one vote per family.) Children live under our government; therefore they should be able to vote. It’s as simple as that.

Politically speaking, a lower voting age would probably help Democrats, since young people tend to be more liberal than old people. (It would probably also eliminate any suspense in the Clinton-Trump contest.) But that’s not the point, just like making election day a holiday isn’t about helping Democrats or increasing turnout. It’s about making sure that everyone has an equal opportunity to hold her representatives accountable.

So I think that if you have the ability to express a preference, you should be able to vote. I recognize that most people won’t agree with that rule. But there’s no reason that states can’t start by reduce the voting age to sixteen. (I’m not a constitutional law scholar, but Nathan Persily is, and he agrees that this is possible.) And do you know what? The world won’t end. And our democracy will be just a little bit stronger.