Friday, November 16, 2012 - Externality and Inequality

Externality and Inequality

by Sinclair Noe

DOW + 45 = 12,588
SPX + 6 = 1359
NAS + 16 = 2853
10 YR YLD -.02 = 1.57%
OIL + 1.05 = 86.50
GOLD – 2.40 = 1714.70
SILV - .29 = 32.41

Top Congressional leaders met with President Obama today at the White House. Democrats said they recognized the need to curb spending. Republicans said they agreed to put revenue on the table. They sang a chorus of Kumbaya; they left the meeting and talked to the press. Mitch McConnell, John Boehner, Nancy Pelosi and Harry Reid all shared the microphone; both sides pledged cooperation; both sides agreed that driving over the fiscal cliff was a big bucket of crazy; no blood was shed today. Don't hold your breath.

Former Federal Reserve Chairman Alan “Bubbles” Greenspan says allowing taxes to rise would be a small price to pay to get lawmakers to accept spending cuts on entitlement programs, even if it leads to a moderate recession. So, what is on the negotiating table is starting to emerge, even though the goal posts are still moving targets. What is most interesting at this point is not the proposals that are on the table but the proposals that never make it to the table. How can we really have a debt to GDP ratio problem when we have a non-convertible fiat currency, a floating exchange rate and debts in currencies not our own? Yea, that isn't going to be part of the discussion.

And that brings us to today's main topic: externalities and inequality.

You may have noticed that the markets don't always produce the best possible social outcomes. The pollution generated by a factory imposes costs on those who live downstream or in the path of its airborne emissions. The risks assumed by banks leading up to the recent financial crisis imposed costs on just about everybody. Market transactions often generate “externalities”, or side effects, sometimes positive but often negative, that affect people who do not participate in the transaction. What's the solution? Well if you want less of something you tax it. You could tax the negative externalities and subsidize the positive externalities.

Does the fact that hedge-fund manager rakes in 100 or 1,000 times what office manager earns impose costs on everybody else? Plenty of Americans think not. Defenders of our income inequality point out that a free-enterprise system requires some inequality. Unequal rewards give people an incentive to work hard and acquire new skills. They encourage inventors to invent, entrepreneurs to start companies, investors to take risks. It’s fine in this view that some people get astronomically rich.

On the other side, many of us have a gut feeling that inequality has gone too far. Our times are reminiscent of the Gilded Age’s worst excesses.

The conventional strategy for fighting inequality is to tax the rich. The idea is based on a foundation of fairness, and the question of what’s fair and what’s unfair turns out to cut different ways, depending on your point of view. You may find it unfair that the very rich take in so much more than others. Somebody else might wonder why the rich should be taxed so heavily. Don’t they already pay disproportionately more than everyone else? These arguments hit a dead end. So, the lemming politicians are ready to run off a fiscal cliff over marginal top tax rates of 35% or 39%, that have already demonstrated negligible effects in reducing inequality. No one even discusses top rates that might make a difference. So what we need to look at is how skewed income distribution imposes costs on the rest of us.

Between the end of World War II and 1973, the top marginal tax rate never dropped below 70%, and for a while it was more than 90%, and growth in real domestic product per capita averaged close to 2.5%; in other words: Good Times. Since the the economy has continued to grow, an average of about 2.1%, but the median household income has only increased 0.4%. The average income of the top 1% has increased more than 300% but the median household income has increased by less than 20%. From 1975 to 2008, the median household income rose by a total of $8,000 (in today’s dollars). Had the distribution remained the same as it was in the postwar years, the increase would have been $40,000. Instead of its current level, $50,000, the median income of US households today would be $86,400. So, that might be considered a real dollar cost.

Also, there is the cost of people who focus narrowly on getting richer. For young people, going where the money is becomes more attractive than a career in science, education, or public service. As late as 1986, only 18 percent of Harvard graduates planned any sort of business career. In 2011, the figure was 41 percent, including 17 percent going into finance.

The new incentives affect the behavior of anyone with a decent shot at getting rich. CEOs of large corporations expect astronomical compensation packages. Wall Street executives pursue riskier lines of business in search of higher profits than they could earn through traditional banking or brokerage; and if they commit fraud, they pay a partial fine and move on to their next risky venture. Doctors and lawyers have an incentive to train for lucrative subspecialties, leaving a shortage of general practitioners and public defenders. All these brain drains and unnecessary risks impose costs on everyone else.

There is yet another cost to democracy. Despite fundamental principles such as one person, one vote, the wealthiest Americans have always wielded disproportionate political influence, but with Buckley v. Vallejo and Citizens United, the courts have granted personhood to corporations and ruled that money is speech not property. The result is politicians are bought and paid for, or at the very least, influenced by legions of lobbyists.

Little wonder, then, that disaffected citizens on the right, on the left, and in the middle; whatever their views on inequality, believe that the very rich and organized business interests have hijacked America’s political process. Sustained economic growth depends on open and inclusive political institutions.

Based on the examples it appears that a highly skewed income distribution results in negative political externalities. The most evident solution? Slap a tax on vastly unequal incomes, and watch the externalities shrink. Then we must ask the question “why” this is a viable solution. First, its purpose is to reduce inequality, not to make everyone pay a “fair share.” This goal cuts through the complaint that the rich are already paying far more than their share in taxes. Second, the tax should seek to change incentives. That is, its goal is to alter the pretax distribution of income, not just the after-tax distribution, to discourage people from seeking to earn exponentially more than their fellow citizens. With higher tax rates, a job in finance might lose some of its appeal to talented young people. CEOs might be happy with salaries averaging 20 times the typical worker’s earnings (the ratio in 1965) instead of 351 times the average, as was the case in 2007.

Finally, a tax on externalities is not designed to stop activity; a tax on pollution is not designed to eliminate industrial production, and a tax on inequality is not designed to equalize outcomes. It seeks only to reduce inequality from a level that threatens democracy to a level compatible with democracy, while still encouraging plenty of work and innovation. There would still be super-rich Americans, just not as many; some of them would be merely rich. And remember that after World War II top tax rates never dropped below 70% and the economy posted the strongest quarter-century of growth in its history. And we know that inequality increases when the top tax rates fall.

It might be argued that this only shows a correlation not causation; and that is possible. So, you might argue that high marginal tax rates are a threat to overall economic growth, but that argument doesn't hold up. There simply is no correlation; the economy grows more with higher marginal tax rates. How is this possible?

In every economy there are positive-sum games, in which market interactions benefit both parties, and zero-sum games, in which one party loses and the other wins. In a positive sum equation, we know the rich don't produce 351 times more widgets than the average worker. The answer is found in zero-sum activities, where the gains come at somebody else's loss. Zero-sum actions include increasing corporate earnings by holding down wages, taking advantage of financial customers by creating and gambling on complex or risky products that customers don’t understand, and lobbying Congress for protection from competition. As these examples suggest, some individuals in the top income group pursue quite a number of activities that others might be glad to see them spending less time on.

The lack of any limit to outsize economic rewards turns out to have a measurable cost, which Americans who aren’t so wealthy keep getting asked to pay. The way to change this is to recognize the externalities exist and to shift the incentives.

Yesterday we talked about the big settlement BP reached with the Department of Justice and the SEC over criminal charges related to the Deepwater Horizon oil rig explosion and spill of a couple years ago. One day later, and there is a new oil rig explosion in the Gulf of Mexico. It appears that 2 people are missing and 4 people have been evacuated; there were unconfirmed reports that 2 people died. The fire has been extinguished. The oil rig is run by a company called Black Elk. They've been fined for safety violations within the past year. The CEO of Black Elk used to work for BP.

JPMorgan and Credit Suisse have reached settlements with the SEC over civil charges that they fraudulently misled investors in residential mortgage backed securities. JPMorgan will pay $296 million, while Credit Suisse will pay $120 million. Both agreed to settle without admitting or denying the charges.

The SEC accused JPMorgan of making materially false and misleading statements about the quality of home loans that backed a $1.8 billion residential mortgage-backed securities (RMBS) offering it underwrote in December 2006. It also held JPMorgan responsible for the failure of Bear Stearns Cos, which the bank bought in 2008, to disclose its practice of keeping cash settlements from loan originators on problem loans that Bear sold into mortgage loan trusts.

Credit Suisse failed to disclose similar cash settlements, and also made misstatements in regulatory filings about when it would buy back mortgage loans when borrowers missed their first payments, known as first payment defaults.

Earlier this week, we learned the euro-zone has relapsed into double-dip recession as the austerity shock in the Mediterranean region spreads to the core countries of the north. The Club Med countries had a debilitating jolt of austerity without the juice of stimulus and the result has been contraction across the entire euro-zone. Unemployment across the EU has hit a record high 11.6%, and GDP has turned negative everywhere except Germany and France; give them time. I imagine Greenspan would find this acceptable, but its not real popular in Athens or Madrid. Even the International Monetary Fund looked at the past few years of harsh austerity and concluded that contractionary policies are contractionary

Palestinian missiles landed in areas around Jerusalem and Tel Aviv. Israel extended its bombing of the Gaza Strip and took steps to escalate. Israeli prime Minister Netanyahu is talking about calling up 75,000 reservists, which could signal a ground incursion into Gaza. About 550 rockets have been fired into Israel over the past two days, with 197 intercepted by their missile defense system. Israeli air strikes have hit more than 600 targets in Gaza. Israel’s air strikes have eliminated most of the long-range missiles in Gaza but there is still a threat. Israel said yesterday that it’s ready to step up its operation if rocket fire continues.

Maybe the Mayans were right.