Ron Paul recently received a lot of criticism for arguing that tax money should not be used to save a sick young man who had decided not to buy health insurance.  Robin Hanson raised a very good point in response to his critics:

But a great many ill, collapsed, etc. folks in the world are largely left to die, at least if curing them costs anything like a US hospital stay. Ezra argues above for “decent” nationalcare, not global care. And even libertarians wouldn’t leave family members to die. So everyone agrees that we heroically help some, and leave others to die. We only disagree on who falls into which category.

I’ve made similar arguments many times, so I am certainly not going to criticize Robin.  Nonetheless, I do support tax funded catastrophic insurance plus mandatory HSAs at the national level.  If Robin is right, how can I do so?

Let’s start with the fact that I am a utilitarian.  We utilitarians believe that everyone’s well-being is of equal value, whether it be Bill Gates or a peasant farmer in Pakistan.  Public policy should maximize aggregate well-being.  So why don’t I favor an international health care program?  Actually, I wouldn’t be opposed to the idea.  But I am also a pragmatist, and for now we are dealing with national governments and voters who are very nationalistic.  I believe that publicly funded health care of the sort I described with boost aggregate well-being, as compared to our current system.  I hope the circle of people’s empathy will continue to shift outward, as it has for the past few centuries.  If the public is eventually willing to make the following shift in health care spending, I’m all for it:

1.  Stop providing publically-funded health care in non-life and death situations.

2.  Use the extra money to fund higher-valued health services in poor countries.

Obviously our culture has not yet reached that degree of empathy, and it seems unlikely that it will in the near future.  Until then I’ll keep advocating the Singapore/Brad DeLong solution.

I do not agree with the following argument by Robin Hanson:

Humans clearly evolved quite different mental modes for thinking about how to treat folks with our our local tribe, vs. how to treat distant strangers. Libertarians largely accept the usual ideas about how to treat both groups. Where they disagree is who counts as a stranger.

Libertarians limit “my tribe” to close family and small chosen communities, much as did our forager ancestors, who were free to change bands at any time. Farmer culture taught farmers to think of distant strangers as “my tribe”, as long as “our elites” said so, or if “we” fought wars together. And nation-states have worked hard over the last few centuries to transfer this feeling to nations. Libertarians mostly just don’t accept this. And though I’m not strictly libertarian, on this I agree – it is far from obvious that nations must be our tribes.

Now people usually try to be nicer to their tribe than to distant strangers. From this one might conclude that libertarians, who see more folks as strangers, are not as nice people. But not only are folks who see their tribe as smaller usually nicer to such insiders, libertarians also tend to be more accepting of mutually beneficial interactions with strangers.

I think the world is a better place if we work to make the “tribe” as large as possible.  Mutually beneficial transactions are great, but only get you so far.  There are many areas of life where unselfish altruism is required to make institutions work effectively, most notably in governance.  If you have a political entity of 5 million people who for deep historical reasons developed a culture of mutual respect, say Denmark, you will end up with more effective governance (and more market-oriented too!) than a political entity of 5 million people who for deep historical reasons lack trust outside the immediate family, such as Sicily.  Indeed even entities of 5 million people who lack a deep historical tradition of trust, but who have worked very hard in recent decades to develop a culture of national solidarity, such as Singapore, will do better than low trust societies.

Self-interest isn’t enough.  If I followed self-interest I would not vote, and I would not blog on important public policy issues.  If I was family-oriented I would spend more time with my daughter.

I don’t doubt that some of the distrust of strangers is hard-wired into us.  But that’s no reason to be defeatist.  If we’ve learned anything from the last 200 years of cultural evolution it’s that technological advances in the narrative arts have gradually made many of the “others” seem much less strange, and thus we’ve gradually increased the size of the circle of races, religions, and lifestyle groups that count as “us.”  There is no reason this process can’t continue until we have a single global tribe by the year 2300.

PS.  Although I favor a global tribe, I also believe governance should be increasing decentralized, except where that is not feasible (say global warming policy.)

PPS.  I should clarify that I’m not predicting that bigotry will completely vanish, as there will continue to be differences between people.  Rather I am arguing that we will become a single tribe for public policy purposes.  For example, there is still racial prejudice in America, but all races now qualify for programs like Social Security and Medicare.

There are two kinds of people, those who eat one marshmallow, and those who eat two.  More specifically, The Economist reported:

FORTY years ago Walter Mischel, an American psychologist, conducted a famous experiment. He left a series of four-year-olds alone in a room with a marshmallow on the table. He told them that they could eat the marshmallow at once, or wait until he came back and get two marshmallows. Recreations of the experiment on YouTube show what happens next. Some eat the marshmallow immediately. Others try all kinds of strategies to leave the tempting treat alone.

Nothing surprising there. The astonishing part was the way that the four-year-olds’ ability to defer gratification was reflected over time in their lives. Those who waited longest scored higher in academic tests at school, were much less likely to drop out of university and earned substantially higher incomes than those who gobbled up the sweet straight away. Those who could not wait at all were far more likely, in later life, to have problems with drugs or alcohol.

I am a libertarian, but I am also a utilitarian, so I don’t really object to reasonable “nudge” policies like making the 401k plan the default option for new hires, or having banks warn people who rely too much on expensive overdrafts.

What bothers me is when I see attempts to redistribute wealth from the two marshmallow eaters to the one marshmallow eaters.  For instance, by the time I retire in 6 years I will have probably averaged about $80,000/year over my working life, which makes me comfortably upper middle class.  Because I am a two marshmallow personality, I’ve probably saved about half of that income.  So I’m doing fine.  Most Americans with similar incomes are one marshmallow types, and save something closer to 10% of their incomes.

What do we do if Social Security needs to be trimmed in order to balance the budget?  I hear lots of talk about cutting back on benefits for those who “don’t need it.”  That would be people like me.  Here’s why I don’t trust the Dems—I see them as the party of one marshmallow eaters.  They represent people who have less self-control.  I fear they will cut my benefits, but not cut the benefits of people who didn’t save for retirement.  I fear they will use “wealth” as the criterion to determine who is needy and who isn’t; not lifetime wage earnings.

In my view there is nothing egalitarian about redistributing income from two marshmallow eaters to one marshmallow eaters.  They’ve already had their fun when young, loading up their three car garages with all sorts of fun toys.  I’ve never even had a garage.

I’m not saying that the rich shouldn’t be the ones who accept cutbacks in Social Security to save the system, that is a defensible argument (although interestingly many progressives oppose the idea, hoping that Social Security doesn’t become seen as “welfare.”)  But if you are going to do means-testing, it should be on lifetime wage income, not wealth.  If they do that then I need not fear for my SS benefits, as most Americans who have averaged about $80,000 a year over their lifetime have not saved much, and would march on Washington if their SS benefits were cut back.

Update:  Commenter Edwin A pointed out that I shouldn’t have picked on the Dems.  I do think they are usually the one marshmallow party, but in this case many Dems oppose means-testing Social Security, and some conservatives support the idea.

I’m going to argue that Tyler Cowen’s new book showed something important, but not what everyone is debating.  Most of the discussion revolves around the issue of whether real economic growth has slowed dramatically in recent decades, and is likely to continue to disappoint over the next few decades.  Perhaps what it really showed is that real GDP is itself becoming an increasingly meaningless concept.

Much of the debate revolves around whether we have accurately measured inflation.  But this debate assumes there is a “true” inflation rate out there, and we just have to correctly measure it.  OK, but what is inflation and real GDP growth trying to measure?  How much more stuff we have?  Or how much more happiness?

I vaguely recall that price indices are supposed to measure how much more money we’d need to keep the same level of utility.  But what is utility?  Lots of economists seem to think it means something like ‘happiness.’   But that can’t be right, as surveys indicate little or no increase in US happiness over time, yet even the pessimists agree that RGDP/capita has grown significantly since 1945.

If RGDP is supposed to measure how much “stuff” we have, then how do we compare items?  Is an iPod more or less stuff than a washing machine?  Is an hour with a pet psychologist more or less stuff than a microwave?  Sometimes when a new product arrives, its value can be estimated by looking at how much more it sells for than an older version of the product.  But this won’t work if the early adopters are wealthy people willing to pay much more for a slightly improved version of flat panel TVs. The masses won’t buy that slightly improved version until its price falls to the old version, and when people take it home they won’t notice much difference when actually watching TV shows.

Maybe inflation doesn’t exist out in reality, rather is merely a concept we create with statistical tools.  Indeed according to the smartest man in the world, it’s not even clear that any sort of reality exists:

Hawking gives a good description of how scientists come to the conclusion that something is real.  We construct intellectual models that, within some range of phenomena, and to some degree of approximation, agree with observation.  But he calls this “model-dependent reality,” and suggests that this is all there is to reality.

Questions about the nature of reality have puzzled scientists and philosophers for millenia.  Like most people, I think that there is something real out there, entirely independent of us and our models, as the earth is independent of our maps.  But I believe this because I can’t help believing in an objective reality, not because I have good arguments for it.  I am in no position to argue that Stephen Hawking’s anti-realism is wrong.  [from a book review by Steven Weinberg]

That’s right, Stephen Hawking says it’s turtles . . . er . . . it’s models all the way down.

But I’m also a pragmatist.  During the 100 years leading up to 1973, RGDP was a reasonable way of thinking about the obvious fact that lots more of almost every type of “stuff” was being churned out.  Living standards were clearly rising as we accumulated vastly more cars, TVs, appliances, restaurant meals, etc.

But how will we measure RGDP growth in the information-oriented economy that Tyler Cowen describes?  We’ve gone from watching TVs with 4 channels, to watching computer monitors with 100 million “channels.”  What is the monetary value of that?  What’s the utility value?  Tyler points out that many of the info tech innovations produce surprising little revenue.  I’d add that in the long run that’s also true of biotech, the other great technological hope.  A complete cure for cancer will initially earn great revenue, but after coming off patent will sell for relatively little, despite continuing to cure cancer.

Tyler Cowen’s book as been both a marketing coup and an intellectual game changer.  It has gotten people to focus on issues they intuitively knew were out there, but for which they lacked a framework for thinking about.  The WSJ recently called him a 21st century Thomas Friedman.  That got me thinking about Friedman’s famous “suck on this” comment.  Well here’s my own suck on this:

If we are serious about utility being the be all and end all of economic growth, then isn’t it possible that there was little economic growth between 1945 and 1973, but lots of growth since?  Suppose all that postwar growth in “stuff” didn’t really make people any happier.  But then after 1973 the widespread use of anti-depressants made people much happier than before.  In that case, isn’t it possible that utility has actually risen faster since 1973?  Economists think they are just technicians, collecting data about the economy.  No need to think about what the purpose of life is.  No need to read Nietzsche.  But if we don’t know what we are measuring, how likely is it that we will come up with accurate measurements?

As soon as I saw Tyler Cowen compared to Thomas Friedman, I knew that his commenters would ridicule him mercilessly.  And I was right.  But those sarcastic comments come from little people, envious of great men like Thomas Friedman.  I’m not too proud to try to emulate the great sage of the 1990s.  Hence the title of this post.

PS.  God I hope that the “sensory impression of snow outside my window” isn’t real; I really don’t want to do anymore shoveling.  Do any others readers have a similar sensory impression?  Confirmation from others won’t show that the snow is “real,” but it will accurately predict whether I am about to suffer.  And pain is real.  That’s because pain (and happiness) are the only things for which the reality and the perception are one and the same.

It turns out that my recent post on finance did not satiate my urge to make counter-intuitive arguments.  So today I’d like to argue that happiness is unrelated to utility, that you should try to purchase a house next door to a child molester, and that the US government first impoverished our banking system, and then took advantage of its weakened state with predatory lending.  (After all, if Michael Pettis can sell out his blog readers for a cushy job in banking, why can’t I?)

Part 1.  What if utility and happiness are unrelated?

Imagine a country called “Lanmindia,” where much of the population has seen its legs blown off in horrible accidents.  Does that sound like a pretty miserable place?  Happiness research suggests not.  The claim is that there is a sort of natural “set-point” for happiness, and that after winning a lottery one is happy for a short time, and then you revert right back to your natural happiness level.  I find that plausible.  They also claim that if someone loses a limb, then they are unhappy for a short period and then revert back to normal.  I find that implausible, but if the evidence says it is the case then I guess I need to accept that.

My claim is that although Lanmindia is just as happy as America, it has much lower utility.  Let’s define ‘utility’ as “that which people maximize.”  People very much don’t want to have their legs blown off, and hence emigrate from Lanmindia in droves.  People behave as if they care about utility, not happiness.

Do I have any proof?  No, but I’ll provide two pieces of evidence, one macro and one micro.  The Economist recently did an absolutely heartrending story about the plight of undocumented farm-workers in California.  I wish I could quote the entire piece, as the cumulative effect is very powerful, but space constraints limit me to a shorter passage:

Farm work has, for most crops, become no easier since Steinbeck’s day. Strawberries, the crop the Vegas started out with, are nicknamed la fruta del diablo (the devil’s fruit) because pickers have to bend over all day. “Hot weather is bad,” says Felix Vega, but “cold is worse” because it makes the back pain unbearable. Even worse is sleet or rain, which turns the field into a lake of mud. The worst is picking while having the flu.

Every crop exacts its own particular discomfort, as this correspondent discovered on an August day picking grapes in the very part of the San Joaquin Valley where Steinbeck’s Joad family looked for work. Working with two Mexican brothers and a young Mexican couple, he cut the grapes, collected them in tubs and periodically dumped them into a wagon pulled by a tractor.

The lanes between vines are exactly as wide as the tractor, so the little group had to duck into and underneath the vines all day long. They crawled alongside the tractor, trying to avoid having their feet run over. Within hours this correspondent’s shins were bleeding as the wagon’s metal protrusions slammed into them, which seemed unavoidable. With an encouraging smile, a co-worker pulled up a trouser leg to reveal his own scarred shin.

Because the pickers were squatting or kneeling under the vines and twisting to reach up for the grapes (the low-hanging fruit proving the trickiest), their necks and shoulders were soon in agony. Standing up to relieve their backs thrust their heads into the vines, which are covered in pesticides. There are many cases of birth defects and cancer in the families of farmworkers. But as the heat climbed above 100°F (about 40°C), the vines, soaked in toxins or not, became allies. The air underneath them is stagnant, as in a sauna, but their foliage is the only available shade.

Just as the heat threatened to overwhelm this correspondent, the woman in the group broke into a slow Mexican song, which somehow helped. But heatstroke is common in the fields. In 2008 Maria Isavel Vasquez Jiminez, a 17-year-old Mexican girl who was pregnant, collapsed while picking grapes and died two days later.

Hungry amid food

As Tom Joad in Steinbeck’s novel discovered, many farmworkers, even as they spend their waking hours picking food for others, can barely afford to eat. Between harvests they have no work. When they do work, their wages are meagre. The workers picking grapes with this correspondent got $8 an hour. That is vastly superior to the $9 a day””not hour””which the tractor driver says he used to get at home in Mexico. But costs in the United States are higher too.

You should read the entire piece, as there is 5 times more of this woe.  At the end, the reporter asks the following question:

Teresa, Felix and Gonzalo Vega only nod sadly when asked about the rancour, the Arizona law, the politics. They feel they had no choice in coming illegally. Would they do it again? “No, not if I had known what lay ahead,” says Felix. But after a silence, he corrects himself. Yes, he would, because even though he doesn’t think he’ll ever get papers, he has two sons who are American and could be lawyers or writers one day, living openly.

Teresa Vega is the most reticent. She admits that her “plan didn’t work”. She hears that Erminio, at home in Oaxaca, is not doing well. He is often ill. “He needs love” and doesn’t get enough, she says. But then she, too, reverses herself. She always thinks of her first son, the one who died because she had no money to save him. Yes, she would come again.

If the life described in this piece is accurate, then life in Mexico must be an absolute living hell.  Why else would millions of desperate Mexicans endure the following to try to reach those California fields?

Once they walked all night through the desert of Arizona, slashing themselves on fences of barbed wire and running out of water, before border-patrol agents ambushed them. The agents tied them up, shouted at them, threw them into a van and then into a freezing jail, where they slept on a bare floor for several nights until enough migrants had been rounded up to fill a bus that took them back to the Mexican side.

On another crossing Mexican bandits waylaid them. They pointed guns, stole their food and stripped them naked. Because the Vegas speak an indigenous language called Mixtec and understand little Spanish (and no English), Mr Vega’s wife and the other women did not understand the bandits and feared they would be raped. They were not, but then had to cross the frigid night desert without clothes, food or water, until la migra caught them again.

Gonzalo Vega, yet another cousin, made the trip with his wife, five months pregnant, and his two younger brothers, who were seven and ten at the time. He carried all their water and food, but the children struggled. After a day and two nights of walking they were desperate for sleep, but Gonzalo didn’t let them rest in the freezing cold lest they not wake up again. He could not light a fire, because la migra would have seen it.

They threw themselves into ditches whenever the border patrol’s SUVs approached. Once Mr Vega’s wife fell hard onto her bulging belly. The worst moment came when la migra caught them again, beat Gonzalo and threatened to take his brothers away from him. When the family was allowed to remain together, even the cold jail floor felt good, he recalls. Gonzalo’s group succeeded on the fifth try.

So just imagine how bad Mexico must be.  Even worse, income in Mexico is highly unequal, with a tiny elite of wealthy and many poor people.  Yet it turns out that if Mexico is a living hell, it is an extremely happy living hell.  Robin Hanson recently cited research that shows Mexico is the second happiest country on Earth.  I claim that Mexico is a country with very low utility, full of very happy people.  Think of ‘happiness’ as “personality,” and think of ‘utility’ as “living conditions.”

Many bloggers have been commenting on a NYT piece where a Chinese mom explains the rigorous upbringing she imposed on her children.  Bloggers as diverse as Matt Yglesias and Bryan Caplan suggested that this type of mother was quite cruel.  Define ‘cruelty.’  My hunch is that these mothers lower their children’s utility, but don’t make them unhappy.  My evidence?  My daughter has a Chinese mom who makes her take all sorts of lessons, and she seems 10 times happier than I was as a kid with enormous freedom.  How’s that for a scientific study?

So what are the policy implications, should government officials try to maximize happiness or utility?  I’m a utilitarian, so naturally I favor utility.  Do you really want to defend a policy goal that implies there’s little point in clearing land mines from Cambodia, Afghanistan, and Iraq, because happiness always reverts to a set-point?  I dare you to see the movie Turtles Can Fly, and then insist happiness matters more than utility.  (Note that this view doesn’t really conflict with Caplan and Yglesias, although I probably left that impression above.)

One last point.  It is true that richer countries tend to be happier.  Does that disprove my set-point theory?  No; countries full of happy people tend to be more civic-minded, as depressed people are resentful of others.  Civic-minded cultures tend to produce governance that is relatively free market and non-corrupt.  Denmark is the happiest of all developed countries, the most civic-minded of all developed countries, the least corrupt of all developed countries, and the most free market of all developed countries.  Coincidence?  I don’t think so.  And yet my theory doesn’t work for developing countries, and I have no idea why.

Part 2.  Why you should move next door to a child molester.

Economists have known for years that deaf people should move right next door to an airport.  The noise won’t bother them, and the house will be much cheaper.  Recent research by Scott Wentland, Raymond Brastow, and Bernie D. Waller Jr. suggests that families without children should move next door to child molesters.  Why?  Because houses are much cheaper, indeed $14,340 cheaper if within 0.1 miles of a child molester in rural Virginia.  I met Scott at the recent AEA meetings, and he talked me into attending his presentation.  I’m glad I did, as I had no idea such bargains were available.  Afterwards Scott told me that he had also been surprised by the large effect, but when he started talking to other people he found that women were especially likely to check the registry of sexual offenders before buying a house in a given neighborhood.

Of course if you actually have young children you might want to live somewhere else.  And even if you don’t, you might want to move two or three houses away from the molester–at least if it gives you a creepy feeling to look out the window and see him (it’s usually a man) barbecuing in the back yard.

Part 3:  Poor, poor, pitiful banks.

Consider the following.  The Fed spots a weakened banking system in mid-2008, and then pounces in for the kill.  They engineer the biggest drop in NGDP since 1938.  More importantly, they drastically reduce NGDP expectations for the out years.   This sharply reduces asset prices and causes a severe banking crisis.  Then in late 2008 and early 2009 they snap up all sorts of financial assets from the weakened banking system at rock bottom prices.  Between early 2008 and early 2009 IMF estimates of banking losses nearly triple, as NGDP growth expectations plummet.  But the worst doesn’t happen and we don’t have another depression.  Instead the Fed begins QE in March 2009, and NGDP expectations start rising.  As they do so the estimated losses to the banking system fall back to more modest levels (again using IMF data.)

Then reports start coming in that the Treasury may actually make a profit from the TARP program, as they forced banks to pay interest on the loans received from the government.  Those banks that did not want to participate were given an “offer they could not refuse.”  At first is seems impossible that the government could profit from these “bailouts,” and people looked for other possible losses outside of TARP, such as the Fed’s purchases of toxic assets.  But then it’s is reported that the Fed made record profits of $47.4 billion in 2009.  It looks like the Fed made some great deals.  Then the doubters claimed that the Fed’s losses would show up once the economy started to recover.  But just yesterday the following obscene profits were reported by the Fed:

WASHINGTON (AP) — The Federal Reserve is paying a record $78.4 billion in earnings to the U.S. government, reflecting gains from the central bank’s unconventional efforts to lift the economy.

The payment to the Treasury Department for 2010 is the largest since the Fed began operating in 1914. It surpasses the previous record $47.4 billion paid in 2009, the Fed said Monday.

The bigger payment mostly came from more income generated by the Fed’s massive portfolio of securities, which includes Treasury debt and mortgage securities.

My more progressive readers will notice that the US government committed almost every imaginable financial sin:

1.  Insider trading.  The Fed waited until things looked very bad, and asset prices were at rock bottom before pouncing.  They knew that they were not going to allow a depression, and then engineered a recovery right after the purchases, through a policy of QE.

2.  They charged usurious interest rates in the bailout, taking advantage of the weakened position of impoverished and desperate banks, just like payday lenders.

Here’s my question:  What should we taxpayers do with this huge windfall received from the banking industry?  Should the Fed profits of nearly $80 billion be used to pay off the national debt, or fund new entitlement programs?  And is it fair to extract so much wealth from the banking industry at a time when they were already seeing a sharp increase in loan defaults?  The Finreg bill has a consumer protection agency, how about a banker protection agency to protect banks from predatory lending by the government?  And is there a moral hazard problem here, with the government not vigilant enough in preventing financial crises, knowing it can profit handsomely during a crisis by taking advantage of weakened banks.

PS.  I was just kidding about Michael Pettis, he is doing great work nurturing alternative rock bands in Beijing, such as The Carsick Cars.  I’m glad he found extra funding.

PPS.  I am actually serious about two of these three posts, can you guess which ones?  (The other is just to annoy people.)

PPPS.  I’ll do another post soon describing my panel (with DeLong) at the recent AEA convention.

PPPPS.   Traumatic events make people say and do some really foolish things.  (I know; I’ve been there myself.)  Exhibit A is the attempt by some progressive bloggers to blame loudmouth Republicans for the recent tragedy in Tucson.  They did the same in 1963, until it was discovered that the killer of JFK was a leftist, not a conservative.  It would not surprise me if we eventually find out that the nut in Tucson was not a loyal fan of Rush Limbaugh.  The populist right should be held accountable for bad policy, not political violence.

Say I’ve got a crazy uncle.  He tells me that there are Martians in his closet.  When I go to look I don’t see any.  “There invisible,” he replies.  I suppose that’s possible.  Or the closet might be empty.  Which alternative seems more plausible?  Occam’s Razor says you should go for the simplest explanation.

My recent post on finance produced some strong reactions.  Many were very good; indeed the comments by Ashwin were extremely good—better than my post.  But I still think Occam’s Razor’s on my side, and I’d like to explain why.  Having said that, I don’t mean to suggest my opponents are seeing invisible Martians.  Ashwin might well be correct.  I’ll let you decide.

The basic idea was that the structure of the economy had changed in such a way as to make financial skills far more valuable than in the 1960s.  I define “finance” as the business of allocating capital, which is a bit different from how it shows up in the national accounts.  For instance, I believe the CEOs of major non-financial companies are being paid (in part) for the decisions they make in allocating capital.  I argued that two changes in the economy had made skill at allocating capital much more important; high tech, and globalization.  But the way, I think these are also the two forces that did in communism.  Remember that the 1960s were the golden age of the Soviet economy.  If all you have to do is churn out iron and steel and washing machines and apartment buildings, it can be done passably well with central planning.  Of course even then the American economy was superior to the Soviet economy, but less superior than later on, when the decisions were about whether to allocate capital to Google or Genzyme, or whether to build that auto parts plant in Detroit or Mexico or China.  It’s no longer about simply mobilizing capital to mass produce clearly defined output of stuff we all know consumers will want.

I argued that those with great skill in spotting good investments would be expected to earn much higher incomes in the modern economy than in the economy of the 1960s.  And that you’d expect income to become more unequal, with some particularly big incomes going to the top.  The strongest arguments against me (and you should look at the comment section, because I won’t be able to do them justice) revolved around the fact that finance is distorted by all sorts of government intervention, which allow the big investment banks to earn enormous profits.  I’ll call this the subsidy argument; although later I’ll address more sophisticated versions that involve market power.

As an analogy, it would be like me claiming that the fast rising salaries of athletes (since the 60s) is due to growing TV money, and my opponents claiming that it’s due to public funding of stadiums.  I used the analogy of farming, which receives lots of government subsidies, but still sees rather modest average incomes, due to competition.  My opponents accepted the fact that this analogy applied to the smaller banks, but not to the big banks, hedge funds, and billionaire investors.  They argue that there are barriers to entry; that certain types of trading are effectively controlled by oligopolies, and that insiders have other related advantages.  I don’t completely dismiss their arguments, but for the following reasons I’m not convinced either:

1.  I’ve always believed that oligopolies are more competitive than they look.  It’s still a dog eat dog world out there, a real struggle to survive.  Lehman and Bear Stearns recently went bankrupt (or almost bankrupt, in the case of Bear Stearns.)  Yes the creditors of BS were bailed out, but the shareholders lost a lot of money.  The most oligopolistic industry in the world might be big jets, where two firms split the market.  And yet Airbus and Boeing seem to compete fiercely for sales.  In contrast, there are dozens of big banks competing in a globalized market.  I must defer to my opponents on the specifics of big banking, as I am not an expert, but are the areas where only a few banks dominate, such as trading certain types of securities, really enough to explain the extraordinary fortunes being earned by the wealthiest financiers?  I’d like to see some data on earnings from market making as a share of GDP.

2.  Hedge funds are much less regulated than big banks, and yet some of the most spectacular earnings go to the managers of top hedge funds.  So that would seem to undercut their argument that it’s all about barriers to competition.  It’s been argued that some of the profits that hedge funds earned came from activities involving the big banks, which are effectively subsidized by the Treasury (as Too Big to Fail means they can borrow at very low rates.)  Here’s Ashwin:

Let me try a simpler explanation – big banks are implicitly protected in scenarios of significant systemic risk. This incentivises them to seek out bets which explode in such scenarios but provide them with small premiums in more normal times (negatively skewed tail bets). Hedge funds such as Paulson, Magnetar etc take the other side of this bet which is a positive NPV trade. Again, at least in the cases of UBS and Magnetar this is not conjecture but based on publicly available information.

Yes, but that doesn’t really undercut my competition argument.  Why don’t others try to get those investments in subsidized markets?  Competition should still drive down the rates of return earned by hedge funds.  The only counterargument I can see here is that only a few hedge fund managers know how to find these easy pickings created by government subsidies.

But now we are veering dangerously close to the world of invisible Martians.  I claimed that the big earnings of rich financiers reflect their skill at allocating capital.  Others say they are benefiting from government favoritism.  I point out that competition should eliminate those gains in industries like hedge funds.  They say the hedge funds are dabbling in subsidized areas.  I ask why others don’t get rich doing this.  Perhaps only a select few have the skill to do these types of investments.  But for me to be wrong it also has to be true that those managers mostly lack the skill to spot socially beneficial investments, they concentrate on socially harmful ones.  Isn’t that one assumption too many?  To be clear, I never said that financiers never benefit from government subsidies, indeed my whole post had a completely different focus.  I argued that one would expect the recent structural changes in the economy to greatly enrich finance.  Either the gains to hedge fund managers come from talent, or they don’t.  And if the returns come from investment talent, then why wouldn’t one expect them to be able to make large amounts of money allocating capital in our dynamic modern economy.  And if they don’t have any special talent, why aren’t we all so rich?

Here’s what I think is the simplest explanation:

The return to hedge fund managers, CEOs, billionaire investors, and Goldman Sachs employees has soared in recent decades because their skills are far more socially valuable than the 1960s, when the biggest decision was whether GM should put tail fins on Cadillacs.  This dynamic, fast changing environment is like a big playpen for the shrewd and savvy investor.  We all know how the founders Microsoft and Google and Facebook got really rich because their “product’ can be produced at ultra-low marginal cost.  Or how great cost savings can be achieved by moving capital overseas.  In that sort of world it’s no surprise that investors who allocate capital to profitable ventures also get much richer than in the world where big corporations raised capital to make predictable products using American labor.

It seems to me that this should be the standard explanation, and any alternative explanation should have the burden of proof.  Instead it usually seems like the opposite is true.  I constantly read opinion pieces that seem to simply assume that the big earnings in finance are unwarranted.  Partly this is a backlash against the behavior of banks in the recent crisis.  I’m just as outraged by our financial system as the next guy.  But those are completely separate issues; one issue is secular trends in financial income, the other is bad regulation in banking.

Some commenters accused me of defending the financial system, which is absurd given that I have been a strong critic of the entire system.  The big bankers would be horrified if I was given dictatorial power over regulation.  I’d get rid of all the moral hazard.  But the investment banks and the hedge funds would still make boatloads of money in a completely free markets.  Perhaps a tad less, but the profits still would have soared in recent decades.

Others pointed out that my description didn’t match the Wall Street they knew.  Yes, lots of managed mutual funds rip off investors, and add little social value.  But that’s always been true, and with the rise of indexed funds is actually becoming less true over time.  Commissions don’t explain the huge growth in income to Buffett or Soros or the big hedge funds.  I doubt it even explains Goldman’s success.

Others argue my hypothesis is inconsistent with my belief in the EMH.  But I’ve never argued the EMH is true for everyone.  I’ve argued it’s a useful theory for regular investors like me, for regulators, and for academics.  But someone has to be doing the work of figuring out where capital should be allocated, and I presume they are rewarded for their efforts.

Some pointed out that my argument seemed to fit venture capital best, but their earnings are modest.  No, the reason the VC earnings are modest is because VC is only a tiny part of capital allocation.  And many investors in VC are not particularly sophisticated.  Others argue that trading shares in secondary markets doesn’t fit the description of allocating capital.  But I say it does, indeed even short selling plays a role in allocating capital.

Some accuse me of defending the wealth of financiers.  But I’m not making a moral argument here.  Because I’m a utilitarian I don’t pay any attention to the concept of “deserving” the money you make.  Our tax policy should redistribute money in the way that best maximizes aggregate utility, and pay no attention to whether it looks like various people’s incomes are “earned.”  Unfortunately I used the term ‘deserve’ in my post title, so I “deserved” that criticism.  🙂

Because of lack of time I will fall behind in my comments.  I’ll catch up eventually.

PS.  Some people talk about the big profits trading currencies, T-bonds, etc.  This is probably a naive question, but precisely who are these profits being extracted from?  If it’s companies that trade, why don’t the companies lean on their own bank for a better deal than GS can provide?  What am I missing?  It’s a learning process for me as well.